DC plans explore alternatives in effort to diversify

Updated with correction.

Seeking to diversify their retirement plan investment menus beyond equities and fixed income, some defined contribution experts are offering alternative investments.

The goal is a long-term one — not just a response to last year when stocks and bonds headed south together — and the results can reflect many months, if not years, of planning and execution.

The challenges are significant. Finding an investment whose returns justify the extra cost is one hurdle. Convincing plans' investment committees is another. And educating participants, especially if an alternative is illiquid, is another.

It took six years of planning before the Washington State Investment Board, Olympia, incorporated in October 2021 assorted alternatives into the target-date series offered to its $18.7 billion 401(a) and $5.4 billion deferred compensation plan participants.

The board wasn't starting from scratch. Its $130.8 billion defined benefit plan invests in various alternative investments through a commingled trust fund. The goal was to give DC participants access to the same investments in the DB trust. The solution was the Total Allocation Portfolio, a unitized version of the DB trust.

"The treatment is similar to shares of a mutual fund," explained James Aber, director of institutional relations for the Washington State Investment Board. "A net asset value is established monthly. The NAV is divided by the number of outstanding units to determine a price. Participants effectively buy units, or fractions of units, when they add assets to their account and sell units when they distribute."

Questions for integrating alternatives into the DC plans focused on cost, performance and cooperation with their record keeper, Voya Financial, and target-date manager AllianceBernstein.

"We saw great performance over decades in our defined benefit plans," said CEO Allyson Tucker. Internal and external analyses showed that adding alternatives to the DC plans via a target-date series could "moderately increase returns and significantly reduce volatility," Ms. Tucker said.

The Total Allocation Portfolio, or TAP, is offered as a component of the DC plans' target-date series for the 401(a) and 457 plans as well as a stand-alone option in the 401(a) plan.

The DC plans' investment lineup also includes eight common stand-alone options.

As of Sept. 30, the target-date series had $6.1 billion in assets, and the TAP accounts for 10% to 25% of target-date assets depending on the vintage — a participant's expected retirement year.

Within TAP, private equity accounts for 28.93% of assets, real estate represents 22.39% and tangible assets account for 6.51%. There's also public equity (23.62%) and fixed income (17.67%), with less than 1% devoted to innovation and cash.

The board selects the underlying investments for the target-date series, but it consults with AllianceBernstein on those investments and in the development of a custom glidepath. AllianceBernstein sets and rebalances the assets for each glidepath.

The previous target-date series was primarily a mixture of passive equity and internally managed fixed income. The board knew that TAP would add to the management fee — rising to 20 basis points from 12 — for the target-date series.

"Fees were a constraining factor in our analysis," Ms. Tucker said. TAP could have added more alternatives but executives decided to refrain. Ms. Tucker said it's possible additional alternatives could be added in the future.

Getting TAP to DC participants required considerable behind-the-scenes work.

"Operational issues had to be addressed when including the TAP within the glidepaths of the TDFs," Mr. Aber explained. "The TDFs are priced daily, but the TAP is typically only priced monthly, although we do have the ability to price the TAP intramonthly as needed."

Participants receive daily liquidity information, "but given the TAP's pricing mechanism, the TDF manager only rebalances the TAP option monthly if necessary," he added. "We also worked with the Department of Retirement Services to modify the record-keeping system to support the TAP's monthly pricing mechanism within each TDF."

The board also had to educate participants. Plan executives used web messages and printed flyers. In the end, "there were more questions than normal," Ms. Tucker said. "But few were negative."

The $688 million 457(b) plan of the New Mexico Public Employees Retirement Association, Santa Fe, added direct real estate to its target-date series based on a recommendation by its consultant, Meketa Investment Group, that it would increase diversification and decrease volatility, said Karyn Lujan, the deferred compensation plan manager.

"We had to educate the board that this could strengthen the portfolio," she said. Plan executives presented the investment to the board in February 2017; the fund was added to the target-date series in the fourth quarter of 2017.

Plan managers didn't consult participants, but there were no negative comments from them, Ms. Lujan said.

The real estate investment is in the Prudential PRREF II Fund, which is about 85% direct real estate and 15% real estate investment trust, she explained.

"The underlying REIT component is valued daily, but they also have a mechanism to daily value to the private (direct) part of the portfolio," she said.

"The private investments are not going to be bouncing around by a percent or two every day like the REITs based on the sentiment of the stock market, but they do make real time adjustments when a property is sold, for example," she said. "The income generated by the underlying properties is also accrued on a daily basis."

This fund replaced an Invesco Ltd. global real estate investment trust fund as part of the target-date series. The Prudential fund had a net annualized return of 7.55% for the five years ended Dec. 31. During that same period, the Invesco fund had a net annualized return of -0.82%, Ms. Lujan said.

A separate REIT fund with $1.3 million in plan assets remains a stand-alone option. The 457(b) plan has 17 core options and a target-date series provided by Voya Financial.

The target-date series had $187 million in assets as of Sept. 30, or 27.2% of the total assets. The Prudential fund accounts for 8% of target-date assets.

The target-date series offers exposure to other alternatives — such as infrastructure, natural resources, commodities and real estate — through the publicly traded Principal Diversified Real Asset Institutional Fund, which has been part of the target-date series since the second quarter of 2012. This fund accounts for 5% of target-date assets.

For the State University of New York, Albany, real estate is an investment menu diversifier, said Michael Consorte, director of university-wide benefits.

For 18 years, participants using TIAA-CREF as a record keeper have been able to invest in the TIAA Real Estate Account, with about $1 billion in plan assets including $250 million in real estate investment trusts and $750 million in direct real estate. The option invests in residential and commercial real estate. Approximately 40,000 participants of the 115,000 SUNY participants for whom TIAA is the record keeper have invested in this option.

"We maintain diversifiers on the lineup for the do-it-yourselfers and managed account managers to pick from when making their asset allocations," he explained.

The stand-alone account is only for participants using TIAA as a record keeper, one of four record keepers available to SUNY employees and retirees. TIAA accounts for about $20 billion of the $22.2 billion in assets among the university's 401(a) and 403(b) plans.

The investment menus are basically the same across the different plans, although only 401(a) participants are allowed to annuitize. For example, among other things, each record keeper offers an actively managed target-date series as a qualified default investment alternative, passive and active large cap domestic equity investments, passive and active U.S. fixed income investments, a money market fund, and a stable value fund.

None of the other record keepers offers alternative investments. The TIAA target-date series invests in direct real estate and Treasury inflation-protected securities.

With 170 investments available to participants covered by the four record keepers, each offering 42 to 45 choices, Mr. Consorte said university officials are reviewing consolidation of record keepers and investments.

University officials also have taken first steps to explore offering a custom target-date series. This is "in the very early stages of due diligence, to learn about them before considering implementation," he said.