The governmental DC industry is generally a follower, not a leader, when it comes to such industry trends. Although some public employers have converted from defined benefit (DB) pensions to 401(a) DC plans, typically mandatory for employees, those remain the outliers rather than the rule: Most DC plans for public employees fall under the 457(b) and 403(b) classifications as optional supplemental retirement savings programs. As a result, their participants’ average personal account balances are far smaller than their private-sector counterparts’ because most of the public workers’ contributions go into the traditional DB pension systems. So when the financial industry introduces new products, their marketers always start first with the 401(k) plans.
It’s not self-evident that much of what soon gets pushed into the private sector will necessarily be viewed as serving the best interests of governmental employees, unless plan fiduciaries do lots more homework before approving whatever new bells and whistles their plan administrators start promoting. Skeptics say that while alternative investments have marketing sizzle, they come with uncertain advantages, greater risks and far higher costs. So don’t expect a quick burst of money flowing from this community into complex, unfamiliar vehicles.
As noted in a previous column, the most notable financial innovation in the DC industry in the last two decades, both public and private sector, was the target-date fund structure. These funds provide the convenience of “set it and forget it” investing for participants, who simply identify when they expect to retire and pick out the fund with the closest target date. Asset allocation is performed within the fund, usually starting with a heavier mix of stock funds for younger workers and then “gliding” automatically over time to a more conservative mix with more allocated to bonds as investors approach retirement age. Most public employers and employees have been happy with the results: It’s been an easier and arguably more efficient way to invest and make gradual portfolio adjustments as employees age. The only real issue for most plan stewards was fees and fee layering, where plan oversight committees sometimes had to push back on opaque products with buried fees and costs.
With $4 trillion of assets, these target date funds are likely to be where the DC industry first sees market penetration by alts. That’s because the easiest sale for purveyors of alternatives will be to the portfolio managers of target date funds, who are more sophisticated and have large chunks of capital to deploy immediately. Why mess with explaining alternatives to 7 million 457 plan participants with midget account sizes when a dozen target date fund teams can flip the switch? The granular detail of what’s inside their multiasset funds is often invisible to most retirement savers, who rarely read the latest portfolio composition reports. It’s doubtful that employees will switch out of a target date fund just because it adds a few percentage points of alternatives to its portfolio.
In the private sector, there’s a national industry organization called the Defined Contribution Alternatives Association (DCALTA ) promoting the concept, with big financial firms now pushing hard to expand this market. They are not sharks — members are well-meaning investment professionals — but they do have a single-minded promotional mission at this stage. To them, it’s the new gold rush: If they can eventually capture 8 to 10 percent of the overall DC asset base, that would open the doors to some $30 billion of new annual revenues for the alternative investments industry, top to bottom. To advance their case, the DCALTA folks published a paper in July on “principles” for thought leaders in DC plans to consider. Read it with a grain of salt.
Cautious Toe-Dipping
If the alts are to make significant inroads into public-sector DC plans, there are viable paths. Notably, Washington state’s system has roughly cloned its own pension fund to offer its statewide DC plans, and then built customized target date portfolios around that. That would likely be the lowest-cost way to implement this ambition — and an idea well worth considering elsewhere. (DCALTA members could easily afford to promotionally subsidize those setup costs for at least an early-bird handful of the top 50 public plans.) Nonetheless, it’s noteworthy that others will disagree that alts have been so good for the traditional DB pension funds that have been moving heavily into them in recent years. Some retail investment gurus have similar objections, and the CFA Institute published a counterpoint article well worth review by DC plan sponsors, consultants and overseers. Good due diligence work by leaders in the public DC space will incorporate all these linked readings.
Despite the naysayers, as a general principle I can live with some cautious toe-dipping to insert a few cost-efficient diversifying alternatives inside the target date funds for starters, and with prudent, modest curated slivers of suitable private equity for the mid-careerists and senior-secured private credit for income-seeking retirees. It’s easy to envision a future DC product cleverly named something like “Senior Secured Income” built predominantly on collateralized private credit. Insurance companies will likely get into the game with “wrappers” and annuity products built selectively around private credit. Plan fiduciaries should set an overall limit, like a 15 or 20 percent maximum per participant, and require online participant risk education.
The first fiduciary issue is liquidity for DC investors. DB funds don’t usually need liquidity — they entered into this marketplace decades ago on the theory that they could then collect an illiquidity premium (higher returns) by tying up long-term capital in exchange for better outcomes than stocks and bonds produce. To the extent that alts investments are feathered into target date funds where the capital is pretty sticky and not usually traded around by participants, the liquidity issue is not much of a concern. One nonprofit company active in this space, MissionSquare Retirement, has already been doing this in the 457 market for quite a while. But the larger industry still has yet to devise and demonstrate new investment structures and portfolio strategies that are workable for capricious plan participants who fiddle with their portfolios regularly.
Illiquidity in private equity has also given rise to continuation funds that provide cash to locked-up investors. But the new money coming in could be the alts-equivalent of junk bond funds. What’s to stop those bailout products from worming their way into unwary DC plan participants’ portfolios?
Another issue related to liquidity is the valuation of alternative assets. For private equity and credit funds, the paper value at any point in time is relatively fictional, often based on the latest private funding rounds for the underlying holdings. Even AAA-rated real estate debt can plunge quickly below its paper value. There is good reason to suspect that this artificial pricing model will eventually open the door to market-timing problems as savvy DC plan participants flip positions to exploit mispriced private assets, at the expense of other investors who are thereby left holding the bag. One of the DC industry’s largest real estate funds had exactly this problem in the Great Recession of 2008-09. The DC industry needs to seriously consider a one-year round-trip rule for alts, limiting participants’ ability to sell out of a fund and then buy back in after a short period, to prevent scandals like those in the mutual fund industry circa 2003.
Second, the money now coming into this industry may well be Johnny-come-lately and might have already missed the golden age of private investments. There are no broad-market index funds for private equity and private credit, making them ill-suited for naive small-scale investors who are far more likely to get the leftovers and dregs, not the best-of-class funds that typically sell out within their old-money networks.
Third, the fees for this asset class are mighty high, and costliest of all for small savers. Several of the big houses are working hard to superficially address that issue with their gigantic economies of scale for the shells of their wraparound fund products — but that’s usually just the tip of the fee iceberg for these multilayered investments. Their real costs lie below the surface in the underlying partnerships where big management fees and carried interest are extracted.
What Participants Need to Know
Ultimately, plan sponsors will be well advised to require participant education sessions on how much of their aspirational returns from dipping into alts will be chewed up by layers of fees that make even the most egregiously costly common-stock mutual funds look dirt cheap. The DCALTA “principles” paper asserts that fiduciaries should not compare alternatives’ fees and costs against those of the traditional asset classes but only within their category. That’s what magicians call misdirection.
The average public employee is probably not likely to understand all the risks they are taking on. Most clerical, corrections and road workers, teachers and cops can’t be expected to know very much about capital markets, and most are risk-averse investors. It’s really hard to make the case for putting complex hedge funds, crypto, commodities and illiquid partnerships into 457(b) and 403(b) plans when target-date funds and pension-fund clones can already provide appropriate diversification with modest allocations and stress-tested liquidity under professional management.
This also raises the question of who on the third-party administrators’ teams will be qualified as the investor interface. Many of those contracted to do sales and service for public plans today would be unprepared — and legally unqualified — to confer about complex investments outside the traditional plan menus. That leaves only the “self directed brokerage window” as a portal for the exotic stuff like crypto, commodities and private funds. Upgrading the entire DC customer-contact workforce with higher-level general-securities licensure to peddle standalone alternative investments looks to be a hurdle that the investment houses are dodging.
These need not be fatal flaws, but they are certainly topics that every oversight committee for a governmental DC plan needs to address. Maybe there really is a there, there. My checklist is not intended to be a deal-killer or to throw icy cold water on the concept, but let’s make sure that each plan’s rationale and strategy is well-founded and thoughtful. Ideally somebody will come up with an independent multidimensional risk-return rating system for these complex vehicles, one even more rigorous than those for mutual funds.
For now at least, I recommend baby steps after adult due diligence as this emerging trend takes shape and the industry improves and refines its product lines. Certainly the Washington state approach should be considered by other systems. But amid the national shift toward pro-business policies and more risk-taking with less regulation, let’s start with caveat emptor just in case a bubble is now forming. Alternative investments will not solve the nation’s retirement underfunding, and very few public employees will ever retire any sooner because of them.
Governing's opinion columns reflect the views of their authors and not necessarily those of Governing's editors or management. Nothing herein should be construed as investment or tax advice. Disclosure: The author was the president and CEO of ICMA-RC over 20 years ago. That firm is now doing business as MissionSquare Retirement; he has no current affiliation or interest there.
