New research suggests workplace pensions could boost returns by 10 per cent if they broadened the assets under management to include ‘illiquid alternatives’. This analysis was conducted by JLT Employee Benefits.
It recommends an allocation to professionally managed liquid alternatives – such as private equity, infrastructure and real estate – as part of the default strategy of workplace DC plans.
This research comes after a recent consultation from the Department of Work and Pensions on using illiquid investments within a DC framework.
JLT points out that DC default funds are rapidly growing in size, thanks to auto-enrolment. As pension funds, with longer time horizons and material cash inflow, there is a much lower need for liquidity, when compared to other investment funds.
However due to a combination of history and regulation, DC schemes predominantly invest in publicly-listed securities, which provide daily liquidity, but preclude DC savers from accessing illiquid alternative asset classes.
Illiquid assets typically have low or negative levels of correlation to traditional assets, such as equities and bonds. Investing in these assets can enhance diversification and generate additional return through an illiquidity premium.
However, JLT points out that investing in these assets means exposure to a number of risks. It points out that some individual illiquid alternatives can have high “failure” rates, though with proper diversification and some smoothing of valuations the measured volatility can appear relatively low compared to listed investments
In addition, the large dispersion of returns between investment managers across the alternatives space means that manager selection is a critical component of the incorporation of illiquid alternatives within DC defaults.
JLT also points out that due to the illiquid nature of these investments, they can be hard to value in certain market conditions.
In order to allow DC schemes to invest in these areas JLT says a number of technical challenges need to be addressed.
Many of these assets have higher fees, so for a meaningful allocation JLT says it may be difficult to meet the AE charge cap of 0.75 per cent.
It says there is a need for more pooled vehicles to ensure optimal diversification. However there is also a regulatory challenge to differential between retail investment funds – which may have higher liquidity needs – and pooled vehicles aimed at longer-term DC savers. The FCA is currently consulting on this.
Similarly trustees, IGCs and sponsoring employers need to be better educated in both the benefits and risks of illiquid alternatives.
JLT head of DC investment consulting, Maria Nazarova-Doyle says: “The pensions industry and the 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.”
“The focus on daily-dealt funds with near 100 per cent liquidity is a fundamentally impatient approach to DC. Many default strategies are currently failing to adequately diversify investments, precluding savers from the valuable illiquidity premium that can be accessed through alternatives.”