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.