The Pensions Policy Institute has published a new report, which examines in detail how DC pension schemes can increase their exposure to illiquid and alternative assets.
This report sets out the various challenges, be it costs or regulatory, operational and governance hurdles. It also looks at strategies to overcome these challenges.
It points out that the increase in scheme size – through the consolidation of master trusts and the wider take-up of auto-enrolment – could address many of these challenges.
The report comes as the Department for Work and Pensions, the Treasury and the FCA are consulting on the best way to enable pension schemes to invest more of their assets in these less traditional asset types.
According to the PPI the vast majority of DC assets (76 per cent) are currently invested in listed equities and bonds. A further 5 per cent of assets under management are invested in cash, with the remainder invested in multi-asset and alternative funds.
The PPI report clearly sets out the advantages for DC pensions to invest in a broader range of assets.
It points out these illiquid and alternative assets (such as private listed equity and hedge funds) can offer better diversification, as these assets are not generally subject to the same market forces as publicly-listed equities and bonds, and therefore may not suffer losses at the same time.
It also adds that these assets often provide long-term returns at or above inflation, and may therefore be suited to pension investment. They also have the potential to deliver a higher, more secure return, net of charges, over time than liquid assets.
However the report points out that despite these advantages there are a number of hurdles preventing DC schemes accessing these asset at present. These include:
- Higher costs – costs are often higher than more liquid assets
- Operational challenges – it can be difficult for schemes to integrate illiquid and alternative assets into their investment strategy for a number of reasons, this can include difficulties in valuation of assets, the sharing of risk/ return across different cohorts, and the variable charges and performance fees that are associated with these asset classes. In addition there may be a shortage of supply to these asset classes, particularly via platforms.
- Governance and regulatory challenges – the complexity and a lack of transparency can make it harder for scheme to do their due diligence, and can interfere with schemes fulfilling their obligation to report on costs and charges.
In addition the PPI points out that Permitted Links regulations have been interpreted as not allowing in investments in assets which do not allow immediate access to funds, though the FCA intents to clarify the wording around these regulations to make it clear that investments in illiquid and alternative assets is allowed.
The PPI report adds that growth, consolidation and the closure of some small schemes could play a key role in overcoming both operational and cost challenges. It estimate that DC assets under management are expected to increase from around £280bn in 2017 to £1.68 trillion by 2030.
At the same time changes to and clarification of regulations may help facilitate more DC scheme investment into these assets.
It says an increase in demand from schemes for these assets should ideally result in investment and development by platforms, leading to a change to the daily valuations and dealing practices of DC platforms, so that assets which are valued less frequently are catered for.
It does add though that asset managers may need more guidance from the regulator on reporting on charges and transaction costs for these assets. In order for schemes to find it easier to comply with disclosure regulations, asset managers may need a prescriptive framework for reporting charges that appear more opaque or vary over time. It points out that the Cost Transparency Initiative is planning to produce templates for this purpose.
The PPI adds that advancements in education and a more “holistic communications approach” – involving consultants, investment managers, platforms and providers – might be necessary to encourage more reluctant trustees to consider these assets.
The report adds that there are methods for calculating the proportion of funds in DC schemes that can be invested in illiquid and alternative assets, to ensure there is sufficient liquid capital to meet ongoing expenses.