Including Alternatives in TDF Glide Path Design

Voya’s approach examines the benefits of incorporating alternatives in target date funds by integrating within glide path design critical elements such as risk premia, skill premia and excess returns relative to fees.

The search for higher returns and diversification potential in retirement plans has led many defined contribution (DC) plan sponsors down the path of considering alternative assets and private fund structures in DC plans such as 401(k)s.

High fees, lack of transparency and lock-ups, however, make plan sponsors and participants rightfully tread with trepidation. For example, alternative investments such as private equity may require multiyear lockups and charge fees that are 10 to 20 times those of a typical target date fund.

Plan sponsors and target date fund managers have an obligation to make an allocation to alternatives only where the portfolio stands to benefit from return streams that cannot be accessed through traditional sources, and at a fee level that is in line with the potential value added.

At Voya, we have developed an approach that examines the benefits of incorporating alternatives in target date funds by integrating the following critical elements within glide path design – risk premia, skill premia and excess returns relative to fees.

Risk Premia and Skill Premia

As detailed in our article “Solutions for a Low Return World,” alternative investments represent a collection of market beta, risk premia and skill premia. Risk premia in alternative investments may be traditional (e.g., equity risk premia in the case of private equity) or alternative (e.g., insurance premium in volatility). Skill premia refer to the magnitude of excess returns due to the skill of the alternative managers utilized.

In traditional asset classes, the dispersion of returns from manager skill is generally muted relative to alternative asset classes, where selecting top quartile managers can have greater impact on portfolio returns than allocating to the asset class.[1]

Skill premia are scarce and hard to access. Plan sponsors with decades of alternative investing experience through their defined benefit plans, and well established relationships with specialized managers, may be better able to access skill premia. For these plan sponsors, providing their DC participants with access to these specialized funds through their target date program may add incremental value.

Identifying skill is difficult in private markets — typical metrics such as internal rate of return do not offer appropriate comparisons in a multi-asset framework. Voya uses alternative measures such as public market equivalents (PME), excess value and replication of returns via public market factors. These measures help us understand private market returns and enable us to better identify manager skill and persistence.

 

Given the scarcity of skill premia, which raises their cost, an intelligent alternatives portfolio would have to balance limited access to skill premia with additional sources of returns; such as alternative risk premia and potentially, replicating the risk premia of private equity at lower cost.

Excess Return Relative to Fees

Investment management fees play an important role in determining the appropriate alternatives approach in target date funds. With the industry average for target date fund fees around 50 basis points (bp), the additional value from alternatives needs to be considered in relation to fees paid.

In the context of target date funds, the additional value from alternatives must be viewed in comparison with the additional value that can be obtained from other sources. Specifically, the excess returns from alternatives should be evaluated against the excess returns from an active allocation to a diversified portfolio of traditional assets (Figures 1 and 2).

Figure 1. Higher private equity fees present a hurdle to inclusion in TDFs
Figure 1. Higher private equity fees present a hurdle to inclusion in TDFs

Source: Voya Investment Management. Fees: for blended TDF assumed fees represent estimated average fees for actively managed TDF over passive TDF. For private equity assumes 1.5% management fee and 2% carried interest. All fees are annualized. Excess returns: for blended TDF assumed excess returns over a static 60/40 MSCI ACWI / Barclays Global Aggregate based on Voya's capital market assumptions plus assumed 15 bp return from active manager selection. For private equity, represents the excess returns over MSCI ACWI based on Voya's capital market assumptions. Results using historical data are similar.

Figure 2. For the same level of fees, private equity may provide only marginal improvement in expected returns
Figure 2. For the same level of fees, private equity may provide only marginal improvement in expected returns

Source: Voya Investment Management. Calculated by allocating a portfolio of the portfolio to private equity such that overall portfolio fees remains constant.

By contrast, a more thoughtful approach to alternatives that balances alternatives allocations between risk premia and skill premia may deliver improved returns for the same level of fees (Figure 3).

Figure 3. Balanced alternatives allocations potentially improve returns for the same fees
Figure 3. Balanced alternatives allocations potentially improve returns for the same fees

Source: Voya Investment Management. Calculated by allocating a portion of the portfolio to private equity such that overall portfolio fees remains constant. Intelligent alternatives represents a diversified portfolio of alternatives risk premia, replicated private equity and actively managed private funds. All analysis based on Voya’s capital markets assumptions.

Illustrative Glide Path Design

Figure 4 illustrates a hypothetical glide path constructed utilizing our stochastic glide path model to simulate various income replacement ratio scenarios at retirement for diversified target date fund allocation, with and without an “intelligent alternatives” allocation. We used a 15% allocation for the illustration.

Figure 4. Hypothetical TDF glide paths without and with diversified alternatives
Figure 4. Hypothetical TDF glide paths without and with diversified alternatives

Source: Voya Investment Management

An allocation to “intelligent alternatives” may potentially increase income replacement ratios (IRRs) at retirement (Figure 5).

Figure 5. Adding intelligent alternatives potentially enhances IRRs
Figure 5. Adding intelligent alternatives potentially enhances IRRs

Source: Voya Investment Management

Conclusion

In a low return and uncertain environment, increasing potential sources of long-term return can be beneficial to individuals saving for retirement. Designing an appropriate target date program requires going beyond conventional analysis and solutions. We welcome the opportunity to discuss with plan sponsors how, by incorporating multiple dimensions of risk, skill and fees into glide path design, we can implement portfolios that may help sponsors better meet their obligations to plan participants.

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