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The Actuary The magazine of the Institute & Faculty of Actuaries

Illiquid assets could boost pension pots by 10%

Defined contribution (DC) pension scheme members could enjoy a 10% boost to their savings by adding illiquid assets to their default investment strategies, research has found.

DC funds urged to change their "impatient" approach ©Shutterstock
DC funds urged to change their "impatient" approach ©Shutterstock

This ‘illiquidity premium’ is based on a 20% asset allocation to professionally managed alternatives such as private equity, infrastructure and real estate.

JLT Employee Benefits, which carried on the research, said a combination of history and regulation had caused DC default funds to predominantly invest in daily-dealt public markets.

But with a long-term horizon to retirement, and rapid growth with material cash inflows, the firm said these funds have less need for liquidity than almost any other type of investor.

“The focus on daily-dealt funds with near 100% liquidity is a fundamentally impatient approach to DC,” JLT Employee Benefits head of DC investment consulting, Maria Nazarova-Doyle, said.

“Many default strategies are currently failing to adequately diversify investments, precluding savers from the valuable illiquidity premium that can be accessed through alternatives.”

However, the researchers warned that alternatives sometimes have high failure rates, although volatility can appear relatively low with proper diversification and smoothing of valuations.

They also said that manager selection is a “critical” component of incorporating illiquid alternatives, and highlighted how these assets can be hard to value in some market conditions.

To address these challenges, the researchers said that legal and tax restrictions on investment structures used by alternatives need to develop so they are fit for purpose.

Pooled vehicles are needed to ensure optimal diversification, while regulations that force liquidity for unit-linked insurance contracts must be designed for different classes of investor.

JLT Employee Benefits also highlighted how the bespoke nature of alternatives often leads to relatively high fees, and that meaningful allocations may struggle to meet a charge cap of 0.75%.

“The pensions industry and government have recognised that current short-termism is misaligned with the long-term horizons of DC savers, but it is now time for decision-makers to work collaboratively and take action to bring the benefits of illiquid alternatives to DC defaults,” Nazarova-Doyle added.

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