Alternative route? Dodging the barriers to DC diversification

Investment

DC investment in alternatives is being held back by daily pricing and the charge cap. But, says Michelle McGagh, managers are finding ways around the problem

Pension fund managers are keen to expand their investment strategies to include alternative investments such as infrastructure, property and private equity. But they have come up against regulatory obstacles that are preventing them from diversifying, meaning they typically have to rely on equities, bonds and cash.

The first hurdle is the requirement for daily dealing that prevents schemes from investing in less liquid assets – which alter­native investments tend to be – and forces managers to hold assets that can be redeemed at short notice.

The second is the 0.75 per cent charge cap for default funds that is pricing managers out of alternative investments, which tend to cost more than the basic mix of equities and bonds.

JLT Employee Benefits senior investment consultant David Will says there is not a “huge allocation to alternatives” because of the DC constraints.

“The requirement for daily pricing and dealing of funds and the charge cap for default funds could limit the use of alternatives because they tend to be more expensive,” he says.

“Allocations to alternatives are not uncommon but only in small amounts. You do find infrastructure or property in default funds for DC schemes but the allocation tends to be small.”

When it comes to the cost of alternatives, it is not only the charge cap that has to be considered but the way in which fund fees are structured.

Age appropriate

The use of alternative investments can make  sense given the age range of members in employee pensions and the breadth of retirement ages.

BlackRock head of retirement planning for EMEA Tony Stenning is a fan of alternative investments but says the daily dealing requirement is a burden on schemes and, furthermore, is illogical when the age of members is taken into account.

“When you have people invested in a pension taking on long-term liabilities of 30, 40 or 50 years, it seems crazy to have daily liquidity,” says Stenning, pointing to the Danish system that allows 30 per cent investment in illiquid investments such as private equity and real estate.

“Danish pension schemes can maintain a liquidity requirement but get the illiquidity premium on offer. If the regulatory regime was aligned with member requirements, we could secure those benefits.”

Nest chief investment officer Mark Fawcett agrees that short-term liquidity is not relevant for younger members and that allocation needs to be more flexible to take into account the range of members.

“As some of our members are as young as 17, we’ll probably invest their savings for a number of decades,” he says. “Investing on these timescales means that short-term liquidity is not important, so it makes sense for us to invest in illiquid assets so that we can earn the extra return available from the illiquidity risk premium.

“However, it is important to note that this risk premium is not constant through time and will also vary by asset class. Therefore the asset allocation process needs to be flexible enough to recognise this, rather than to blindly invest in a constant proportion to alternative illiquid assets.”

DB advantage

The flexibility to invest in alter­natives has been useful for defined benefit schemes, according to Will.

“DB schemes have a distinct advantage in their unique ability to take illiquidity risk,” he says.

“DB schemes include allocation to alternative asset classes….Most DB schemes will be cashflow positive or, even if they are negative, they can normally – with a combination of contributions and income generated from investments – meet most short-term needs in relation to member payments without selling assets. So they can allocate a proportion of their portfolio to property, private debt or private equity; that may have a lock-in period that would not work as investments for DC schemes.”

Will says it can be argued that DB schemes are run better and that a more flexible approach to alternative investments “certainly has advantages over DC”.

DB schemes also benefit from greater assets under management, which means they “take up a lot more of the investment governance budget” despite this arguably being more important for DC investors “where individuals are bearing the investment risk”.

He adds: “DB schemes certainly have more opportunities and are run in a very different way. And, while they cannot ignore the short-term focus from regulation, they take a longer-term approach to valuation and look at alternative investments.”

As DC funds under management grow, there is more opportunity to diversify the investments held by the schemes and take a bigger cue from DB schemes, says Will.

“This is particularly the case with trust-based DC schemes where the structure can be put in place to facilitate that in a way that is not possible with a contract-based arrangement, where each member has a contract and can ask to take out assets at any time.

“As DC assets become larger and the schemes get bigger and more sophisticated in terms of approach to investment, we will see a greater allocation to alternatives. We do see small allocations to commercial real estate and hedge fund-like strategies but only a small amount given the charge cap.”

In fact, diversification is happening already and DC schemes are finding a way to add alternatives to their default fund investment strategies, such as through the use of target-date funds and “more sophisticated diversified growth vehicles that invest in, for example, currency and direct trades in the overall structure”, says Will.

This is particularly noticeable in the shift from lifestyle funds to target-date funds, the latter being “better placed to take on more illiquid risk without necessarily having to give up daily dealing” because the funds are more structured than lifestyle funds, which allows quicker access to assets.

Nest too is finding ways to invest in alternatives without breaching the requirements for daily dealing.

Fawcett thinks daily dealing does not necessarily prevent DC schemes from benefiting from the illiquidity risk premium provided by alternatives.

“Many property funds price daily,” he says. “While it may be a constraint for infrastructure, which tends to be valued only quarterly, this can be managed provided there is a way of estimating fair daily valuations – for example, by using a proxy pricing vehicle – to ensure that members are not systematically disadvantaged by money flowing in and out of the fund.”

In addition to the problems over access to the money, Faw­cett says Nest faces the challenge of “being able to get the money invested efficiently in a timely manner” because “our cash inflows are currently so strong”.

‘Volatility control’

In their efforts to dodge the obst­acles to investing in alternatives, DC pension schemes are taking a “volatility control” approach to their default funds, says Will. Although this does not solve the difficulties of staying below the charge cap and daily dealing, he believes it enables schemes to be much more “outcome focused”.

He says: “It is an alternative approach to allocation – a technique of managing risk and thinking about volatility on a wider scale.”

In order to manage volatility, schemes are investing in more passive investments at an equity and bond level. They are also using passive investments to gain exposure to alternative assets.

“They need cleverer, cheaper ways to invest in alternatives. But they are becoming more acc­essible through new derivative structures – like ETFs and smart beta – rather than physical investments,” says Will.

“Schemes are very conscious of the need for a wider, more diversified approach, not just in terms of physical allocation but in terms of risk exposure. The equity risk premium is not always guaranteed to come through.”

In Focus: View from the Nest

MarkFawcettNest chief investment officer Mark Fawcett says the government-backed pension scheme has found ways to gain exposure to alternatives, but cost “can be a challenge”.

He says: “This is not because of the charge cap primarily – our charges for most members come in well under the charge cap – but because a number of illiquid assets, such as private equity, have fee structures that aren’t appropriate for Nest.

“DC schemes generally struggle with performance fees from an accounting perspective. The fees get paid annually but the appropriate rate of accrual through the year is uncertain.

“Moreover, we philosophically have an issue with performance fees [and] do not believe they align incentives in the way managers claim. They too frequently serve just to reduce returns to investors.”

Fawcett believes alternative investments offer a boost for DC schemes, particularly when stockmarkets are turbulent, and are a way for managers to control risk.

“Nest has a strong belief in the benefits of diversification, not only as the primary way to manage risk but also as a way of gaining different sources of return,” he says.

“So, for example, in the past year, while many equity markets have struggled to deliver positive returns, UK direct commercial property has delivered double-digit returns.”