The issue of private market assets within defined contribution (DC) pensions is grabbing the attention of lawmakers on both sides of the Atlantic. But while the UK government is adopting a big stick approach to private market allocations in DC, the US’s approach is more focused on creating a level playing field between public and private asset classes.
Jonathan Epstein, founder and president of DCALTA, the US-based DC Alternatives Association, has campaigned for a decade to promote greater use of alternative investments within pension portfolios.
A recent edict from President Donald Trump has blown wind into the sails of this campaign, as the US government looks to liberalise and broaden the asset classes used in retirement plans, and help mitigate the litigation risk that stalks US plan sponsors whatever asset allocation strategy they pursue.
Last month Trump signed an executive order – Democratizing Access to Alternative Assets for 401(k) Investors – that aims to lower regulatory barriers and litigation risks to DC plans offering alternatives. The range of assets goes beyond the private equity, private credit, real estate and infrastructure that are the target of the UK government’s Mansion House Accord initiative, also including crypto, commodities and lifetime income products.
Executive order
Epstein says: “The executive order in and of itself is basically saying to the SEC and to the Department of Labor and the Treasury, let’s work together and find out the most effective way to have participants invest in alternatives.”
As is the case with ESG investing, private equity has been the target of legal proceedings in the US. An action brought six years ago against Intel’s Corporate Investment Policy Committee (Anderson v Intel) argued that fiduciaries wrongly made allocations to hedge funds and private equity funds, leading to poor performance and high charges.
That case was rejected on appeal in May this year, where the court found that the duty of prudence was prospective, that is to say forward-looking, and that it did not make sense to challenge investment strategies on the basis that actual returns delivered, were, with the benefit of hindsight, lower than they could have been.
This judgment has been interpreted as indicating that, under the Employee Retirement Income Security Act (ERISA), allocations within DC to private equity or hedge funds is not of itself imprudent.
Epstein says: “A lot of the suits that are brought against the large corporations stems from fees, performance and risk. The Intel suit touched on worries plan sponsors have had as to why they should incorporate something more expensive.
“When the suit came to dismissal in Intel’s favour, it asked why compare a private equity fund to an S&P 500 fund. You need to compare these funds to like asset classes and like structures. That was a very powerful message and opinion by the judges, and that has resonated with the media coverage, which is now far more glass-half-full than previously.”
Litigation risk
Epstein’s description of the US DC sector paints a picture of a level of litigation risk faced by US plan sponsors that is on a completely different scale to that of UK sponsors, where legal challenge is virtually unknown.
“Large corporate plans get sued no matter what they do. They can get sued for including a money market fund. And then the same law firm would sue a different employer for including a stable value fund instead of a money market fund. This litigation is really just stifling innovation,” says Epstein.
Employers can get safe harbour where Qualifying Default Investment Alternatives (QDIAs) are used, the US equivalent of a UK qualifying default fund. Around two-thirds of 401k investors are in QDIAs, mainly in target date funds (TDFs). This rises to over 90 per cent amongst new joiners.
Private credit yields
A recent paper from DCALTA argued that private credit can offer yields between 2 and 5 per cent higher than public bonds, driven by factors such as illiquidity and higher credit risk. That report highlights the way the post-financial crash regulation of the banking sector, including the stricter capital requirements of Basel III, has made it harder for corporates to access capital through public channels.
While the UK seems actually slightly further ahead when it comes to multi-employer provider allocations to private markets – Epstein points to a number of employer-sponsored plans that are making allocations. Lockheed Martin has just started to put private equity into its bespoke TDF.
“Providers are looking at private assets and asking which types they want to put where, and replacing what,” says Epstein. “So they look at the risk profiles of each and say maybe they can embed private real estate as a separate strategy to replace a portion of the fixed income allocation.”
For QDIA TDF providers, the challenge then comes down to the eternal question with private markets – are you prepared to pay more to potentially get a higher return? And if so, how do you go about increasing your charges?
“The fiduciaries of each plan have to decide on behalf of their participants whether this is valid. I think litigation will soon start looking at plan sponsors that aren’t looking at alternatives. If the goal is net-of-fee return, with an investor you know is going to retire in 30 to 40 years, then why are you not doing this,” says Epstein.
DB DC crossover
Epstein explains the way in which the crossover from defined benefit (DB) to DC is also driving adoption of alternatives in the US, in some cases even through public sector schemes.
“The state of Washington has a total allocation portfolio (TAP) for their DB plan that invests around 55 per cent into alternatives. They have unitised it and put it into their DC plan as a balanced option. And they have that in their target date funds.”
Trump is famously focused on promoting digital assets and driving stablecoin investments in the US. “There is nothing that says you can’t invest in crypto at the moment. Personally I look at things more from a technology and blockchain standpoint, to help facilitate the investment of alternatives within digital assets.”
Whether these assets will make it into big TDF plans remains to be seen, but green shoots of private market allocations are beginning to appear, although it is fair to say that the US is behind the UK when it comes to multi-employer allocations to private markets.
While a handful of big corporates have their own bespoke TDFs that may hold sleeves of private equity, hedge funds and real assets, off-the-shelf multi-employer pooled TDFs from the likes of Vanguard, T Rowe Price, BlackRock, Capital Group and Fidelity have steered clear for now, apart from real estate.
One area of innovation amongst these top end providers however is the partnership between State Street Global Advisors and private markets giant Apollo. The State Street Retirement IndexPlus Strategy offers a 10 per cent exposure to a diversified portfolio of private markets investments via a pooled investment vehicle managed by Apollo, with 90 per cent allocated to private markets.
The US and the UK DC sectors may be approaching private markets as a result of different triggers, but the goal is the same – improving risk-adjusted returns for the millions of individuals relying on them for their security in retirement.
