Advocates Say DC Plans Should Be Considered ‘Accredited Investors’

Public markets are shrinking, and more of the wealth generated by the U.S. and global economies is locked in private markets accessible only by the wealthy.

Art by Mark Wang



Charlie Nelson, CEO of retirement and employee benefits for Voya, recently joined the board of directors at the Defined Contribution Alternatives Association.

Asked why he has decided to work with the nonprofit organization that provides education about the benefits of including alternative investments within a defined contribution (DC) plan framework, he tells PLANADVISER the topic has long been both a personal interest and one that Voya shares. 

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Simply put, Nelson says, public markets are shrinking, and an ever-greater proportion of the wealth being generated by the U.S. and global economies is locked away in private markets, which, by design, are accessible only by the wealthy.

This fact is often overlooked by individual investors and even otherwise financially savvy advisory professionals who have seen the strong growth in the value of the publically traded equity markets over the last several decades. However, as Nelson explains, the overall growth has masked the fact that there are only about half the number of publicly owned companies available to trade today than there were 20 or 30 years ago. Because the markets have grown by leaps and bounds while the number of companies being traded has halved, this, by definition, means risk is more concentrated in publically traded portfolios.

The current system governing the private equity offerings was put in place by the U.S. Securities and Exchange Commission (SEC) to help ensure less wealthy investors do not take excessive risk in complex private markets and do not invest unknowingly in highly illiquid or otherwise restrictive securities. This goal makes sense, Nelson argues, but at the same time, we must acknowledge the landscape of individual investing has changed substantially since the current system was put in place, thanks in no small part to the dramatic growth of the defined contribution (DC) plan system.

Nelson says the DC Alternatives Association is, for all these reasons, making the case to the SEC and other regulators, such as the Department of Labor, that it is time to update the definition of “accredited investors,” i.e., those who are eligible to participate in private offerings and to invest in certain other types of “alternatives.” He notes that Voya recently joined the DC Alternatives Association in submitting a comment letter to the SEC, making this same argument. The letter encourages the SEC to, among other things, consider modifying the definition of accredited investor to make private offerings more readily available to retirement plan participants, who benefit from fiduciary oversight under the Employee Retirement Income Security Act (ERISA) or a similar state or federal fiduciary standard.

The Opportunity Set

J.P. Morgan Asset Management’s newly updated long-term capital markets assumptions provide some context for these comments. The projections suggest that developed market equities may grow by 6.3% in U.S. dollar terms annually over the next decade. The projection for large-cap U.S. equities is somewhat lower, at 5.60%, while the emerging market economies are projected to grow around 9.2% in the aggregate—albeit with much higher volatility potential. 

The projections for private equity investments are much higher than those for developed market equities, with more palatable volatility profiles compared with the emerging markets. On a cap-weighted basis, J.P. Morgan projects private equity will generate 8.8% growth per year over the 10 to 15 year forecast horizon.

Standing Up for Main Street

“I’m very excited to join a number of my industry peers in an effort to try to advance the cause of creating additional investment opportunities for DC plan investors in the United States,” Nelson says. “I think this is an important issue, and we think it’s a great cause to join—to work with industry providers, regulators and Congress to address this gap that DC plans investors are subject to.”

Nelson says it is important for DC plan advisers to learn more about this topic and to take steps to better educate their clients about the opportunities available today and the need for changing some of the SEC rules. He says another important factor at play here is the increasing average age of companies that are taking the step of going through an initial public offering (IPO).

“Think of some of the companies that have gone through recent IPOs,” Nelson says. “The average age of the companies doing an IPO today is much older than even what we saw just 10 years ago. This means the companies coming onto the public exchanges are already more mature and it means there is a lot of wealth that has already been reaped by private investors, before public investors can get involved.”

Nelson says success in this endeavor would not mean that DC plans invest solely in the private markets—far from it. He says an appropriate allocation to alternatives and private equity assets for the typical DC plan participant might be just 5% to 10%. .

“There’s an increasing volume of wealth generation opportunities that fall under the broad umbrella of alternatives,” Nelson says. “Not all of them are venture capital-type, high-risk opportunities. For all these reasons, I think there is momentum at the SEC for them to start looking at this issue. In the meantime, we want to make sure plan sponsors and plan advisers know this is an important conversation to push forward.”

Insurance Companies Are Experiencing Investment Challenges

Since some retirement plan investments are tied to insurance company portfolios, should fiduciaries monitor these accounts like other investments?

Art by Isabella Fassler

According to research from Cerulli Associates, U.S. insurance companies, which have more than $4 trillion in mostly investment-grade bonds in their portfolios and more than $6.2 trillion in total invested assets, view the late stage of the credit cycle as “very concerning” as compared to other investment concerns, such as the low-interest-rate environment, market volatility and market liquidity.

“A prolonged period of historically low long-term rates has proven extremely challenging for insurers from a business perspective, both making it difficult to reach annual book yield goals and raising the present value of longer-term liabilities,” Cerulli says.

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The firm’s surveys show nearly two-thirds (64%) of respondents plan to increase their allocations to private debt and half expect to add to structured or securitized debt during the next 12 months. Among alternatives investments, which are limited in insurers’ general account investment portfolios due to regulatory capital constraints, a majority of insurers plan to add to infrastructure investments (75%), alternative fixed-income strategies (63%), and private equity (55%).

Why does this matter to retirement plan fiduciaries? Because the performance of capital preservation investment options, such as stable value funds and guaranteed investment contracts (GICs), depends on how insurers’ general accounts—and possibly other accounts—perform.

How Insurers Protect Portfolios

John Simone, managing director and head of Voya’s Insurance Investment Solutions business in Chicago, says the challenges of insurer’s general account investors is akin to the task of offsetting future liabilities for defined benefit (DB) plans.

“Rates staying low for long is an issue, as well as tightening of spreads with regard to the credit market. Longer-term investments are maturing, and new vehicles have lower rates,” Simone says. “Insurers need to generate rates of return to meet obligations, but they can’t dial up risk because that may cause their credit rating to go down. There are only certain things they can do to secure yields, like buying long-duration securities.”

However, he says insurance companies are well-suited to address these challenges because of the breadth of their access in capital markets. “At Voya, we favor private assets over public in many areas where an investor can get greater diversification and better yield and better protections. When an investor buys a public bond, it doesn’t have a say if the company starts violating covenants; it can only sell. But, with private assets, investors have some say,” Simone says.

Insurers are also using high-quality, low-volatility assets, such as federal home loan bank borrowing or floating rate borrowing to invest in floating rate securities, according to Simone. In business and finance, a floating rate loan (or a variable or adjustable rate loan) refers to a loan with a floating interest rate. The total rate paid by the customer varies, or “floats,” in relation to some base rate, to which a spread or margin is added (or more rarely, subtracted).

They are also buying securitized assets with terms not necessarily tied to corporate balance sheets. Simone says if firms securitize assets, the terms are tied to U.S. consumer asset-backed securities like credit cards, high quality student loan debt and mortgages. Securitization is the financial practice of pooling various types of contractual debt, such as residential mortgages, commercial mortgages, auto loans or credit card debt obligations (or other non-debt assets which generate receivables) and selling their related cash flows to third party investors as securities, which may be described as bonds, pass-through securities, or collateralized debt obligations (CDOs).

Investors are repaid from the principal and interest cash flows collected from the underlying debt and redistributed through the capital structure of the new financing. Securities backed by mortgage receivables are called mortgage-backed securities (MBS), while those backed by other types of receivables are asset-backed securities (ABS).

When investing in alternatives, Voya prefers primarily private equity or private mezzanine funds that provide attractive yields in areas it feels have asymmetric risk. According to Simone, “We feel comfortable in mezzanine renewable energy funds, currently generating around 11%. People need power, and there has been a shift globally from fossil fuels to renewable energy.” He says infrastructure is a theme with alternative investing.

Russ Ivinjack, senior partner at Aon Hewitt Investment Consulting in Chicago, says insurers do position portfolios to meet their current needs or, if they are planning for a market pull back, they may move into the highest quality securities. A pullback can also be seen as a buying opportunity. “Generally, what we’re seeing is insurance companies continue to diversify portfolios with Treasuries trending downward. Asset-backed securities and real estate debt are among the investing opportunities to boost yield,” he says. Ivinjack adds that it’s not just in their general accounts that insurers are moving to different investments.

Still, he says that because of the lower yield environment, the performance of stable value funds and GICs will trend downward.

Monitoring Insurer’s General Accounts

So, should retirement plan fiduciaries monitor insurer’s general accounts like they do other investments?

“Fortunately, insurance companies are rated by groups that make sure they are solvent,” Simone says. “And, there is protection in terms of the amount of capital they have to hold based on total assets they hold and risk.”

Larry Steinberg, an investment adviser with Claraphi Advisory Network LLC, an SEC-registered investment adviser, and CIO of Financial Architects, based in Pasadena, California, says retirement plan fiduciaries are looking at the credit rating of the insurance company backing the investments in general accounts. And, as far as monitoring the investments backing annuities in qualified plans, he says that has not come up as an issue. “We are still seeing how annuities in qualified plans are going to work. Insurance companies are inventing products right now, and we’ll see what gains acceptance in the market,” Steinberg says.

However, Ivinjack says there are two things retirement plan fiduciaries should do. First, understand what capital preservation funds are investing in, asking whether assets are commingled with an insurance company’s general account or are kept in a separate account. Second, if they are exposed to an insurance company’s general account, look at the underlying credit quality of the insurance company.

He explains that, if the assets are separated, that fund is segmented for the sole purpose of paying investors in that fund and is not linked to the credit quality of the insurer. If plan fiduciaries are looking at a strategy where yields look much higher than peers, they should be concerned that could be too good to be true. “If yields are much higher, [plan fiduciaries] need to understand why,” Ivinjack says.

If yields are competitive for different capital preservation funds, retirement plan fiduciaries should compare what else is in the market, he adds.

“Most folks can bear a decent amount of volatility in equities, but in fixed income—the safety investment—everyone is concerned,” Ivinjack says.

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