Managing Illiquidity Problems
Private markets investments are illiquid, and traditionally were only available in closed-ended funds with a scheduled wind-down date. That was a problem for DC savers: although their daily liquidity needs are typically low, they still need some cash-flow management for regular contributions, strategy rebalancing or de-risking, and (for those in retirement) withdrawals.
Daily liquidity is unnecessary for private assets held within a diversified DC portfolio. But daily oversight is important, because it’s crucial to manage liquidity effectively at the overall strategy level, and to ensure both that private market investments represent value for members and that default strategies continue to offer flexibility.
The traditional approach to delivering DC default strategies in the UK, known as lifestyle or lifecycle strategies, depends on asset allocation plans that are implemented mechanistically by scheme administrators. With these arrangements, there’s no daily portfolio manager oversight for the strategy, and this has historically prohibited private market investments in DC.
The Financial Conduct Authority (FCA) has sought to overcome the illiquidity problem by encouraging open-ended product innovations, such as Long Term Asset Funds (LTAFs). To make liquidity available, these typically combine private and public market investments into a single fund vehicle—with the public market investments available to meet subscriptions/redemptions into/from the DC portfolio.
We believe these hybrid vehicles are often sub-optimal because their costs may be unnecessarily high and their dealing times restricted. LTAF charges, for example, are typically higher than public market funds and apply the same fixed fee across their combined public and private investments. Many of these open-ended hybrid structures are still subject to significant (e.g. 90-day) notice periods to redeem investments and have limited dealing opportunities.
Managing liquidity at the overall strategy level is more efficient, in our view. TDFs enable this approach as all asset allocation decisions over the term to and through retirement are applied within a single multi-asset fund. With a dedicated portfolio manager directing cash flows for every TDF at the overall strategy level, DC savers’ cash flows can be allocated to private market exposures within their existing TDF, and redemptions can be sourced from more liquid exposures. This process ensures that the daily liquidity needs of DC savers can be met, all while minimizing unnecessary costs.
Managing that process needs experience and ingenuity. For instance, fund managers can create a liquid asset buffer fund within TDF strategies that can help minimize trading activity and trading costs in illiquid exposures such as private credit.
Listed private market vehicles (such as investment trusts) offer an alternative way to access private market exposures and can help provide liquidity too. These vehicles reduce the need to transact underlying illiquid exposures, as investors can buy and sell shares daily on an exchange. That said, these vehicles are less liquid than securities of large publicly traded companies and still need liquidity management processes.
Coping with Higher Management Fees and Costs
Private market investments are inherently more expensive than public market equivalents for several reasons. They’re less mature than public markets, the investments are not easily replicable at low cost and they rely on active management to drive exposure. Management base fees in private asset classes are often in the 1%–2% range, and additional performance fees are much more common than in public markets.
These higher (and potentially variable) fees can challenge cost-constrained DC schemes. The current default charge cap (0.75%, ex-performance fees) should provide adequate headroom for DC pension plans to allocate meaningfully to private markets, but a constant focus of regulators, commentators and brokers on cost over quality has deterred fiduciaries. It’s also created an unwelcoming commercial environment for master trusts, which aim to price considerably lower than the charge cap and so may be reluctant to incur the extra cost of private market allocations.
TDFs, in our view, can provide a ready solution. Leading TDF managers typically have enough scale and expertise to negotiate competitive private market fee levels, and can use their streamlined investment approach to help curb the administrative and operational expenses of private assets.
Accessing Leading-Edge Investment Platforms
Most UK DC plans use investment platforms to construct and deliver their DC default strategies, but private markets can be problematic for investment platforms for several reasons. These include illiquidity, operational challenges (for instance, limitations in systems capability, or inability to manage cash flows) and regulatory obstacles (for example, inability to meet “permitted links” liquidity requirements).
DC plans’ demand to access private markets will incentivize and promote innovation among investment platforms, in our view. Platforms that fail to support private asset exposures will risk losing client assets. And those that develop ineffective solutions risk regulatory or reputational issues from potential failures. We believe that it’s critical to identify and partner with leading-edge investment platforms that are able to accommodate and effectively implement exposures to private markets.
Ensuring Member Fairness
Infrequent pricing presents particular problems for DC savers. It can result in valuation mismatches with the true asset value—and these typically favour members selling private market investments to the detriment of those buying. These mismatches may result in the unjust systematic transfer of wealth from sellers (i.e. older members) to buyers (i.e. younger members) over time. Poor macro-level management of private market investments is another potential pitfall that can result in opaque (and higher) transaction costs or unfair pricing for those looking to transfer benefits or to draw down at retirement.
That’s why it’s vital to consider pricing methodologies carefully when implementing private market exposures, in the interests of fairness and transparency for members.
Education and Governance
Many DC fiduciaries lack knowledge and experience of this segment of capital markets. Although some DB pension plans in the UK have been significant investors in private markets and have associated DC sections, the delivery of DC in the UK has been heavily concentrated through traditional pension providers, master trusts and retail self-invested pension plans. These typically have limited overlap with DB pension provision.
The inherent difference in fiduciary responsibilities and the ability to fund shortfalls between DC and DB pensions may also result in some hesitancy by DC fiduciaries to allocate to more complex non-traditional investments like private markets. So, in addition to the removal of physical implementation hurdles, many recent industry and regulatory initiatives have focused on building confidence and collective understanding in private markets.
Time and resources can be a big constraint. Understanding and selecting managers and overseeing private market allocations is a labour-intensive challenge for DC fiduciaries, particularly considering their already heavy burden of regulatory reporting and oversight of service providers. These problems are aggravated by the relatively small allocation sizes that private markets will likely represent (at least initially). To ease this burden, advisors and outsourced managers can play an important role to help with training, manager research and daily portfolio oversight/management. Using TDFs can offer an important advantage, as they are actively managed by investment professionals and incorporate functions which fiduciaries would normally need to acquire and pay for separately such as: research, manager selection, oversight, governance and compliance, and fee and cost control.
UK DC pensions savings have come a long way, moving from often basic investment options with limited regulation and relatively few participants, to an auto-enrolled mass-market savings business with onerous compliance requirements and increasingly complex investment needs. Given these changes, we believe fiduciaries should consider their choice of investment vehicle with the same rigour as their choice of asset strategy if they are to take full advantage of the opportunities private markets can provide.
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