Can Alternatives Spruce Up Target-Date Funds?

BY CHRISTOPHER ROBBINS


As new research has found that an allocation to alternatives can benefit target-date products, a debate remains about whether these funds are worth the cost.

Allocations to private equity, private real estate and hedge funds can lead to better outcomes for target-date investors, including more retirement income and less volatility over time, according to “The Evolution of Target Date Funds: Using Alternatives to Improve Retirement Plan Outcomes,” a report from Georgetown University’s Center for Retirement Initiatives and Willis Towers Watson.

On the other hand, adding certain asset classes to target-date funds could dramatically increase the fees paid by investors, who would also sacrifice some liquidity in order to access alternatives. Plan sponsors and advisors may be ill-prepared to implement direct real estate placements, and target-date funds might not be able to access much of the private equity and hedge fund space, argues Jeff Schwartz, president of Markov Processes, a Summit, N.J.-based investment research firm.

According to the Georgetown paper, using alternatives in target-date funds can improve portfolio outcomes, assuming a target-date fund spends through 30 years of retirement. When the researchers replaced a portion of a target-date fund’s equity allocation with private equity, annual retirement income increased: If investors’ private equity allocations tapered from 20 percent at the beginning of their careers to 10 percent at retirement, and then to 0 percent 10 years after retirement, they could generate $11,000 in additional retirement income per year over a traditional target-date fund portfolio.

When real estate was incorporated in two different target-date fund-like glide paths as a replacement for a portion of both equity and bond allocations, it tended to reduce volatility, but also ended up increasing retirement income for low-income earners while reducing the amount of retirement income generated by high earners.

As they did with direct real estate, the researchers allocated to hedge funds from both the bond and equity portions of a target-date portfolio, creating two different glide paths with different levels of allocation. In this case, investors of all stripes would enjoy marginally higher retirement income and less downside over time.

Diversification Works

A target-date fund incorporating all three types of alternatives researched had a higher probability of maintaining positive assets and offered higher expected returns than a target-date fund using only traditional asset classes. In a best-case scenario, the fully diversified target-date fund would generate $94,000 in retirement per year for every $100,000 in annual income earned by a participant before retirement—while a target-date fund limited to traditional asset classes would generate only $77,000 annually for every $100,000 per year in pre-retirement wages.

In the study’s worst-case scenario, the traditional target-date fund strategy would produce only $21,200 annually, while the target-date fund using alternatives would generate $23,500 each year.

Alternatives also helped mitigate the sequence of returns risk in target-date strategies, according to the research. A target-date fund diversified with hedge funds, real estate and private equity carried lower downside risk at the time of retirement and 10 years after retirement than a target-date fund using only traditional asset classes.

A diversified target-date fund could beef up annual retirement income by 11 to 17 percent depending on market conditions, said Angela Antonelli, executive director of the Center for Retirement Initiatives, in a comment.

The researchers assumed that an employee would participate in a defined contribution plan for 40 years, between the ages of…

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