If you participate in most 401(k) or other defined contribution retirement plans, you should be angry. Almost every investor class in the world except yours has access to alternative investments—including private equity, private real estate and hedge funds.

Alternative assets can strengthen and diversify retirement portfolios. They can enhance returns and dampen risk. Yet the vast majority of employers do not use or offer them in their DC plans, even if their traditional defined benefit plans do. DB plans are usually closed to new employees but remain available for workers hired at a company in the past. 

Alternative assets are still widely used in these traditional pensions because companies know these investments generate better returns and lower risk in the portfolios. Yet the participants themselves don’t actually benefit from this strategy, because their payouts are the same whether or not the company uses alternative investments. (The benefit is defined, after all.) Instead, if the investments do their job and diversify the portfolios properly, the company itself benefits, because it will need to put less of its own money into the pension over time.

There’s nothing wrong with that. A smart company is simply making a pension promise and funding it through smart investing.

But defined contribution participants don’t benefit from defined benefits. They have to fund their own retirements and make their own diversifying securities choices. Yet no matter how sophisticated these participants are, the vast majority of employers will not offer them alternative investments as plan options.

OK. So let's say these employees are not actually so sophisticated and barely know stocks from bonds. No problem. That’s when target-date funds come into play.

Congress has made clear these funds are approved for DC plans. It doesn’t matter if you don’t know how much you should have in Treasurys or corporate boards, or know how much risk you should have in your portfolio at age 35 or 65. Instead, the target-date fund knows when you are supposed to retire, and a sophisticated institutional investment manager can make all those decisions for you—using alternative assets in that effort to generate better risk-adjusted returns.

Not only are these funds professionally managed, but in June 2020 the Department of Labor published guidance indicating that they’re actually especially appropriate for alternatives (as long as they’re handled by sophisticated third-party investment managers).

So target-date funds use alternatives, right? Wrong. Actually, very few of them do.

Why don’t they? Well, they make many excuses.

For example, they claim alternatives are too complex, even though that makes no sense. The investment staff of the traditional pension plan has enough expertise to use alternatives. Even if your company doesn’t have a traditional pension, if it offers a target-date fund, the institution managing it has the required expertise.

The second excuse is that there’s no daily valuation in alternatives (because most of these assets don’t trade daily). But a lengthy paper on this topic by the Defined Contribution Alternatives Association has shown how it can be done. Market proxies and modeled behavior can be used that rely on well-established techniques.

The third excuse is that alternatives aren’t liquid enough, something target-date funds need them to be. But these funds can still offer liquidity with alternative investments in their portfolios—in a variety of ways. For example, they can maintain a cash buffer or include assets with higher liquidity profiles.

At this point, you might console yourself and think, “Well, at least I’m in the same boat as other individual investors. If institutions can invest in these assets and individuals can’t, maybe that makes sense. Besides, I’m no worse off than the other guy.” 

Except that’s not true. When the other guys are wealthy—“accredited” or “qualified” investors—they’re allowed to invest in alternative assets while you aren’t. 

The two real reasons employers don’t adopt alternatives in 401(k) and other DC plans is because of the supposed complexity and fees.

If you are reading closely, you will think, "Didn't he just say complexity is not an appropriate reason?” We’re talking about something different here: the pension and benefits departments and record-keepers at DC plans are busy. This topic requires extra work for them, and it can indeed be complex. Besides, there’s no outcry from employees asking for the new assets.

That’s no excuse, of course. The plan sponsor is a fiduciary and owes the worker a prudent person standard of care. That includes, among other things, a duty to diversify investments. It is widely known that alternatives can help with that and meet the prudent person standard. It is time for employees to insist on this kind of diversification, for advisors and consultants to promote it, and for employers and target-date fund managers to provide it.

The question of fees is a legitimate issue. Costs and fees are always important, and alternative assets often do charge higher ones than other investments. But the real question to ask is about the value provided after fees. As we discussed before, the diversification these assets can provide can be very powerful. The general rule is that fees must be reasonable. And that can be taken care of with an appropriately limited allocation to alternative assets that’s blended with more traditional assets to create a target-date allocation—and with total expenses that are reasonable for an ERISA plan.

So if you think your 401(k) should be allowed to use alternative investments and you don’t want to look for a job at one of the rare plan sponsors that do offer these options, then call your benefits department and tell them you want them to meet the prudent person and diversification standards of ERISA and to provide a target-date fund with exposure to these important investment classes.

And if you are an advisor, remind your plan sponsor clients that this is prudent person fiduciary activity.

Charles E.F. Millard is the former Director of the U.S. Pension Benefit Guaranty Corporation.