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DC Plans Need Private Investments, Neuberger Berman Says

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Defined contribution retirement plans would be significantly helped by private and alternative investments, according to investment management firm Neuberger Berman, the Defined Contribution Alternatives Association (DCALTA) and the Institute for Private Capital (IPC).

“Investing in private funds increases average portfolio returns and reliably increases Sharpe ratios, or return per unit risk in 100% of cases,” Neuberger Berman said a new study, called “Why Defined Contribution Plans Need Private Investments.

The results of the study “suggest that typical diversified portfolios could benefit from allocations to private and alternative investments, such as private equity and venture capital,” according to Neuberger Berman, which is a founding research partner of DCALTA, publisher of the research paper with IPC.

The call for private equities to be added to retirement plans comes after the Securities and Exchange Commission’s June 18 concept release on harmonization included the idea.

But not all investment experts agree that it’s such a great idea to open retirement plans to private equity. For example, John Rekenthaler, vice president of research for Morningstar, said in a July 9 post at his firm’s website that concerns include the fact that “private-equity databases are incomplete.” He explained: “Because private-equity funds are unregistered, they do not submit public filings. Instead, they report their performances to whom they wish, when they wish. This process overstates the industry’s totals, because the top private-equity funds are happier to share their results than are the bottom-fishers, who would prefer to remain unnoticed until their fortunes improve.”

An even larger issue is that “there are major problems with the performance calculations for those private-equity funds that do report,” Rekenthaler said.

Public comment was sought by the SEC on the issue and it wasn’t immediately clear what its next move would be on the subject.

As defined contribution plans “look to provide more of a ‘DB experience’ to their participants, we believe including alternative exposure within their asset allocation offerings is a natural progression,” according to Michelle Rappa, managing director at Neuberger Berman and a DCALTA board member who contributed to the paper.

Although the study’s findings favor the advantages of including private investments in diversified and time-varying portfolios, they also suggested that the “extent of the benefit depends on the type of private investment,” Neuberger Berman said. Therefore, the research paper was designed “not only to illustrate potential return characteristics and diversification benefits, but also to offer allocation strategies to guide investment decision making,” the firm said.

For the study, DCALTA and IPC used a sample of more than 2,500 U.S. private equity funds to create a hypothetical simulation of historical performance for diversified portfolios that include allocations to private fund assets.

DCALTA and IPC conducted historical simulations where part of the public equity portfolio was replaced with allocations to private equity funds, according to the paper. They used actual private fund cash flows and rebalanced public assets on a quarterly basis back to target allocations for equity and fixed income, the paper pointed out, adding: “All aspects of our simulations are feasible and do not rely on making secondary market transactions in private funds.”

DCALTA and IPC then examined the risk and return characteristics of the portfolios that included private fund allocations, “paying careful attention to the fact that returns of the portfolio are artificially smoothed by the lack of observed price data,” the paper said.

There were three main results of their actions, according to the paper: (1) “Returns are consistently higher for portfolios that incorporate private equity funds.” (2) “Risk is consistently lower for portfolios that include buyout funds. In contrast, [venture capital] funds tend to increase portfolio risk but much of this risk is related to positive skewness in returns and thus represents “upside” risk. In addition, Sharpe ratios are consistently higher for portfolios with buyout funds and with a combination of buyout and VC funds.” (3) “It is challenging to hit specific allocation targets in all years with only primary commitments to private equity funds. We estimate a simple parametric model that improves asset allocation for dynamic strategies such as target date funds.”