Read this article to understand:
- How private assets could help enhance returns for defined contribution pension schemes
- The challenges which have already been addressed to open doors for patient capital to invest in UK private markets
- The liquidity tools which can be used within Long Term Asset Funds (LTAFs)
The UK has been making concerted efforts to encourage greater investment by defined contribution (DC) and local government pension schemes in private (unlisted) assets. Recent initiatives include the Mansion House Reforms, a package of measures announced by the UK Chancellor in 2023 to make capital markets more attractive and encourage long-term savers to invest.1
The idea is that making higher allocations to less-liquid asset classes might bring higher risk-adjusted returns over the long term, allowing savers to grow their pension pots, as well as creating broader economic and social gains.
Encouraging financing into infrastructure, real estate, private equity, private debt and venture capital (VC) offers the attractive prospect of fuelling growth and driving innovation, as well as speeding the capital-heavy investment needed to decarbonise the economy.2 The tangible, often localised benefits of these investments can also help members feel more engaged with their schemes and connected to their capital.
But there are obvious challenges that come with investing in assets like land, energy and communications infrastructure, commercial buildings, social infrastructure, housing and intellectual property. Bringing such projects to fruition is not a short-term business, and there are many operational hurdles to address. They include the practicalities of investing in higher-risk and less-liquid asset classes, how much participation will cost and whether investor protections will ultimately stand the test of time.
This article sets out five things DC schemes need to know, for a rounded view of where we are, and what might be on the horizon for LTAFs.
What are LTAFs and why are they needed?
Long-term Asset Funds (LTAFs) are open-ended, authorised Alternative Investment Funds regulated by the UK’s Financial Conduct Authority (FCA). They are designed to provide institutional and sophisticated professional wealth investors access to long-term and less liquid assets within clearly defined rules and guidelines (see Figure 1).
Introducing LTAFs was part of a package of reforms intended to improve access to private markets in the UK for “patient capital” (those investors positioning for the long term and not reactive to short-term challenges). The structure, which was finalised after extensive industry consultation, is specifically intended to address the challenges faced by investors in daily-dealt private market funds in the past.
Figure 1: LTAFs: A new regulatory regime shaping the future of access to private markets in the UK
Enabling access
Enabling access to long-term private asset classes for "patient capital"
Portfolio composition
Liquidity of underlying assets is aligned with that of the fund, materially fewer restrictions than prior regimes enabling dynamic portfolio composition
Economic and societal impact
Supported by the UK government, regulator and investment community with ambition to deliver long-term, positive economic and societal impact
Source: Aviva Investors, September 2024.
How LTAFs differ from other UK-regulated funds
LTAFs are flexible, dynamic structures, but each fund must have at least 50 per cent of its portfolio invested in illiquid, long-term assets.3 Investments in unlisted and listed illiquid securities are permitted, as are investments in other regulated and unregulated pooled schemes. Non-UK assets can be included.4 Borrowing is allowed up to 30 per cent of net asset value at the fund level, and that borrowing can be used for liquidity purposes if necessary.
Most significantly, there is no daily dealing. Managers align the ability to trade in and out of the fund with the liquidity of the underlying assets: the asset mix should influence the actions investors are ultimately able to take. The baseline is that redemptions cannot be made more than monthly, and the notice period for exits must be at least 90 days and may be longer if appropriate (Figure 2).5
The asset mix should influence the actions investors are ultimately able to take
The broad aim is to promote a long investment horizon and prevent managers needing to sell assets in haste in down markets, to the detriment of investors, as well as to try to manage the risk of fund suspensions better. The liquidity rules also help reduce the need for funds investing in illiquid assets to hold excess levels of cash to meet any short-term liquidity needs in daily-dealt fund structures. To achieve this, various liquidity tools can be used, including minimum holding periods, limits on the number of units that can be sold at one time and gates to prevent aggregate redemptions.
The features of LTAFs were designed in response to market events which can trigger liquidity mismatches in funds with daily dealing, which have the potential to create systemic risk. In periods of market stress, if many investors try to exit together, managers may be forced into “fire sales” of the most liquid assets, potentially to the detriment of both the investors that wish to stay and the wider market.6
The hope is that there will be less scope for investors to have their savings unexpectedly locked into a fund for longer than they anticipated
By ensuring outflows are managed in a measured way, the hope is that there will be less scope for investors to have their savings unexpectedly locked into a fund for longer than they anticipated, or vulnerable to large shifts in value. Nevertheless, it is of course impossible to anticipate the risk of suspensions in all future scenarios, and it is therefore important for investors to be comfortable with the inherent illiquidity of some unlisted assets, and structure their holdings appropriately.
The characteristics of LTAFs differentiate them from previous fund structures. Traditionally, outside large, sophisticated institutions, UK investors have typically invested in illiquid, long-term assets via closed-ended structures like limited partnerships, VC trusts and investment trusts.7 Having an FCA-authorised structure through which managers can invest in long-term assets is intended to give investors more choice, widening the options available to them.
Figure 2: How LTAFs seek to align redemption terms with the liquidity of the underlying assets
Redemption frequency
No more than monthly
Notice period
Minimum 90-day notice period, longer if appropriate
Liquidity management
Portfolio must deliver “natural liquidity” to meet redemption requests (yield or distributions should match the expected level of redemptions in a steady market).
Liquidity management tools, including minimum holding periods, extended notice periods, limits on the number of units that that can be redeemed at one time and gates blocking aggregate redemptions for all investors may be used.
Source: Aviva Investors, September 2024.
Who might benefit from LTAFs?
In addition to institutional investors, DC pension schemes, government pension schemes and larger charities could all potentially benefit from exploring LTAFs within a carefully managed risk and liquidity context.8 Broad access to LTAFs also allows high-net worth and more sophisticated wealth investors to invest up to a ten per cent cap, if appropriate for them.9
The benefits of accessing diverse return drivers in unlisted assets
Access to different types of assets, with characteristics that might be unique or hard to replicate, in opportunity sets which are less heavily researched than those in public markets, can all be important differentiators. The key is how the features come together to offer different drivers of returns and potentially generate better outcomes for savers. Appreciating the subtle but important differences can be diversification- and return-enhancing.
Appreciating the subtle but important differences can be diversification- and return-enhancing
These features are highly relevant for DC schemes with long-term liabilities. Private market assets could prove a natural fit and help address concerns about the financial constraints faced by large segments of the working population when they retire.
Longer life expectancy could mean greater reliance on the state pension and other state benefits, and/or other savings in later life. Awareness of this challenge is driving the reform agenda and wider conversations on retirement planning.10
Scope for illiquidity premia to enhance returns as part of a diversified approach
Harvesting an “illiquidity premium” in private markets (the additional return that may be on offer to compensate for holding an asset that is more difficult to sell and turn into cash) at an appropriate time might be a partial solution, as part of a diversified approach. That premium may also reflect the greater complexity that comes with managing idiosyncratic assets.
As well as scope for higher risk-adjusted returns from higher return buckets early in the savings journey, appreciating the different investment characteristics of other asset classes can be useful for other purposes, including reducing volatility, later on.
Implications for DC schemes
We have used scenario modelling, with a ten-year forward-looking horizon, to show how adding private markets allocations might be of benefit to DC schemes. These scenarios are illustrative; one of the features of private markets is that data is not readily available or always reliable.
Figure 3 shows how using Aviva Investors’ Climate Transition Real Assets LTAF strategy and Real Estate Active LTAF strategy, both FCA-approved LTAFs, could potentially help investors, at different parts of their savings journey, under certain conditions.
The turquoise “Growth” box shows the expected annualised return in sterling that a younger saver might expect to receive for accepting 90 per cent of the risk of investing in listed global equities, with equity exposure via the MSCI All County World Index (ACWI) and public bonds including global sovereign and investment grade debt. If our two funds were to deliver performance in line with their targets, allocating either five or ten per cent to them would likely boost risk-adjusted performance, as illustrated by the two dark blue circles.
We have used scenario modelling to show how adding private markets allocations might benefit DC schemes
The turquoise “Diversified” marker shows the annualised return someone closer to retirement, who favours a portfolio only half as risky as global equities, could expect to receive. In this case, the portfolio invests in global equities and bonds in roughly equal amounts. Once again, adding our two funds could potentially improve risk-adjusted performance were they to deliver returns in line with their objective.
The turquoise “Retirement” box represents the expected return from a portfolio with just 35 per cent of the equivalent risk of investing in global equities. 70 per cent of the portfolio is invested in fixed income and the remaining 30 per cent in equities. Allocating to illiquid assets could potentially enhance returns for a similar level of risk.
Figure 3: DC Illustrative portfolio outcomes: Modelled impacts of adding LTAF blend at 5 per cent and 10 per cent allocations into the asset mix
For illustrative purposes only. Estimates are based on internal assumptions and simulations. Targets may not be achieved. Forecasts are not a reliable indicator of future performance.
Note: Data used for assumptions are based on objective data and take into account different scenarios in different market conditions. Returns are stated net of fees in sterling. Our Capital Market Assumptions (CMAs) provide forward-looking expectations for asset risk and return over a long-term investment horizon. The CMAs are an important ingredient in Aviva Investors’ investment decision-making process, and offer a robust framework based on historical data, economic trends, and market insights. We adopt a stochastic approach to generate multiple scenarios to capture the uncertainty inherent in capital markets, aiming to build resilience in long-term portfolio strategy.
Source: Aviva Investors. Data as of September 17, 2024. Outcomes assessed over a ten-year horizon per June 2024 CMA release. Scenarios (‘+5%’ and ‘+10%) reflect modelling outcomes from a 50/50 blend of Aviva Investors Climate Transition Real Assets LTAF and Aviva Investors Real Estate Active LTAF based on the assumption the two funds deliver performance in line with their targets.
What are the challenges?
There are both structural and operational challenges impacting the flow of funds into LTAFs.
The main structural challenge is the fragmented nature of the UK pensions market
The main structural challenge is the fragmented nature of the UK pensions market. Although consolidation has been underway for years, numerous DC schemes exist, including more than 500 with under 99 members.11 For many smaller schemes, the complexity and cost of investing in illiquid, private assets might feel prohibitive.
Many smaller, single trust schemes have been contemplating moving to a collective master trust, to bring down costs, increase the range of investment options available and bring oversight from professional trustees. The organisational uncertainty appears to be preventing some smaller schemes embarking on long-term private markets strategies, because allocating involves long-term decisions and takes time.
Costs of investing in private markets
Costs tend to be higher than in liquid markets, because managing entry and monitoring the assets and exit processes is more complex and labour intensive. Assets can take years to mature and each asset may be unique and difficult to value, as there may be few obvious comparators, therefore requiring more inputs and active management. These characteristics, which vary significantly by asset class, have important practical implications throughout the investment lifecycle.
Assets can take years to mature and each asset may be unique and difficult to value
Some important considerations for DC schemes include whether their preferred LTAF will charge for private markets access as soon as the selection is made, or on drawdown, how queuing systems will work to ensure fair access for competing client requests, and whether the platform provider will be giving access to “pure play” private markets risk.
Liquidity is of course another major consideration; it is critical within any default strategy design, particularly in relation to subscription and redemptions.
How has the asset management industry responded?
With regulatory hurdles to meet, the initial start was slow and no LTAFs were authorised in the first year. The arrival of a new regulatory regime tends to take time to feed through, and there are now a range of funds available and others awaiting full authorisation.
Some LTAFs have started to scale quite rapidly. Aviva Investors’ LTAFs already have £2.1 billion under management, underpinned by seeding from Aviva Wealth DC default business, and that scale is expected to grow into 2025 with the planned launch of further funds and capital commitments.12 Scale is important. Having scale enables a fund to invest in a more diversified set of assets which offers the prospect of better risk-return outcomes for the client.
A lot of work has already been done to improve platform capabilities to handle non-standardised commitments
To enable delivery, a lot of work has already been done to improve platform capabilities to handle non-standardised commitments. There is now “proof of concept”. As one of the largest UK default DC providers, we believe we are well-positioned to understand and respond to the operational onboarding and administrative challenges posed.
Practical questions, like how to queue competing client requests and manage large allocations, have been addressed. For example, identifying liquid, proxy investments which can be used for allocations until deals of the right scale, nature and quality are originated. In this environment, the advantages that could accrue to “early movers” could be significant, in our view.
On the charging front, greater flexibility has been introduced around the charge cap that applies to all DC schemes used for auto-enrolment. Most importantly, by splitting out a performance-related element from the annual fees, the focus can shift from cost alone – a major consideration of the DC market – to value. If the total value being generated by the illiquids manager is significant, that can justify an uplift in overall fees, but failure to perform will show on the manager’s bottom line.
What happens now?
Investment in more idiosyncratic infrastructure and real estate assets, and higher risk, illiquid growth investments, has been inhibited by practical logistics issues for a long time, but as those challenges are addressed, the hope is that investment horizons will broaden.
As a result, we expect investment in private market assets by UK DC schemes and others to pick up, as they seek to leverage the growth in this universe. Ultimately, exploring the diversification- and return-enhancing characteristics of private market assets could create more value in savers’ pension pots and contribute towards a better retirement.
Now the regulatory backdrop is set for LTAFs to proliferate, but it feels inevitable that not all will be successful. In the longer term, we anticipate an environment with fewer but larger DC schemes managed under master trusts. They are likely to be serviced by a handful of platforms able to manage the operational onboarding and administrative challenges, including regulatory, compliance, valuation and tax issues.
