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Do 401(k) Plans Need the High Fees, Complexity of Liquid Alts?
It’s easy to knock alternative investments, but without them defined contribution plans have little hope of keeping up with institutions.
At a time when defined contribution plan sponsors can’t switch fast enough into low-fee index funds, the Washington State Investment Board is going in the other direction. They are pushing to incorporate private equity and other alternatives into its DC investment options.
For Washington State the initiative is about providing better performance to DC participants as well as responding to changes in the markets, including the decline in the number of publicly listed companies that are available to investors.
“It’s timely. There’s been a significant shift from public to private [companies]. DC participants should be able to invest fully in privates,” said Theresa Whitmarsh, executive director of Washington’s investment board, during an interview after a press talk on use of alternative investments in target date funds. “We believe in the investment case for institutions. Why not for individuals?” said Whitmarsh at the Pantheon-sponsored event.
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Washington State, which has $100 billion in assets, was founded in 1981 to manage 17 different city and state defined benefit retirement plans. In the mid-1990s, emboldened by the run-up in technology stocks, teachers pushed the board to start offering a defined contribution plan. Teachers thought they could generate higher performance than the investment board. WSIB introduced a hybrid retirement plan that mixed defined benefit and defined contribution choices. DC assets now represent about 10 percent of the total plan.
Whitmarsh said WSIB’s 30 years of institutional experience has given it strong evidence of the performance advantage of investing in private markets. It was one of the earliest institutions in private equity, having invested in the asset class since its founding.
As of June 30, 2018, the fund’s private assets outperformed its public equities by 4.78 percent annually over 20 years. Public equities returned 6.07 percent, while private equites generated 10.85 percent during that time period.
Washington State now wants to add private assets to its DC target-date funds that it launched in 2011.
WSIB launched its target-date funds in 2011 as an alternative to the Total Allocation Portfolio, a commingled account that mirrored the portfolio construction of Washington State’s defined benefit plan. The mission was to create a mini DB plan — alternatives included. Total Allocation was offered as a choice to DC participants and later became the largest fund. The board felt it would be prudent to offer multiple target date funds in addition to Total Allocation, which was generally too conservative for younger workers and too aggressive for older employees.
But then the Washington Board was faced with the challenge of including private assets in TDFs. Whitmarsh said it’s fairly straightforward to incorporate alternatives into TDFs from a strategy perspective. The challenges, which the board is still wrestling with, are with record-keeping systems, and the public’s perception of both fees and the complexity of private investments.
Record keepers need to undertake expensive overhauls of their systems to accommodate alternatives. That’s a cost that participants in the investment board’s DC plan would have to bear, said Whitmarsh. Record keepers, which have their own proprietary target-date funds, have little incentive to re-do their systems for third-party products.
David O’Meara, senior investment consultant at Willis Towers Watson, says challenges such as fees can be tackled by focusing on net-of-fee performance as well as setting a fee budget and making sure the overall costs of the TDF are kept in check. As for litigation risks, O’Meara said, “any large DC sponsor will be sued at some time.” The important thing is to use a defined process that evaluates options based on potential results for participants.
O'Meara said the performance advantage — and downside protection — of adding alternatives is clear. According to research Willis Towers Watson conducted with Georgetown University’s Center for Retirement Initiatives, expected annual retirement income increases from $53,000 to $62,200 when a diversified set of alternatives is added to a TDF. At age 65, investment returns could increase from 5.1 percent to 6.1 percent with alternatives in the mix.
It would make it easier for the WSIB to add alternatives to TDFs if the DC market overall gets on board, giving record keepers critical mass and helping educate participants about the options. “I need market acceptance so we can offer this,” said Whitmarsh.
It seems an unlikely time to add alternatives to TDFs as many sponsors have gotten conservative when it comes to the options they offer and the fees the funds charge. That’s because lawyers have filed numerous lawsuits against large companies, alleging breaches of fiduciary duty for a broad range of actions, including offering active funds that haven’t beaten their benchmarks. Litigation prompted a wholesale shift into low-fee, passive funds that companies think few can criticize.
The WSIB may be an outlier in terms of being able to offer alternatives. Whitmarsh said she’s not worried about litigation because the board is a public plan.
Critics of alternatives often point to daily valuation and liquidity as primary stumbling blocks. There is no rule that requires plans to provide daily liquidity, but participants have come to expect it. In most cases, investors would be better served if they could not make daily changes to their 401(k) retirement plans. “I wish we could put the daily valuation genie back in the bottle,” said Christopher Nikolich, head of glide path strategies at AllianceBernstein.