Most pension experts agree that in an ideal world, exposure to illiquid investments would be good for defined contribution (DC) schemes, boosting returns over the long term, while adding diversification and reducing risk.
With DC illiquid investment currently in its infancy, delegates at a round table event held by Corporate Adviser last month explored the obstacles to greater uptake and the ways industry stakeholders could work together to improve access to this valuable range of asset classes. (Download a PDF of the 16-page round table supplement here).
The investment case for illiquids is strong. A recent paper from the Bank of England/DWP/FCA-sponsored Productive Finance Working Group pointed to empirical estimates by Oliver Wyman and the British Business Bank that suggested a 22 year-old new entrant to a default DC scheme with a 5 per cent allocation to VC/ growth equity could achieve a 7 to 12 per cent increase in total retirement savings. They also showed that between 1970 and 2016, global VC/growth equity assets have outperformed global public markets by 7 per cent a year. That paper also referred to Pensions Policy Institute work suggesting the illiquidity premium has varied between a 1 per cent and a 7 per cent increase in returns over the long term.
Obsession with cost
For Department for Work and Pensions senior policy adviser, pensions investment Andrew Blair, changing the industry’s focus on cost to one of value is key.
“At DWP we are seeking to address market failures. Since automatic enrolment kicked in in 2012 we’ve had the emergence of master trusts which have competed very aggressively on price. Costs have a role to play in overall value for member outcomes. But we are now seeing that cost element define the way in which schemes are chosen by single employer trusts that wish to consolidate,” he said.
“A key aspect of our work going forward is to shift the focus of DC schemes away from a narrow focus on cost towards an overall focus on value,” he said, adding that the £2bn to £3bn scheme size access point for illiquids was a key factor in the DWP’s consolidation drive.
But he rejected the suggestion that the government is pushing this consolidation agenda to boost its own infrastructure spending plans.
“Illiquids tend to give you more active way of investing and some impacts that you might not get in traditional assets, and that happens to have trickle down effects to some government objectives – levelling up, building back better and the transition to net zero, but our position is about removal of barriers rather than forcing schemes in any particular direction in terms of investment,” he said, adding that the charge cap was not a big factor given how few scheme charge anywhere near it.
Rene Poisson, managing director of Poisson Management argued that trustees would be unlikely to want to focus on UK illiquid assets in any event.
“If I want private equity, probably the leading managers in that area are on the west coast of the US. If I want infrastructure, there are clearly best-in-class managers and they’re not necessarily located in the UK. And so if I’m looking to provide best value for my investment buck to the member, it probably is not going to be entirely correlated to the broader objectives of the UK government,” he said.
Overseas expertise
Natixis Investment Managers head of UK DC sales & strategy Nick Groom said: “There is a lot of capability we’re looking for in the UK, which is domiciled somewhere in continental Europe, especially for the energy transition, for example. They’re better at that in France than we are at the moment – that’s a fact.
“We have to go overseas to find some of this capability and these guys overseas can ply their trade in markets where they don’t have to consider lower fees for what they do. As a global fund manager at Natixis we do ask why should we put capacity in the UK when we can go to Asia and charge double the price? And that’s one of the one of the conundrums that we face in managing the sort of asset classes that we all want coming into the UK, that are going to create an impact and give a big ESG tick is difficult at a price point that works.
“We have a polarised marketplace, with master trusts not playing anywhere near the charge cap. We have investment budgets of 10 to 15 basis points. Are we going to have a passive core and an active outlying bubble effect where in the end the price of illiquid assets are so high that you probably can’t get more than
10 percent into a portfolio, so why bother. Do schemes actually think it’s worth it, going through the more quite complex route of actually finding a way to get illiquids into a DC scheme?”
Mindset problem
Imran Razvi, senior policy adviser on pensions and institutional market issues at the Investment Association said: “I think the charge is not really the barrier that everyone thinks it is. There are specific issues around performance fees, but my expectation would be that managers will adjust to the needs of the market.
“But it’s really hard to change that mindset over a relatively short period of time where, frankly, the message from regulators since auto-enrolment began has been that actually cost really does matter. The asset management market study had a very strong implicit preference for index funds exhibited by the regulator.”
Razvi also said historically DWP submissions to the Work and Pensions Committee had suggested it was difficult to find active managers who will outperform on average, with the result of pushing DC funds heavily down the index route.
“I think it’s quite difficult to just suddenly change that mindset overnight,” said Razvi.
Poisson, who is chair of the JPMorgan single-employer DC scheme, argued the cap does remain restrictive. He said: “Even within a scheme like the Morgan scheme, where all of the underlying admin and other costs are paid for by the employer so that the only thing charge covers is investment, there is still a significant limit on what you can incorporate and remain within charge cap. I’m happy to use 60 basis points if that provides value for my members, but it still restricts to a very significant extent the quantum of assets I can get in.
“So on value, you really have to ask the question are illiquids the best way to add value for that level of investment cost? Or are there perhaps other areas of active investment which can provide a better bang for that investment buck?”
Separated by bps
Poisson agreed attitudes to charges needed to change. “I’ve sat on board of a master trust for a very long time now, watching the RFPs come in from prospective clients. And when you see that the difference between being invited to tender and not being invited to tender is 2 basis points of investment cost, it really brings the issue of illiquids and their cost into perspective, because it’s actually not the master trust or the investment manager at that point, you need to be persuading. It’s actually the purchasers of those services. If you see a world in which master trusts can give 10 basis points of investment to the default solution then it really begs the question ‘how do you bring in illiquids?”
Mercer partner and UK wealth leader Tessa Page pointed out the real-life challenge of actually raising charges. She said: “If own trust schemes are going to make any change to their default arrangement, they need to write out to members. Writing to your members, saying your charges are increasing is a really hard behavioural thing to do and there needs to be evidence that that will bring value for members. Yes, if there is evidence that these things do deliver better outcomes for members, then the cost impact should not be an issue. But, in reality it’s really hard. I had a case recently where the scheme was not trying to implement illiquids – just a slightly better index tracker within their default. And it involved an increase in costs for the members. It was really hard for the trustees to make that decision and they were nowhere near the charge cap.”
Page agreed that messaging from the Government or regulator that cost is not the be-all-and-end-all would help move the dial on this issue.
Razvi said: “There’s a fundamental issue in DC that we all need to grapple with, which is how do you get a focus on member outcomes in a world where those outcomes are fundamentally uncertain.
Regulatory burden
Poisson also argued that any master trust or own trust scheme has a limited budget for governance and investment. “So you have a slightly contradictory situation in which there’s a desire to accentuate investment in, to use the blanket term, illiquids. But actually, the incremental burdens that may counterbalance the overall value proposition in terms of what the trustees can spend their time governing and adding value on. There’s a need for some more joined up thinking across the totality of the issue rather than investment over here, ESG over there and regulatory reporting somewhere else.
“When as a trustee board, we think about whether to go into a new asset class or whatever, we are going to have to now think about ‘and what are the knock on effects of that decision in terms of the overall running of the plan going forward?’ In the old days, it was it was relatively simple. It’s a new fund, it’s a new manager. We want to meet them twice a year. We want this sort of reporting. Suddenly, we’ve got a significant incremental set of issues to try and work our way through.”
TCFD reporting
Connected Asset Management chief impact officer Rachel Neill highlighted the challenge of Taskforce on Climate-related Financial Disclosures (TCFD) reporting with illiquids. “There will come a point where trustees will have to have to look at how that asset classes reports under TCFD and along ESG and sustainability lines. Sometimes it will be easier depending on the actual asset class, and sometimes it will be a little bit harder.”
But she added that illiquid investments offered real opportunities for impact, developing the ‘S’ in ESG, and also for engaging members.
“If you think more broadly around stories and messaging that you can have around energy transition and investing in wind farms, that ticks the TCFD box. But you can also engage members around stories about what their savings are actually doing. Where it might become a little bit more complicated is if in the area of say social housing, where, yes, you’re looking for that carbon reporting under the TCFD, but you also can look at how many families are housed. You’re looking at different metrics but there’s lots of different frameworks out and not much standardisation.”
Page added: “We need to also recognise the difference between metrics and data versus actual ESG integration because in many respects for some of these asset classes, the ESG is better, but it’s just that we haven’t got a number on a spreadsheet that says it’s better. So I think that more holistic assessment is really important.”
Stewardship opportunity
Groom pointed out that illiquids had great potential for delivering real ESG influence. “We always thought stewardship would be much easier achieved by being a stockholder than perhaps a credit manager in a loan environment. What you get with illiquids is you get a far greater degree of due diligence over the deals that they’re actually putting together, so they must work that much harder. That’s why we get a higher price in these particular markets – they work much harder around due diligence. With the solution we have within the Smart structure the credit offering has introduced a ratchet system for loans to be ratcheted up or down based on their KPIs from an ESG score perspective. That’s really neat. You can do that in an illiquid environment because you’ve got that relationship with fewer clients. The learning for me there was that it was interesting to see stewardship being as possible from a credit perspective as it was from an equity perspective.”
Product availability
But delegates agreed that the more players entering the market, the better. Page said we are ‘reasonably fortunate’ in that there is a small handful of good quality investment products available in this space for UK DC schemes. “But it’s nowhere near the level that would be there for any other asset class. Look at all the ESG funds suddenly come out of nowhere, and yet we’ve got one or two viable illiquid asset funds. There is a need for more product development.
“There is a significant governance and bandwidth problem at the medium and smaller end of the DC market. It might be that they just need to consolidate because they’re unable to provide good value for their members. But there are some very good old trusts that do try and do the right things, but at the moment they’ve got a lot on their agendas. And so actually getting to this [illiquids] doesn’t always feel like a priority area.”
Razvi agreed, but said commercial realities could impede a mass of product innovation any time soon. “Firms are very interested in the DC market, but there is a recognition that it’s going to take time and allocations are likely to be small. And that’s challenging from a commercial perspective and is also one of the reasons why when as a manager you think about developing new products, not just looking at the DC market, and so the fact that UK regulators have been so resistant to looking at broader retail distribution of the LTAF is a problem from a commercial perspective. It comes back to bite DC because it reduces the overall commercial viability of producing the product in the first place.”
Page agreed, saying: “I’ve lost count of the number of fund managers who have been very keen to talk to us about new potential products. And then we have the conversation and we talk to them about the cost issues and the platform issues, and you can gradually their interest, the light in their eyes, just days away and then we never hear from them again.”
The end DC investor will be hoping this light is reilluminated as the potential of the defined contribution market is more broadly understood. With DC savers bearing the investment risk themselves, they need the best asset classes possible.
