Over the past few years, the retirement industry in the US, and beyond, has witnessed a shift from defined benefit (DB) to defined contribution (DC) plans. This trend is evident in mature retirement markets like Canada, the UK and Australia, where DC plans have become the primary vehicle for retirement savings. As the importance of these plans grows, investment options have had to adapt, and has led to the emergence of target date funds (TDFs).
A recent study by the Georgetown University Center for Retirement Initiatives and CEM Benchmarking Inc. examined whether DC plan sponsors should consider increasing allocations to illiquid assets, such as private equity and real estate, within their target date fund options. The analysis, covering period 2011–2020, compared the potential impact of including illiquid assets in TDFs against traditional DC options.
In the three scenarios modelled by the study, the addition of a 10% private equity sleeve had the strongest impact on returns, boosting median returns by 0.22% per year. Similarly, a 10% real asset sleeve resulted in a median improvement of 0.11% per year. Combining both private equity and real asset sleeves yielded a median improvement of 0.15% per year, with 82% of outcomes showing improved results.
The advantages of diversifying TDFs with private assets are substantial. While there are operational challenges and costs associated with such a move, the net impact is shown to be decidedly positive.
Private equity investments provide return enhancement, while enhancing diversification across equity sub-asset classes, leading to improved outcomes for investors. Real assets serve as a valuable diversifier, mitigating risks associated with traditional stocks and bonds while providing inflation sensitivity.
While including illiquid assets in TDF’s presents challenges, they can be addressed. DC plans might face potentially higher liquidity needs, fee disclosure requirements, and daily valuation demands. Successful examples in some markets like Australia where illiquid assets are common in DC options, shows that these challenges can be overcome.
One critical consideration is cost. Private asset investment generally involves higher fees than public markets. However, it is essential to focus on value rather than cost in isolation. The study’s performance is calculated after accounting for higher costs, reflecting the true net performance gained by plan members. Tolerance for higher costs is justifiable if it delivers greater value in the long run.
As public markets face uncertain economic times and potential changes in interest rates, it is crucial for DC plan sponsors to optimise their asset allocations. With significant potential benefits in diversification and returns, private assets can be a valuable addition to the retirement investment toolkit.
