With the maturing, growth and increasing importance of defined contribution plans to the retirement security of US employees, many plan fiduciaries and managers of designated investment alternatives designed for defined contribution plans are considering whether it is appropriate and prudent to include a broader array of asset classes in defined contribution plan portfolios to enhance diversification, investment return and retirement outcome for defined contribution plan participants. This Legal Update reviews recent trends, considerations under the Employee Retirement Income Security Act of 1974, as amended, ("ERISA") and potential legal risks arising out of the investment of defined contribution plans in alternative asset classes.

Background and Trends

The Pension Protection Act of 2006 (the "PPA") gave a boost to the movement to better diversify defined contribution plan portfolios. In particular, the PPA added a new Section 404(c)(5) of ERISA that created a new fiduciary safe harbor for "qualified default investment options" or "QDIAs," which are discussed in more detail below. For the first time, participants who did not direct the investment of their accounts under a 401(k) plan could be defaulted into a professionally managed, diversified investment option without the risk of fiduciary liability for the investment election. Since the PPA, thanks to the QDIA safe harbor and other PPA enhancements designed to encourage and support retirement savings and investment, including automatic enrollment,1 assets in professionally managed, diversified target date funds and other QDIAs have grown exponentially

Investment Case for Alternatives in DC Plans. A number of recent academic, consultant and industry group studies have focused on this trend and advocate for the need to better diversify defined contribution plan assets into private equity, hedge, real estate, infrastructure and other alternative asset classes that are commonly included in defined benefit plan portfolios. Listed below is a sampling of the resources in support of alternative investments in defined contribution plans:

  • The Evolution of Target Date Funds: Using Alternatives to Improve Retirement Pan Outcomes – Georgetown Center for Retirement Initiatives in conjunction with Willis Towers Watson 2018, https:// /cri.georgetown.edu/wpcontent/uploads/2018/06/PolicyReport1801.pdf (academic study urging DC industry leaders and policymakers to consider ways in which DC plan structures can be improved to increase participants' chances for success. A major concern with DC plans today is the volatility of underlying accounts, which are invested primarily in a mix of stocks, bonds and cash. The risks of such a concentrated investment mix was experienced by participants in the 2008 market recession when global equities lost 41.1 percent of their value. The study demonstrates how a diversified allocation to alternatives can significantly reduce volatility and improve retirement outcome.)
  • A Path to Better Retirement Outcomes – Allocating Real Estate Assets to Defined Contribution Portfolios – Defined Contribution Real Estate Council ("DCREC") 2014, https:// /dcrec.org/Resource (Academic study demonstrating how an allocation to real estate in a DC plan portfolio improves retirement outcomes for plan participants.)
  • Real Estate Allocation in the DC Lifecycle: A Dynamic Approach – DCREC 2016, https:// /dcrec.org/resources/Documents/DCR EC RE Allocation Within the DC Lifecycle White Paper 12.1.16.pdf (Academic study results underscore the portfolio benefits of real estate in a DC context for a DC outcome-oriented multi-asset portfolio.)
  • Institutionalizing Defined Contribution Plans – Defined Contribution Institutional Investment Association ("DCIIA") 2011, https:// /dciia.org/page/WhitePapers (Reviewing research into reasons for the performance gap between DB and DC plans and changes needed to "institutionalize" defined contribution plans, including adding alternative investments.)
  • Is It Time to Diversify DC Risk with Alternative Investments? – DCIIA 2013, https:// /dciia.org/page/WhitePapers (Reviewing evolution of DC plans, the performance gap justifying need for alternatives and the considerations for including alternative assets in DC plans.)
  • Capturing the Benefits of Illiquidity – DCIIA 2015, https:// /dciia.org/page/WhitePapers (Discusses investment benefits of hedge, real estate and private equity investments; reviews concerns and considerations for defined contribution plans, including daily valuation and liquidity, and includes case studies of four defined contribution plan sponsors that have added illiquid assets to their defined contribution plans.)
  • Alternative Assets: The Next Frontier for Defined Contribution Plans–AON 2013, https:// /dcrec.org/page-1861906 (Alternative investments such as hedge funds, private real estate and commodities have historically been excluded from defined contribution plans. This trend is changing, and Aon expects the pace of change to accelerate over the next several years. Alternative investments are most appropriately included in defined contribution plans through multi-asset funds such as target date funds and diversified core options, which reduces the potential for misuse by plan participants. An evolving product space has led to an increasing number of attractive options.)
  • The Alternative Route: A Smoother Ride for Defined Contribution Plans – NEPC 2014, https:// /dcrec.org/page-1861906 (White paper with research supporting better outcomes for defined contribution portfolios that include alternative assets by reducing risk with uncorrelated assets.)

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