Especially when included in a retirement plan menu as part of a target-date fund (TDF) or another automatic asset-allocation solution, illiquid private equity investments can significantly benefit defined contribution (DC) account owners.

An analysis from the Defined Contribution Institutional Investment Association (DCIIA) finds that “a strong case can be made for including such assets in DC plans,” and numerous precedents for non-market pricing methods exist to guide plans through the implementation process.

An important fact acknowledged first by the DCIIA is that the Department of Labor enforces strict liquidity rules under the Employee Retirement Income Security Act (ERISA), which have historically weighed down the use of private equity and other illiquid asset classes on DC menus. But, according to DCIIA’s new report, “Capturing the Benefits of Illiquidity,” daily liquidity needs can be effectively managed as part of a broader asset-allocation solution and with cash buffers, through which plans can maintain sufficient trading liquidity without precluding use of illiquids.

DCIIA identifies three categories of illiquid investments that may fit well within a given DC plan— hedge funds, private real estate and the broader category of private equity. Plan participants are not likely to have the sophistication to use these investment styles effectively as stand-alone options, DCIIA warns, but within a smartly crafted TDF or perhaps a managed account, the potential downside protection and reduced volatility these asset classes present are compelling.

“These assets can provide significant potential for improved total return performance and can help serve as an important tool to diversify portfolios,” explains Lew Minksy, executive director of DCIIA. “They reduce reliance on traditional equities and bonds, decrease volatility, and mitigate against downside risk.”

The DCIIA report derives key considerations from early adopters of illiquid strategies within DC plans, including the determination of fair market value, liquidity management and fee controls. Overall the analysis finds “valuation and trading issues with illiquid assets are manageable” and really only come to the fore during periods of severe market stress. It’s key for illiquid equity options to be presented to participants within TDFs or other approaches that take trading and asset-allocation decisions out of the hands of participants, DCIIA concludes, but this should not discourage their use.

NEXT: Daily valuation has a downside 

According to DCIIA, the ability of defined benefit (DB) plans to use illiquid assets more freely than DC plans has resulted in a clear performance dispersion favoring DB. Relying on figures from CEM Benchmarking, DCIIA finds over the last 18 years, DB plans have at least a 1.1% advantage in annualized investment performance.

The advantage comes in small part from better performance in traditional asset classes, but among the biggest drivers of DB plan outperformance is a broader exposure to less-liquid real estate funds, hedge funds and other forms of private equity. Inclusion of these asset classes, according to DCIIA, leads to better volatility-adjusted returns and over time reduces reliance on market beta as a source of return.

Other experts have shared similar sentiments with PLANADVISER, including Toni Brown, a long-time retirement industry professional and senior defined contribution (DC) specialist at American Funds. Brown recently suggested daily liquidity has improved the ability of retirement plan participants to move money around on demand, but, she asks, is this really such a good thing?  

Part of the problem with including alternatives and illiquid assets comes from the culture of the DC workplace investment industry and its regulators, Brown notes. “There is a perception that you have to have daily liquidity to use something in a DC plan. I think it’s unfortunate that the DC industry was designed that way, because this really doesn’t line up with the long-term nature of the savings effort one is making in a retirement plan.”

Brown, like DCIIA researchers, feels DC plan officials “should want to give up some liquidity for greater potential long-term gains. I think it would be better if individuals weren’t looking to move assets on a daily basis, especially when they are just reacting to financial media headlines or water cooler gossip.”

Brown says she still occasionally, albeit rarely, sees 401(k) plans organized with only annual liquidity. Participants can’t pull their money out at a moment’s notice, Brown observes, but the plans manage to remain in compliance and deliver strong outcomes. 

NEXT: Fiduciary considerations 

“The success comes from the way these plans build their portfolios, in an efficient way,” Brown says. “The lack of liquidity is not a problem for participants in the plans because they are informed at the start—they understand they won’t be able to pull their money out on a moment’s notice and they’re okay with that."

It’s something for the industry to spend some time thinking about: whether it’s possible or preferable to get the daily liquidity genie back in the bottle. 

Not all plans, however, will want to take on the challenge of running only annual or quarterly liquidity—especially those with a more traditional mindset and approach to DC. Brown agrees with the DCIIA analysis that, for this group, the best place to include illiquid asset classes will be within the qualified default investment alternative (QDIA).

DCIIA also urges plan officials to consider implementing alternatives in DC plans via custom portfolios or white-label investment options. Whatever the approach settled on, another helpful strategy is to carefully control cash flow to illiquid investments, creating a “liquidity buffer” that can give participants some extra leeway in pulling money back.

“As custom QDIA options grow in size, support for including alternatives also increases,” DCIIA researchers note.

DCIIA further suggests plan officials should, before making any major investment lineup decisions, conduct gap analyses of legal risks and available tools, such as legal structuring, contracting, disclosures and insurance. Use of a 3(21) co-fiduciary, or even full delegation to a 3(38) fiduciary investment manager is often advisable, DCIIA suggests, especially in cases where internal expertise is lacking.

The full report is available here as a free download.