I am a fan of adding private assets to DC default portfolios. My enthusiasm is based upon evidence from other institutional investors that broadening the asset classes in which they invest is likely to boost long-term investment returns through illiquidity and diversification premia.
To this extent, the Mansion House Compact is welcome, but it is curiously limited to private equity rather than private assets generally. That, I think, is a mistake and will not necessarily be in the best interests of members, and that is a problem for trustees.
Indeed, most investment managers I have spoken to are building products that focus on a range of private assets. Further, at this stage of the investment cycle, they mostly favour private credit over equity. And demand from trustees seems mainly to be for diversified multi-private asset strategies.
The multi-private asset approach seems right to me, not least because it should benefit from the managers’ active management of the allocation to the various private assets available. More sophisticated single private asset strategies may develop later.
The Compact encourages DC trustees to direct more of their assets into “high growth companies” in the UK. I remain unconvinced about this focus for several reasons.
First, most DC schemes hold their equities in passive funds and many of these will have a global equity index benchmark. As the UK share of the total world equity market is under 5 per cent it follows that a “neutral” asset allocation against the benchmark will be around this percentage.
Second, although many DC schemes have historically been overweight UK equities relative to a global benchmark the performance of this part of their portfolios since the financial crisis of 2008 has been negatively impacted by the poor returns on the UK market. Consequently, schemes which had been overweight to the UK market have in recent years progressively reduced their allocations closer to neutral.
This leads to an important commercial perspective. Most master trusts exist in a highly competitive market. The consultants who act as advisers to companies seeking a master trust apply a complex set of criteria to their selection process, including investment performance. The poor performance of the UK equity component of their default has therefore hurt their competitive position and resulted in a justifiable commercial rationale for changing their asset allocation.
The policy intent of the Compact is that DC scheme trustees should allocate 5 per cent of their portfolio to private equity by 2030, preferably with a bias to UK companies. I believe the restrictive nature of this target will be difficult for trustees to achieve in practice.
First, trustees will likely set a more general target allocation to private assets. Based upon my experience of including private assets in a DC default and the consensus of views of trustee advisers I have spoken with, this seems likely to be between 15 per cent and 20 per cent. The policy target therefore implies a private equity allocation of between a third and a quarter of trustees’ likely target allocation.
This seems too high to me given the wide range of private assets available for consideration. Add in the proposed UK bias and I think you would end up with an unacceptable concentration risk to one asset class and geography.
Second, it is far from clear that all DC schemes should invest in illiquid assets. Indeed, if those smaller schemes about which The Pensions Regulator has reservations were to invest in this way, it could prove a considerable barrier to the regulator’s ambition to see them consolidate into master trusts.
In my view, it would be preferable if private asset investments were restricted to those well-run master trusts and the largest single employer schemes whose trustees have the expertise and resources to carry out the necessary due diligence and ongoing governance that private assets require.
In summary, the Mansion House Compact has stimulated welcome debate about DC schemes investing in private assets. However, caution as well as enthusiasm is required.
The focus on private equity only is too limited and it will be preferable if a wider range of private assets is considered.
Further, the focus on the UK will likely be problematic because it creates concentration risk, and it is more likely in any case that trustees will find a greater choice of suitable private asset investments overseas.
Finally, care is needed to ensure that illiquid assets added to sub-scale schemes do not act as a barrier to the policy objective of small scheme consolidation.
The views expressed are those of Andrew Warwick-Thompson and do not represent any statement of policy by Capital Cranfield Trustees.
