A brave new world for UK DC pensions sees larger schemes start to offer increased allocations to private market investments. Jesal Mistry, head of DC investment at Legal & General, sets out the opportunities and challenges ahead
Will increased DC investment into private markets improve retirement outcomes for members?
Millions more people now save into pensions thanks to auto-enrolment. But this DC pensions revolution has not gone far enough. We need to ensure people are saving enough for their retirement. While we wait for the government to act on proposals to increase minimum contributions, we can at least ensure people’s money is working for them — and this is where increased allocations to private markets can help.
To date, DC investment strategies have focused primarily on equity and bond markets. This has led to some very concentrated portfolios, potentially increasing risk. Markets are also changing, and what served investors in the past may not do so in future. Investing in private markets offers better diversification that may also be better placed to capture growth opportunities.
Why invest in private markets?
Since the millennium, the number of IPOs has halved. Companies are also listing later in their life cycle: in 1980 the average company floating on the stock market was six years old, with a value of £105m. But in 2021, the average IPO was 11 years old, with a valuation of £1.3bn. By only investing in listed equities, investors are potentially missing out on full market opportunities and much of this earlier growth.
We think there is also a bigger prize at stake. People are becoming more interested in where their pension funds are invested. Our research found people are happy to pay higher fees to invest in areas like renewable energy infrastructure or affordable housing. As a result, we think the right private market investments can enhance pension engagement, helping improve understanding of how these savings schemes work. This will hopefully lead to people making better decisions about their retirement options, boosting overall outcomes.
Is this a significant change in strategy for DC schemes?
This certainly reflects a change in focus, but it is not an entirely new investment strategy. DC schemes have held direct investments in property and real estate for many years. The illiquid nature of these investments has created challenges in the past, but the sector has learned from this.
Defined benefit schemes in the UK have also had significant investments in private markets, and DC schemes can benefit from some of the solutions DB schemes have created around governance, liquidity, valuations and pricing.
Is the UK DC market well-placed to invest in private markets?
DC schemes have grown exponentially in recent years, and their scale now makes this a viable option. Consolidation in the master trust sector is enabling schemes to access a range of different investment opportunities.
This move has been supported by government initiatives, such as the Mansion House Compact and proposed regulation around value for money. Rather than looking solely at charges, this has focused attention on the services and outcomes savers are getting for these fees.
This has all helped shift the mindset of providers, asset managers and advisers when it comes to incorporating private market assets into DC. Issues around daily pricing and higher fees are still a potential challenge that the industry is now addressing, but no longer a barrier to investment.
What private market assets might DC schemes invest in?
It’s important to recognise that ‘private markets’ cover a range of asset classes, including infrastructure, real estate, private debt and private equity, all of which can have distinct risk and return profiles. During the early years, there are likely to be more significant allocations to riskier assets with higher growth potential, for example private equity, global real estate or infrastructure. As savers approach and move into retirement, managers will dial down the level of risk and focus on more income-related opportunities, for example real estate with long leases.
But this goes beyond looking at these broader asset classes. Managers need to look at individual private market investments to spot future opportunities — particularly when it comes to themes like climate transition and AI. With equity investments, it is often about how wider market indices perform, be it the FTSE 100 or S&P 500.
But you can’t look at the performance of private market investments with the same broad brush. Schemes need to ensure they have skilled managers with the knowledge and expertise to seek out the right individual opportunities. At LGIM, we have private markets experience and extensive capabilities in this area, but we also choose to partner with external specialist managers where appropriate, to ensure we are delivering for members across these different areas.
