Daily pricing of investments is not a legal requirement
To paraphrase Tony Blair, one of the golden rules of investing is diversify, diversify, diversify. Yet defined contribution (DC) pension schemes are failing to do so. The Defined Contribution Investment Forum put out a paper last month detailing the case for a relaxation of daily dealing requirements for DC pension schemes, saying that daily pricing of investment funds is stopping DC funds from benefiting from the diversity and growth potential offered by less liquid asset classes.
Nest, the Government’s default DC scheme has a long term hold on pension savers’ cash – unlike other workplace schemes you cannot transfer out of Nest – and therefore it is free to invest in assets that require a longer-term view. Assets such as infrastructure, private equity and real estate.
These less liquid assets offer diversification – and the chance for greater returns. But other DC schemes do not. Restricted by the restraints of daily trading, most workplace schemes are a mish-mash of equities, bonds and cash.
Nico Aspinall, Towers Watson’s head of UK DC investment consulting, argues that an overly short investment horizon has been imposed on DC schemes – reducing risk-adjusted returns in the long term in comparison to DB. “Having to be capable of trading on a daily basis forces funds to hold assets which can be redeemed at a moment’s notice,” he says. “Only holding investments which can be redeemed tomorrow, when you know you are not going to be able to retire for decades, is a very strange way to invest and definitely reduces diversification and risk-adjusted returns over the longer term.”
Currently, this bias towards assets that are priced daily means that DC pension scheme members do not have access to the same top-notch portfolio construction methods which are available to DB schemes.
DC investors do not have the same access to the available variety of portfolio construction methods as their DB counterparts. Risk and asset “pooling” make complex and sophisticated structures more easily accessible to DB investors, says Jupiter institutional director Charlie Crole. Moreover, he argues, in the absence of a corporate covenant and a governance structure that can in aggregate tolerate greater short term volatility and illiquidity this is perhaps not particularly surprising.
But Hymans Robertson senior investment consultant Rona Train says that in time she expects DC schemes to broaden the type of investments they invest in.
“DC schemes are still generally small but as schemes get larger, there will be more opportunity to include a wider range of asset classes generally, including less liquid assets” she says. “This is the model which has developed in Australia through the Super Trust market with economies of scale allowing investments in areas which might otherwise be too expensive or too illiquid to include in DC schemes.”
Over time this may change in the UK, particularly in master trusts as these gain critical mass.
Train expects more products to be developed over the coming years that will allow DC members to gain more access to the types of assets currently used by DB schemes.
“Scale is the real issue at this stage as schemes generally lack sufficient bargaining power and critical mass,” she reiterates. “In some cases, DC schemes already gain access to a wide range of asset classes through multi-asset funds – including diversified growth funds – and we expect to see more products developed in this space over the next year to 18 months.”
Barclays Corporate & Employer Solutions’ Paul Wilson says a move to broaden the type of assets held in DC scheme portfolios is a great idea.
“Steps have already been taken to bring a greater number of illiquid assets into the DC arena, such as direct investment property funds and commodity funds, and we have seen the emergence of diversified growth funds that often use such asset classes,” he says.
“However, for the DC market, there are hurdles to overcome to open these assets out to the market further.”
Top of the list is technology. Current DC administration platforms can’t generally cope with non-daily pricing and updating this technology will be costly.
Adding to the financial woes are higher trading costs. Illiquid assets often have high management charges, arguably too high for a default strategy where pricing pressures are acute.
Changing the culture of daily trading may feel like a big issue to members, but Aspinall argues the value members derive from daily trading is overstated.
“If DC schemes became monthly traded, so that everything went into the market on the same day as the payroll cycle, and if they also were told that some types of trade – for example investment switches rather than retirement, transfers or death – may be held for a period of time, I think members would get used to this approach and work with it,” he suggests.
Under this model much of the trading would be done between members rather than the market. This sort of trading would help keep costs down too.
He does concede that this move would initially be expensive to do however, and for all but the largest funds it would be hard to do without the platform and the administrator taking the lead.
It would have to be spearheaded by a bundled provider announcing they would move their pension offering away from daily trading. Aspinall predicts that this bold move will not happen until auto-enrolment has been fully implemented in 2018.
Costs aside, investing in less liquid assets does raise a question over transparency – something that under auto-enrolment the pension industry is keen to uphold.
“As we have seen with hedge funds in previous years, understanding what these funds invest in is not always an easy task. Bringing illiquid asset class funds to DC would increase the governance burden not only on trustees but also on employers who would need to know more about what they are investing in, which in turn would need to be fed down to the members,” Wilson warns.
“Often the hardest part of investing in illiquid assets is knowing when to disinvest as well as the time it takes to disinvest. Waiting for a full quarter to redeem assets is not ideal for a DC member, in contrast to DB trustees who can make informed decisions about when to disinvest, taking account of timings.”
Crole agrees. He argues there is much to be said for simplicity and cost-effective and transparent pricing – both of which can be emphasised to increase member involvement and understanding.
Also acting against illiquid assets are their volatility. Although greater risk can lead to greater return, thanks to auto-enrolment tens of thousands of employees will become first-time pension savers over the next couple of years – and these novices might not be able to stomach the risk.
Train says that while she expects the level of illiquid assets held in DC schemes to increase, there will always be restrictions to this type of investing.
“You can have a fair idea of how much will go into and out of a fund on any given day so can invest at least some of the portfolio in some illiquid assets if the scheme is large enough, but you need to make sure that you will not need to realise assets quickly – as this will not be possible if there are significant investments in illiquid assets,” she says. “Some schemes already invest in illiquid assets such as property. While we expect to see an increase in less liquid assets in DC schemes over time, we expect this to be no more than around 10 per cent of portfolios.”
Crole suggests liquidity rated funds could be one way forward, as could co-mingling small percentages of less liquid assets in more liquid overall investment strategies.
Life-styling products could also allow greater exposure to illiquid alternatives at the early stages of the fund life-cycle.
There may not regulatory requirements to manage DC funds on a daily pricing basis, but this does not necessarily mean they can voluntarily switch their methodology.
“One of the biggest barriers to changing daily dealing could come from providers’ systems,” says Train. “It would be a major investment to change systems, as well as pension schemes expectations in relation to daily dealing. This is likely to mean little or no change to the system in the foreseeable future.”
According to State Street Global Advisors managing director and head of UK defined contribution Nigel Aston, the pensions sector needs to distinguish between any requirement to value DC assets daily and the perceived need to have absolute liquidity of all of a fund’s components. He said that there is no real reason why investment vehicles with dealing cycles other than daily cannot be included in a DC fund structure.
“We are starting to see DC clients happy to forego the convenience of total liquidity of their fund’s underlying components in order to consider, for their members, new and broader sources of return,” he argues. “Some DC platforms may have their own rules that demand a daily dealing capability, but it would be a shame if certain assets are precluded on this basis, even though they otherwise have attributes – such as inflation protected income generation – that make them attractive to long term DC savers.”
Wilson says that additional thought needs to be given to this issue from the individual members’ perspective.
While there has been much discussion in the market regarding transparency, simplicity and member understanding, he argues that the introduction of more complex, illiquid asset classes will lead to a more complex investment strategy which the majority of individuals are unlikely to understand.
“If members don’t understand their investments, then there will always be some element of apprehension with regards to future investment and pension saving,” he says.
“Direct access to illiquid asset classes requires specialist knowledge and an individual member is unlikely to have the ability or the time to be able to do this effectively. This explains why diversified growth funds have been so popular in recent times, as they take a broad spectrum of asset classes, often some quite specialist, and bring them together in a strategy with regular review and expert oversight.”
Aston believes there are four advantages of DB plans that should be imported to DC.
“Firstly, and most obviously, higher contributions; if the average DB saving rate of 20 per cent or more was paid into a DC plan, outcomes would improve no end. Secondly, rotation; DC plans need to become much more nimble as far as the risk on/risk off dynamic is concerned,” he argues. “Thirdly diversification; the equity risk premium is only one of a series of risk premia that can be used to affect both the return and the volatility of the portfolio. Finally, the use of institutional grade index components, rather than retail funds, to achieve portfolios of high quality and good value.”
DC schemes may be the future of the UK pensions industry, but it is a far from perfect system. The millions of workplace savers who will come to rely on their defined contribution plans deserve the very best fund solutions possible.