Adding alternative investments to target-date funds within defined contribution plans can improve returns for participants while not making their lives any more complicated.

So says a policy report from Georgetown University’s McCourt School of Public Policy, which points out that in the absence of defined benefit plans, secure retiree income is “becoming a thing of the past” and the volatility of holdings in DC plans endangers the ability of participants to retire.

As a result, the report recommends that TDFs be diversified to include asset classes such as private equity, real estate and hedge funds as a means of improving retirement outcomes while at the same time not making the DC plan any more complicated for the participant.

Such diversification provides better returns, the report says, “when compared with a portfolio solely composed of equities and fixed income.” In addition, it can mitigate loss in downside scenarios, as well as improving the probability of not running out of assets for those participants who leave their assets in the plan after retirement.

Says the report, “A diversified TDF has a higher probability of maintaining positive retirement assets after 30 years of retirement spending; it also provides higher expected returns and lower downside risk at the time of retirement and 10 years post-retirement, mitigating the negative impacts of a short-term market shock for those participants at or near retirement.”

At a roundtable of industry participants, David O’Meara, head of DC strategy at Willis Towers Watson and a contributing author of the Georgetown report, shared data from Willis Towers Watson’s DC Plan Sponsor Survey that 81% of plan sponsors now only offer a DC plan to their new employees and that TDFs dominated qualified default investment alternatives to the point that the majority of new DC plan contributions flow into TDFs.

O’Meara explained at the roundtable how expected annual retirement income increases from $53,000 to $62,200 when a diversified selection of alternative investments is incorporated into a TDF. He was quoted saying, “The expected retirement income can be increased dramatically while also mitigating downside risks. At age 65, an individual could expect investment returns to increase from 5.1% to 6.1%. The challenges to creating better investment solutions in DC plans can be effectively managed to allow plan sponsors to take steps toward enhancing retirement outcomes for their participants.”

There are issues remaining to be worked out in incorporating alternatives into TDFs, including liquidity and pricing, but plan sponsors and policymakers should be considering such products, the report says, to “enhance participant outcomes for a more secure retirement.”

— Check out The Keys to an Effective 401(k) Plan Design, According to Wells Fargo on ThinkAdvisor.