How plan sponsors can bring alternatives into retirement portfolios

As alternative investments become increasingly accessible to defined contribution plans, plan sponsors and advisors are facing new questions about suitability, education, and fiduciary responsibility.

Chip Castille, managing director at Wilshire, spoke with InvestmentNews about how sponsors can thoughtfully bring alternatives into participant portfolios while maintaining balance between risk, liquidity, and opportunity, noting that identifying which participants are most appropriate for alternative investments starts with assessing risk.

“Plan sponsors and advisors determine which participants are best suited for alternatives in retirement accounts generally by considering the risk of the investment option,” he says. “In cases where liquidity is restricted, sponsors and advisors can use an approach that is similar to how they determine risk. In much the same way that sponsors consider the appropriate levels of risk for participants by evaluating the relative amounts of human and financial versus an average risk preference, sponsors can determine appropriate liquidity needs by comparing the relative consumption of near- to medium-term consumption from wages or 401(k) account balances.”

For Castille, alternatives serve a familiar purpose in a diversified retirement portfolio, similar to that of any other asset classes.

“Alternatives provide return and risk opportunities that can be considered for use in a portfolio to the extent they enhance return and also offer the opportunity to diversify and manage the uncertainty of outcomes,” he explains.

Education and visualization tools are critical for participant understanding and Castille says that plan sponsors should consider giving participants tools to compare and contrast portfolios with and without alternatives and let them see the impact of restricted liquidity on consumption needs over long periods of time.

Integrating alts into DC plans

Recent innovations are making it easier to integrate alternatives into DC plans.

“Interval 40-Act funds and semi-liquid collective funds are making alternatives easier to use in DC plans,” Castille says, pointing to structures that allow limited liquidity while remaining compliant with ERISA and other regulatory frameworks.

For advisors, Castille advises viewing liquidity considerations through the same fiduciary lens as investment risk.

“Just as advisors consider risk preferences when designing retirement plans, they must also consider liquidity preferences when adding alternatives with restricted liquidity,” he says. “They should be looking for ways to extend current best practices that incorporate liquidity preferences and make allocation decisions while considering both simultaneously.”

Balancing those liquidity needs is especially important for participants who may need access to savings over shorter horizons.

“Sponsors and advisors can determine appropriate liquidity needs by comparing the relative consumption of near- to medium-term consumption from wages or 401(k) account balances,” he says.

Technology’s expanding role

Technology, Castille says, is transforming how advisors handle the complexity of alternative investments in retirement portfolios, especially in portfolio construction, performance measurement, and risk management.

“In portfolio construction, we are incorporating liquidity preferences into existing best practices,” he says. “In performance measurement, we are developing new statistical techniques to make public and private performance measurement directly comparable, and in risk management we are developing new databases to better understand the real diversification ability of adding alternatives to retirement portfolios.”

As the market grows, economies of scale could help reduce costs over time, but with limitations.

“It’s important to remember that a lot of alternatives markets are deal driven, meaning that compared to public markets, there may be both limited knowledge of which deals are available and the number of deals,” Castille cautions. “Most industry observers assume there are more companies in private markets and venture capital, but the capitalization of those companies is fairly small by public company standards.”

Castille notes that regulators appear increasingly open to the inclusion of alternatives in retirement plans.

“However, if participants are going to get the expected benefits, regulators need to do more to assure sponsors how to maintain safe-harbor protections while adding these assets to participant portfolios,” he says.

Looking ahead, Castille expects that adoption will continue to expand as comfort and understanding grow.

“These strategies are likely to be used broadly and in purpose specific ways within retirement portfolios as sponsors, advisors, and participants become more familiar with their characteristics and how they can potentially improve investment outcomes,” he concludes.