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Could Private Equity Solve DC Plans’ Underperformance?

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Is there a role for private equity in defined contribution plans?

The view of Pantheon, a global investor in private equity, is that private equity has an important role to play in addressing the performance gap that exists between defined benefit and pension plans, and defined contribution and 401(k) plans.

Historically, DB plans have outperformed DC plans for reasons that include a shift toward alternative assets and differing investment fee structures.

“Even professionally managed components of a DC plan, which are typically called target date funds, significantly underperform professionally managed DB plans,” Kevin Albert, Managing Director at Pantheon, said during a media briefing in New York.

Pantheon set up its first office in London in 1982 and has expanded to six global offices with $33 Billion in AUM. Pantheon is working to make it easier for plan sponsors to use private equity in defined contribution plans. Its efforts to date in the DC market focused on tackling structural considerations for liquidity and valuation. Now it is looking to further innovate with fee options.

Pantheon recently announced that it has introduced performance-based pricing as an option for its private equity strategies targeted at the DC market. Pantheon defines private equity strategies as illiquid private assets investments, including but not limited to private equity, infrastructure, real assets and credit.

According to a study by Cliffwater, a pension consulting firm, state pension plans outperformed professionally managed DC plan returns by 80 basis points annually from 2006 to 2015. Willis Towers Watson also found similar results: From 1995 to 2011, DB plans outperformed DC plans by an annual average of 76 basis points.

On top of that, a study from the Center for Retirement Research at Boston College finds that 52% of American households are currently at risk of not having enough to maintain their standard of living during retirement.

“Retirees really can’t afford to leave 80 basis points or some significant number of annual return on the table,” Albert said.

Since DB plans have largely been phased out as a retirement-saving vehicle, more people may be at risk now or in the future of experiencing DC plans’ underperformance.

“Most new employees and many existing employees in the corporate sector no longer have the benefit of that assured income” that DB pensions provide, according to Albert. He added that “there are 90 million U.S. citizens covered by DC plans with assets in access of $6.7 trillion who are currently at risk of being exposed to this continued underperformance.”

Pantheon then did the math to see how much DC plan participants could be losing.        

Pantheon used the annual average contribution that an American makes to a DC plan — about $6,400, according to Vanguard’s “How America Saves 2016” study. Pantheon then compared the investment performance of that $6,400 in the average professionally managed DC plan to a professionally managed DB plan — by looking at the annual 80 basis-point difference.

“Annually over 35 years, [that 80 basis points] left retirees in a professionally managed DC plan 20% worse off at retirement compared to their DB contemporaries – a difference of approximately $150,000,” Albert concluded.

Pantheon wants to put DC plans on the same playing field as DB plans, and it thinks private equity may be the missing link.

“We believe it’s essential that the industry take action to close this performance gap between DC and DB plans,” Albert said.

Based on the strong returns the private equity asset class has delivered in recent years, Pantheon believes that private equity strategies have the potential to address the performance delta between DB and DC plans and merit consideration as a viable investment option by plan sponsors.

According to Michael Riak, principal and head of U.S. defined contribution at Pantheon, DC plans could benefit from having an allocation to private equity in target date funds.

“DB plan sponsors have been investing in private equity successfully for many, many years,” Riak said during the media briefing.

So, what’s stopping DC plans from using private equity?

According to Albert, there are mechanical issues with taking private equity — which is a relatively nontransparent, illiquid asset class that works well in a DB plan context — and moving it into the DC environment.

DC plans require “pricing transparency on a daily or periodic basis,” “some modicum of liquidity for participants because DC plans allow people to change their investment choices,” as well as “a necessity of DC plans to allow people to withdraw if they change companies or when they retire,” Albert said.

About three years ago, Pantheon decided to develop a platform that would address these structural issues of introducing private equity to the DC market. Pantheon established Pantheon Defined Contribution in 2013, and the vehicle allows DC participants and plan sponsors to incorporate comprehensive, institutional-quality private equity investments into their retirement savings plans. The vehicle is also designed to attract individual investors through their IRAs.

Pantheon’s defined contribution strategy fixed many of the mechanical issues. It provides for transparency through daily published NAVs. It also provides liquidity by investing a minority of the account in cash, and a liquid security that provides market return as opposed to cash grab, according to Albert.

However, challenges still remained in getting plan sponsors on board — private equity is an expensive asset class and the risk of litigation regarding fees has become a growing concern.

To address these concerns, Pantheon announced its performance based pricing option for its Pantheon Defined Contribution strategies.

The performance pricing option applies only to that portion of a portfolio actually invested in private equity investments — so, not including cash and liquid securities. A performance-based fee is only accrued when the performance of the private assets in the portfolio beats its benchmark, which is the S&P 500.

Pantheon does not receive all the performance fee it accrued immediately. Rather, when a performance fee is accrued, it is gradually paid to Pantheon over at least eight calendar quarters so that there can be a reservoir available to reverse performance fee accruals in scenarios of underperformance.

Because Pantheon’s strategy intends to accommodate periodic trading, and the fee accrued would be reflected in the strategy NAV as of the relevant period, investors will not pay for performance they did not experience.

“If we perform, both investors and Pantheon benefit,” Albert said. “If we don’t perform, we both share in that underperformance.”

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