In asking whether a lack of asset diversification in DC retirement plans has been a potential missed opportunity, the findings of a new study suggest the answer is yes.
More specifically, the Georgetown Center for Retirement Initiatives (CRI), in conjunction with CEM Benchmarking, set out to assess what returns plan participants might have obtained if DC plan sponsors emulated defined benefit (DB) plans by increasing—or, in most cases, introducing—allocations to illiquid assets within target date fund (TDF) options.
The study observes that one of the more significant trends with DB plan funding over the past few years has been the increased investment in private, illiquid asset classes such as private equity, real estate, and infrastructure due to the potential for improved total-return performance.
When applied to TDFs, the study finds that the amount by which returns would have increased would have generated $5 billion per year in additional net return if this change had been applied to the entire U.S. TDF universe.
Using what the study says are reasonable assumptions for an individual DC participant who saves for 40 years and then draws down for 20, the return improvement might represent an additional $2,400 per year in spending power in retirement for a retiree already drawing $4,000 per month or $48,000 per year in retirement income.
The analysis focuses on the period 2011–2020 and assesses how DC plan participants’ experiences would have changed had DC TDFs made higher allocations to illiquid assets during that time. It used the actual range of reported annual real asset and private equity portfolio return series of DB pension plans, net of all costs to implement the portfolios, to calculate a range of adjusted outcomes assuming the adoption of investment alternatives under a set of three DC target date scenarios.
The analysis then compared the returns obtained by DC plan participants invested in TDFs without illiquid assets to the modeled range of returns that would have been obtained had those funds included private equity, real assets, or both.
Findings from the three scenarios included the following:
Scenario 1, “Add a 10% Private Equity Sleeve”: Allocations to private equity that substituted for publicly traded stocks had the strongest impact on returns, boosting the median return by 22 basis points a year. The proportion of outcomes that were improved was also high, at 80%, the study notes. While investors usually say they target “top quartile” managers in private equity, this analysis found that second- and even third-quartile portfolios outperformed over the period of the study.
Scenario 2, “Add a 10% Real Asset Sleeve”: Allocations to real assets that substituted for mixtures of U.S. large-cap and core bonds showed improved target date performance in most outcomes, the researchers found. Notably, 72% of potential outcomes had higher 10-year returns than the original performance without real assets. The median improvement in return was 11 basis points per year.
Scenario 3, “50/50 of Scenarios 1 and 2”: Smaller allocations of both private equity and real assets had a performance impact between Scenarios 1 and 2, with a median improvement of 0.15% (15 basis points) per year. The diversification impact was the most compelling, with the highest percentage of improved outcomes (82%) over the same 10-year period.
The 15 basis-point-per-year-return improvement in Scenario 3 represents the $5 billion per year cited earlier in additional net return if applied to all U.S. target date options. What’s more, a 0.15% return improvement to the entire U.S. DC market would represent $35 billion per year in additional net return, the study further shows.
In short, the researchers conclude that there can be significant benefits to adding private equity and real assets to TDFs. Moreover, the net impact is materially positive, they suggest. “This analysis changed the asset allocation on, at most, 10% of the portfolio without substantially changing risk. Over time, such a modest adjustment can have a material impact,” the researchers write.
Consequently, those without the scale to access these asset classes efficiently may consider what sort of structures—PEPs or an Outsourced Chief Investment Officer (OCIO)—might broaden the investment opportunities they can deliver to their participants to achieve better results, they suggest. Large providers of TDFs can use their scale and buying power to deliver above-average value in these asset classes via their offerings to plan sponsors and their participants.
Meanwhile, regulators can continue to provide a clear framework for fiduciaries to include private assets within DC plans,[1] they further suggest. “Doing so removes a key barrier to adoption by prudent sponsors who see a compelling investment case on behalf of their participants,” the researchers maintain.
The report’s authors include Angela Antonelli, executive director of the Georgetown Center for Retirement Initiatives; Chris Flynn, head of product development and research at CEM Benchmarking; Quentin Spehner, research associate at CEM; and Kevin Vandolder, director of client coverage at CEM.
Footnote
[1] The Department of Labor in June 2020 issued an Information Letter addressing the use of private equity (PE) investments in DC plans, affirming that PE investments as a component of a professionally managed multi-asset class vehicle structured as a target date, target risk or balanced fund can be offered as an investment option for participants in DC plans under ERISA. However, in December 2021, the DOL issued a supplemental statement cautioning that PE investments in participant-directed retirement savings plans may not be appropriate in certain cases. The DOL advised that, except in a minority of situations, plan-level fiduciaries of small, individual account plans are not likely suited to evaluate the use of PE investments in designated investment alternatives (DIAs) in individual account plans.
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