Q: What is fi360's position on the usage of “alternative asset classes” in Defined Contribution plans?
A: The first thing we always say when asked about the appropriateness of an investment is that no investment is imprudent on its face. Prudence is dictated by facts and circumstances.
Moving past the idea that any investment can be considered, we believe alternative investments do not make sense for most defined contribution plans and should only be considered by sophisticated fiduciaries capable of extraordinary due diligence, as described below.
The first step in considering alternative investments would be to make sure the investment is specifically permitted in the investment policy statement. If alternative investments are specifically prohibited, then you can stop right there, the decision has already been made. Otherwise, because alternative investments can be difficult to categorize into an asset class and because reasonable risk, return, and correlations statistics for them can be elusive, the IPS should specifically authorize their use and specify their role within the overall investment strategy.
The next step is to assess the proposed investment itself. Generally, alternative investments are not regulated, transparent, easily valued nor liquid. In place of those safeguards, a fiduciary needs to have well-reasoned explanations to each of the following questions in regards to the management of the investments:
- Why are alternatives being considered?
- What alternatives will be used?
- Who will implement and who will monitor them?
- Where (which asset classes) will the investments be made?
- When will the investments be made and reviewed?
- How will the investments be governed?
- How much will be devoted to these investments?
Another important consideration for alternative investments is fees. Alternative investments typically involve performance fees, which have the effect of both being a drain on performance and rewarding managers for taking greater risks. They also require a higher level of monitoring than typical investments to ensure consistency to the agreed upon fees. An alternative investment should only be considered when it is determined that fees are reasonable when compared to similar options and will not impede the potential benefits of the considered investment.
If the fiduciary is comfortable with the fees, the management of the investment, the permissibility of the investment according to the IPS, and with the investment's benefit within the goals of the portfolio, then perhaps an alternative investment could make sense.
However, because of the extensive due diligence required and the increased risk that is inherent in the nature of alternative investments, they are better suited for pooled portfolios with long time horizons, such as defined benefit plans, that allow for more asset classes to be implemented and for greater dispersion of risk.
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Do you have experience you using alternative investments in defined contribution plans? If so, what due diligence did you perform before implementing the investment? Let us know what you think in the comments section below.
If you have a question you would like to see us answer in a future Fiduciary Q&A, send it to blog@fi360.com. All questions will remain anonymous.
While you point out some important considerations, two others immediately come to mind:
1) No alternative investment should ever be used in any qualified plan without an assessment of whether or not it is potentially a prohibited transaction. This is especially important if the proposed investment is coming from the plan participant or from a third party that has approached the participant. For example, the purchase of a piece of real estate with plan assets should trigger questions about the use of the property to assure there is no intent by the participant to use the property personally. There are other examples as well, especially for promissory notes and “debentures.” Other types of alternative investments would trigger different sorts of questions.
2) Valuation of the asset on a periodic basis must be considered. Who will pay for the valuation of a non-marketable or non-publicly traded asset? Is an independent firm going to provide the valuation? Will the plan’s custodian arrange for it and charge the plan, or charge the plan participant? Will the cost outweigh any possible incremental performance over publicly traded assets?
Jan Sackley
Principal, Fiduciary Foresight(SM)
Fiduciary Risk Management and
Regulatory Compliance Professional
twitter@jansackley
269-323-8119
jansackley@gmail.com
Posted by: Jan Sackley | October 01, 2009 at 08:53 PM
To minimize risks and returns its always better to invest in short term investments with decreased rate of return reducing changing market impacts .
Posted by: Free and Clear | October 20, 2009 at 05:35 AM