How Adopting Alternative Investment Strategies Can Reduce Plan Costs in a Defined Benefit Plan

Defined Benefit (DB) plans have long relied on traditional investments such as stocks and bonds to meet their funding obligations. However, recent shifts in market conditions and evolving plan sponsor needs have led many to explore alternative investment strategies as a way to reduce plan costs. These alternatives—ranging from private equity to real estate—can play a critical role in improving portfolio performance, reducing volatility, and better aligning assets with liabilities, ultimately lowering the overall cost of the plan.

Diversification and Reduced Volatility

One of the most significant advantages of alternative investments is their potential to reduce portfolio volatility. Traditional investments are often highly correlated with the broader market, meaning they may move in the same direction during downturns. In contrast, alternative investments, such as hedge funds, infrastructure, or private real estate, tend to be less correlated with traditional assets, offering a diversification benefit. According to research, this diversification can help reduce overall portfolio risk and smooth returns over time, resulting in fewer instances where the plan requires additional contributions to make up for shortfalls [1].

Potential for Higher Returns

Another key benefit of alternative investments is their potential for higher returns. Certain asset classes, such as private equity or venture capital, may deliver outsized returns compared to traditional stocks or bonds. These higher returns can help DB plans achieve their funding targets more quickly, reducing the need for additional contributions. As noted by experts, many plan sponsors are turning to private investments and other alternatives to boost returns and improve overall funding levels [2].

Liability Matching and Long-Term Strategy

Many alternative investments align well with a liability-driven investment (LDI) strategy, which is often employed by DB plans to match the timing and amount of their future liabilities. Long-duration assets like infrastructure and real estate can provide stable, predictable cash flows that align with the plan’s payout obligations. This helps reduce the risk of a mismatch between the plan’s assets and its liabilities, ultimately lowering the need for emergency funding and reducing long-term costs [3].

Improved Funding and Risk Management

Alternative investment strategies can also help improve the funding status of DB plans by managing risk more effectively. The Global Financial Officers Association (GFOA) highlights that adopting a diversified asset allocation strategy, including alternatives, can help optimize returns and manage the risks associated with volatile markets. As a result, plan sponsors may see reduced volatility in their funding requirements, which can stabilize contribution levels over time and reduce the cost of maintaining the plan [4].

Conclusion

Incorporating alternative investment strategies into a DB plan can significantly reduce plan costs through increased diversification, potential for higher returns, and better alignment with the plan’s liabilities. While these strategies may come with higher management fees, the long-term benefits often outweigh the costs, making them a valuable consideration for plan sponsors looking to optimize their investment approach.

References:

[1] Russell Investments. (2023). How alternative investments provide portfolio diversification. Retrieved from https://russellinvestments.com/us/blog/alternatives-strategic-evaluation
[2] Cambridge Associates. (2021). Private investments may improve outcomes for defined contribution plan participants. Retrieved from https://www.cambridgeassociates.com/insight/better-alternatives-private-investments-may-improve-outcomes-for-defined-contribution-plan-participants/
[3] Mercer. (2023). Defined benefit long-term funding strategy. Retrieved from https://www.mercer.com/en-us/insights/investments/portfolio-strategies/defined-benefit-long-term-funding-strategy/
[4] GFOA. (2020). Asset allocation for defined benefit plans. Retrieved from https://www.gfoa.org/materials/asset-allocation-for-defined-benefit-plans

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