Shalin Bhagwan and Gareth Mee on the benefits and challenges of investing in illiquid assets for defined contribution pension schemes
As the UK economy looks for growth drivers in a post-COVID-19 world, expanding the breadth of assets into which retirement savings are directed seems worthwhile. Listed capital markets (equities and bonds) tend to form the mainstay of investments for most savers in defined contribution (DC) arrangements, but there are clear benefits from diversifying into illiquid private market assets, which can offer more attractive returns to savers as compensation for taking on illiquidity and complexity risk.
Furthermore, with DC workplace savings potentially doubling to £1trn by 2030 and defined benefit (DB) pension funds increasingly de-risking, it is clear that private markets assets will become more reliant on DC members to invest in them. We focus on default investments, given that this makes up 73% of open schemes’ investments according to the Pensions Regulator.
However, a legacy ecosystem (including fund wrappers, platforms and fee models) has been designed around the premise of daily dealing and pricing, which presents challenges for DC default funds that wish to invest in private assets.
Fund wrappers used by DC administration platforms are designed to ‘pool’ investments across multiple savers, rather than for the professional management of a DC default investment portfolio.
There are signs of change, with the recent relaxing of the Financial Conduct Authority’s rules setting out the types of assets that can be held in unit-linked insurance funds (the so-called ‘permitted links’ rules). This increases the flexibility of one of the main wrappers in use in the UK – a life-wrapped pooled fund.
The novice in this area may rightly observe that the challenge of holding an illiquid asset in a pooled, daily dealt fund has been previously encountered by pooled property funds, with holdings in direct property that cannot easily be liquidated. However, since the 2007-08 financial crisis and Brexit, the mismatch between redemptions (liquid) and underlying investments (illiquid) has been exposed, so changes are still needed. Market value reductions are helpful in dealing with lags in the revaluation of illiquid assets, but being able to also apply an anti-dilution adjustment could be a useful tool in reducing the likelihood of ‘gating’, ie removing the ability to redeem units for a period of time. This was the case post-Brexit, when an anti-dilution adjustment was shown to be effective in meeting redemption requests without having to write down the net asset value of the fund. This was done by redeeming units at a lower value to reflect asset sales at discounted market values.
Proposals have also been made for a new type of fund wrapper that could better accommodate private market assets, a so-called long-term asset fund.
DC administration platforms have been designed for investments that are listed, liquid and priced daily. There is no regulatory requirement for DC default portfolios to have daily pricing or trading, so the inclusion of illiquid assets would seem relatively straightforward. Historical practices have got in the way of innovation, but in an increasingly competitive market, DC administration platforms are showing signs of flexibility. Early movers are hoping to steal a march on their competitors by winning new business from those looking for more sophisticated investment solutions. The explosion of master trusts in the UK may also force
a change; they have started to consider solutions that view accumulation and decumulation as a single continuous journey, which may allow illiquid assets to be retained as the member transitions from pre to post-retirement.
While higher fees and the charge cap of 0.75% per annum on the default fund are often cited as stumbling blocks to the inclusion of illiquid assets, this has not proven to be the case, with fund managers showing the requisite flexibility on fees. For example, performance fees may hit against charge cap requirements, but asset managers have been prepared to compromise and propose flat fees.
Another hurdle arises from the perspective of a trustee tasked with ensuring equal treatment of members. It is inevitable that, in including illiquid assets whose pricing and dealing frequency is mismatched to that of the default portfolio in which it sits, some cross-subsidies could occur between different investors in that portfolio. Trustees may adopt differing stances in addressing this issue. Two possible approaches are illustrated in Figure 1.
In the first solution, illiquid assets are included in a daily priced and dealt default portfolio, but trading in the illiquid part of the default portfolio only occurs in line with its normal dealing cycle, which is likely to be quarterly at best. However, new contributions continue to be allocated to both the liquid and illiquid portfolio, with allocations to the illiquid portion taking place at an extrapolated (and possibly stale) daily price. Disinvestments are treated similarly.
In this scenario, the risk that allocation to (and from) the illiquid portfolio takes place at a stale price is shared across members that remain in the portfolio. It is possible for sophisticated members to select against other investors, for example by disinvesting just after a market downturn but before the illiquid portfolio has been repriced.
In the second solution, an attempt is made to address these shortcomings by ensuring the illiquid portfolio is not only priced and traded daily, but also includes listed market proxies so that contributions can be invested immediately and disinvestments can be funded from a more liquid bucket. The inclusion of listed real assets such as infrastructure and real estate recognises that, over the long term, these assets provide a good proxy for returns in the equivalent illiquid asset classes – even if they can be highly correlated with listed equity markets in the short term.
A word on jumbo DC pension funds
Not all DC pension funds are created equal. Some large ones find themselves in the unique position of being able to shape their destiny. This could be for a variety of reasons:
- Some are associated with large sponsors that are willing to share some of the cost burden of offering more sophisticated investment solutions.
- Scale often brings the negotiating power to drive service providers to be more flexible than they may be for smaller schemes
- Scale may also make customised solutions more economical
- Some DC pension funds sit alongside the same sponsor’s DB pension fund, which itself may be invested in illiquid assets – easing some of the operational challenges.
As the weight of retirement savings shifts towards DC, UK savers stand to benefit as competition among service providers hots up. Scale and competition should not only lead to keener pricing and less leakage from retirement pots, but also help savers access a broader spectrum of investments – investments that have mostly been the domain of (large) investors which could afford to pay the ‘exclusivity premium’ commanded by those assets.
The webinar on which this article is based, Challenges of Including Illiquid Assets in DC Pension Funds, was held on 9 July 2020 and featured Imran Razvi of The Investment Association, John Forbes of John Forbes Consulting, Rene Poisson of JP Morgan Pension Plan, Jenny Doyle of USS, Michelle Darracott of Smart Pension and
Emma Douglas of LGIM. It can be found on the IFoA website.
Shalin Bhagwan is head of UK Pensions Advisory at DWS
Gareth Mee is EY’s UK actuarial lead and chair of the IFoA’s Finance and Investment Board