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ALTERNATIVE AND ESG INVESTING IN THE DC SPACE

In a world of aging populations, changing demographics and issues of inequality, it’s imperative that the average US worker has access to quality investments to help them build and maintain their wealth, particularly when it comes to retirement. Unfortunately, the typical defined contribution (DC) participant doesn’t have access to the same types of investment strategies currently available to institutional investors and high-net-worth individuals, such as private equity, hedge funds and direct real estate. Given the long-term nature of retirement savings, some investors believe they can also benefit from other diversification tools such as responsible and sustainable investments. Indeed, an increasing number of investors feel that environmental, social and governance (ESG) factors can materially affect the long-term success of a company and the returns of its securities. PGIM recently completed a survey of more than 130 DC plan sponsors in an effort to capture insights about the current landscape related to the implementation of alternative investments in DC plans. Our research also examined the use of ESG investments. Here we offer our findings. (Part 1 of our research series, focusing on the expanding role of OCIOs, can be read here.)

PGIM canvassed more than 130 DC plan sponsors to learn about the current trends in the DC market. The research was conducted by Greenwich Associates using an online, quantitative approach with DC plan sponsors who have at least one 401(k) plan and a minimum of $100 million in 401(k) assets. See an explanation of our methodology at the conclusion of this report.

USE OF Alternatives IN DC PLANS

By the numbers

Sophisticated investors of all kinds understand the benefits of unique investment strategies to grow wealth and manage risk. Given that plan sponsors and consultants have the ability to bring this approach to the typical participant, at institutional pricing, there is a compelling case to be made that they try and do so. But do they? Our proprietary research shows that most DC plan sponsors do not offer alternatives as part of their target date funds (TDFs). Indeed, within the TDF arena just 5% of plans say they currently offer or are considering offering hedge funds to their participants via their target date fund, while 7% currently offer or are considering offering private equity. Real estate private equity has the support of 11% of plan sponsors.

THE ROLE OF TDFs

Easy, But Not Simple

The objectives of investors often differ, as will their investment solutions, and it is the institutional approach taken by these investors that can improve the success of defined contribution plans. And the need for simple-to-use solutions like target date funds does not necessarily mean the underlying investments must be simple. As an example of an institutional approach, alternative asset classes such as private real estate have historically been a strategic allocation of institutional portfolios. But individuals also rely on investments in property to build and grow their wealth, highlighting the importance of consideration for inclusion in DC menus.

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According to National Real Estate Investor, 62% of high-net-worth individuals hold average allocations to real estate of 5-25%.

Risky Business?

To Offer or Not Offer Alternatives

One of the biggest drivers of the trend toward the simple approach in DC plans has been perceived litigation risk by plan sponsors. Ironically, one could argue that the trend of moving towards simpler and cheaper investment menus actually creates more legal risk by putting sponsors’ interests ahead of participants’ interests. Importantly, the Department of Labor’s (DOL) stance on the use of private equity in DC plans has changed, giving plan fiduciaries the opportunity to take a more innovative approach. To be sure, the DOL’s recent information letter was not a safe harbor, nor was it a new regulation. The DOL merely stated its view that the inclusion of private equity is not inherently improper. The letter did provide some special considerations a plan sponsor should evaluate given the unique nature of this asset class.

Reasons for Not Considering Adding Alternatives to Investment Menu or Target Date Fund

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Operational challenges

34%

Litigation risk

33%

Cost

27%

Lack of internal expertise

17%

other*

14%

A Mixed Bag

ESG investing is of continued interest for investors

As part of our research, we also asked plan sponsors about their ESG use. ESG investing is of continued interest for investors in the US and around the globe - it’s an evolving area with varying views, differing definitions, and where new research is being unearthed on a regular basis. In our survey, almost a quarter of plan sponsors (4% who strongly agree and 20% who somewhat agree) said they have taken action to incorporate ESG approaches into their 401(k) plan over the last 1-3 years, while 52% (30% who strongly disagree and 22% who somewhat disagree) said they have not, with the remaining respondents on the fence.

Incorporation of ESG in 401(k) Plan

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Strongly agree

Somewhat agree

Neither Agree nor disagree

Somewhat disagree

Strongly disagree

view by plan size

Conclusion

Raising the Bar in the DC Space

Defined contribution should have access to the same types of investment strategies currently available to institutional investors and high-net-worth individuals, including alternatives and ESG investments to address their long-term investment challenges. Starting with alts, the DC market is an obvious place to focus on, the result of:

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For more info contact Josh Cohen, Head of Institutional Defined Contribution, PGIM Institutional Relationship Group at josh.cohen@pgim.com or learn more at pgim.com/dc

METHODOLOGY

OUR METHODOLOGY The research was conducted by Greenwich Associates from March 5th to July 17th, 2020, using an online, quantitative approach with DC plan sponsors who have at least one 401(k) plan and at least $100m in 401(k) assets. The research was conducted on an unsponsored/blind basis with no mention of PGIM as the study sponsor. Participants were incentivized to participate with a summary of the research findings as well as a charitable donation to the American Red Cross or AMEX gift card ($100). Respondents had the option to determine whether to disclose their participation and/or individual responses.

This is the second part in a three-part series from PGIM exploring the growing impact of ESG. Part one takes a deep dive into key trends in the DC space in the United States and contains analysis specific to the United States and future research will examine alternatives and income in retirement.

An introduction

strongly agree

somewhat agree

20%

neither agree nor disagree

23%

somewhat disagree

22%

strongly disagree

30%

Participant education

67%

PGIM does not establish or operate pension plans. PGIM does not provide legal advice and these materials do not contain or purport to provide any legal advice.

• • • •

How we conducted our research

of sponsors currently favor hedge funds and 7% favor private equity.

The lack of alternatives use is at least in part a function of sponsors believing that, because most participants are novice investors, they should not have exposure to more “sophisticated” investments that other institutional investors often use. But if there are suitable investment options available it seems all participants should have access. To the extent it is operationally feasible, DC sponsors should look to portfolios of their institutional counterparts as guidance when designing investment options.

BRINGING INSTITUTIONAL SOLUTIONS TO INDIVIDUAL PARTICIPANTS

Plan sponsors should look to portfolios of their institutional peers when designing investment options, most notably around extended credit sectors, alternatives and private assets.

As an example, private real estate has historically been a strategic allocation in institutional portfolios and also relied upon by individuals in building and growing their wealth.

In analyzing private real estate's impact on retirement outcomes, we have found that a modest allocation in multi-asset portfolios results in a meaningful reduction in both the magnitude and range of projected portfolio drawdowns. The benefits of this effect can be significant in reducing sequence of return risk around retirement and keeping plan sponsors committed to their investment selections.

Alternatives as Part of 401(k) Plan - currently part of Target Date Fund

Not Considering Adding

Considering Adding

Currently Offer

Target Date Fund

Investment Menu

Target Date Fund

Real Estate Private equity

89%

real estate private debt

93%

Hedge funds

95%

private equity

93%

Liquid Alternatives

92%

Not Considering Adding

Considering Adding

Currently Part of

Whether it’s private equity, other alternative strategies or any investment strategy, a fiduciary should be able to go through a process and rely on their own expertise and the expertise of their advisors to evaluate whether they believe a strategy will benefit their participants. The most common reason cited in our research for not considering adding alternatives is the need for enhanced participant education, followed by the operational challenges presented by using alts and litigation risk. What’s more, 28% of respondents said they don’t believe in alternatives from an investment perspective.

Do not believe in alternatives from an investment perspective

28%

What’s more, as investors look to diversify their portfolios with responsible and sustainable investments, they will require more than one-size-fits-all strategies to meet their changing needs and shouldn’t be faced with compromised returns. While there is no “right way” to approach ESG investing, as the DC space continues to evolve workers should have made available to them more investment options that are aligned to their ESG preferences and that meet fiduciary standards of appropriateness. There is a fairness case to be made to democratize investment opportunities and allow more American workers access to the types of strategies that only institutions and wealthy Americans currently utilize. While many plan sponsors have fiduciary concerns in adding these to DC plans, there are similarly fiduciary concerns of not making these investments available given the compelling case to do so.

Professional Management

Long-Term Time Horizon

Institutional Pricing

Fiduciary Oversight

Fiduciary Oversight: There is no higher fiduciary standard than ERISA, and participants in a DC plan have a fiduciary that needs to ensure their best interests are served.

Institutional Pricing: Employers can use their scale to bring certain institutional investments to the average American worker at a price they could not have achieved on their own.

Professional Management: In a DC plan, certain alternatives can be incorporated in professionally managed solutions like TDFs, overseen by knowledgeable investment professionals.

Long-Term Time Horizon: Many alternative investments are illiquid and require a long-term holding period to pay off. Saving for retirement can be a half-century or more proposition, making certain alts an investment option for less liquid investments with a longer-term payoff.

Broadest Access

Broadest Access: For most middle-income Americans, the bulk of their wealth is in housing and their retirement plans. If we want to provide access to alternative investments to a majority of Americans, DC plans are where this can best happen.

Liquid Alternatives

88%

real estate private equity

91%

Hedge funds

96%

private equity

92%

Real Estate Private Debt

96%

Total (138)

By Use of OCIO

Over $5B (7)

$1B-$5B (26)

$500m-$999m (29)

$250m-$499m (42)

$100m-$249m (34)

14%

29%

57%

19%

12%

19%

46%

31%

17%

24%

19%

24%

31%

21%

Currently Using (23)

Evaluated/Considering using (27)

Not using/Not considering using (88)

26%

22%

26%

11%

33%

30%

16%

27%

19%

32%

22%

26%

PART 1

PART 2

PART 3

Liquid Alternatives

private equity

hedge funds

real estate private debt

real estate private equity

Alternatives as Part of 401(k) Plan - currently part of Target Date Fund

Plan sponsors should look to portfolios of their institutional peers when designing investment options, most notably around extended credit sectors, alternatives and private assets. As an example, private real estate has historically been a strategic allocation in institutional portfolios and also relied upon by individuals in building and growing their wealth. In analyzing private real estate's impact on retirement outcomes, we have found that a modest allocation in multi-asset portfolios results in a meaningful reduction in both the magnitude and range of projected portfolio drawdowns. The benefits of this effect can be significant in reducing sequence of return risk around retirement and keeping plan sponsors committed to their investment selections.

BRINGING INSTITUTIONAL SOLUTIONS TO INDIVIDUAL PARTICIPANTS

$100m to $249m

$250m to $499m

$500m to $999m

Over $1B

$100m to $249m

$500m to $999m

Over $1B

$250m to $499m

According to National Real Estate Investor, 62% of high-net-worth individuals hold average allocations to real estate of 5-25%. Typical American workers are not accredited investors and therefore can’t access many of these strategies on their own, but it can be done within a DC plan. Our research reveals that more larger plans are offering TDFs with alternative investment options embedded in their offerings, and real estate is a main component. Of the plans surveyed with between $1 billion to $5 billion in AUM, 19% say real estate private equity are offered within their TDFs.

Alternatives as Part of 401(k) Plan - Target Date Fund

by total aum in 401(k) plan

$100m to $249m

$250m to $499m

$500m to $999m

$1B to $5B

Over $5B

$250m to $499m

$500m to $999m

$1B to $5B

Over $5B

View all

$100m to $249m

Participant education

Operational challenges

Litigation risk

Cost

Lack of internal expertise

Other

Do not believe in alternatives from an investment perspective

80%

70%

60%

50%

40%

30%

20%

10%

Over $5B

$1B to $5B

$500m to $999m

$250m to $499m

$100m to $249m

Participant education

Operational challenges

Litigation risk

Cost

Lack of internal expertise

Other

Do not belive in alternatives from an investment perspective

80%

70%

60%

50%

40%

30%

20%

10%

Participant education

Operational challenges

Litigation risk

Cost

Lack of internal expertise

Other

Do not belive in alternatives from an investment perspective

80%

70%

60%

50%

40%

30%

20%

10%

Participant education

Operational challenges

Litigation risk

Cost

Lack of internal expertise

Other

Do not belive in alternatives from an investment perspective

80%

70%

60%

50%

40%

30%

20%

10%

Participant education

Operational challenges

Litigation risk

Cost

Lack of internal expertise

Other

Do not belive in alternatives from an investment perspective

80%

70%

60%

50%

40%

30%

20%

10%

Participant education

Operational challenges

Litigation risk

Cost

Lack of internal expertise

Other

Do not belive in alternatives from an investment perspective

80%

70%

60%

50%

40%

30%

20%

10%

PART 1

PART 2

Incorporation of ESG in 401(k) Plan total

Hover over chart to explore data

somewhat disagree

22%

somewhat agree

20%

neither agree nor disagree

23%

stongly disagree

30%

By Total AUM in 401(k) Plan

$100m to $249m

$250m to $499m

$500m to $999m

$1B to $5B

Over $5B

$100m to $249m

$250m to $499m

$500m to $999m

$1B to $5B

Over $5B

12%

35%

18%

29%

12%

35%

18%

29%

19%

24%

31%

21%

31%

17%

24%

19%

12%

19%

46%

14%

29%

57%

view all data

Hover over chart to explore data

Hover over numbers to explore data

view full charts

Alternatives as Part of Target date funds

Real estate private equity

Real estate private debt

Hedge funds

Private equity

Liquid alternatives

considering using

Currently Using

considering using

Currently Using

Alternatives as Part of Target date funds

Real estate private equity

Real estate private debt

Hedge funds

Private equity

Liquid alternatives

strongly agree

We asked, "To what extent do you agree with the following statement. Over the last 1-3 years, we have taken action to incorporate ESG (Environmental, Social and Governance) approaches into our 401(k) plan."

Strongly agree

Somewhat agree

Neither Agree nor disagree

Somewhat disagree

Strongly disagree

Late last year, the DOL issued its final rule outlining its stance on ESG investing. The ruling requires plan fiduciaries to select investments based on pecuniary factors – that is, any factor that a responsible fiduciary prudently determines is expected to have a material effect on risk and/or return of an investment. Some in the industry may invest in an ESG strategy purely for social reasons, but doing so for an ERISA plan would be impermissible. But many also believe it’s important to consider ESG factors when investing because doing so may result in better long-term performance. While the DOL doesn’t forbid ESG investing, the proposed regulations and pronouncements around it seem to be skeptical that this approach has investment merits. The regulation would make it critically important for fiduciaries to follow a prescribed set of standards in order to be able to justify ESG investments. The remaining question is whether plan sponsors who believe in ESG investing will take the necessary steps or will instead forgo such investments out of fear of perceived fiduciary risk. We also expect the Biden administration to revisit the current policy.

The Evolving Defined Contribution Landscape

Alternatives & ESG as long-term solutions for long-term challenges

Alternatives as Part of 401(k) Plan - Target Date Fund

$100m to $249m

$250m to $499m

$500m to $999m

$1B to $5B

Over $5B

$100m to $249m

Real estate private equity

Real estate private debt

Hedge funds

Private equity

Liquid alternatives

Currently offer

Considering adding

Not considering

$250m to $499m

Real estate private equity

Real estate private debt

Hedge funds

Private equity

Liquid alternatives

Currently offer

Considering adding

Not considering

$500m to $999m

Real estate private equity

Real estate private debt

Hedge funds

Private equity

Liquid alternatives

Currently offer

Considering adding

Not considering

$1B to $5B

Real estate private equity

Real estate private debt

Hedge funds

Private equity

Liquid alternatives

Currently offer

Considering adding

Not considering

Over $5B

Real estate private equity

Real estate private debt

Hedge funds

Private equity

Liquid alternatives

Currently offer

Considering adding

Not considering

Currently offer

Considering adding

Not considering

12%

88%

97%

Real estate private equity

Real estate private debt

Hedge funds

Private equity

Liquid alternatives

98%

95%

90%

10%

86%

93%

90%

93%

10%

88%

92%

96%

92%

While there seems to be greater interest in alternatives for larger plans, this reverses for mega plans. However, we had limited responses here and it tends to be a group that is sometimes risk averse due to fear of litigation.

The Evolving Defined Contribution Landscape

$1B to $5B

Over $5B

OUR METHODOLOGY • The research was conducted by Greenwich Associates from March 5th to July 17th 2020, using an online,quantitative approach with DC plan sponsors who have at least one 401(k) plan and at least $100m in 401(k) assets. • The research was conducted on an unsponsored/blind basis with no mention of PGIM as the study sponsor. • Participants were incentivized to participate with a summary of the research findings as well as a charitable donation to the American Red Cross or AMEX gift card ($100). • Respondents had the option to determine whether to disclose their participation and/or individual responses. • An additional 5-question survey of 20 OCIO managers was conducted by Curcio Webb from fall 2019 to summer 2020. These OCIO managers represent $16.8 trillion in total assets and $1.2 trillion in OCIO assets (all plan types).

PGIM does not establish or operate pension plans. PGIM does not provide legal advice and these materials do not contain or purport to provide any legal advice.

*Other includes liquidity risks, mismatch with fiduciary expectations, complexity for non sophisticated investors, Covid-19 circumstances, limited demand from participants.

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