The defined contribution (DC) plan space may not appear to change all that much, but that doesn’t mean there aren’t asset managers thinking about serious innovation. DC plans have evolved into the primary retirement savings plans for most workers in the U.S., so it makes sense that a manger with a laser focus on the retirement market would lead the way.
ICMA-RC is best known for its work with public sector retirement plans with the specific mission to help public employees build retirement security. In support of that mission, ICMA-RC launched a DCIO division that serves both public and private DC plans.
At the moment, ICMA-RC is working through the challenges and solutions of what is something of a holy grail for DC plans – how to incorporate alternatives into the plans so participants can reap the benefits of more institutional-like strategies that are the hallmark of defined benefit (DB) plans. II recently sat down with ICMA-RC’s Matt Brenner, Managing Vice President, Investments, and Craig Lombardi, Managing Vice President and Head of DCIO, to discuss their pursuit.
Why is there so much interest in adding alternatives to DC plans?
Matt Brenner: There’s been a major migration from DB plans to DC plans as the primary source for saving for retirement. But in that transition, the available tools for investing have been limited. A DB plan in the institutional space has access to a whole host of investment options. However, even with a default investment in a DC plan – typically a target date fund (TDF) meant to somewhat mirror what a DB plan would accomplish – the tools currently available aren’t on the same level as those a DB plan can leverage. That means the opportunity set for DC plan members is limited.
Our research indicates that in the DB to DC transition there’s a give-up in the return potential for participants, and a different risk structure in a TDF vs. a defined benefit plan. The overwhelming evidence from our research suggests that the lack of the availability of alternative investments correlates very highly to those two things.
Are there other ways that DC plan participants are handcuffed as it were?
Brenner: Yes, in the time horizon, for example. A DB plan pays out over decades, so it can manage liquidity appropriately and try to gain some of the benefits from various illiquid asset classes. TDFs not only feature daily liquidity, but their underlying investments are daily liquid. Since the obligation of preparing for retirement is now on the shoulders of DC plan participants, they are surrendering one of their most valuable assets – the time that they have to invest. A 20-year-old or even a 40-year-old, their investment horizon is not measured in days, months, quarters, or potentially even years. It’s measured in decades. And yet all of their assets underneath their DC plan are daily liquid. That dynamic has really led plan sponsors and many individuals to say, “Why can’t we access some of these DB-like things that align really well with what people are trying to accomplish in their DC plans? They have a long time horizon, too.”
Craig Lombardi: Within the spectrum of what investments managers have had on the DC side, there have been three areas of focus to drive returns – equities, fixed income, and cash. Now they’re looking for another arrow in the quiver that could possibly provide a risk adjusted return, and that would look more like a DB plan embedded within model portfolios and/or TDFs. That’s where the interest is coming from – they see the risk/return profile of alternatives.
So, to date, what has prevented alternatives from being adopted by DC plans?
Lombardi: Foremost, a standalone alternative product available to an individual investor would probably inspire hesitation on the part of plan sponsors and consultants. There are complex regulatory, operational, private litigation and risk hurdles to consider and overcome. However, if you go back to that risk/return profile, when it’s embedded in an overall asset allocation fund and/or TDF, you find investors can reap some of the investment the benefits that a DB plan would by being exposed to alternatives, without having to put all their eggs in one basket.
A second point is that some sophisticated investment teams, whether at the consultant or plan sponsor level, may not have the resources to properly identify those opportunities. That’s where an asset manager can help bring to light different types of alternative investments in a packaged product, that they can use, and trust, and see, and dig into, and understand. In that scenario, plan sponsors and consultants don’t need an entire team dedicated to do due diligence on a sleeve of alternatives. They can just perform due diligence on the managers, as they always do.
You’re hinting at challenges on the operational side. Are there other operational challenges to including alts in DC plans?
Brenner: For certain. If we’re talking about a truly illiquid alternative, that requires people to make allocations that they may not be able to get out of for a while. But even if you could do that, in the context of direct investments, it becomes a little harder for the manager to figure out how exactly to allocate capital. Most DC plan participants are saving every two weeks, or twice a month with deductions from their paycheck. If you’re trying to allocate capital as an investor, that’s a little more challenging given the nature of these flows.
Beyond managing liquidity, pricing, and flows if you’re the investment manager, there are certain regulatory requirements regarding qualified investors that limit a participant’s ability to directly invest in alternatives. Which gets us to the idea of doing something that’s part of a TDF, or some other type of asset allocation product. A single manager who’s managing a TDF may have the resources to do something in-house. But they may not really have the ability to do it effectively within a TDF due to its structure. Also, with a single manager, you can get some diversification in the types of investments, but you don’t have any manager diversification across alternatives. Manager diversification is important given the different types of alternatives available.
It sounds as if when alternatives are available to DC plan participants they will come in the form of a TDF.
Brenner: We think that’s the likely step, particularly in this regulatory environment, and with the operational considerations we just mentioned. A TDF solves for a lot of these issues because it is diversified to begin with, and you have flows in and out. As a result, you have a better idea of how you’re going to be allocating capital over time. Also, the manager of the TDF is controlling the allocation to alternatives, whereas if the participants themselves are controlling the allocation there’s far less experience analyzing what may happen.
So, for example, different TDFs could have different percentages or size of allocation to alternatives?
Brenner: I think that’s right.
So, an alternative light and alternative medium, so to speak?
Brenner: Absolutely. There is no single glide path across the target date industry – people have different interpretations as to what a glide path should look like. I anticipate that allocations to alternatives could vary, based on the glide paths and views of different managers. We think that if you’re thinking about an allocation to alternatives you should be mindful of the investment horizon for the investor. In other words, an allocation to a 2040, 2050, or 2060 fund, may be more appropriate than an allocation to a 2020 fund.
Lombardi: More and more we’re seeing large plan sponsors are really trying to solve how they make their DC plans more like DB plans. So, there’s a lot of interest in custom TDF – and you can see they’re looking for alternative types of investment, to crack the code. So that’s an area that we’re looking into closely.
Brenner: We’re really looking for innovative ways to capture some of that premium on alternatives that has not been readily available. To that point, in many instances when somebody thinks alternatives, the first thing that comes to mind is hedge funds. We do believe that some hedge funds may offer a true illiquidity premium, but many are really not alternatives – they are vehicles that may allow for long-short strategies, or some other type of strategy that occurs entirely in liquid markets. What we’re trying to capture are asset classes’ risk premium that you can’t get to in the same way in liquid markets. That leads us to things like private equity, infrastructure, real estate, and private debt, for example.
The alternatives market is pretty broad, and it’s not just about identifying an investment opportunity. It’s just as much about identifying managers, having access to top tier managers with experience and track records that give confidence for investing in similar types of investments in the future. Those things aren’t necessarily a given with every manager. That’s where a manager’s resources come into play. Once you decide that what you believe is a good investment, you need to get an allocation to that investment. If you can obtain an allocation, that can contribute to a target date fund and to a glide path, and ultimately benefit participants.
Currently, in DC plans and with TDFs, the flow of money is pretty seamless. If alternatives are included, would that flow be disrupted?
Brenner: TDFs allocate to underlying funds, and they change the allocation to those funds over time. Most TDFs are mutual funds, which have their own legal, regulatory and operational requirements. There are real challenges to including alternatives in that type of structure, because there are operational and regulatory limits regarding liquidity to consider.
To have a meaningful allocation to an alternative in a target date fund, theoretically you would have to include the same amount of alternatives in each of those underlying funds. You could adjust a little bit, but theoretically it’s essentially the same, and that makes no sense. Why would you include something illiquid in what’s supposed to be a liquid fixed income fund? That has been a real struggle for the target date industry, and that has to be solved.
In any DC plan, there are inflows and outflows, people are taking loans and reallocating. How do you accommodate that? We believe that you can manage the liquidity of an overall target date fund that has an illiquid component in it. And even within that, you can manage around the illiquid needs of your alternatives’ allocation if you go about it thoughtfully – considering the base-case scenarios, and more extreme scenarios such as what would happen during market shocks.
Pricing would be a challenge, too, yes?
Brenner: If you have flows on potentially a daily basis, ultimately you need to have a daily calculated net asset value (NAV) for your target date fund. That’s not the easiest thing in the world, but it is not impossible either.
Everything I just mentioned is a challenge, but we don’t think it’s impossible. It requires a lot of work, but it is very much possible to arrive at daily valuations that ultimately translate into a NAV that can be traded on a daily basis.
Lombardi: We believe we can find a way to make an offering that is benefits sensitive based on the allocations that will be within the portfolio itself. If you compare a 2035 fund to a 2055 fund, you’re going to have a different allocation to alternatives. But because of everything else that’s in the portfolio, it will remain benefits sensitive. Overall, you’ll still have cash positions, you’ll still have fixed income, and you have other areas to source any liquidity needs, but as in DB plans, you’ll be able to remain fully invested to get that risk return benefit over time.
Brenner: We believe that in a carefully structured TDF that includes alternatives, there are several levers that allow you to successfully manage liquidity concerns even in the event of a major drawdown. If structured appropriately, you should have the flexibility to generate liquidity through a portfolio that is overwhelmingly liquid. You can also build in safeguards along the way that contemplate that there may be drawdowns at certain points – so there are ways to address and alleviate liquidity concerns.
Disclosure:
This information is intended for institutional use only.
This is not intended as a solicitation nor does it constitute investment advice. The asset class discussions included herein are not meant to be exhaustive. Vantagepoint Investment Advisers, LLC (VIA) and its affiliates are not responsible for any investment action taken as a result of this piece. Investors should carefully consider their own investment goals, risk tolerance, and liquidity needs before making an investment decision. Investing involves risk, including possible loss of the amount invested.
Investment advisory services are made available to institutional clients through VIA, an SEC registered investment adviser and wholly-owned subsidiary of ICMA-RC. For more information, please see VIA’s Form ADV, available at www.adviserinfo.sec.gov. When Funds are marketed to institutional clients by our Defined Contribution Investment Only (DCIO) team, the Funds are offered by ICMA-RC Services, LLC (RC Services), an SEC registered broker-dealer and FINRA member firm. RC Services is a wholly-owned subsidiary of ICMA-RC and is an affiliate of VIA.
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