Risk
Strategy & Tactics: Are TDFs Ready for Private Equity?
Reported by Dawn Reiss
“I think all managers are going to take a look at how do you break into this marketplace,” said Jeffrey Snyder at Cammack Retirement Group.
Despite resistance, some in the industry are saying it’s just a matter of time before private equity finds its way into the conservative world of defined contribution plans, and private equity giant Blackstone’s recent acquisition of Aon Hewitt’s DC recordkeeping business may be an indication that the industry is moving in that direction.
“I think all managers are going to take a look at how do you break into this marketplace,” said Jeffrey Snyder, vice president, senior consultant, public market practice leader at Cammack Retirement Group, who says his firm is working with a public plan client with more than $10 billion in assets on bringing private market assets into its DC plan. “I think the market is underserved. Right now it’s been a captive market.”
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That doesn’t mean everyone is willing to quickly make the jump. Jagdeep Singh Bachher, chief investment officer and vice president of investments at the University of California, is quick to pose a rhetorical question in return: Is there ever a reason to put more risk into a TDF?
“I don’t see any reason to do it,” said Bachher, who manages the second largest public DC plan in the US after the Federal Thrift Savings Plan. “Whenever you look at the inclusion of private equity, the question becomes why are you doing it? Do you want higher returns? Do you want to take more risk? I can make the argument that the public markets could also be risky depending on where they are on valuations and what might happen. You are taking on higher costs, higher risk and more illiquidity, and there’s never a guarantee of returns.”
With firms such as Pantheon Ventures, Carlyle Group and Partners Group in the mix, many are trying to “crack the code” to get buy-in, Snyder said, likely starting with a large public plan that isn’t beholden to ERISA regulation and has enough assets to make it worth paying premium prices to set up and manage such an asset class. Once that happens, he predicts a floodgate will open.
The volatility in the market over the last couple of years has helped make that case, he said, coupled with rising interest rates and lower returns on the traditional equity-bond split. “There’s a real case to be made from an investment perspective to including this in order to increase your alpha and get better returns,” Synder said.
“Is there ever a reason to put more risk into a TDF,” asks Jagdeep Singh Bachher, chief investment officer and vice president of investments at the University of California.
But everything starts with the plan sponsor. “The recordkeepers aren’t going to build anything if the clients aren’t demanding it,” Synder said. “So unless there’s a demand for it, meaning that many clients want it, you’re never going to have the infrastructure in place.”
Overcoming Hurdles
Regardless of who you talk to in the industry, the biggest obstacle remains a fear of litigation. Since 1998, over 800 lawsuits have been filed by participants against DC plans for breach of fiduciary duty, with more than 75 related to excessive fees, Kevin Albert, managing director at Pantheon Ventures, noted. Many of these were over management fees, including the still-pending 2015 lawsuit of Christopher Sulyma, a former employee who sued Intel Corp. for allegedly breaching its fiduciary duty by putting defined contribution plan assets into high-cost hedge funds and private equity funds.
As a result, the discussion of including private equity into DC plans is still in its infancy. “We are in the early stages of development and there are some fairly big hurdles to overcome before private equity makes a big mark in the defined contribution world,” said David O’Meara, a senior investment consultant at Willis Towers Watson. “Right now there are just too many hurdles.”
“There needs to be a catalyst, coming from the DOL itself or the legal outcomes from the lawsuits,” said David O’Meara at Willis Towers Watson.
Still, there’s what O’Meara calls a slow creep, even though the current number of DC plans using private equity is “close to zero,” over the next decade, he feels that might change.
Much of the litigation concern stems from the fact that private equity isn’t cheap. There are some ideas: Pantheon has proposed a fee structure for DC plans, with a greater use of performance fees, instead of having a large fixed fee.
Even though Pantheon has said it will only get paid if it outperforms its S&P 500 benchmark—with 1/8 of its fee paid out initially, with the remaining 7/8 of the fee paid out over the next seven quarters and subject to a clawback for money already disbursed if Pantheon underperforms its benchmark—fees ultimately still need to be paid at some point.
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“It is going to help on the margin, but it’s still going to be expensive no matter how the fees are charged,” O’Meara said.
Instead, he said what really needs to happen for it to gain momentum is that participants need to be comfortable with the net of fee return and focus more on what their expected outcome is, instead of the potential fee drag. “If you get too focused on the fees, then you turn down a lot of pretty good investment opportunities,” O’Meara said.
O’Meara added: “There needs to be a catalyst, coming from the DOL itself or the legal outcomes from the lawsuits. Right now, it’s up in the air, and that’s why we are seeing a lot of these lawsuits. Right now they are afraid to make changes that might increase fees because of the litigation.”
If 20 percent of a portfolio is allocated to alternatives or private equity within the TDF, create a 15 percent liquidity buffer.
Jonathan Epstein, president of DCALTA, an IRC 501(c) nonprofit association that focuses on using alternative investments within DC plans, concurs that litigation is the primary hindrance in adoption, however, he added: “We are certainly seeing a demand for it within the large plan sponsors who are already using it in their DB plan. The interest and demand is there.”
A September 2015 white paper by the Defined Contribution Institutional Investment Association (DCIIA) highlighted case studies by Intel which included alternatives within custom TDFs, H-E-B, which used custom risk-based portfolios with a 20% allocation to illiquid assets, Washington State which created a total allocation portfolio within its hybrid DB/DC retirement plan, and SunSuper which is managing illiquid assets through “risk-testing requirements.”
The paper points to how having an asset mix of 5% in real estate and REITs, 2% in hedge funds, and 4% in private equity has netted 18-year returns of 9.5%, 7.6% and 11.1%, respectively between 1997-2014 and how alternatives can improve volatility-adjusted returns.
That’s why, O’Meara said, although it might take a while for changes to occur with the current White House administration dealing with other concerns, the pendulum may swing in the opposite direction. “I can also see there being a period of time where private equity does exceptionally well and crushes the public market, so there could be lawsuits on the other side, suing plans for not considering it,” he said.
In the meantime, Australia is already using private equity within its superannuation guarantee, which allows its citizens to choose a super fund and to which employers must currently contribute.
With the more litigious climate in the US, one other concern is a ramping up period that can take five to 10 years to build a private equity program from scratch. “There could be a lot of timing risk,” O’Meara said.
Often, on the onset of building a private equity portfolio, there’s cash going out and no return on that capital for a period of time. “Defined contribution isn’t set up to have these lumpy returns or exposure to the market,” O’Meara said. “In order to overcome some of these funding issues, you really need to speed up the ramp time in a portfolio; that generally means a manager would have to use a lot of secondaries, as opposed to primary market. Those tend to not be as attractive of investments, so there’s some hesitancy from the plan sponsors.”
That’s why he said it’s easier to make a case for using private equity within a fully operational, fully funded program than growing from zero assets over term. For those considering making the jump, O’Meara suggests “legging into the investment over a period of years, selecting different managers and vintage years, which is very important in private equity.”
Instead of trying to time the market, O’Meara suggests dollar-cost averaging, which might be harder to do in DC plan, but can be done if plan sponsors take their time to build a portfolio.
Then make sure there’s a good liquidity buffer. For example, if 20 percent of a portfolio is allocated to alternatives or private equity within the TDF, create a 15 percent liquidity buffer. Synder suggested Treasuries, a short-term investment fund, or short-duration bond fund to give some short-term upside.
“You figure it’s going to sit there for 30 days or more, so you want to earn something, and that allows you to deal with the liquidity that needs to happen on the DC side,” Synder said. “We always ask the clients, ‘Do you have a liquidity buffer from which to pay dispensations, distributions and handle contributions?’ If they do, it can pretty much mitigate potential problems.”
Other Considerations
Either way, it’s important for CIOs to take a multi-pronged approach when it comes to communication, education and documentation since TDFs can technically transact on a day-to-day basis, even if most participants infrequently change their plan.
“I think that’s where plan sponsors, chief investment officers, and most importantly record keepers, get hung up,” Synder said. “The challenge CIOs have is they see the investment piece as a thesis supported by investment, but when you get into the day-to-day of recordkeeping, it becomes very challenging because there are so many other layers within a recordkeeper that have to be addressed.”
Don’t underestimate the importance of the recordkeeper, which can cost companies dearly if an incorrect share price is transacted and has to be reconciled via an independent auditor. “You want to make sure all those financials tie out,” Synder said. “If not, there’s a potential for being out of sync and additional costs. It does have an impact.”
That comes with being able to see the bigger picture. “Often what happens is you can make the investment case, but CIOs of big public pension plan may not understand there are all these other layers associated with managing a DC plan,” Synder said. “The DC plan is very different in terms of the interaction with the participant.”
He added: “You’ve got to make participants aware of what the default is, what is included within the portfolio makeup. There is a cost and time associated with that.”
Either way, CIOs should proceed with caution. “There’s a variety of ways you could get access to these markets, but be mindful and turn over every stone and ensure everyone is on board and can address the illiquidity, and you’ve got time to ramp up, and what that [all] ultimately means,” O’Meara said. “Don’t lose sight of the potential outcomes. We are going to have a tough transition from defined benefit into defined contribution, and there are plenty of people who haven’t saved enough.”