As new research has found that an allocation to alternatives can benefit target-date products, a debate remains about whether these funds are worth the cost.

Allocations to private equity, private real estate and hedge funds can lead to better outcomes for target-date investors, including more retirement income and less volatility over time, according to “The Evolution of Target Date Funds: Using Alternatives to Improve Retirement Plan Outcomes,” a report from Georgetown University’s Center for Retirement Initiatives and Willis Towers Watson.

On the other hand, adding certain asset classes to target-date funds could dramatically increase the fees paid by investors, who would also sacrifice some liquidity in order to access alternatives. Plan sponsors and advisors may be ill-prepared to implement direct real estate placements, and target-date funds might not be able to access much of the private equity and hedge fund space, argues Jeff Schwartz, president of Markov Processes, a Summit, N.J.-based investment research firm.

According to the Georgetown paper, using alternatives in target-date funds can improve portfolio outcomes, assuming a target-date fund spends through 30 years of retirement. When the researchers replaced a portion of a target-date fund’s equity allocation with private equity, annual retirement income increased: If investors’ private equity allocations tapered from 20 percent at the beginning of their careers to 10 percent at retirement, and then to 0 percent 10 years after retirement, they could generate $11,000 in additional retirement income per year over a traditional target-date fund portfolio.

When real estate was incorporated in two different target-date fund-like glide paths as a replacement for a portion of both equity and bond allocations, it tended to reduce volatility, but also ended up increasing retirement income for low-income earners while reducing the amount of retirement income generated by high earners.

As they did with direct real estate, the researchers allocated to hedge funds from both the bond and equity portions of a target-date portfolio, creating two different glide paths with different levels of allocation. In this case, investors of all stripes would enjoy marginally higher retirement income and less downside over time.

Diversification Works

A target-date fund incorporating all three types of alternatives researched had a higher probability of maintaining positive assets and offered higher expected returns than a target-date fund using only traditional asset classes. In a best-case scenario, the fully diversified target-date fund would generate $94,000 in retirement per year for every $100,000 in annual income earned by a participant before retirement—while a target-date fund limited to traditional asset classes would generate only $77,000 annually for every $100,000 per year in pre-retirement wages.

In the study’s worst-case scenario, the traditional target-date fund strategy would produce only $21,200 annually, while the target-date fund using alternatives would generate $23,500 each year.

Alternatives also helped mitigate the sequence of returns risk in target-date strategies, according to the research. A target-date fund diversified with hedge funds, real estate and private equity carried lower downside risk at the time of retirement and 10 years after retirement than a target-date fund using only traditional asset classes.

A diversified target-date fund could beef up annual retirement income by 11 to 17 percent depending on market conditions, said Angela Antonelli, executive director of the Center for Retirement Initiatives, in a comment.

The researchers assumed that an employee would participate in a defined contribution plan for 40 years, between the ages of 25 and 65, with savings starting at 4 percent of wages initially and rising to 7.5 percent of wages by age 65, with an employer match of 50 percent on the first 6 percent of savings. Wages were assumed to increase at the rate of the Consumer Price Index plus 2 percent until the participant was 45 years old, and in line with CPI afterward.

The report’s authors also created a median glide path using a blend of different currently available target-date strategies, noted Markov.

“There’s other methods that could have been used to do this kind of analysis that might have produced different results, and that’s a caveat in reading an analysis like this,” says Schwartz. “Whether these numbers will end up being predictive and accurate, I can’t say.”

Vanguard’s View

In August 2017, Vanguard did its own research into the potential for alternatives in target-date funds using similar saving, spending, market and glide path assumptions, arguing that any asset class used in a target-date fund should be low-cost, simple, transparent and liquid. On that basis, the asset manager rejected the idea of using hedge funds, private equity or private real estate in target-date funds.

“As for liquid alternatives, target-date funds that incorporate them may offer access to strategies typically found within a hedge fund structure at a slightly reduced cost and with increased liquidity and transparency,” wrote Vanguard’s researchers. “However, liquid alternatives represent a diverse category of alternative strategies. Many of them are highly dependent on active management skill, and thus plan sponsors need to consistently select top managers. Because of this, we exclude liquid alternatives as a general category from further analysis.”

Instead, Vanguard focused on investments Markov’s researchers consider “traditional,” namely, REITs and commodities. Adding a 10 percent commodities allocation or a 10 percent overweight to REITs in a target-date product had, at best, a marginally positive impact on risk-adjusted returns and volatility.

Vanguard’s researchers did acknowledge that adding alternatives would require additional education for participants and plan sponsors. Vanguard also balked at the potential cost of including alternatives in target-date funds.

“Alternative investments generally have greater explicit costs in the form of higher fees, and studies that highlight their benefits without taking cost into account can be misleading,” wrote Vanguard’s researchers. “And, though admittedly more challenging to measure, there are additional implicit costs for sponsors, such as the time, energy and resources required to ensure due diligence manager oversight and additional participant education. These added costs, as well as the increased level of participant confusion, can offset any potential risk-return improvements in a glide path created by an alternative allocation.”

Implementation Issues

The Georgetown researchers noted that including private equity, hedge funds and real estate within target-date funds would require more investor and plan sponsor education and more oversight by plan fiduciaries.

Unlike Vanguard, the authors of the Georgetown report did not think issues like liquidity, pricing, benchmarking, fees and governance would prevent the inclusion of alternatives in target-date funds.

“Defined contribution service providers’ capabilities have vastly improved,” said David O’Meara, head of defined contribution strategy at Willis Towers Watson, in a release. “Operational challenges, including the need for daily liquidity and daily pricing, and participant-controlled cash flows, can easily be addressed. This can already be seen in the increased use of custom funds in defined contribution plans.”

Schwartz fell more on Vanguard’s side of the argument, asking whether private equity, direct real estate and hedge funds made sense in plans.

He questioned the assumption that a 401(k) could handle the liquidity needs of its participants if it held relatively illiquid asset classes.

“I’m not so certain that a defined contribution plan would be able to respond to liquidity needs over a prolonged crisis period—not a day, week or quarter, but in a Great Recession-type environment,” said Schwartz. “I don’t know that they would be able to withstand the liquidity needs while having money locked up in something like a private equity fund.”

The Georgetown center paper also assumes that target-date funds would be able to choose the top managers in private equity and hedge funds, which is probably unrealistic. Large pensions are often unable to access any hedge fund or private equity opportunity they choose, and the best managers often have to refuse money.

Furthermore, there’s a great deal of dispersion in strategy and performance in the asset classes in the Georgetown report, said Schwartz. Actual outcomes would depend on manager selection, and there’s no evidence that target-date managers would be able to identify the best opportunities for their investors.

High fees could also bite into the modest benefits offered by alternative allocations, said Schwartz.

“The fees are a massive trade-off,” said Schwartz. “The ability of higher fees to erode any diversification benefits and alpha over time is very real. … High fees can turn alpha into negative alpha. There’s no question that fees need to be looked at as an issue here.”

Rather than seek alpha from an outstanding hedge fund or private equity manager, target-date investors would be better off embracing diversification by adding more asset classes. Those benefits could probably be accessed at lower cost from the liquid alternative universe, said Schwartz, or in ETFs that replicate hedge fund strategies.

Creating a Better 401(k)

The Georgetown report’s authors argued that there’s a need for better investment options within defined contribution plans. While pensions typically include allocations to alternatives, most default investments within 401(k)s and 403(b)s do not, limiting themselves to stocks and bonds. When they were developed, defined contribution plans were not thought of as replacements for pensions as primary retirement savings vehicles and sources of retirement income, so they did not encompass the same range of investments.

In 2016, the average pension plan had more than 10 percent of its assets dedicated to hedge funds, real estate and private equity—and the average public pension had approximately 25 percent of its assets allocated to alternatives, according to the report.

Because of the marketing issues and the costs associated with alternatives, there’s an ethical question about whether plan fiduciaries should offer certain alternative asset classes in target-date funds, said Schwartz, as these funds have become the default investment of choice within qualified retirement plans. Until additional research is conducted, the question of whether the benefits of alternative allocations in target-date funds exceed the costs remains unanswered.

Nevertheless, the Georgetown/Willis Towers Watson researchers called on policy makers and plan sponsors to implement alternatives within retirement plans.

Even without policy maker action, Antonelli said, “plan sponsors with an interest in implementing portfolios with [alternative] asset classes can work with their advisors, custodians and record-keepers to implement solutions that enhance participant outcomes for a more secure retirement.”