Daniela Silcock is head of policy research at the Pensions Policy Institute
For years a debate has raged in the defined contribution (DC) pensions world about – “why don’t more DC schemes invest in illiquids?”. Many argue that it is in the best interest of members to temporarily lock away say 10% to 15% of scheme funds into projects such as building schools or new company start-ups.
The logic for this is straightforward: investing in illiquids allows funds access to returns which are less correlated with the rest of the market, particularly publicly-listed bonds and equities. These assets have the potential to provide returns above the level of “standard” investments because they develop at a different pace.
This low correlation also provides risk protection, because when public bonds and equities go down, illiquids (and other alternative assets) can stay the same or even increase returns.
It seems self-evident that illiquids are a good investment opportunity. However, there are problems that have so far proved insurmountable for a lot of, especially smaller, schemes.
The main issue is cost. The majority of illiquids are in the private market; not listed on the stock exchange or subject to the same price and regulatory pressures as assets which are traded daily at high volume.
Some illiquids, for example, private equity (generally newer companies), might require several hundred thousand or even millions of pounds as an initial investment.
Smaller DC schemes generally do not have the cash-flow to lock away substantial funds, and even if they did, might not want to if it represents a large proportion of assets under management.
Alongside this, the charges and costs associated with these types of investments are high and can include performance fees: higher charges paid if assets perform particularly well – basically you pay more but higher return means you still come out the winner. These assets can also carry greater risk, which costs money and resources to judge and mitigate.
Higher costs are problematic because schemes are judged by how much they charge members. Ensuring low charges is a positive trend the charge cap and resulting industry response has led to competition and DC schemes need to charge members around 0.3% and 0.5% of assets under management to stay competitive.
There are also issues around infrastructure. Most DC schemes use investment platforms to access and manage investments. These are necessary services for schemes who do not have the funds to bring their investment management in house. Platforms have been built around supplying accessible assets to schemes that service volumes of members on low incomes.
Therefore, these platforms provide liquid funds that can be valued and traded daily, making holding illiquids, which do not have a daily value, quite tricky. Asset managers have designed a handful of funds, which include illiquids, that are hosted on platforms, but not all platform managers are comfortable with hosting these and they are still more expensive than standard funds.
The government has been working to make it easier for DC schemes to access illiquids. They have reformed the charge cap so that performance fees can be more easily integrated and have published papers encouraging greater use of illiquids.
The Productive Finance Working Group is a government initiative designed to help schemes overcome barriers to investing in illiquids, and a further consultation on charge cap reforms is currently underway.
Will these moves help more DC schemes to access illiquids? Maybe. But a key issue is how young most automatic enrolment DC schemes are. Many did not exist until 2012 and are only starting to see the levels of positive cashflow associated with access to sophisticated investment strategies.
Nest, the largest master trust, has brought some of their investment in house and is starting to directly invest in the private market.
As other schemes continue to grow, we expect to see greater demand on platforms to provide illiquid funds and more direct access by schemes.
Regulation changes should also help, as will the subtle change in messaging that we are seeing from the Department for Work and Pensions and The Pensions Regulator that cost is not always king and returns and diversification matter, too.
