Alternative Investments Are Sneaking Into DC Plans

Although interest among plan sponsors is growing, most see adding alternatives as a long-term goal

Alternatives have been sneaking into retirement plans via target-date funds. Alternatives have been sneaking into retirement plans via target-date funds.

Alternative investments have long been used in defined benefit plans, but adoption has been slow in defined contribution plans, despite evidence that the strategies have led to better performance for participants.

Research from Cerulli Associates suggests that over the next few years, alternative investments will become “commonplace” in defined contribution plans. The global edition of The Cerulli Edge found that more than 47% of plan sponsors feel alternatives “have a role to play in DC investing.”

An article in the Winter 2015 issue of The Journal of Alternative Investments, written by David Kupperman and Scott Kilgallen of Neuberger Berman, found that additional performance from alternative investments (in this analysis meaning mutual funds that use single or multiple hedge funds strategies) in DB plans led to better returns overall for participants than those in DC plans.

“Although some of the disparity between DB and DC performance may be attributed to such factors as fees, portfolio construction and market timing by participants, we believe the lack of alternative investments is an important factor in DC plan underperformance,” according to the authors.

Growth of alternatives as a standalone DC plan investment has been hindered by regulations that aim to protect investors. 

“Given the increased complexities and lack of liquidity — particularly for limited partnership structures — of these investments, it would be imprudent to let unsophisticated investors participate in less regulated (and often riskier) investments,” Cerulli noted.

Enter target-date funds. Alternatives have long been used in defined benefit plans, but they’ve been sneaking into DC plans by way of target-date funds for some time. Cerulli expects that trend will continue. TDF assets are expected to pass $2 trillion by 2019, Cerulli found, with an estimated 35% of total 401(k) assets and 88% of contributions by then.

Furthermore, Cerulli predicts proprietary target-date funds will lose ground to more customized solutions, like open architecture products, active and passive hybrid target-date options, customized glidepaths and manager lineups, and more competitive pricing.

Almost 30% of plan sponsors will eventually add alternatives, although not any time soon, Cerulli found, but a similar percentage (27.7%) are planning on adding alternatives as a standalone investment option or part of a prepackaged solution like a TDF, and another 19% will only consider them in a prepackaged option.

The biggest hurdle for sponsors is participants. A quarter of sponsors said they were not considering alternatives because they didn't think participants could understand them, even if they provided education. Less than 14% said they weren’t considering alternatives due to operational issues or because they were too expensive.

Cerulli found more than a third of asset managers expect new business from the DC channel, but most indicated adding alternatives was a long-term goal. The firm “expects the use of alternatives within packaged diversifying solutions to continue within DC plans, we agree that growth will be slow given the obstacles.”

--- Read For Advisors, This Year’s Disruptors Will Likely Be Next Year’s Standards: Cogent on ThinkAdvisor.

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