Beyond Stocks and Bonds: Building More Diversified Retirement Portfolios

Introduction

Defined contribution (DC) retirement plans have evolved from limited investment menus to sophisticated options such as target-date funds, managed accounts, and investment advice tools. However, many participants remain heavily exposed to traditional stock market risk, making their retirement savings vulnerable to market volatility.

The Defined Contribution Institutional Investment Association (DCIIA) highlights alternative investments as a potential way to improve diversification, manage risk, and enhance long-term retirement outcomes. By examining practices used by defined benefit (DB) plans and institutional investors, DC plan sponsors can evaluate whether alternatives may contribute to more efficient retirement portfolios.

1. The DB/DC Performance Gap and Asset Allocation

Historically, DB plans have invested across a broader range of asset classes, including private equity, real estate, and hedge funds. DC plans have generally relied more heavily on publicly traded stocks, bonds, stable-value investments, and employer stock.

Historical studies cited by DCIIA identified differences in investment performance:

• Callan Associates: DB plans outperformed DC plans by approximately 200 basis points annually from 2006 through 2011.

• CEM Benchmarking: DB plans achieved approximately 140 basis points higher annualized returns than DC plans from 1997 through 2011.

CEM data showed that DB plans allocated approximately 9% of their portfolios to alternatives, while the DC plans in the comparison held none in these categories. DB plans also invested more in international stocks and fixed income, while DC plans had greater exposure to employer stock and stable-value investments.

These findings suggest that asset allocation may have contributed to the performance gap. However, alternatives alone cannot be identified as its sole cause, and historical results do not guarantee future performance.

2. Understanding Alternative Investments

Alternative investments include nontraditional asset classes and strategies that complement conventional stocks and bonds. They may provide different sources of returns, diversification opportunities, and access to private markets.

Three major categories are particularly relevant:

• Absolute-return and total-return strategies: These strategies invest across traditional and alternative markets. Total-return approaches adjust market exposure according to investment opportunities, while absolute-return strategies generally seek positive returns across different market environments. Their results depend on manager skill, investment approach, and market conditions.

• Private equity and infrastructure: Private equity provides access to privately held companies, with managers seeking value through active ownership and operational improvements. Infrastructure investments include assets such as bridges, toll roads, and pipelines. These investments may offer long-term opportunities but can involve significant illiquidity and valuation uncertainty.

• Real estate: Investments in commercial and residential property may be made through private holdings, publicly traded real estate investment trusts (REITs), or both. Their return characteristics may differ from those of traditional investments, potentially contributing to diversification.

3. Potential Benefits for DC Participants

Incorporating alternatives into retirement portfolios may provide several advantages:

• Diversification: Different investment return drivers can reduce dependence on traditional stock and bond markets.

• Risk management: Lower correlations among investments may reduce overall portfolio volatility, although losses remain possible.

• Return enhancement: Certain strategies may offer additional sources of long-term returns.

• Portfolio efficiency: Combining complementary investments may help investors pursue their return objectives at different levels of risk.

• Greater consistency: Diversification may moderate portfolio fluctuations across market environments.

These potential benefits depend on investment selection, fees, market conditions, and implementation. Alternatives do not guarantee improved returns or reduced losses.

4. Integrating Alternatives into DC Plans

Plan sponsors can incorporate alternatives through two principal approaches.

Managed multi-asset solutions: Alternatives can be embedded in target-date funds or other professionally managed portfolios. Managers determine allocations and rebalance investments, simplifying participant decision-making while integrating alternatives into an overall investment strategy.

Standalone or bundled investments: Alternatives can be offered directly through the investment menu, allowing participants to choose their own allocations. A bundled portfolio can provide exposure to several alternative strategies through one investment option.

The appropriate approach depends on plan design, participant needs, investment complexity, liquidity, and fiduciary oversight.

5. Key Considerations for Plan Sponsors

Before incorporating alternatives, plan fiduciaries should evaluate several important factors:

• Manager selection and due diligence: Assess expertise, investment processes, organizational stability, and ongoing performance.

• Liquidity: Some private investments restrict withdrawals for months or years. Sponsors must consider participant transactions and access to funds during market stress.

• Valuation and transparency: Understand how investments are valued, how frequently prices are reported, and whether sufficient information is available to monitor risks and performance.

• Leverage: Borrowing and derivatives can increase both potential returns and losses. Appropriate guidelines and oversight are essential.

• Fees: Management fees, performance-based compensation, and underlying expenses should be clearly evaluated and disclosed.

• Participant education: Participants need understandable information about investment objectives, risks, costs, and liquidity restrictions.

• Fiduciary and legal responsibilities: Under ERISA, plan fiduciaries must prudently select and monitor investments, conduct appropriate due diligence, and obtain specialized advice when necessary.

• Benchmarking: Benchmarks should reflect each strategy’s objectives and risks rather than relying exclusively on traditional market indexes.

• Advice-tool integration: Managed accounts and investment advice systems should be capable of appropriately incorporating alternatives into portfolio recommendations.

Conclusion

Alternative investments offer DC plans an opportunity to expand diversification beyond traditional stocks and bonds. Through strategies such as private equity, real estate, and absolute-return investing. Plan sponsors may provide participants with additional sources of return and different approaches to managing portfolio risk.

Historical DB/DC performance comparisons highlight the importance of asset allocation, but alternatives are not a guaranteed solution to the performance gap. Their effectiveness depends on careful investment selection, appropriate liquidity, transparent fees, reliable valuations, participant education, and ongoing fiduciary oversight.

DCIIA supports considering alternatives within retirement plans, particularly through professionally managed target-date funds or bundled investment solutions. Ultimately, the objective is to thoughtfully expand investment opportunities while protecting participants’ interests and supporting long-term retirement security.