Can they, should they, will they?

Read this article to understand:

• The regulatory changes designed to encourage DC pension schemes to invest in illiquid assets
• The advantages of multi-asset approaches
• How operational challenges and alternative fee structures could be addressed

What kind of retirement can the 24 million members of the UK’s defined-contribution (DC) pension schemes look forward to?¹ Will the returns from liquid assets like bonds and equities be enough to smooth the journey through years, or decades, outside active employment? Or will they need less liquid, private assets to enhance returns?

These thorny questions are back as the UK’s Productive Finance Working Group (PFWG), a forum backed by the Bank of England, Financial Conduct Authority (FCA) and HM Treasury, has been working steadily to address the barriers preventing investors from investing in illiquid assets, including infrastructure, real estate, private equity and private debt.² One outcome is the new fund authorisation, the Long-term Asset Fund (LTAF) structure, the first four of which have received FCA approval this year, including the Aviva Investors Real Estate Active LTAF.^3,4

So, will private assets prove a natural fit for DC investors with long time horizons or might the cost, complexity and administrative challenges prove too much?

To get answers to these questions and more, Heather Brown, senior client solutions director in our UK pensions team spoke to Mark Meiklejon (MM), Aviva Investors' head of real asset investment specialists, Stephen Budge (SB), head of DC investment strategy at LCP and Gerald Wellesley (GW), independent trustee at Vidett.

Let’s start with the big question. Should DC schemes invest in illiquid assets?

SB: Yes. The question for me is why DC schemes are not investing in illiquids more. It comes down to two factors – the investment case and considering how to achieve the best outcome for members.

We need to think about growing member savings, trying to diversify the drivers of returns, which includes private markets, and seeking new opportunities in the early phases of the savings journey. Then, later in the glide path, we also need to think about ways to minimise volatility.

Investing in illiquid assets could be a big opportunity, but it should be used in different ways depending on where the member is on that journey.

GW: It is all about the best chance of achieving the best member outcome. What is it that will deliver that? Back testing has suggested holding 100 per cent in equities will do it, and that strategy has provided good returns since the global financial crisis, notwithstanding weaker performance around the COVID-19 pandemic. But will that route be effective in future and, if it isn’t, what will we do for members?

Another factor is value for money. Members care about net returns and fees erode returns over time. Will that mean master trusts are less inclined to include illiquid assets because it is such a competitive market? Master trusts aim to back good propositions. When it comes down to the final two on a shortlist for a single employer trust, cost is an easy metric to focus on.

The other factor is the scale of the allocation and how that could impact net returns. You need to have more than ten per cent in illiquids to make it worthwhile in a default strategy. Is a member going to be disadvantaged by the cost? The accepted wisdom is “probably not”.

MM: I take this back to first principles and the argument for private markets. Various estimates suggest about 90 per cent of global GDP is in private as opposed to public hands. Can we provide access to some of those assets to collective scheme members? If you think about it like that, it seems anomalous DC members should not be able to access private assets.

The practical issues are not new; they include cost, liquidity and operational challenges, but the underlying investment characteristics are compelling.

The other thing DC schemes need to be aware of is that we have had an almost unbroken 15-year bull market since the financial crisis with cheap beta in private markets. We need to be mindful of this as we look backwards and forwards into the future.

The FCA has now approved the first LTAFs. Will this help?

MM: It’s not a panacea but what the LTAF does is bring regulatory focus to a new regime. It demonstrates the regulator, government and asset managers are trying to address the structural and operational considerations that have been impediments to DC schemes. I believe the industry will galvanise behind LTAFs, but we need to be aware of what they can and cannot offer.

SB: The LTAF structure gives important comfort that funds do not have to be daily tradeable and daily priced, but we already have funds that invest in private markets, so it is not going to create a brand new asset class. It just helps provide more comfort and controls around cashflows and notice periods, which are helpful for DC.

What difference does LTAF authorisation make from the perspective of a master trust?

GW: It makes it possible to continue the conversation beyond “Yes, but…” The early movers have already addressed the questions, and as a result conversations can be unlocked. It is not a silver bullet, but certain obstacles can be overcome. It’s good to have that focus.

As a result, asset managers are producing products that are more DC-friendly. But “illiquid” is just a word; it does not give insight into the underlying assets. It describes an impediment; it does not describe an enabler. I think it’s helpful to have something that can cut through that.

What innovation is taking place?

SB: We have spoken to all our DB private markets managers where we are confident in the solutions they are running in debt, infrastructure and so on to explore and understand the market. Some have started to plan for DC while others are still thinking how they might do it.

What we see in our client discussions is interest in multi-asset solutions within private markets. Having the ability to invest across asset classes has value from a DC perspective; it means you allocate to a multi-asset solution rather than a specific asset class. There are some schemes looking at single-sleeve allocations, but these are secondary to interest in multi-asset solutions.

We are starting to see allocations into illiquids by a lot of large schemes, covering bespoke and pooled solutions – the latter have additional cashflow and member fairness considerations that need to be managed carefully.

MM: We have spent time thinking about implementation, covering drawdown profiles, cash management, valuation, dealing frequency, and managing money in and money out.

We also see benefits managing on a multi-asset basis, as it should allow for quicker drawdowns, greater diversification and better liquidity management. Overall, though, our view is that early-stage DC schemes will look to harness illiquidity premia.

Cost is a major impediment that inhibits investment in some asset classes. The question is whether we can split the cost into acquisition fees, asset management fees and performance fees. It creates complexity. A single annual charge is simpler.  

GW: Another element you touched on is accumulation versus decumulation. Can inflows in the accumulation phase be balanced by the need for steady returns in the decumulation phase? You need both sides of this to work. I don’t envy you trying to resolve it!

MM: Another factor we have not touched on is sustainability; specifically, the increasingclimate focus and ESG in a broader sense. Our experience is that an increasing number of platforms, trustees and schemes are focusing on net-zero targets. One of the most tangible ways to achieve them is through private assets.

SB: Our clients are already talking about having to report in a way that is aligned with the Task Force on Climate-related Financial Disclosures guidelines. Anything new that comes into the portfolio must be considered from an emissions perspective, particularly when it comes to physical infrastructure and real estate.

GW: We also have the Task Force on Nature-related Financial Disclosures guidelines coming up to address biodiversity. This is a tough area to produce suitable metrics. Within an illiquid strategy, there is the flexibility to think about investments that might be advantageous from a biodiversity perspective, and they might be attractive in terms of member engagement. There is potential to evolve these strategies as they could go into areas others could not.

How accommodating have investment platforms been in addressing operational challenges?

SB: A lot of work has been done around platform capabilities and access to non-daily-tradeable investments. In DC, many processes are automated: cash goes in, it is invested, and the processes are seamless. LTAF allocations will have to be more ad hoc. This takes us to valuations and how quickly they will be passed through to the platforms.

Some master trusts and larger trust-based schemes are not working through a platform but through custody-based models. Which might work better for DC?

GW: A custody platform may be more appropriate for a segregated strategy. In terms of liquidity, most master trusts are concentrating on accumulation. You might have a blended or white-label fund that allows flexibility within it.

With a traditional lifestyle with fixed allocations, there is money going in and out, and management has to be prescribed. Now the market is moving in ways that allow greater flexibility, but it is not clear how quickly the change might happen.

What about schemes making regular contributions to illiquids?

MM: It’s difficult to talk in generalities because every platform is different and there are nuances in every scheme and master trust.

The approach we have taken is from a capital contribution perspective where a scheme makes an asset allocation call, say to allocate five to ten per cent to private markets, and we start by placing that in a queue.

The feedback we are getting is that funds need to be able to accommodate more frequent inflows, but of course the manager will not want to hold too much cash in these vehicles. That will generate cash-drag and could undermine the investment characteristics investors are seeking. We expect the products we are launching to be able to accommodate regular inflows separately to an initial capital contribution.

SB: At this stage, we are not expecting contributions to be invested regularly. Our concern, particularly when seeding funds, is that they get to scale. Once that happens, there is potential for regular cashflows coming in and out. Within the LTAF environment, we are not expecting the 90-day notice period to be used frequently.

GW: The investment lead time for the fund to become fully invested means money can come in regularly, but there may be a holding period where it can be invested within established guidelines to ensure members are not disadvantaged in the meantime. In a world where you can get five per cent on investment-grade bonds, you can park funds profitably and safely, so there are ways to make this work.

SB: Each of these questions need to be addressed. How are you going to manage cashflows? Do you need notification before the 90 days? How will it work? Platforms should be able to talk through and explain all the steps.

MM: Conversations tend to focus on redemptions, but in fact the discipline of “cashflow in” is going to be one of the most important parts to build longevity. You need to be disciplined and not under pressure to deploy capital too quickly into the wrong type of assets.

SB: Yes – that’s a red flag. If a manager has not thought about that challenge, I’m nervous.

What about returns?

GW: Equities have been remarkably successful in the last 15 years, but what kind of returns might be possible in illiquid assets? If returns are in the high single digits and dependable, that becomes attractive.

What about performance-related fees in DC?

SB: I was pleased to chair the workstream on performance fees within the Productive Finance Working Group to establish views on how it could be done. However, our view is that trustees would prefer a single charge because of its simplicity. The interest from managers is also mainly in fees structured ad valorem (proportionate to value).

Performance-related fees have advantages as they help align the manager’s interests with members. If a scheme wants to access an investment with a performance fee, that should not be a barrier to invest. There are considerations around fairness, but hopefully this will open the door rather than suggesting certain investments are off limits.

GW: Performance fees generally operate exclusively on the upside. From my perspective, if this is an attractive new market, managers need to orientate appropriately. That may mean the ad valorem charge needs to be adjusted and explained. This is one view – I am responsible for the member outcome and paying as little as possible!

MM: Fees are front and centre for DC. We need to give schemes choice. In asset classes like private equity or opportunistic equity, the best managers will only operate on a performance fee basis. However, the vast majority of schemes might prefer something simpler and more transparent.

What are your thoughts on the cost J-curve, where the costs of investing in illiquids are elevated at the beginning, and what that means for member equality?

MM: If you are buying into a development fund with a closed-end structure, the J-curve is an issue. But in a blended, balanced, diversified portfolio where you have some development and some standing assets, it is less of an issue. If you are a long-term investor looking to harvest the illiquidity premium, this is a factor that tends to smooth over the long term.

SB:  When you are considering investment in a new strategy, you must be comfortable with the timing of the investment and the expected pricing point. If you are anticipating a multi-asset investment with separate phases of investment, in theory you get beyond the J-curve effect through using other assets – secondaries and so on.

If a scheme that has invested in illiquid assets decides to go to a master trust, does this create issues for trustees from a transition management perspective?

GW: Trustees govern an investment range and there are instances where bespoke strategies can be accommodated. A single employer trust could come in a bespoke arrangement, advised separately, and in that example could transition the assets. But it depends on the platform requirements.

SB: We need to think about the future and cashflows involved. As part of that, you need to get the commitment from the sponsor to invest for the longer term. You could potentially move to a master trust taking illiquid assets with you, but it might not be right for everyone.

What about moving illiquid DB allocations into DC, given DB schemes might be looking to exit their allocations in run-off?

MM: This comes down to governance and transfer pricing. Many schemes moving to buy-in or buy-out have a tail of illiquid holdings in directly owned assets, co-mingled funds or private equity. Might these plug gaps for DC? It comes down to transfer pricing and ensuring value for scheme members.

Will DC schemes invest in illiquid assets?

GW: Yes, but progress will be measured. I expect the trickle to start in 2024 and grow from there. There is interest and they will to do it but there are issues in the way. There are not many master trusts on the sidelines. Everyone is looking actively, some more than others.

SB:  Our largest clients, multi-billion DC schemes, are on that journey. Either they have invested, are thinking about it or are implementing. But that is not all our client base. The question is how far that momentum carries to smaller single-sponsor arrangements. What scheme size will want to invest? In theory they will all be able to.

MM: As the macro environment continues to be difficult and returns from other asset classes look challenged, I believe progress will be client-led. I have never seen such client support to push capital into private assets. My view is that about 90 per cent of DC schemes will implement a ten per cent illiquid allocation. We shall have to see whether that will prove material from a return perspective.