However, while the responsibility for investing for retirement has increasingly shifted to individuals in recent decades, adding alternatives — and the benefits they can provide — to the portfolio mix simply hasn’t been an option for most. We believe individual investors should have the same opportunities as institutional investors as they fund and grow their retirement plans.
Increasingly, both market participants and academic research are focusing on the potential benefits of adding alternatives to target-date funds in an effort to potentially improve retirement income for plan participants. One recent study suggests that a diversified target-date fund could materially increase a plan participant’s annual retirement income by utilizing alternatives, depending on market conditions.
In our view, alternative investments have a role to play in the target-date investment mix due to their:
- Superior Long-Term Returns: Many classes of alternative investments have outpaced traditional investments over the long term. For example, Vantagepoint’s research shows that during the past 30 years, private-equity investments have outperformed the S&P 500 by 3% to 4% on a rolling 3-year average basis.
- Risk Diversification: We believe adding alternative investments can help diversify risks because they often have different properties than traditional stocks and bonds, so they often react differently to economic and stock market changes. For example, a portfolio of a few stocks is just as risky as a portfolio with only a few return drivers.
- On the other hand, a properly constructed investment portfolio, which includes investments and strategies that are uncorrelated to each other, can be beneficial because different asset types react to changes in the economy and the markets in varying manners, particularly over the long term.
- Less Volatile Returns: In a well-diversified portfolio, returns will tend to be smoother due to the lower correlation among assets. We believe adding alternative investments to a portfolio further diversifies the portfolio, resulting in even less overall volatility.
- Illiquidity Premium: There is also the potential for an illiquidity premium — an excess return that is gained by investing capital for the long term that is absent in a traditional stock and bond portfolio. That illiquidity premium is commonly associated with many types of alternative investments, including private equity, hedge funds, private real estate, private debt, and others.
Understanding the Risks
Alternative investments are like most traditional investments, where there is the potential for the loss of principal. However, they also bring their own set of risks to the table. It’s important to know that alternative investments are often illiquid, making them difficult to exit and value. Also due to alternatives’ illiquid nature, fund managers typically take several years to invest an alternative investment fund’s capital. That means investors may not realize the full potential benefits of such an investment in the near term.
The combination of illiquidity and difficult valuations also means alternative investments can be more volatile than a traditional stock or bond might be. Alternative investments can also involve higher fees and expenses than a traditional investment, and they’re not subject to the same regulatory protections as traditional stocks and bonds.
Developing Alternative Strategies
We believe strategies can be created to mitigate alternative investment risks in order to level the investment playing field and broaden the types of investment assets that are available to individuals as they plan for their retirement.
Ultimately, the goal of adding alternatives to target date funds or model portfolios focuses on improving the probability of retirement security, including generating suitable retirement income and mitigating longevity risk through higher expected returns with lower downside risk.
Policymakers may need to be involved in driving the acceptance and understanding of including alternative asset classes in defined-contribution plans, specifically through target-date fund and model portfolio structures.
But there is still plenty that plan sponsors and investment managers can do to address the issues that have held back the adoption of alternatives into target date funds. By focusing on such operational challenges as liquidity, valuation, fees, and governance, plan sponsors and investment managers can lead the way to achieving better fund construction and better outcomes for participants who increasingly bear the sole responsibility for financing their own retirements.
We believe that the opportunity to gain exposure to alternatives should not just be the purview of pensions, endowments, and high-net-worth individuals. Rather, these investments should also be made available to individual investors as part of a diversified strategy that leads to better chances of overall retirement security. In our view, the retirement industry should work to create innovative fund structures that incorporate these types of investments into the fund lineup table.