More Pathways Open for DC Plan Sponsors

Seismic shifts continue to open pathways for defined-contribution plan sponsors to invest in alternative assets and private real estate. Following regulatory changes and an increasing investor awareness that has been hastened by a number of high-profile plans—led, notably, by Intel—there have been significant strides in navigating the existing liquidity, valuation, and fee concerns that could lay the groundwork to rapidly grow this nascent investor base.       

“We are identifying groups who have put money to play,” says Scott Brooks, a co-founder of the Defined Contribution Real Estate Council an industry group that works with DC plan sponsors to help promote the asset class within their portfolios. These include Intel, the State of Washington, the grocery chain H.E.B., Michigan Municipal Employee Retirement System, and the Australian superannuation fund, SunSuper, he adds.

Brooks shines a light on the ever-widening number of DC plans that have allocations to alternative asset classes. “It’s accurate to say there have been a dozen formal searches for private real estate in DC plans over the past year, with somewhere in the range of $1.5B allocated as a result of those searches.”

While there are many factors driving the interest in diversification, the sizable capital flows heading into target-date funds (TDFs)—widely popular structures that allow DC plans to invest in alternatives—are quite compelling. Stemming from the 2006 Pension Protection Act, TDFs were defined as “qualified default investment alternative (QDIA) structures,” removing fiduciary liability for plan administrators who auto-enroll employees, hoping to increase participation. Brooks explains, “In a world where people are too busy to make decisions, if an employee doesn’t choose investments in their retirement plan, they will get automatically enrolled by the plan sponsor into the plan’s QDIA [target-date funds].”

According to reports from Northern Trust and BenefitsPro, DCs are increasingly choosing TDFs and, more importantly, custom (or managed) TDF solutions to balance “extreme allocations.”    

“The importance of investment structures in DC has gotten on the radar of finance teams, and they are getting more involved and in control of these decisions,” observes Lew Minsky, president and CEO of the Defined Contribution Institutional Investment Association, also a leading nonprofit industry group. “There’s an opportunity to capture the liquidity premium and have a real risk-management focus. It has as much to do with capturing the correlation to performance and returns, as well as doing a better job of hedging, with all the investment solutions that are available. If you are only in mutual funds, there are limits to what’s available.”

Both Minsky and Brooks relay that, while there is growing goodwill for illiquid investments, there are still hurdles to their broad adoption.

“There are two very strong macro trends that are coming up against each other,” says Minsky. “One is a strong desire by large plan sponsors to shift focus to drive better outcomes. The competing factor—as a result of regulatory initiatives, litigation, and scrutiny—is a bit of myopia towards low costs and a focus on fees.”

Brooks concurs, adding, “The ‘2 and 20’ fee model is harder to justify over 30-basis-point fees found in passive structures. Yes, it’s more expensive, but the industry is beginning to see that it’s worth the cost because of the real benefit in excess of fees. Plan sponsors with treasury and finance teams get it—they have a keen understanding of what works in creating an optimal asset allocation. As more professional finance people become focused on [the] marketplace, interest in TDFs and managed accounts will gain more strength.”

Valuation is also a concern, going hand in hand with asset classes such as real estate. Brooks comments that “while demand for liquidity is declining for the leading edge of this business, it’s still a concern. Real estate has done a good job of positioning daily valuation through third parties, though for many plan sponsors, quarterly reporting is all right with them as well.” He also highlights the success of Intel as a framework for other plans: “What’s beautiful about Intel—which has been doing this for seven years—is that they have closed-end PE funds and traditional hedge funds in their overall allocation.”

Brooks advises that the most beneficial industry shift will come from accountants “sharpening their pencils” and figuring out the best methods based on generally accepted accounting standards. “It’s work, but once you establish the process, it’s pretty easy when we are talking about between 5 to 15 percent of the overall portfolio,” he says. “It would take huge missteps to move NAV at the overall fund level.”      

The DC space is prime to move towards closed-end funds. Plan sponsors are looking to achieve the narrower range of risk-managed outcomes of their defined-benefit counterparts, which will work in real estate’s favor. As managers find a better path to reporting and representing the value of their expertise, DC plans are poised to shift the investor landscape.

“My hope is that factors come together [to where] the shift is a focus on value for money over fees,” Minsky says. “That’s where the evolution will come, and decisions in the DC space will look like the DB space, where decisions are based on the best value and outcomes.”