When last year’s Autumn Budget outlined plans to open up patient capital investments for defined contribution (DC) pensions, the reaction from the wider industry was broadly positive but cautious. Some felt the challenges of integrating illiquid assets into DC schemes would ultimately prove too great.
My feeling however is the greater risk lies in relying on the status quo for DC investing to deliver the long-term risk-adjusted returns savers need; illiquid assets and private markets need to be part of the future of DC.
So far master trust investment strategies have been designed to focus on public markets and ensure costs are kept low. This made sense while schemes were starting up and the amounts being invested were small.
But the DC market is growing, and growing quickly – we’ve seen another rise in auto enrolment minimum contributions, making the total amount 8 per cent. In addition, we’re now experiencing more volatile markets and lower expected returns than we’ve seen in previous years.
Against this backdrop we need new options to keep our members’ money growing sustainably.
Risk management is all the more important in the context of automatic enrolment schemes, which serve 10 million new savers. There is ample research demonstrating these typically younger and lower earning savers are especially sensitive to volatility and losses – the emotional responses explained by Prospect Theory are particularly acute.
Schemes should therefore be developing an investment approach that looks beyond indexed equity markets; diversification is key and finding new ways to produce good, steady returns for similar or even lower amounts of risk than public markets alone can offer.
Already Nest has taken strides in moving towards alternatives. Last year we added a commodities fund to our portfolio with the plan for the allocation to be around 5 per cent across the fund.
But the next big step is into private markets and illiquids. It’s the natural progression for a DC scheme of our size.
We know this in part because we’ve seen it done successfully in other countries. Australian super funds and workplace schemes in the US have been accessing private credit for decades and it is a mainstay of default fund asset allocations.
In the coming months Nest will appoint the fund managers who will manage our new mandates allowing us to enter into private credit, including global infrastructure debt, real estate debt and mid-market corporate loans.
Nest’s membership can really benefit from the illiquidity premium – our youngest member is 16 and she will likely remain invested with Nest throughout her working life. We have the cash flows and scale to give our younger and older members alike exposure to the benefits of long term illiquids, and also the sophistication to work with fund managers to open up the private credit universe.
But this isn’t just unique to Nest. Most large master trusts have the growing membership and AUM which means collectively we can bring a scale that makes fund managers want to work with us in providing innovative ways to access private markets. Master trusts should find costs less of a barrier than they have in the past.
Private markets should not be seen as off-limits, nor a risky asset. In fact, we hope to demonstrate illiquids can play an important, perhaps essential role in many schemes’ default investment strategies.
Stephen O’Neill is head of private markets for Nest