Including private assets in DC defaults is likely to boost long-term investment returns and improve member outcomes through illiquidity and diversification premia. Private assets also offer new sustainable investment opportunities through unlisted technology, infrastructure, real estate, and power generation projects.
So why haven’t DC schemes done it already?
The first perceived barrier is trustees’ fiduciary duty. I think this is a red herring and that the Law Commission addressed this adequately in July 2014 when it published its Fiduciary Duties of Investment Intermediaries report which concluded that trustees should take into consideration factors which are “financially material” to the performance of an investment.
It is hard to argue, for example, that climate change is not financially material. In fact, there is overwhelming evidence that it is, and the government has introduced the TCFD regulations which force trustees to measure the carbon intensity of their portfolios and consider how to reduce it.
The second barrier is lack of product, and this is real. For historical reasons, most DC schemes invest via an insurance platform. Any investment through an insurance fund must comply with the permitted links regulations. These allow unlimited investment in unlisted securities, but only when these securities are “readily realisable in the short term”, and many private assets are not.
The FCA responded to this problem with the “Long-Term Asset Fund” (LTAF), a new category of UK authorised open-ended fund vehicle which was introduced in November 2021. Properly designed, an LTAF will comply with the permitted links regulations.
However, the first LTAF (Schroders Capital Climate+ LTAF) didn’t launch until earlier this year and it has only one DC client so far (Cushon Master Trust). Several asset managers are known to be working on sustainable LTAFs, but any trustee looking to invest in the short term will find a very limited choice, about which they should, rightly, feel uncomfortable.
Solving the illiquidity problem
The third barrier is also very real – the complexity of managing illiquidity within the traditional DC market norm of daily pricing. In an institutional environment, such as a DC Master Trust, daily pricing is unnecessary – it is a hangover from unit-linked retail business, and we need to move on – and if members are to fully benefit from long-term private asset investment, trustees must create new illiquidity management practices.
They must ensure that they have sufficient liquidity to meet day-to-day transactions such as switches, retirements, and the payment of death claims and individual transfers out. In many cases, this can be met from contribution inflow – most DC Master Trusts are strongly cashflow positive and are likely to remain so for the foreseeable future, for example – which should cover day-to-day liquidity requirements.
Liquidity can also be created on the investment platform by blending a liquid buffer into the fund which holds the LTAF shares. Designs will no doubt vary, but an obvious one would be to hold some global listed equity fund units, which are daily priced, alongside the LTAF, which might only be priced and open for new investment quarterly. Contributions can then be allocated daily to the global equity units, building that holding up until the LTAF next opens to investment when the global equity units are realised, and the proceeds invested in the LTAF. Liquidity events within the LTAF might follow the same process but in reverse.
Some managers might also create some liquidity within the LTAF itself, in much the same way as described. This would accommodate the requirements of schemes whose investment platform provider is not sophisticated enough to manage illiquidity on their behalf.
Trustees will also need to think through how to manage a substantial transfer out – for example, an employer electing to move its section of a Master Trust to another scheme. It is entirely possible that this will require either the re-registration of the LTAF shares to the investment platform of the new scheme, or the new scheme accepting a transfer of assets in specie from the LTAF. This needs to be discussed and agreed with the manager at outset.
The bottom line for DC trustees, though, is that they, their investment advisers, their platform provider and their LTAF manager, need to think these illiquidity management issues through, and then the trustees should agree an illiquidity management policy setting out which approach, or combination of approaches, they will follow.
None of these barriers is unsurmountable, but the pensions industry needs to recognise that change is required if we are to innovate in this area for the benefit of our members.