Ross Bremen spoke about what the new guidance signals for the future of defined contribution plans in a recent PLANSPONSOR article.

Last week, the Department of Labor (DOL) issued an Information Letter that essentially approves the use of “a professionally managed asset allocation fund with a private equity component as a designated investment alternative for an Employee Retirement Income Security Act (ERISA) covered individual account plan.”

Ross Bremen, a partner in NEPC’s defined contribution (DC) practice in Boston, says it’s not a new consideration. “Pension plans and other institutions include private equity as a source of additional diversification and returns, and over the last decade or so, DC plan sponsors have also looked to include private investments to get return enhancement and smooth volatility over time,” he notes.

“At a high level, anything that gives plan sponsors the ability to do what’s in the best interest of participants is a good thing,” Bremen adds. “The DOL letter saying the inclusion of private equity in asset allocation products is not a violation of law gives plan sponsors flexibility if they believe including private equity would be in participants’ best interest.”

On a more granular level, sources say the DOL letter opens the door for investment managers to build products—and plan sponsors to use them—to create better outcomes for retirement plan participants. David O’Meara, an investment consultant with Willis Towers Watson in New York City, points out that the letter Groom Law Group sent to the DOL that resulted in the issuance of the Information Letter cited a 2018 paper from Willis Towers Watson that suggested allocating to a more diversified portfolio with alternative investments improved expected outcomes by 17% while also improving downside risks.

Results of a study published in November by Neuberger Berman research partner the Defined Contribution Alternatives Association (DCALTA), in collaboration with the Institute for Private Capital (IPC), suggest that including private equity funds in defined contribution plan portfolios both improves performance and has diversification benefits that lower overall portfolio risk.

“DB [defined benefit] plans are touted as more successful in risk and reward because of their ability to diversify into private markets,” notes Scott Brooks, head of distribution and chief operating officer (COO) of RealBlocks in New York City. “It is prudent for DC plan sponsors to consider the inclusion of alternative investments.”

Issues With Private Equity in DC Plans

There are definitely challenges with accessing private equity in DC plans, O’Meara says. DC plans are a daily liquidity, daily priced environment and private assets don’t trade every day so they don’t have an explicit price. Private investments are in companies that are not publicly traded and are looking for seed money.

Valuation and liquidity issues are reasons the DOL did not sanction private equity as a standalone investment option in DC plans. “Liquidity just needs to be well managed,” O’Meara says. “If private equity is put into a multi-asset fund where the private equity portion is 10% or 20%, other assets can satisfy daily liquidity needs. As long as private assets are set at a reasonable level, I think liquidity can be managed with no issues for participants.”

Bremen says information about private investments is not as readily available as data about public investments, and the private market is not regulated the same way as public markets. Fee structures are also different and can be high. This is why he suggests that plan sponsors need experts that are familiar with these types of securities.

The DOL Information Letter detailed considerations for plan sponsors in the selection and monitoring of private equity investments as part of an asset allocation vehicle. O’Meara says DC plan sponsors should first evaluate their governance structure to see if they have the capability to facilitate the use of private equity within asset allocation funds in their plans. “It is a complicated asset class and it can be difficult to understand and to know how to allocate to. Plan sponsors need to have the scale in their plans to justify the cost. They need to determine whether they have internal expertise or need to hire someone, as well as to determine whether they think it will provide value to their own participants,” he says.

Bremen points out that the legal environment has shown that plan sponsors may be criticized for anything they do. “So for any plan sponsor that decides to go down the route of private equity, a prudent process will be critical to address things the DOL laid out in its letter. And it needs to be documented. The DOL points out considerations around risk, performance, fees and also participant communications,” he says.

The How

Including private equity as an underlying asset in DC plan investment vehicles is not new. It has been done successfully by others. Earlier this year, Serge Boccassini, head of institutional global product and strategy at Northern Trust Asset Servicing in Chicago, said he examined the mandatory “Superannuation Guarantee” contributions program in Australia. “Many investments in those plans include assets in illiquid alternatives, such as private equity and real estate,” Boccassini said.

He added that alternatives are incorporated in the balanced fund—the default fund for superannuation plans. These funds are the typical 60% equity/40% fixed income split, and, on the equity side, between 2% and 15% is invested in alternatives. From a liquidity perspective, it works, because buys and sells needed are made with cash and liquid investments other than alternatives.

Boccassini has seen the inclusion of alternative assets result in better rates of return and a better response to challenges when the market slides.

In the U.S., when markets started to flatten and investors, including retirement plans, weren’t getting the same types of returns, many plans went back to a master trust strategy, or one in which multiple plans—DB or DC—could be combined into one investment trust, and assets could be unitized, according to Boccassini. He explained that if a large plan sponsor has a DB plan with a global equity portfolio that invests in 50 stocks, with 20 in private equity, including venture capital and buyout funds, it can allow its DC plan to invest in that portfolio. For the DC plan, the global equity fund can represent 60% of the plan’s balanced fund.

If a plan sponsor only has a DC plan, it would sit down with an asset manager or consultant to create a separately managed balanced fund or a target-date fund (TDF) with assets in private equity. Boccassini said there exists both the technology and processes to peg illiquid assets to the actual trading market through marketable assets and to peg to them to an index. The net asset value (NAV) can be calculated every day, using plus or minus cash flows and what happened in that particular industry.

There are also providers such as iCapital, Artivest or RealBlocks that can facilitate the implementation of private equity in DC plans. Perrin Quarshie, CEO of RealBlocks in New York City, says RealBlocks is a technology platform built to accelerate distribution of alternative investments and private real estate. It connects managers with products. “The unique thing about our system is a built-in mechanism for feeder funds or collective investment trusts [CITs] for secondary trading. We have the benefit of allocators to conduct secondary trades,” he says.

Brooks further explains that there are a variety of ways to accomplish the integration of private equity in DC plans. “One easy solution is creating vehicles that combine private market funds with public market vehicles to provide the liquidity bucket in portfolio,” he says. “Secondly, lines of credit in a portfolio can be used to provide interperiod liquidity. Third, a fund can use secondary sales of underlying funds that may be illiquid—that is something RealBlocks can help with.”

Brooks continues: “The way we see us contributing to this is providing the appropriate packaging in in the form of CITS or other solutions that are constructed to meet liquidity and valuation demands placed by DC plan fiduciaries and asset allocation funds that can invest in the vehicles we provide. As an example, if there is a private equity fund with a 10-year lockup, we could construct a feeder fund with the ability for secondary trading. That would allow a TDF manager to buy and sell units to other buyers to obtain liquidity to satisfy the needs within the TDF portfolio.”

Brooks points to DCALTA, the Defined Contribution Institutional Investment Association (DCIIA) and the Defined Contribution Real Estate Council (DCREC) as resources for plan sponsors to learn about the “how” of implementing alternative investments in their DC plans.

Brooks and O’Meara said they think the DOL Information Letter can open up possibilities for other alternative investments to be included in DC plans. “I think the guidance that the DOL gave in its letter can be applied to other asset classes,” O’Meara says. “The question was specific to private equity, but the process and considerations detailed by the DOL appear to be able to be applied to other less common asset classes like real estate and hedge funds.”

“This is an important step forward in my mind for a business that has been stifled in innovation because of heavy regulator pressures and heavy litigation concerns,” Brooks says. “Innovation is sorely needed to improve retirement outcomes.”