Could alternatives fit in retirement portfolios?

The popular diversifiers are beginning to draw the attention of 401(k) plan sponsors.

Nov 17, 2013 @ 12:01 am

By Darla Mercado

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Retirement plan consultants are seeing heightened interest from their large-plan clients for alternative investments, looking at the asset class as a way to mitigate the ill effects of inflation on participants' savings. Plan sponsors are supplementing their core menu of large- and small-cap stocks, fixed-income and stable-value instruments with investments such as commodities, hedge fund strategies, real estate investment trusts and Treasury inflation-protected securities.

However, there is more to adding alternatives to a retirement plan than just plopping new funds into a 401(k)'s menu. Retirement plan consultants and financial advisers note that plans need to find a happy medium between diversifying the lineup and keeping it easy for workers to understand.

“We definitely have been seeing [plans] incorporate alternatives into custom target date funds with a few of our larger plan sponsors,” said Daniel Farkas, senior investment consultant at Morningstar Investment Management, a division of Morningstar Inc. that provides investment advice to retirement plans.

“These are plan sponsors who are in the billions of dollars, are established companies and have defined-benefit pensions that have been in alternatives,” Mr. Farkas said. “So they're familiar with them and comfortable enough with them to incorporate them.”

Small plans tend to stay far away from alternatives, simply because they may not have the in-house expertise to handle the investments, and may not have the same priorities as their large-plan counterparts. Small employers tend not to be attracted to the latest investment trend.

“Let the big players — the manufacturers, the jumbo- and large-plan markets — figure it out,” said Jason C. Roberts, chief executive of the Pension Resource Institute. “Do you really want to add layers of complexity? Do you want to detract from common-sense things you can do to help your participants?”


But on the large-employer side, firms are looking to jazz up their investments by working in alternatives in a variety of ways. For instance, there's the idea of adding alternatives through a custom target date fund, which will call for the creation of a diversified portfolio of alternatives to act as a component of the target date fund. Concentration to the alts, at least in Mr. Farkas' experience, tends not to exceed 10%; that peak is reserved for the middle part of the glide path.

You might also see alternatives as part of a multimanager open-architecture asset class solution. “Here is your real assets portfolio, and that's where you might see commodities show up,” said Drew Carrington, head of defined contribution-institutional at Franklin Templeton Investments.

The benefit is that participants aren't the ones making the call on how to work the alternatives into their investment plans, and they're not deciding to go all-in on alts just because it's trendy — what Mr. Carrington refers to as “the running-with-scissors problem.”

“You aren't asking the participant to make a decision about commodities, but they get the exposure through a professionally managed solution,” he said.

Streamlining fund menus also has been a priority for large companies that want to add alternatives without making their selections complicated.

“We believe that offering fewer options helps participants focus their attention on what's important,” said David O'Meara, senior investment consultant at Towers Watson Investment Services Inc.


Those who want to add alternatives may want to consider consolidating their major asset classes. For instance, if they offer six U.S. equity options, try to collapse that into one investment so that participants have some bandwidth to comprehend the new menu additions, Mr. O'Meara suggested.

The biggest stumbling block with incorporating alternatives is communicating them to employees. “You want to get internal and external counsel on whether this is something they can support from a legal point of view and be comfortable with the communications sent out to participants,” Mr. O'Meara said.

It might also help to inform plan sponsors that adding alts into the mix may have a dampening effect on returns in some situations.

For instance, real estate investments, commodities and TIPS inside target date funds had less-than-stellar returns compared with other asset classes for the trailing-12-month period through Sept. 30, according to data from Ibbotson Associates. Real estate had returns of 6.2%, while commodities were down 14.3% and TIPS were down 6.1%. In turn, target date funds with exposure to those asset classes suffered a bit, according to a report from Ibbotson.

Regardless of how advisers incorporate alternatives, employees and employers need to rationalize their expectations and understand how alts work, as well as the fact that they can zig when other investments zag. A hot alternative investment doesn't guarantee strong returns.

“If the last five years have taught us anything, it's that REITs are the opposite of real estate,” said Michael J. Francis, president of Francis Investment Counsel. “In the spring of this year, when real estate started to come back, REITs got creamed because rates are moving up again.”

“For alts in general, if you're going to give people the tools, you need to give them the instructions on how to use them,” he added. “Education is key.”


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