The Inclusion of Alternative Assets in DC Plans: What Are the Opportunities and Challenges?
Perspectives from Retirement Plan Sponsors
By Chris Nikolich, Brad Creel, Dan Larsen, and Marco Merz
Interest in including private investments in defined contribution (DC) plans continues to grow as plan sponsors look for ways to improve participant outcomes by offering alternative diversifiers. On November 10, 2021, four leading industry associations — the Defined Contribution Real Estate Council (DCREC), Defined Contribution Alternatives Association (DCALTA), Defined Contribution Institutional Investment Association (DCIIA), and Pension Real Estate Association (PREA) — collaborated on a webinar that brought together several industry experts to discuss their experience with adding alternative options to DC plans. The full panel discussion can be viewed here, and highlights are presented below in Q&A form.
These questions were posed by moderator Chris Nikolich, who leads AllianceBernstein’s Glide Path Strategies in its Multi-Asset Solutions business. The three panelists were:
- Brad Creel, who manages Lockheed’s $3 billion real estate portfolio and oversees the real estate investments in their DC plan. Creel was recently part of a committee tasked with providing more innovative options to DC participants.
- Dan Larsen, who manages various real estate portfolios for the state of Utah’s defined benefit (DB) plan and oversees the state’s private real estate investments for its DC plan.
- Marco Merz, head of DC plans for the University of California. He is responsible for plan design, investment strategy, and execution of the chief investment officer’s (CIO’s) business plan, as well as overseeing $34 billion in 403(b), 457, and DC assets.
Why should we include alternatives such as private real estate and private equity in defined contribution plans?
Creel: In our case, we sought high-risk–adjusted returns with low correlations to the other asset classes, and we needed to modernize our options. This meant recognizing that our target date funds (TDFs) were drastically underutilized compared to our peers. We also had too many options. We needed to streamline, cutting the non-performers and anything that was underutilized. In this process, we knew we needed to simplify, and we wanted to innovate where we could. Ultimately, we were trying to improve retirement outcomes for our plan participants.
Merz: We, as plan sponsors, need to remember that participants on the DB side are the same people on the DC side. On the DB side, participants generally have access to private equity and the greater potential for returns that offers, and those in DC plans do not. Going forward, wealth accumulation increasingly will happen on the private side before going public. That, of course, is even more of a problem for DC plans, as we will see an even greater widening of the gap between expected returns on the private and the public sides. That nuance in private for longer is going to be a real challenge down the road. We, as plan sponsors, have to solve that, and quite frankly, we need to remember the philosophical disconnect that our participant base is identical. That is fundamentally why we believe it is so important to incorporate alternative assets, and especially as we go forward. If you look at virtually every plan in the country, we are all increasing our strategic asset allocation to privates on the DB side. For us, that is fundamentally why we believe alternatives should be in the DC plan.
What were some of the key considerations that you helped solve as you thought about incorporating alternatives in the DC plan? What were some of the actual versus perceived obstacles in this process?
Larsen: We had to jump through several hoops, beginning with the concept phase, and we had to bring together the DC and DB teams. The DC team are experts on the structure and the administrative side. On the DB plan side, we are more experts on questions of determining whether this is a good manager, real estate proxy, etc. We had to learn what really mattered to each team.
Daily valuation and liquidity are realities that we do not deal with on the DB team. We had to educate ourselves, first and foremost, about what is important to the DC team — but we also had to let them know what is important to us. They have a consultant who focuses on the administrative side. We have a consultant who helps us decide what good investments are. We also met with many managers multiple times to make sure all the DC questions were being answered, and all the DB questions were getting answered.
We held a lot of brainstorming meetings to work through the issues. Our legal, compliance, and administration teams were involved, with huge concerns about liquidity. We were just coming out of a financial crisis, so we wanted to make sure we had appropriate guardrails in place if we went through another downturn.
Are the DB and DC cohorts or groups within Utah continuing to work more closely together because of this partnership that was developed by incorporating privates into the DC plan?
Larsen: Yes — a lot of the learning we have taken from the real estate side, we are applying toward some of the other alternatives, because they are not nearly as far along as private real estate is. But it was good to have forged the relationships and communication internally — to be able to work on both sides and not be so siloed.
Once you have decided to start including alternatives in your plans, how do you make it happen? Can you describe a roadmap for the process for incorporating alternatives? Who needs to be involved, both internally and externally, as you embark on a project such as this?
Merz: For us, it started with the office of the CIO. We have our academic senate, which is the representation for faculty that we needed to get on board. That was relatively straightforward. The biggest hurdles were our HR staff and our legal staff, quite frankly: having those two stakeholders on board, helping them understand, and getting over the hurdles. On the plan sponsor side, I often hear reasons such as “We cannot do this” or “We do not want to do this,” which usually means, “There is fiduciary risk, the fees are high, and valuation and liquidity are a problem. And that is why we should not be doing it, right?”
To work through those challenges and help people understand that each of them can be overcome, you must start very early and engage stakeholders from the get-go of a project. That was critical for us — getting stakeholders involved early rather than telling them, “This is what we worked on. This is the strategy.” And, in the case of HR: “Now, just communicate this for me.” That would not be a successful way to achieve your goals. That is true for every change of the DC plan. Get your stakeholders involved early; make them part of the team that thinks about this as you incorporate changes, particularly in alternatives. The communication aspect is critical from my perspective.
Which external parties might need to be a part of that process as well? How can they help?
Merz: It depends on your size. For a larger DC plan, engagement of external partners will depend on how many resources you have internally. If you have a dedicated private real estate team, as we do, you will not have to rely heavily on outside help. Going down the spectrum in size, it will be critically important to consider an outside consultant. That nuance between larger and smaller plans will factor into how you incorporate private real estate.
We have a fully diversified real estate private equity portfolio. Our plan is to unitize those assets and hold a fully diversified, fully seasoned, vintage, diversified portfolio that we simply carry from the DB plan to the DC plan. That is a luxury we have, because we have those internal resources and portfolios. That will be different for a smaller plan, so it is dependent on the individual plan sponsor.
What would you do differently if you went through this process again?
Creel: We were very fortunate in that all the parties involved (from our internal DB side investment committee to the corporate side, the CFO, CIO, the treasury functions) were on board. Everyone involved needs to understand the enormous time commitment necessary to identify red flags early, and to always remind all parties that no matter how many red flags pop up, these orders come straight from the top.
At the end of the day, I think we overlooked how necessary the internal communications team would be. No one involved should be overlooked. The legal department understood from the outset how much work this would be. If we had to do it again, I would add resources to Team Legal ahead of time for some of the groundwork.
As you consider the risks and the benefits of adding alternatives to DC, how do you respond to questions about fees and litigation risk?
Merz: I will start with fiduciary risk. As plan sponsors, we need to ask ourselves if it is worth taking on the fiduciary risk. If everyone on our team agrees, yes, there is going to be some fiduciary risk, but it is worth taking, then we move forward. These are the discussions that we are having internally. It also depends on where you think about incorporating privates. If it is on the standalone side, the fiduciary risk is probably higher than it is under the hood of the target date fund. All those issues — fiduciary risk, liquidities, fees — become much more muted when you incorporate these strategies into the target date fund.
With fees, we are all a little bit guilty of our own success. For years, we have talked about how we have been able to reduce fees, costs, and administrative charges. Now, we need to teach our board that fees should not be considered in isolation. Instead, we should be focusing on improving outcomes for participants. If you have to pay a bit more for better expected returns and outcomes, then you should be taking on higher fees.
Before you approach your board about incorporating alternatives, the first step should be to update this narrative about fees. They are important, but they have to be viewed in context. Prepare your board for the time when you will eventually go to them and say, “I want to include private equity. It costs substantially more, but we need to do it.” Then, ideally, your investment committee or your governing board would be able to respond, “Yes, we have talked about this. We have reduced fees, but fees cannot be viewed in isolation.” I think laying down crumbs on the way is going to be really important.
Then, what follows is the point that the DB plan is outperforming the DC plan, and private equity is outperforming public equity. If you start having that conversation with your governing board, show them how expected returns and actual returns have improved on the DB side. Then, look at the DC plan. Start with why we are doing this on the DB side, rather than talking about fees first.
Could you address liquidity and daily valuation, both inside products and outside?
Creel: For us, liquidity fears led ultimately to having an option in real estate but not having an option in private equity (PE) yet. When we looked at the plumbing and how the daily value funds worked, we felt some of the real estate offerings were well ahead. We do not want to see a high Real Estate Investment Trust (REIT) component to subsidize a participant’s need to bounce in and out of these vehicles on a daily basis, but we understood the need for the plumbing to work. It is a bit of a necessary evil to have exposure to the REITs. The foundation of why we wanted private real estate to begin with was that we felt as if the public real estate was already there, just with more equities.
What I think we will see next is more offerings on the DC side that have this plumbing figured out. Marco and his team should be applauded for their attempts toward unitization, and where they already have it and the expertise that built it. For us, we felt fears of litigation risk, or perhaps it was the easier path than going through the re-enrollment.
Merz: I would add that obviously the traditional players — the recordkeepers, custodians, consultants — are thinking about these issues. There is also good innovation in how to value these on a daily basis, especially on the private equity side, with the real estate space being much farther ahead than private equity.
How do you go about providing information to participants that they need to make informed choices? And maybe how do you think about it differently if, as you mentioned earlier, the alternatives are offered on a standalone basis, or if they are offered as part of the multi-asset class portfolio, such as a target date fund?
Merz: We are part of the CIO’s team, and we use the jargon of investing, so, we realize it is critically important to have somebody who can translate that industry jargon into words almost everybody will understand. We have 300,000 individuals, and they are not investment professionals. I cannot expect them to understand what we are talking about. With anything we do, the partnership between HR and us is vital. It is not our team’s purview to create collateral and content in education. That is on the HR side.
One of the first things we did was to make sure we had an ongoing bond between those two teams. That is not unique to alternatives, but having ongoing connectivity is critically important. We sometimes get outside help to translate some of those more complex parts down to easy, digestible, and understandable bites. We need to remember that the way we talk about privates is not going to be the way it is digested by participants.
Within the target date fund, I almost do not think that has to be hugely discussed and broadly explained because the overarching wrapper does not change. It is just an additional asset class. You do not necessarily communicate when you move from Active Manager A to Active Manager B either, so communication will be more important on the standalone side than it is on the target date fund side. But the critically important thing is getting help from somebody who can translate the industry-talk that we are so used to into understandable content for the participants.
Ultimately, if you are adding private real estate or private equity to your core lineup, and then you are trying to explain to your participants why that is a good exposure they should be having, the uptake is going to be negligible. That is true for almost any new exposure or new fund you add to a DC lineup. That is the other thing I would think about: Are you really going to get significant assets into private real estate and private equity for participants if you simply offer a standalone solution? The answer is no. That was, for us, another reason for getting this into the target date fund, because it is great to talk about how risk-adjusted returns are better on private equity and private real estate, and to say, “Let us add a lineup item to it.” The reality is you are not going to get many assets into it on its own.
That is the other thing about helping participants understand this. It is important, but sometimes — and this is going to sound blunt — force-feeding is the right way to go about things. We do auto-enrollment and auto-escalation these days. Getting private equity — private real estate — into a DC plan, ultimately, in my view, is only going to happen through the target date fund, not through a standalone sleeve.
What, if anything, are you thinking about for the future as it relates to alternatives?
Larsen: We are looking at other alternatives, private equity as well, where we have also had many conversations about unitizing, just to see how that would work. We have no firm conclusions on that yet, but we are exploring it and trying to figure out what ultimately is best, given our constraints, size, and all the other variables. Part of the reason for even looking into it is opportunistic, just as we are looking forward into the space of private real estate. It feels a little like the early 2010s, when a lot of the options that were available to us just happened to be managers saying, “We have a large, open-end, commingled fund; let us provide some sort of an option so defined contribution dollars can be invested in this,” which is great.
That was probably needed, but it was not specifically designed for these dollars.
It also feels like right now, the DC dollars are going to get very large. I am trying to think of the evolution of this space — the evolution of products that will be available, managers, and options. Right now, it is good. You can put dollars into these large, commingled funds, but comparing that to the DB side, we do not just put all our dollars into one manager and call it good. That is one thing we would like to look at: maybe more options and more creativity on the DC side.
Are there any other key takeaways or insights you would like to share?
Creel: We are in the early days of real innovation here. It is interesting, and our next step obviously is going to be in private equity, so we are watching the Department of Labor (DOL) and we are watching the GPs. We’re seeing a rapid evolution in terms of products. Watch the regulatory, watch who is going to build a better mouse trap, and we go from there. But that is what we are doing: monitoring.
Merz: Ultimately, it is going to take a village to get broad adoption. We have talked about fees and regulatory challenges. The sponsors today are doing a great job. Anything we can do jointly as plan sponsors and consultants to drive the narrative of why this is important, and get that voice collectively out there, is going to be important. We need to do more to gain broad acceptance, and it has to be a concerted effort. We all need to drive the narrative that we are doing this to improve outcomes for our participants. Tying this all back together, this is not about private equity or real estate — this is about improving outcomes. If we go back to those basics, this is going to end up working.
Chris Nikolich is a Senior Vice President and Head of Glidepath Strategies, Multi-Asset Solutions for AllianceBernstein; Brad Creel is the Director of Real Estate Investments for Lockheed Martin; Dan Larsen is a Senior Portfolio Manager for the Utah Retirement Systems; and Marco Merz is Managing Director and the Head of Defined Contribution for the University of California
January 2022, 22-01
Angela M. Antonelli, “The Evolution of Target Date Funds: Using Alternatives to Improve Retirement Plan Outcomes,” Center for Retirement Initiatives, McCourt School of Public Policy, Georgetown University and Willis Towers Watson, Policy Report 18-01, June 2018.
Defined Contribution Alternatives Association (DCALTA)-Institute for Private Capital (IPC), “Why Defined Contribution Plans Need Private Investments,” October 2019.
Defined Contribution Institutional Investment Association (DCIIA), “Considerations for Offering Private Equity in Defined Contribution Plans,” July 2020.
Defined Contribution Real Estate Council (DCREC), “Evolving Landscape for Liquidity within DC Plans,” September 2021.
Michael P. Kreps and Angela M. Antonelli, “Use of Alternative Assets in Target Date Funds: Challenges, Strategies, and Next Steps,” Center for Retirement Initiatives, McCourt School of Public Policy, Georgetown University, Policy Report 20-01, February 2020.