Clearing Hurdles: Landing Private Assets in DC Plans

Private assets have much to offer. What’s holding plan sponsors back?

Target-date solutions play a critical role in retirement outcomes, and we believe adding private assets to the glide path may boost return potential and diversification.

But while interest in and access to private markets have grown over the past decade, these assets remain underrepresented in defined contribution (DC) retirement plans.

Why? Our conversations with plan sponsors have focused on three key fiduciary hurdles: higher expense ratios, litigation risk and liquidity needs. We think sponsors can clear all of them, but doing so requires familiarity with the implications of adding a private dimension.

Of Costs and Benefits    

Let’s start with fees. Adding private strategies to a DC allocation would typically raise the portfolio’s expense ratio. This is partly a result of the added complexity of private strategies, which require active, hands-on management to capture return potential.

Of course, it’s up to plan fiduciaries to determine whether a strategy’s return history—and potential future returns—justify the added cost. Overpaying for alpha potential can harm outcomes for plan participants. But once sponsors recognize that the strategy offers value for money, dwelling on how costs stack up to public fees may obscure some of the benefits private assets offer.

We think plan sponsors should focus on the value that a given strategy offers in exchange for the fee it carries. That includes whether a private strategy has consistently delivered returns in excess of public market equivalents on a net-of-fees basis. By that metric, performance has been strong in recent years (Display).

Adding privates to the mix may also broaden the opportunity set. As the following Display shows, fewer than 15% of companies with $100 million or more in revenue are publicly traded. Credit growth, too, is increasingly coming from private, nonbank sources.

Meanwhile, correlations between public stocks and bonds have risen in recent years, and with inflation likely to stay higher for longer, these assets alone may not generate enough purchasing power for plan participants when they retire, or provide the diversification they need to manage risk.

Legal Arguments

Sponsors have frequently cited litigation risk as another potential impediment to broader private asset adoption. But legal challenges are frequently tied to fee structure and whether plan participants are getting adequate value for the cost of their investments.

We think sponsors can seek to overcome this hurdle by adopting certain safeguards, including a thoroughly documented due diligence process that governs the selection and inclusion of private strategies for a given plan. In our view, fiduciaries should prioritize doing the right thing for participants.

What’s more, the U.S. Department of Labor issued an information letter regarding private equity investments in defined contribution plans in 2020 and a supplemental statement in 2021 providing guidance on the inclusion of private equity investments in target-date funds and the fiduciary responsibility of plan sponsors. Both documents are interpreted by some in the industry to apply broadly to private investments in DC plans.

Natural Liquidity

The relatively illiquid nature of private investments is a concern for some plan sponsors, too. But even on this score, many private investment strategies are becoming more DC-friendly, thanks to three inherent features that create natural liquidity.

First, target-date funds are diversified pools of assets that belong to participants across a wide range of ages. This is important. When older participants need to make withdrawals, younger ones continue to contribute regularly through payroll deductions, naturally replenishing the fund’s liquidity. This ongoing inflow from the young helps to balance out the liquidity needs of retirees.

Second, target-date funds are multi-asset portfolios that typically include public assets, which can be used as an additional source of liquidity when needed.

Finally, the proliferation of evergreen fund structures—private investment vehicles with no fixed term, periodic liquidity windows and imbedded allocations to liquid investments—has enhanced the ability of private strategies to meet participant liquidity needs.

In Search of Better Outcomes

Ultimately, the decision on adding a private dimension to target-date glide paths should depend on the answer to a fundamental question: Does adding private exposure have the potential to improve expected outcomes?

To answer “yes,” we think plan sponsors should be confident that the additional risks and costs justify the potential rewards from integrating a private dimension in target-date glide paths.