The Evolution of DC Plan Diversification

How much diversification is enough? The answer is evolving, as DC plans borrow from the DB plan approach — including offering a broader array of assets in their menus so participants can create an investment strategy to help them adequately save for retirement. Relying on a mix of stocks and bonds, while a good start, may not offer investors sufficient diversification.

Increasingly, DC plan sponsors are trying to help their participants attain their desired retirement outcomes by adding key asset classes to their investment offerings, such as inflation-hedging asset classes that can also enhance returns and reduce portfolio volatility.

Treasury Inflation-Protected Securities (TIPS), commodities and global real estate have been included within some target-date fund allocations for a few years now, but, until recently, only a small number of DC plans had included these asset classes as stand-alone investment choices.

"We feel that by offering all three asset classes in one blended solution, plan sponsors can provide participants with a broader toolkit to build a more diversified portfolio — and combat inflation," said Lee Freitag, senior investment product manager in Northern Trust's DC Solutions Group.

Although TIPS have been part of an expanding group of asset class offerings in recent years, TIPS alone don't fully address inflation risk, and they tend to have different performance patterns than commodities and global real estate. To more effectively address the different aspects of inflation risk and achieve better diversification and higher potential returns, other assets classes should be used to complement TIPS.

Commodities have lower correlations to stocks and bonds, and they can effectively hedge against inflation. That's because their prices typically rise as inflation picks up, which can also lead to attractive returns. Global real estate tends to have equity-like characteristics, but it provides diversification through unique cash flows and potential property appreciation.

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An Educational Process

Susan C. Czochara, senior product manager in Northern Trust's DC Solutions Group, said plan sponsors are interested in learning more about these additional asset classes, but sponsors' concerns about implementation and risks must be addressed. For example, sponsors are concerned that providing more asset classes to plan participants, some of whom may have limited investment knowledge, could lead to overexposure to riskier assets.

Traditionally, alternative assets, such as TIPS, commodities and global real estate, have comprised 10% to 20% of asset allocation within professionally managed portfolios.

Eventually, Czochara believes the asset allocation envelope will extend even further, with allocations to gold and infrastructure as well. However, a number of concerns will have to be addressed. These include liquidity, cost efficiency and the need for a reliable track record of performance.

In the meantime, DC plan participants have an increasingly powerful and diverse asset allocation toolbox to use. "It comes down to how investment managers work with plan sponsors," Freitag said. "One sponsor placed hard caps on allocations to particular asset classes to prevent overweights by plan participants."

For more insights on diversification, read Northern Trust's white paper, "Rethinking Diversification in Defined Contribution Plans."

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