With potentially better-than-stock market long-term returns for a fraction of the volatility, it’s not surprising that the question of introducing illiquids into defined contribution (DC) scheme is such a recurring theme. But the technical challenges of introducing illiquids into products normally the preserve of listed assets can seem like introducing a square peg into a round hole. (Download the 16 page round table supplement here)
Delegates at a Corporate Adviser round table event last month agreed that with a collective will from stakeholders at all points in the value chain, illiquids such as private credit, real estate, private equity, venture capital and direct holdings in infrastructure could be made more accessible to DC investors. But, delegates agreed, there is still much to work out before illiquids become commonplace.
Speaking at the event, Natixis Investment Managers head of UK DC sales & strategy Nick Groom set out some of the challenges of bringing illiquids to DC.
Groom said: “There are a number of technical challenges to get managers thinking differently about how to put a solution together that would deal with the needs of the UK DC market. It is very different from the world that they’ve been living in. We want evergreen in DC, but illiquid investment have generally been closed ended funds, with valuation points from quarter to quarter, if you’re lucky, and also coming in at a high price.
“Managers of illiquids are used to receiving a high level of fees, including performance fees. So our role is to make them understand how to access the DC market in a different way – how positive cash flows for a period of time would give access to deal flow that they probably haven’t had before. In order to succeed, you need a very collaborative group of people through the chain with the will to make it happen within a DC scheme environment.”
Connected Asset Management chief impact officer Rachel Neill, who was formerly at Smart Pension where she headed up sustainable investment and worked with Natixis developing the master trust’s private credit solution, agreed. “We really need everybody along the investment chain on the same page when it comes to illiquids. We can have trustees with the will, but maybe a platform that isn’t accommodating in terms of the requirements, or consultants that are struggling from a valuation perspective. So it really has to be everyone along the chain on the same page for it to happen.”
Mirroring performance
Tess Page, Mercer partner and DC investment adviser, and chair of the Association of Consulting Actuaries’ DC committee, said: “There are a small number of private markets funds that are aimed at DC, where there have been tweaks made to an existing DB focused illiquid product. We’ve done analysis of the differential in the performance of those funds and the full fat version. The DB fully illiquid version has over the last five years performed better than the DC one, which, while it contains a healthy dose of illiquid assets and has outperformed things like diversified growth funds, is still not as strong as the pure illiquid portfolio.”
Groom said: “Those equivalent DC solutions have to take into account liquidity for all sorts of different reasons. We had to account for having an illiquid side of our solution alongside a liquid side to take money in and deploy without cash drag. You’re not getting all of the illiquidity premium like you are in the DB version.
“We’re not talking about Nest here, which can deploy a huge amount of assets on a regular basis to give certainty of deal flow, without the platform implications. Most of the DC world is sitting on platforms, and needs a built in self-contained liquidity solution.”
Daily pricing
For Rene Poisson, managing director of Poisson Management, it is possible to overcome daily pricing and performance fees challenges if schemes are net-cash-flow-positive. Poisson is chair of the JPMorgan single-employer DC scheme, which has around £5.4bn of assets, a director of the Standard Life Master Trust and a director of the USS pension scheme, which has a DC section. Both the JPMorgan and USS schemes are already investing in illiquids, and Poisson says the Standard Life Master Trust has been exploring the idea.
Poisson says: “If you’ve got monthly flows coming in and the pricing is wrong, then it’s wrong on the way in and it would be wrong when a member leaves. If you can establish a daily price, even if trading is suspended, then if the scheme is a net cash inflow world, you can manage the ins and outs within the scheme. It was that sort of analysis that we went through when we introduced illiquids into the Morgan scheme, to satisfy ourselves, one, that we could treat our members fairly in terms of the ins and outs, and secondly, that were we to hit that horror story of a fund being closed to redemptions, we would still be in a position to deal with fund flows going in and out.”
David Porter, director, DC at Mobius Life, the platform provider, suggests the industry should take baby steps in terms of pricing funds, to see what works and what doesn’t. He is chair of the Pensions Administration Standards Association (PASA) master trust working group, and was formerly at AllianceBernstein, which introduced illiquid private equity in 2017, using the Mobius platform.
Porter said: “You might have a different benchmark or a different way of creating a proxy price. And then you might have a fund that values every three months or every nine months or every 12 months or 18 months. You can’t have a sale price in a daily valued fund, so you do need to have some sort of accurate proxy which can be revalued on an event driven basis. And then that can trickle down into your daily proxy because the last thing you want is having a sale and then something has gone horribly wrong, possibly at the end, and how does that get covered? How do you then correct everything that you’ve been trying to value on a daily basis? It has to be net cash flow positive.”
Porter suggested testing the water on systems for valuing illiquids would help grow knowledge on how to manage difficult scenarios.
“Do we start by dipping our toes in the water to these funds that are valued every three months and get used to the mechanism over time? We can get more confident in some of the assumptions we’re making, especially over how we think about performance spike fees, for example?”
‘Cultural obsession’
Department for Work and Pensions senior policy adviser, pensions investment Andrew Blair quizzed panellists on whether daily pricing was a cultural ‘obsession’ of DC, or a necessary element of running a scheme.
“One of the things that we and the FCA are thinking about is the monthly pricing of a Long-Term Asset Fund (LTAF) and how we get these schemes familiar with that and comfortable with that, rather than pandering down to a daily price for those funds and creating a value which is a proxy, yes, but probably no more than a finger in the air.”
Porter agreed with Blair’s assessment. He said: “Are we just stuck in the old ways of doing things in terms of fee structures in the illiquids world? Probably. Perhaps [asset managers] need to think about things in a different way so they can just come up with a set fee. There’s no silver bullet here. Everyone’s talking these issues through and trying to come to a solution. The Natixis-type funds have just an AMC, which is obviously a lot easier to deploy.”
Imran Razvi, senior policy adviser on pensions and institutional market issues at the Investment Association said: “Daily pricing is partly cultural, but at the same time, given that we’re talking about relatively low levels of illiquid allocations, it seems unrealistic to expect to upend the entire daily dealing model when you’re really allocating 5 to 10 per cent to illiquid assets.
“There doesn’t appear to be any appetite from providers to say, OK, you’re 90 per cent invested in liquid assets. You can get those whenever you want, but the remaining 10 per cent, there’s going to be a lag based on however long it takes to liquidate those assets. So until that appetite changes, you’re talking about trying to shoehorn this into the daily deal environment, and that issue exists in the retail world as well, by the way.”
Poisson said: “We need to distinguish daily pricing / valuation from daily trading. A daily price that is, if you’ll excuse the phrase, good enough for government work, is critical because every DC plan has its monthly payroll and investment on a different day. So if you don’t have the right price on the day you do the investment, how we talking about appropriate treatment of members? Unless you mandate that people can only retire or die or transfer to a new employer’s fund on a particular day of the month, you need to have a price that’s good enough.”
Benchmarking proxy
Porter said: “We need to get used to some sort of benchmarking proxy, something that we can get some confidence in over time. Or we could introduce a sweep method where you say, we’re going to give you what we think the value is as at last month, and then we’ll pay out the difference once we’ve done the valuation at month end. It’s an administrative nightmare. You suggest that to a bunch of administration teams out there and they’re just going to say ‘no’.”
For Groom this is an area where talking to managers about new structures can lead to simpler solutions for administrators.
Groom said: “The reality check on that is that we have daily pricing, we have daily liquidity in our in our prospectus. But actually we’ve worked with the platform to be flexible and go from a monthly experience. 90 percent of the assets are listed public assets and there’s huge positive cash flows. So it doesn’t make sense to use an illiquid fund for the liquidity.”
Performance fees
Blair highlighted the complexity of apportioning performance fees fairly. He said: “The DWP has introduced a smoothing of performance fees mechanism around the charge cap and is interested in allowing schemes to pay performance fees if they believe that they are good value. I don’t think we’re going to get DC schemes, especially master trusts, paying anything like 2 and 20, but maybe there’ll be some performance element to private equity fees.”
For Blair, a deeper complexity was apportioning the cost of performance fees fairly across a scheme’s evolving membership.
“It is very easy to allocate a flat fee to members as they move in and out of the fund because you just pro-rata it. But I see a real barrier to the payment of performance fees. That’s going to be really difficult to administer.”
Porter agreed that this would be complex. “On value performance fee spikes, I agree – you can’t do it,” said Porter. “If you’re going to smooth it going forward, you’re doing so based on the fact that I’m paying for something that someone else has enjoyed and left. On day 364 I’ve enjoyed the improvement in performance or I’ve paid a fee that’s higher because there’s an assumption that there’s going to be a performance kicker.
“Then day 365 five comes along. I’ve left, I’ve taken all that, but I’ve paid nothing or I’ve not suffered any loss because actually it hasn’t performed as well as expected because the final numbers have come in. I don’t agree that that can be done on any platform or any administration tool because it’s an input that doesn’t exist. It’s not treating customers fairly.”
Poisson agreed. “The performance fee is an issue in the context of fair treatment of members. Unless you can be satisfied that you’re applying the performance fee on a daily basis, then you’re not fairly allocating cost between members, and that will be true in the default to some extent, just as much as it is in a self-select world,” he said.
Groom said this was an area that needs new thinking from asset managers, to reflect the potential long-term value of them of dealing with the emerging DC market. “So we’re saying ‘factor in some performance fee on top of your annual management charge’ and they’re saying, ‘okay, we’ll do that for known cash flows in the future’.”
Permitted links
Razvi raised concern over impact of the permitted links rules in the life-wrapped world. He said: “If you look at trust-based DC investing outside life wrappers and contract-based, the life wrapper is a complete pain from an illiquid allocation perspective.
“You can think of it as the FCA trying to put on retail protections to an institutional investment process, and it doesn’t really work. I’m talking particularly here about the, at the moment, 35 per cent cap that exists on illiquid assets in the unit linked fund.
“The FCA are partially addressing it through the Long-Term Asset Fund (LTAF) work – they will designate the LTAF as a permitted link in its own right, which will really help. But the LTAF is currently restricted in the FCA’s proposals to the default, so it’s just not going to work for those schemes that want a self-select option if you’re going through the life world.
“So it seems utterly bizarre that you’ve got this situation in DC, where to the member, it all looks the same, but if you’re going through the life world, you’re much more constrained. If you sit outside the life world, you’ve got a lot more flexibility to bring in a wider scope of asset classes. Levelling the playing field towards the non-life way of doing things would be enormously helpful.”
Porter said: “If you’re a trust based scheme or a master trust at the moment, you’re not going to be put 35 per cent allocation into it. So really, the regulation at the moment from the permitted source is more than adequate for super solo, as they’re calling, large single DC schemes nowadays, and also for the larger master trusts that do have that significant 10 per cent allocation of their overall holdings to invest. So at the moment, regulation isn’t stopping allocation to illiquids.
“On the wider point of being able to bring more DB-esque levers and more esoteric investment asset classes to the fore, then yes, levelling that playing ground for the life platform would be very helpful.”
The UK DC sector is still relatively immature – but as schemes consolidate and continue their exponential growth, demand for investment in illiquids is only going to increase. Those schemes that have the will to iron out the technical difficulties and make illiquids work can expect better returns, which should, in the long term, mean greater market share.