Fundamental reasons for adding alternatives to DC pension portfolios

There are two fundamental reasons for including alternatives in a defined contribution pension portfolio, according to Ed Studd, solutions manager for U.S. portfolio solutions at Schroders, during a session at Benefits Canada’s 2019 Defined Contribution Investment Forum in Toronto on Sept. 27.

First, alternatives can help the portfolio achieve better diversification by accessing different types of risks, he said. Second, they can help the portfolio access better alpha opportunities which can generate incremental returns. “The combination of these two benefits compounded over the lifetime of a retirement savings journey can be quite powerful.”

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When plan sponsors are considering alternatives, said Studd, it’s important they’re subcategorized to better grasp their potential within the broader asset universe. He highlighted several of these categories, including liquid beta investments like high yield debt, emerging market debt, as well as liquid versions of private assets such as real estate investment trusts. These assets can be grouped together as they’re all useful for accessing different types of investment risk, or alternative beta, but still possess relatively high liquidity, he noted.

However, while they have many potential uses, alternatives need to be weighed against other assets in other ways. For example, different fee structures may be a constraint for using them within a DC plan, said Studd. “Certainly, we would expect any strategies that we’re using here to generate performance after any fees justify being in the portfolio.”

As well, alternatives introduce additional complexity, he noted, and they introduce different types of risks than more traditional asset classes, so it’s important for an investor to fully grasp the nature of those risks and whether they’re comfortable taking them on.

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In using alternatives most effectively within an investment vehicle that uses a glide path, it’s important to consider the need for a position in alternatives isn’t necessarily going to be consistent across a given time frame, said Studd. “Optimal allocation may not be consistent depending where we are on that retirement savings journey.”

Notably, he shared a scenario that demonstrated the benefit of adding alternatives, specifically in a malleable way. At the beginning of the accumulation stage, a zero to 10 per cent allocation to alternatives makes sense depending on the stage of the market cycle. “It starts to increase as you get to the mid-stage of that journey and then it starts to decrease again as you start to incorporate more bonds into the allocation. So this is picking up one way that you might incorporate this dynamic exposure and vary it over time to incorporate it into a glide-path methodology.”

Depending on the amount of risk and return the portfolio is targeting, according to its placement on the glide path, alternatives provide a varying level of benefit, said Studd.

Read more coverage from the 2019 Defined Contribution Investment Forum.