Why Allocate to Private Credit in Your DC Pension Plan?

04 July 2024

6 min read

Henry Smith, CFA| Investment Strategist—Multi-Asset Solutions

David Hutchins, FIA| Portfolio Manager—Multi-Asset Solutions

Saving for a pension isn’t getting any easier. But allocations to private assets—such as private credit—could help.

It’s getting harder for UK defined contribution (DC) savers to accumulate realistic amounts of capital for their retirement. Prospective real returns from most asset classes look unlikely to match those of recent years. And the cost-of-living crisis is making it tougher for savers to maintain their current pension contributions, let alone increase them in future. How can DC savers get ahead?

Allocating to private assets can help. We believe investments like private credit can meaningfully improve DC savers’ return potential over the long term. Given that DC savers have long-term horizons, we believe DC fiduciaries should aim to overcome the hurdles that have prevented meaningful private market exposures and unlock the benefit from the additional returns associated with the illiquidity premium.

How Private Credit Helps Enhance Returns

Private credit is simply an alternative form of lending. It can take various different forms—from corporate lending to commercial real estate lending to specialty finance (for instance, credit card loans and residential mortgages). All of these specific classes of private credit have distinct risk and return characteristics.

One of the most popular classes of private credit is corporate direct lending. These loans are directly sourced and privately negotiated credit investments with a single or small group of lender(s). While there are opportunities across the private credit spectrum, this specific area has been a focus for our research—and is what we refer to broadly as “private credit”.

Private credit has historically offered a return premium above public fixed income (Display, below).

Private Credit Has Provided Premium Returns

US Market Comparisons

Over the 10 years to end-2023 private credit returned annualized 8.1% versus US high yield 4.6% and US investment grade 3.0%.

10-Year Annualized Returns in US Dollars
Index returns shown are Cliffwater Direct Lending Senior Index (Private Credit), Bloomberg US High Yield 2% Issuer Cap Index (US High Yield Credit) and Bloomberg US Corporate Bond Index (US Investment-Grade Credit).
Through 31 December 2023
Source: Bloomberg, Cliffwater and AllianceBernstein (AB)

An illiquidity premium has played a big part in that performance advantage. Given the lack of an established secondary market, direct loans require lenders to provide a long-term commitment to borrowers, funded by a long-term capital commitment from their investors. In return, investors demand additional yield as compensation. Historically, this illiquidity premium has averaged around 2%, as we can see by comparing new issue yields in direct lending versus those in the syndicated loan market.

Structural changes in the capital-raising function of the global economy have also supported private credit’s return premium: notably, shrinking public-securities markets and the retreat of traditional capital providers.

Private credit today is a credit arbitrage opportunity—it fills a void left by a more cautious banking sector that has scaled back its lending activities since the global financial crisis (GFC). The net effect: less credit offered by banks to small- and medium-sized businesses.

We think these factors will continue to support a return premium for private credit over public credit.

When integrated into a DC glide path strategy, we believe this asset class can generate a modest enhancement of real returns. And by investing the glide path allocation within the same risk profile, the additional return could involve no increase to the strategy’s risk budget.

On an annualized basis, this return enhancement may not sound substantial. However, the compounding effect can be material, particularly for savers with longer horizons—younger members, or those targeting continued investment and income drawdown in retirement.

Private Credit Can Help Mitigate Portfolio Risk Too

Extra return without more risk sounds almost too good to be true. But we think there are several reasons why allocating to this asset class can provide DC savers with an improved risk/reward profile.

Private credit has historically provided stability during volatile economic environments and periods of market stress. For instance, drawdowns, which measure the decline from a market peak to its trough, were much more severe for public credit markets during the GFC and the COVID-19 pandemic than for private credit (Display, below).

Private Credit Has Experienced Shallower Drawdowns than Public Debt Markets

Maximum Peak-to-Trough Drawdown (Percent)

Private credit’s drawdowns were far smaller than leveraged loans or high yield in the GFC, COVID, and 2022 Fed tightening.

Past Performance does not guarantee future results.
Maximum peak-to-trough drawdown reflects the largest peak-to-trough drawdown in quarterly index value during the specified periods: Financial Crisis: 3Q 2007–4Q 2008, COVID: 1Q 2020–4Q 2020, 2022 Fed Tightening: 1Q 2022–4Q 2022. Private Credit is represented by the Cliffwater Direct Lending Index, which reflects the unlevered performance of U.S. middle market corporate loans. High Yield is represented by the Barclays US Corporate High Yield two percent Issuer Cap Index. Leveraged Loans is represented by the Morningstar LSTA US Leveraged Loan Index.
As of 31 December 2023
Source: Bloomberg, Cliffwater, Morningstar and AB

We think private credit’s more defensive profile results from structural features.

Private credit typically involves a single entity lending to a borrower, which creates important advantages. Since managers generally don’t actively trade in and out of loan positions (instead, holding them until they are repaid by borrowers), private credit is more insulated from the technical selling pressure that is typical in down markets in traditional, publicly traded asset classes.

Direct loans are often executed at the top of the capital structure and therefore benefit from large equity cushions to absorb potential declines in a borrower’s value. These loans are also typically structured to give lenders a priority claim on a borrower’s assets, including equity in the underlying business.

Lenders can negotiate protective covenants, such as a cap on the amount of borrowers’ leverage or a required minimum liquidity level. These covenants provide lenders with negotiating power to amend loan terms in their favour or to effect other resolutions if a borrower underperforms.

Unlike traditional publicly traded fixed income, most private credit loans are floating rate. In other words, the interest rates paid by borrowers move in tandem with changes in benchmark interest rates. This dynamic provides a natural hedge against rising interest rates and means that private credit is less sensitive to monetary policy (i.e. has no duration risk).

Private credit has relatively low correlations with traditional equity and fixed-income markets for both idiosyncratic and structural reasons. Within the broad private credit asset class, the diversity of available credit strategies means that investors can have greater control over their exposure to economic factors like the health of corporate borrowers and consumers, and to real assets.

Start with an Appropriate Investment Vehicle

Of course, illiquid investments have historically been difficult for DC investors to access, but today it’s possible to work around the implementation obstacles and achieve cost-effective exposure to assets such as private credit. Highly capable investment vehicles such as target date funds (TDFs) can incorporate complex asset classes while remaining simple for fiduciaries to use and easy for members to understand. DC savers invest in a single TDF corresponding to their desired retirement window, and the TDF glide path is actively managed in line with the target date.

With a TDF approach, professional investors oversee all asset allocation and cash flow decisions for each of the multi-asset funds in the TDF range. This helps avoid many of the complications associated with investing in illiquid markets. For example, there’s no need to use separate hybrid listed / private market fund exposures to facilitate cash flows; instead, DC TDF savers’ cash flows can be allocated to private market assets within their existing strategy.

This approach also avoids unnecessary private asset trading costs because liquidity needs can be met at the TDF strategy level. Governance, fee and cost issues are all addressed at the TDF strategy level, too.

Using Private Credit Across the Age Spectrum

The depth and variety of private credit markets enables different strategies according to DC savers’ ages and risk profiles. For instance, to add private credit in UK TDFs, we believe an allocation can be structured consisting of several distinct strategies—each used at different points along the journey to retirement and each offering differentiated approaches to private credit investment.

Given the growing scale and buying power of UK pension plans, further supported by the pooling effect of default strategies managed by pension providers and asset managers, we believe that fiduciaries can offset some of the upward fee pressure that active private market allocations involve. By extension, using TDFs can help keep the administrative costs and fee expense of such allocations to a minimum. With this approach, it’s possible to implement a meaningful private credit allocation with a minimal to very modest increase in total charges, with the exact cost depending on the glide path position. We believe that this level of increase in fees represents attractive value considering the private credit allocation size and expected long-term return enhancement.

In the evolving landscape of DC pension saving, private credit offers a promising avenue for higher returns and risk diversification. It’s time for fiduciaries to consider embracing this opportunity to help secure the future of DC savers.

For further details, download our White Paper:

Grasping the Private Markets Opportunity: Accessing Private Credit for UK Defined Contribution Savers

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams. Views are subject to revision over time.

About the Authors

Henry Smith, CFA

Henry Smith is a Vice President and Investment Strategist on AB’s Multi-Asset Solutions team. He is responsible for the product strategy and communication of AB’s UK defined contribution, custom multi-asset and sustainable multi-asset solutions. Smith joined the firm in 2019, following more than two years at Lane Clark & Peacock, where he provided investment, research and governance advice to a range of UK defined contribution pension schemes. Before that, he worked at Capita Employee Solutions, where he advised both UK defined contribution and defined benefit pension schemes. Smith holds a BSc in financial economics from the University of Essex and is a CFA charterholder. Location: London

David Hutchins, FIA

David Hutchins is a Senior Vice President and Head of AB's Multi-Asset Solutions business in EMEA. He is responsible for the development and management of multi-asset portfolios for a range of clients. Hutchins joined the firm in 2008 after spending two years at UBS Investment Bank, where he was responsible for devising and delivering innovative capital markets risk-management solutions for pension schemes. Prior to that, he spent 13 years at Mercer, where he served as a European principal and scheme actuary, providing trustee and corporate advice to a range of UK pension funds and their sponsors. Hutchins holds a BSc in mathematics and a PGCE from the University of Bristol. He has chaired the Investment Management Association's Defined Contribution Committee and formerly chaired the defined contribution industry working group for the UK government's "defined ambition" project. Hutchins is a Fellow of the Institute and Faculty of Actuaries. Location: London

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