The creation of the target date fund (TDF) sought to make available a professionally managed solution for individuals saving for retirement through their employer’s defined contribution (DC)/ 401(k) plan. In the U.S., DC assets represent 61% of total retirement assets1 and that percentage is expected to continue to rise. However, despite improvements to investment options and participant behavior, on average, DC plans continue to see returns that lag defined benefit (DB) plans. Looking across two recent studies, this deficit is clear:
- Corporate DB plans outperformed DC plans by an average of 70 bps, net of fees, per year between 1990 and 2012.2
- For the 10 years ended in 2016, DB plans saw annualized net returns of 5.4% compared with DC plans’ annualized net returns of 4.9% – a net return difference of approximately 50 bps.3
One possible reason for that gap is that DC plans do not currently have access to the same “toolkit” of investments that is available to DB plans. This is evident when looking at allocations to private markets. Access to those markets for DC plan participants is the focus of this special report.
BlackRock believes that, as long-term investors, DC plan participants who are invested in target date funds should have access to both public and private markets. However, access may not be the only obstacle for DC plan participants wishing to invest in private markets. The structure of the 401(k) market, which demands daily liquidity, also could create challenges. How to level the playing field so DC plan participants have the opportunity to benefit from the growth of private markets is the subject of this lively conversation with BlackRock’s Nick Nefouse, Head of Retirement Solutions and Global Head of LifePath®; and Pam Chan, Chief Investment Officer and Global Head of Alternative Solutions.
Traditionally, DC plans haven’t been able to access private markets in the same way that DB plans have. What are the main potential benefits to a DC plan from investment in private markets?
Nick Nefouse: Although private markets are growing significantly faster than public markets, young DC plan participants who have up to a 45-year investment horizon have not had much opportunity for exposure to private markets and the related potential for benefit over that time horizon. For older investors, private markets may still be return enhancing, but they’re more likely to be looking for a way to mitigate risk. For example, in this low-interest-rate environment a portfolio may benefit from exposure to different types of assets, such as infrastructure pipelines, or maybe even green energy – investments whose primary contribution to the portfolio is diversification rather than return enhancement. In short, wherever an investor is in their lifecycle, private market investments can add to the toolbox within a target date fund.
Pam Chan: Private markets continue to grow at an accelerated rate, so over time they can potentially address missed return generation opportunities for DC plan participants, and provide diversification benefits. Retirement saving is about putting money away for the long haul. Private markets are designed to be multi-year holds and allow for longer-term value creation, not subject to the day-to-day fluctuations of the liquid markets. Put another way, private markets can match the longer timeline of retirement savings while exhibiting relative resilience given more muted mark-to-market volatility, greater insulation from sentiment, and avoiding forced selling.
Over the course of time looking across private market asset classes, return premium has been somewhere between 200 to 500 basis points so that could make a very meaningful difference compounded over many years.4 One of the reasons clients are looking to private markets is because of where fixed income is today versus their absolute return targets. A final point that is particularly noteworthy: the spread between public and private market valuations today is meaningfully wide. When we see institutional investors that have always invested in private markets significantly increasing their allocations, it hints at the possibly important role that private market investments could play in DC portfolios.
You mentioned the role private markets can play in a portfolio and that’s a nice segue into the cost of adding private market investments to DC portfolios. What would the challenge be there?
Nefouse: The DC portfolio’s costs would go up, no two ways about it. But there are some levers we can use to help keep them reasonable. First, scale matters in alternatives. Working with a firm with the size and scope of BlackRock can offer advantages in terms of access, opportunity sourcing, and institutional-scale cost advantages. Private market issuers are aware of the potential scale and relative stability of DC plan investments, which could have a bearing on the issuers’ offered cost.
Second, and more importantly, is the potential net-of-fee benefit to investors. The benefit of including private market alternatives in a target date fund may be in return enhancement or diversification and risk mitigation – or perhaps both. We have to look at the after-cost benefits, and if there’s no substantial reduction in risk or substantial increase in returns, there may be no value proposition, and we may be just adding unnecessary complexity.
Chan: You go into private markets seeking return enhancement and risk diversification through asset-specific outperformance and deal-level attributes. You’re not buying an index. The investor is paying for the human effort and edge in sourcing, underwriting, and managing the asset through to disposition or repayment, as the case may be – each private market deal needs to be manufactured and actively managed. To that end, private market investments need to make sense on a net return basis.
Private market alternatives are heterogeneous in nature. What types of alternative assets do you envision in a DC plan?
Nefouse: I think it’s right to use the term private markets instead of private equity. We’re looking at accessing private markets, and that could be in credit, real estate, infrastructure, private equity – the market is deep and diverse. We’ve been analyzing private market alternatives with Pam’s team through a lifetime asset allocation lens, and as rule of thumb for young investors, we’re looking for growth assets that will outperform public equities. Later in life, as we mentioned earlier, it becomes more of a risk mitigation story. What’s made this conversation even more interesting since March is that with interest rates where they are, it’s a struggle to find risk mitigating assets in the U.S. public markets outside of U.S. treasuries.
But let’s give this some context. It’s not just “Let’s bolt on some private equity for a 22-year- old.” We have to understand how the risk and return profile and the cross-asset correlations of the whole portfolio are adjusted for the unique circumstances of including private market exposures in a diversified pool of otherwise public market assets.
Chan: To dive a little deeper into the growth assets part of what Nick was just describing for the younger investors, I would broadly describe it from a cash-flow profile perspective. It’s about where investors are seeking to get meaningful capital appreciation. In private market investments, an investor seeks upside on exit, whether in the context of equity in a private company, a real estate property, or an infrastructure project. There are also a number of other ways to mix the growth element with some income. For example, within opportunistic credit, some of the total return is designed to come from income, but there could also be an equity component attached to the structure of the transaction providing some potential equity upside to the investment.
Also, to underscore one of the elements of the whole portfolio approach Nick described: once you put it in the ground, it is in for a multi-year period. But at some point, that money will hopefully come back, and if it does, the investor can figure out where to put those incremental cash flows. Private markets are less dynamic than the public markets because investors can’t change their investment overnight, but an investment plan shouldn’t be static. One element on the private market side that less people talk about is the ability to evolve the portfolio over time as distributions come back. The investor just has to be very intentional and deliberate about it.
What are some of the structural issues that represent challenges to having private market investments in target date funds?
Nefouse: There are two distinct areas that worry me the most. First, the investment nature of private assets, which draw down capital and invest opportunistically, potentially lagging in time to invest and/or resulting in negative returns for early years of capital investment. Second, the need for liquidity at the target date fund level. On the drawdown return profile, it’s really about education, with DC plans and participants realizing that it may take time to see the return benefits associated with private assets. On the liquidity question, investments in 401(k) plans typically offer daily liquidity, which creates a mismatch outright with private market alternatives that may not be liquid at all or may require a discount to sell. While this asset-liability mismatch can’t be perfectly solved, there will end up being a scenario that in part includes optimization of liquid and illiquid assets within a target date fund. This is perhaps the most acute challenge – a target date fund can’t, in a period of persistent outflows, just get more and more illiquid as the public securities are sold to fund redemptions. We believe that, with some creativity and innovation from asset managers and private market issuers, these will prove to be solvable problems.
Chan: If we’re able to “equitize” the J-curve period, that may help along the way. Equitization is about finding liquid assets that introduce some of the attributes of the private market assets we would look to add to the portfolio over time. That could be a function of market factor exposure or income profile, and so on. The key with equitization is ensuring that it preserves capital. Early on in the J-curve, capital calls will be lumpy, and the investor doesn’t want to be in a place where you don’t have sufficient liquidity to fund a capital call. If well designed, equitization can be better than holding cash, which is what a lot of folks do today. We’re talking about filling the gap partially, not all the way – because, if you could fill it completely, you wouldn’t need private markets in the first instance.
Nick, how would sum up the challenges of including alternatives in DC plans? And how can working with the right alternatives manager help DC plans overcome those challenges?
Nefouse: Structure, access, cost, and education. We just covered many of the structural challenges, and they are significant barriers that will require innovation on all sides to overcome. Regarding access, one way to look at it is that the top managers tend to stay the top managers over time, and access to those managers is the objective. Private asset transactions may be privately negotiated and not widely available, so sourcing capacity with managers that see good deal flow and can set terms is important. On the third point, cost: a really good manager with a track record of delivering good returns isn’t offering you a discount. There is a cost premium, as Pam spoke about earlier, and that premium is generally pretty stable for top managers, who often get paid base fees but also a performance fee based on the return of the assets. Fee complexity is a challenge for DC plans, which need to allocate costs across all participants in a predictable, regular way. Finally, education. Education is really about explaining the nuance to plan sponsors – the difference between public markets and private markets so they can in turn educate participants.
BlackRock can help plan sponsors with all of these elements by collaborating across the firm. On the Retirement business side, we are experts at lifecycle investing, and on the Alternatives business side, we have an industry-leading platform with the required expertise and the depth of knowledge in private markets. We think diversification and scale will matter here – this isn’t just about bolting on a private equity allocation to your target date fund. We would encourage plan sponsors to think about the whole portfolio approach of private markets and public markets.
Chan: Investors with BlackRock can benefit from the breadth of the investment strategies that we have, liquid to illiquid. Even the largest institutional investors sometimes struggle moving across the private market space because it can be complex and cumbersome. You need a team that has specialist expertise in each of the private market verticals, and that has the expertise to underwrite and seek alpha. We have those experts across the board. And let’s face it – a firm that only invests in private equity is always going to want to sell you private equity no matter how high the valuation multiples. With our whole portfolio view, we can greatly expand the toolkit for investors to express what that private market premium is for them.
In the end, it feels as if a lot of this just comes down to everyone with a 401(k) account having a fair shot at optimizing their preparedness for retirement.
Nefouse: I love covering 401(k) plans. I get to look right at the people in those plans and understand the purpose of what I do every day. And there’s no reason I should have to explain to them why they don’t have access to these investments if people who benefit from DB plans do. It’s democratization, but we need to do it in a way where the experts build the products because of the nuances we’ve touched on here. We have to get the access part right for sure, but also need to innovate to get access to the right things at the right times in an investment lifecycle.
Chan: You need boots on the ground to source these transactions. That’s where a scaled platform like ours comes into play. I cannot underscore this enough – finding the right deal and structuring it the right way is still powered by humans. It’s blood, sweat, and tears to get there. Picking up on that, this isn’t like investing in an index or in public markets. That’s why the access is hard, relationships matter, and historically private markets have fed predominantly into the institutional investor space. And capital begets more capital, right? So, the big investors become even bigger, and they benefit from the tailwind as returns are generated. And the lack of access compounds over time for DC plan participants. That’s something to reflect on as we think about equality, and how appropriately structured participation in private markets may help to close some of the current equality gaps.
1 Global Pension Assets Study 2020, Thinking Ahead Institute Research, Willis Towers Watson
2 Alicia H. Munnell, Jean-Pierre Aubry, and Caroline V. Crawford, “Investment Returns: Defined Benefit vs. Defined Contribution Plans,” Center for Retirement Research at Boston College, no.15-21 (December 2015)
3 Sandy Halim and Maaike van Bragt, “Defined Contribution Plans Have Come a Long Way!” CEM Benchmarking Inc. (February 2018).
4 This is based on an analysis using data from Thomson Reuters from 2009 through 2019. It was conducted across 4 asset classes, Buyout, Private Credit, Real Estate, and Infrastructure. Premium was measured over the MSCI World for Buyout, Barclays Global HY for Private Credit, FTSE EPRA/NAREIT Global Index for Real Estate, and DJ Brookfield Global Index for Infrastructure.
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