Understanding the 401(k) Market – Eric Mogelof, KKR (EP.464)

0:00It's not an if, it's really a when. There's no doubt in my mind in a decade from now, we will see very meaningful allocations within that DC market to private markets. Whether it's 10%, 15%, it's going to be really, really big. I would say over the next three to five years, the off-the-shelf is going to take the longest time to get adoption to move. But in the meantime, you're going to see a lot of allocations through managed accounts and custom target date. It will be a hockey stick, but it's not going to be a hockey stick in the next couple of months or couple of quarters. It really is going to take years for this to play out.

0:43I'm Ted Seides, and this is Capital Allocators. The movement of private wealth allocations to alternatives is one of the biggest questions impacting the future of private markets. Our Private Wealth miniseries shared perspectives from allocators and managers on the space. Since then, an executive order opened the door for 401k plans to adopt alternatives. I wrote in recent musings for our premium members that private market allocations in retirement plans may be a big deal down the road, but there's no need to worry about a flood of capital hitting the private markets anytime soon. To understand why, I asked Eric Moguloff to come back on the podcast and explain how capital flows in the retirement markets.

1:33Eric is the head of Global Client Solutions at KKR and joined me on the Private Wealth miniseries. In this hot take, Eric breaks down the retirement market across defined benefit, defined contribution and IRA plans, the importance of target date funds to 401ks, and the decision-making process required for these various structures to adopt alternatives. I hope you enjoy the show. And if you do, this week, if you happen to be in a married or committed relationship, and one night you turn to your partner and say, hey, babe, what do you think? And they turn back and say, sorry, hon, not tonight. I have a headache.

2:12Why not turn a lemon into lemonade by responding, I have a better idea. Let's listen to the Capital Allocators podcast together. You can snuggle up and share a night of stimulating intellectual bonding. Thanks so much for spreading the word to your partner. Capital Allocators is brought to you by my friends at WCM Investment Management. To outperform the markets, you have to do something differently from others. In my 30-something years investing in managers, there may be no one I've come across who does that as clearly and as well as WCM. I've seen it up close as an investor in their international growth strategy for the last five years.

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4:17Please visit wcminvest.com for WCM's ADV and further information. Capital allocators is also brought to you by Morningstar. What if data wasn't just a bunch of raw numbers, but a clear and decisive language to help connect investment strategies with long-term investor needs in a constantly evolving market landscape. Morningstar created that language, bringing order and utility to insight-rich data so you can prepare for your next opportunity no matter the asset class or market. Visit wheredataspeaks.com to see what Morningstar data can do for you. Please enjoy my conversation with Eric Moguloff.

5:02Eric, thanks so much for doing this. Ted, thanks so much for having me. So as a follow-up to our last conversation, there's so much noise about what's happening in the retirement markets, moving to alts. I thought you'd be the perfect person to help lay this landscape out, how it really works and what's going on. Maybe the place to start is just at the highest level when people think of retirement accounts. How do you think of what that landscape is? Sure, you're right. There is a lot of energy and news and activity around the retirement space. If you were to look at the retirement market in the United States today, there is more than$40 trillion of assets in, quote, retirement accounts.

5:42And we think about it in terms of three large buckets, defined benefit, defined contribution, and the IRA market. Each of them are ultimately holding assets that are supporting the retirement of individuals. So if you look at those three categories, that$40 trillion has a breakdown. The defined contribution market, which is about$12.5 trillion, represents about 30 % of the overall retirement market. And then DB and IRAs are split pretty evenly, about 35 % each. So they're all really important. But what's really interesting to note is DC is growing the fastest. And if you look at it today, more than 100 million Americans have a defined contribution balance, and it really is becoming the primary vehicle for people to save for retirement.

6:35That$40 trillion is in the ground today. How is that money invested, asset allocation? Maybe we'll start with the IRA market. The IRA market follows the private wealth market. If you think about it, most individuals are investing in their IRAs through some type of wealth platform. Given the horizon of IRA money, longer-term horizon, most balances tend to be skewed more heavily to equity risk. So if you think that traditionally there's a 60-40 stock bond portfolio in IRAs, it's probably 60 % to 80 % equity risk. Historically, it's been primarily through the public markets, so public equity and public fixed income.

7:16However, we are starting to see private markets get incorporated into IRAs. That's something that's happening and accelerated pretty quickly. And if you look at just that piece today, what percentage of that do you think is private market? A couple of percent. Two, three, five, depends on what data you find, but growing very quickly. And is there particular flavors at private equity, private credit, real estate? It's really all of the above. Early on, private credit was an area that was probably of greater prominence that you'd find in private wealth and also within the IRA space. Also, given the deferred tax nature of IRAs, private credit actually fits in pretty well.

7:57But what we're finding today is it's PE, it's infrastructure, it's real estate, and it's private credit. So how about the DB channel? The DB channel, interestingly, for decades has been investing in the private markets. By the way, just as quick background, within DB, there are really two different types of DB. There are public DB and then corporate DB. Public, think of governments like state pension plans or city or local municipalities. And then corporate DB, think of companies offering defined benefit plans. Both of them have historically had very significant allocations to private markets, north of 30%.

8:33Within the public space, that continues to be the case. public DB plans are heavily allocated to equity beta, equity type of risk, north of 30 % in public market equities, north of 30 % in private market allocations. Corporate DB used to look that way, but over the last 20 years, more and more of the assets in DB plans from corporates are getting allocated to fixed income. Now, about 20 years ago, there was some accounting changes which gave companies a really strong incentive to start moving more assets to a liability hedge. And so that's why you probably see north of 50 to 60 % in fixed income, but still 20 plus percent in alternatives and private markets.

9:15So that leaves the DC plan. Where are we today? The DC market asset allocation has been, in my mind, one of the most interesting evolutions that I've ever seen in the marketplace. DC plans have been around for a century, but the reality is, given some changes in regulation and legislation, DC plans were really created in the early 80s. Back then, there were investment lineup options that were public equity funds, public fixed income funds, something called stable value, which we can, by the way, spend an hour on. But the reality is they're really just a conservative, principally protected type of investment.

9:53But what was also interesting was back in the 80s and 90s, companies would provide a 401k match using company stock. And so by the end of the 90s, more than 25 % of all DC assets were in company stock. Now, interestingly enough, if you go to 2001, 2002, 2003, there were some pretty meaningful defaults. And so there was legislation that made it much easier for plan participants to diversify out of their company stock. And by the way, many 401k plan sponsors, virtually all of them stop matching contributions in company stock and rather matched in cash. And so you saw a really meaningful change in allocation away from company stock ownership.

10:37And it's around that time that the creation of target risk and then target date funds emerged. Just to give you a little bit more background. So these target risk and target date, essentially it enables the plan participant to outsource that portfolio construction to an asset manager. If you look at where we are today, roughly 40 % of all DC assets are in some type of investment solution, whether it's an off-the-shelf target date fund, a custom target date fund, or some sort of managed account. If you look at the DC assets today, what's the mix of traditional stock bond and alts? There is very little money in DC today that's in alternatives or private markets.

11:25Small amounts, very bespoke plans, but virtually all of the allocations today are sitting in public markets. So when you hear the numbers, $12.5 trillion in these DC assets and all it takes is 1 % or 2 % or 5%, then it's gonna be hundreds of billions of dollars. How does it work? So if you break down the DC category into the different investment options that an employee could pursue, How do you get from here to there? There is reason to believe that over time, we're gonna see a really meaningful allocation to private markets in DC. But you're right to ask the question of how is it gonna happen?

12:06I would point to two different things that have to happen. There are some structural things, which we can talk about as it relates to daily pricing and NAVs and the way these things are set up in terms of liquidity. But then, and you're getting to this, is how do people actually access the target date funds? I should mention, north of 60 % of all new flows in DC are going into target date funds. It's a really important part of the market. The way to think about these investment solutions are there's three ways that you can get exposure to a professionally managed investment solution. The first is off-the-shelf target date funds.

12:43So think of, in a 401k, a corporation wanting to offer a 401k plan. Most corporations will find a record keeper to administer the plan, and then they will select an investment lineup. And that investment lineup is in funds or CITs, which is just a different type of vehicle that incorporates and is managed by an asset manager. That is the majority today of target date fund exposure and investment solution exposure. So there's$4.5 trillion in these investment solutions. Three and a half are in these off-the-shelf custom target dates. For alternatives to be incorporated into those, you would look to the asset managers.

13:26The second category are custom target date funds. So there are large companies that don't pick off the shelf funds, but they actually create their own. They create their own investment glide paths. And these companies, there are some really big ones like Boeing and Ford and Intel, IBM. Many of them had DB plans and they had built investment teams around them. And so it was natural for them when they were building out their DC plans to create custom target dates using multi-manager, best-in-class managers. And so that's another way plan participants can get access to these target date strategies or experiences.

14:08The third way is through managed accounts. So most 401k platforms have their investment lineup, but then they also have an option for participants to get a managed account. And those managed accounts are customized based upon the individual. And either it's a financial advisor that's customizing those exposures, or it's a financial engine where a plan participant will provide a certain set of information about who they are and their investment goals, objectives, and then they will get a generated custom managed account for them. So those are the three ways that individuals get exposure to target date.

14:46Now, each of them have a very different way that you can actually then get alternatives embedded in them. If you start with the off-the-shelf target date funds that are in the hands of an asset manager, what asset managers are involved in that space? There are really six managers that dominate the market, probably have 85 plus percent of the assets. That's Vanguard, Fidelity, BlackRock, State Street, T-Row, and Capital Group. So they have a really important strategic decision on how they want to think about incorporating alternatives. One important piece of information which is helpful to have, which will inform their decision-making processes, is how they originally sold those off-the-shelf custom target date.

15:36If you think about the decision-making process, for most companies that choose off-the-shelf target date funds, the individuals that are making those decisions are either someone from their finance teams or someone from their human resources teams. They're not professional investors, and it's not their full-time job to actually administer the 401k plan and do manager selection, manager due diligence. and historically the single most important factor in picking a target date fund lineup were fees. That's one of the reasons why you see the majority of target date funds today are in passive, very low cost strategies.

16:19And as a matter of fact, there was really an incentive for plan sponsors to pick the low fee option because in the DC market, there's a lot of litigation risk. So there was a view that by picking the lowest cost it would potentially shield you from litigation that you could have from plan participants. So in that segment of off-the-shelf target date funds, how do you move off of that and get into a higher fee alternative? There are two potential options. One is you can have these asset managers use their existing target date funds and add alternatives to them. I personally think that's highly unlikely.

16:58And as a matter of fact, as you talk in the industry, it's pretty apparent that that's not the avenue. Part of the reason why is, is if you're a company and you've made a decision to invest in a certain investment strategy that had a certain risk exposures, certain fees, it's hard to imagine that someone is going to unilaterally change that strategy without you opining on it. Imagine you were subscribing to cable and you looked at all the different cable providers that may cover your house and you looked at all the different packages and you said, you know what, I just want the lowest basic package.

17:32It's unlikely that that cable company is going to be able to go to you and say, hey, Ted, I've got great news for you. I'm adding all of these great channels, but I'm going to really increase your fees. It's probably not going to work. You may not want all those channels. You may be happy with the fees you're paying. What's much more likely is that asset managers that offer these off-the-shelf target date strategies are creating new target date funds that incorporate private markets. Now, what will have to happen then is the asset managers through intermediaries and advisors will have to engage with all those corporate plan sponsors and have a conversation with them that says, hey, you have this target date fund.

18:12Are you interested in having a second target date fund on your platform? Here are all the benefits of incorporating private markets into a target date fund and a glide path. Would you like to add one? Would you like to take your existing one and map it to a new one? The challenge will be if you wanted to incorporate more alternatives into these, if you add a new series of target date funds, but also keep the existing target date ones, you likely won't see a ton of movement into those new target date funds. That might be different if you make the target date funds with alternatives your QDIA, meaning the default option.

18:51What's more likely is we'll see a faster move if you take your existing target date fund series and map it to a new one, where you take all plan participants and you move them automatically into a new target date strategy, which does happen. Over time, as more and more companies understand the value and the benefit of incorporating private markets into a glide path, we'll likely see that. It's easy to see why that switch could be challenging. There's also the question of flows. So there's a certain amount of money in the ground. What does that picture look like of the money that's coming in to the DC world each year and then the money that's going out?

19:32Good question, Ted. So there is a tremendous amount of new money going into the DC space, but we also have to acknowledge that there's actually a fair amount of money coming out each year as well. And think about it, it's coming out in two different ways. One is because people are retiring and they need to draw on their savings to support their spending. But as people change roles, change jobs, it does also create pivot points for them to roll money out of their 401k into a rollover IRA. So while there is huge dollars going in, there's a meaningful amount of those dollars that is ending back up in IRAs that are professionally managed by wealth platforms and financial advisors.

20:14If you go to the next group, the custom target date funds and the managed accounts, how does that decision process work? That is where we would expect to see much faster adoption curve. In custom target date, you have professional investors at these companies that have created multi-manager, best-in-class target date strategies. Many of them use investment consultants, the same ones that they use potentially for their DB assets. They're very familiar with private markets. We at KKR work with a lot of those plan sponsors and have conversations with them all the time about their DB assets. So it's super easy and natural for them to start thinking about, okay, I can incorporate these into the DC glide path as well.

20:58Also keep in mind that these professional investors, they understand the value of private markets. They understand the value of net of fee returns. And so, again, it's a lot easier to envision that that happens sooner. So you've alluded to these two challenges of liquidity and daily pricing, which are not things that are typically characteristic, particularly of private equity. How do you incorporate those needs into an investment in one of those strategies? Nice. The 401k market and broadly DC market have all been built on a chassis that's really created for public markets and daily pricing and daily liquidity.

21:40Today, not all, but most 401k plans enable participants to allocate dollars by week, by monthly, or at the end of each month. And the plans can accept them and invest them right away. It also gives plan participants the ability to reallocate or change their allocation and even withdraw on some sort of more periodic basis than just month end. Maybe it's daily, maybe it's weekly. And so we all know that private markets are not daily liquid. However, there is the ability to incorporate private markets into target date funds where the funds can manage the liquidity. Maybe they have a liquidity sleeve.

22:18And so you can still have private markets in a target date fund and offer the ability for investors to invest or withdraw. So there is a solve there. The bigger challenge, which as an industry we can overcome, is you still need to be able to mark these strategies on a daily basis. If people are going to invest in a target date fund on a daily basis or redeem, even if you're not changing the underlying allocation to private markets, you still have to transact at a NAV. But we as an industry have actually already made progress. Historically, private markets were marked on a quarterly basis. Now, with the advent of Evergreen Wealth vehicles, they're marked on a monthly basis.

22:55And in fact, some private credit is marked on a daily basis. So one of two things have to happen. Either the chassis in 401k needs to change and you restrict transactions to a monthly basis. What's more likely is we, over time as an industry, work on daily pricing all of the various different private markets. What is the one thing that you've found that most people misunderstand about what's happening now with this money in the private markets? Most people don't understand the decision-making processes around how a target date fund gets on a platform and how the evolution and change would happen.

23:35Most people will say, oh, this is great. All of a sudden, all the target date money is just going to drop an allocation to private markets. And the reality is there's structural reasons why that are real barriers that have to be overcome. And so that's why I don't see this as a massive revolution. I see this as a normal, natural evolution as these alternatives become available as legislation changes. But it is going to take one by one engaging with plan sponsors to make them understand the value of incorporating private markets, understanding the value that you're receiving on a net-of-fee basis.

24:11And I think the industry doesn't fully embrace and understand the decision-making process to get there. Where is this already happening and where might it never happen? In the managed account world, it's already happening. And that's where you have most oftentimes record keepers that are administrating a 401k have a managed account platform right adjacent. And there they're already starting to add alternative private market options, evergreen wealth vehicles onto those platforms and starting to incorporate them into the financial engines. And then many of the financial advisors are already familiar with it.

24:49So that's where it's happening very quickly. By the way, there's another area that is evolving, which is there are new plans called PEPs or pooled employer plans, which is an alternative to a 401k. So plan sponsors, instead of administrating their own 401k, they can actually outsource it to either an investment consultant or an RIA. It's already happening there. Within custom target date, it's just starting to happen. And the conversations are just emerging with many of those plan sponsors. They already know all of the alternative providers because they're using them in their DB plans. On the off the shelf, it's really early days.

25:29Because again, the decision maker is not a professional investor necessarily, and it's not somebody's full-time day job. But there are whole teams of advisors and professionals that are engaging and cover these clients. It's just the education process is going to take time. And that's also where legislation and government can make a difference. So we saw the executive order. We just recently saw the DOL put out a statement regarding potentially incorporating private markets into some type of potential safe harbor. Where if you're a plan sponsor and you have a qualified default investment option that incorporates private markets, it's an acceptable, prudent investment.

26:11So if you add up the various decision-making processes that have to work through some of the obstacles, some of the logistical challenges, when people think of, oh, there's$40 trillion or there's$13 trillion in DC plans, and if only 10 % of it's in the private markets, there's$1.3 trillion coming in. How do you take those crazy large numbers and distill it to what you think may actually happen over the next, say, five years? It's not an if. It's really a when. There's no doubt in my mind in a decade from now, we will see very meaningful allocations within that D.C. market to private markets. Whether it's 10 percent, 15 percent, it's going to be really, really big.

26:57I would say over the next three to five years, the off-the-shelf is going to take the longest time to get adoption to move. But in the meantime, you're going to see a lot of allocations through managed accounts and custom target date. It will be a hockey stick, but it's not going to be a hockey stick in the next couple of months or couple of quarters. It really is going to take years for this to play out. But you think about that North Star of what the benefit of private markets is into a longer-dated, longer-horizon investment pool, that leads to not if, but really when. Over the next few years, are there meaningful differences in the adoption of different sub-asset classes within private markets?