The Defined Contribution Institutional Investment Association outlined the benefits and challenges defined contribution plan sponsors might face when considering if they should include alternative investments in plans, and explained how several types of alternative investments can be used.

The new information resource, titled “Alternative Investments in Defined Contribution Plans,” examined including three alternatives: hedge funds, private real estate and private equity investments.

DCIIA explains that defined benefit plans have benefited for decades from including alternatives in their plans, beginning in the 1970s, and some DC plans have included alternative sectors for over 30 years.

Coming out of the pandemic, plus the corresponding recession and rebound, DC plan sponsors might be able to boost participant returns through greater exposures to alternatives, and mitigate lower return expectations for traditional asset classes, DCIIA notes.

“As the economy begins to move toward a new business cycle, the downward shift in traditional asset class return expectations, in addition to the risk of inflation and continued volatility, creates new challenges for participants to reach retirement goals,” DCIIA states. “Private real estate, private equity and hedge funds may offer a range of benefits, including a source of enhanced returns that could help investors mitigate the impact of macro challenges and support stronger retirement outcomes over the next cycle.”

DC plan sponsors providing participants with exposure to alternatives are presented with several considerations—depending on the alternative asset—including cost, valuation, liquidity, benchmarking and participant communication.

Nonetheless, DCIAA says alternatives can bring portfolio diversification, through reduced correlation to traditional equity and bond markets; income in stable yield; stability and downside protection, by reduced overall portfolio volatility; enhanced returns, with the potential for additional returns versus traditional public markets; and absolute return potential unrelated to market performance.

DCIIA also explains how each alternative can be implemented within DC plans.

Hedge funds are prevalent in multi-asset strategies: target-date funds (off-the-shelf and custom) and standalone options—using liquid alternatives funds. Private equity is most implemented in multi-asset strategies and TDFs (off-the-shelf and custom); and private real estate is in multi-asset strategies, TDFs (off-the-shelf and custom), white label funds (real assets, risk-based), income funds/retirement tier and standalone options.

DCIIA also outlined challenges for implementing alternatives, as well as corresponding potential mitigants.

The paper noted that alternative investments are typically more expensive than traditional asset classes in DC plans. Fees may manifest in higher administrative expenses for the plan’s custodial services and the attendant need for investment advisers to help evaluate and monitor the investments.

Concerning fees, DCIIA states that costs have “compressed” over recent years, as DC private real estate exposure is supported by “aggregation discounts.” 

Further, “Modest allocations can limit impact on fees while maintaining meaningful impact of alts in multi-asset portfolios; and adjusting [the] active/passive portfolio mix can provide ‘funding’ for higher-cost alts,” DCIIA adds.

DCIIA advises that DC plan sponsors can mitigate daily valuation challenges with independent third-party valuation services to appraise the investments. For liquidity concerns, one possible mitigant is to implement alternatives within fund vehicles, such as target-date funds and multi-asset funds that can manage liquidity “within the context of the fund’s broader portfolio allocation and periodic rebalancing.”

The 2020 Department of Labor letter on the use of private equity in DC plans affirmed that private equity investments could be included as a component of a professionally managed multi-asset class vehicle structured as a target-date, target-risk or balanced fund. A supplemental letter from the DOL’s Employee Benefits Security Administration clarified that stance by cautioning plan fiduciaries against the perception that private equity is generally appropriate as a component of a designated investment alternative in a typical DC plan, in response to stakeholder concerns.

Furthermore, evidence in a study published by Neuberger Berman research partner the Defined Contribution Alternatives Association, in collaboration with the Institute for Private Capital, suggests that including private equity funds in a defined contribution plan can improve performance and has diversification benefits that lower overall portfolio risk.

“Pension plans and other institutions include private equity as a source of additional diversification and returns, and over the last decade or so, DC plan sponsors have also looked to include private investments to get return enhancement and smooth volatility over time,” Ross Bremen, a partner in NEPC’s defined contribution practice in Boston, previously said.