Moving Past Regulatory Noise of Private Markets in DC Plans

Plan fiduciaries weighing the addition of private market investments in defined contribution retirement plans can look to the fiduciary and regulatory guardrails in the Department of Labor’s proposed “safe-harbor” rule. But a recent report by Morningstar recommends that fiduciaries tackle this issue as a team.

Adequate investment design and execution are needed for private assets to fit into DC plans, and that takes collaboration between plan sponsors and their plan advisers, asset managers and recordkeepers, according to Morningstar’s report, “Don’t Go It Alone: Collaboration Matters When Implementing Private Assets in Defined-Contribution Plans”.

This collaboration can take on a number of forms, said Hal Ratner, the report’s author and head of research at Morningstar, in an email with PLANADVISER.

For plan sponsors, this means posing the right questions before investing. Morningstar recommends figuring out what exposure, if any, might be missing from a plan’s investment lineup, and how private market investments can be implemented.

“For managed accounts, it would make sense for the primary investment manager—the one doing the private [investments]—to understand the plan adviser’s investment process,” Ratner said. “They can then get a handle on things like rebalancing frequency, how the private market exposures fit into the portfolio construction model and how such allocations evolve along the glide path. The plan adviser, in turn, needs to understand what the private [investments] manager is doing to ensure everyone is on the same page.”

Plan advisers can help by assessing which economic exposure makes the most sense within the investment model and making that information accessible and clear for sponsors.

Morningstar gives as an example that advisers with a current allocation to property through Real Estate Investment Trusts, or REITs, might view a direct real estate fund as a logical entry point into private markets for their already–developed investment model. While this kind of decision may come down to fees, liquidity demand and overall product quality, the report warns that a mediocre private real estate fund should not displace a high-quality REIT.

Advisers can also assess what kind of managed solution the exposure can be placed into. For example, for vehicles like target-date or balanced funds, where liquidity is not as much of a concern, participant cash flows can be directed to or sourced from any of the vehicle’s underlying holdings, allowing for the adviser to let the illiquid private allocations “float” to the extent they deem prudent.

While concerns over recent regulatory developments are valid, the report states that regulatory guidance alone still does not address all of the practical realities of implementation.

“The DOL proposal sketches out a decent framework for fiduciary decisionmaking, with the six pillars. It’s not, of course, an instruction manual, and I think that we will see an uptake in outsourcing to consultants,” said Ratner.

Advisers, alongside sponsors and asset managers, need to address liquidity management, rebalancing mechanics and the impact of participant‑level investment structures on the DC system, according to the report.

Ratner said understanding how the alternative investments fit into the portfolio, will “dictate the size and composition of the public market exposure as well as how much pure liquidity in the form of cash is needed. It may also impact the composition of the private or semiliquid component itself.”

For liquidity management, plan fiduciaries can take into account which private markets run higher liquidity risks than others. Private equity, for example, is highlighted in the report as one of the riskiest and inherently most illiquid of private investments.

In response to this illiquidity, the report suggests creating a large liquidity sleeve, where a manager can access cash through an S&P 500 Index fund exposure.

Meeting the demands of an allocation to illiquid assets requires close collaboration among advisers, asset managers and recordkeepers, with the report emphasizing that all parties need to move beyond a product‑selection mindset toward shared responsibility for outcomes.

“The goal is to jointly solve the product construction process. At least this is the ideal,” Ratner said.