Greater Illiquidity Could Boost DC Pot Sizes by 5%

(May 17, 2013) — Defined contribution (DC) funds’ propensity to insist on daily pricing and trading is hampering their potential, according to a new white paper.

The Defined Contribution Investment Forum (DCIF) – a collective of investment firms and other industry participants that have a passion for pursuing investment excellence for DC schemes – has called for the industry to reconsider whether daily pricing and trading is damaging member outcomes by preventing the schemes from investing in illiquid assets.

There are no legal parameters forcing daily dealing and pricing for UK DC schemes, but most DC providers have stuck to assets which are priced and dealt daily because members liked being able to see their pot size’s actual value, assets can be realised more quickly, out-of-market exposure can be switched quickly, and lifecycles could be operated more efficiently.

However, this approach effectively shuts the door on asset classes like hedge funds, property, infrastructure and reinsurance. The DCIF paper suggests granting access to these assets through relaxing the daily pricing and trading rules would increase diversification across DC portfolios and improve their retirement pots’ value by as much as 5%.

Some schemes are gaining exposure to real estate and private equity through listed private equity funds, but even here the illiquidity premium is dampened by the significant cash buffer listed private equity funds are forced to hold, causing a performance drag of as much as 100 basis points, according to the paper. Listed vehicles are also more volatile than unquoted direct funds.

The diversification argument is a strong one – current estimates suggest as much as 80% of UK DC assets are invested in equities.

In Australia, where DC schemes are more mature, many superannuation funds invest as much as 10% of their assets in infrastructure, despite the pressures of daily pricing. This could be because there has been very low switching and related activity by members under normal market conditions.

Research from the Australian Prudential Regulation Authority found not-for-profit funds outperform retail funds on a risk-adjusted basis by an average of 144 basis points per year, and a quarter of this performance difference is attributed to the greater positive impact of illiquid investments on the net returns.

But there are issues DC schemes would have to overcome if they are to embrace illiquid assets – not least a change in mindset for trustees, who see them as expensive and struggle to see the value in them.

One of the DCIF members was quoted in the paper as saying: “A small allocation to illiquid funds may be possible. But the challenge that exists for those who want to see more is that they must do this in a product which is made available at 20 to 30 basis points, because in general we are looking at a world where members pay 50 basis points all in for all administration and investment.”

Another member said: “The investment case for illiquid assets is not proven, and they are expensive. We need more proof. We have to choose a cost effective solution for our members, and there are cheaper and more liquid ways of getting access to these asset classes: for example accessing infrastructure via ETFs held in quoted companies that have an infrastructure story.”

There are also operational hurdles to overcome for DC platforms. By removing the daily pricing/trading requirement, new systems would have to be designed to cope with the issues that would arise when contributions entered and ultimately left the scheme, as well as what happens when assets move between funds and need rebalancing.

Solvency II requirements also make DC investment managers nervous, as illiquid assets such as infrastructure will require bigger capital buffers.

Despite this, the case is growing for DC managers to consider how to best expose members to the potential upside of real estate, infrastructure, private equity and hedge funds.

Consultants Towers Watson issued a paper in February on the issue, concluding that while a wholesale move away from daily pricing and trading would be a bad thing, it is sensible to reopen the question of whether there is a place for less frequently priced and traded products in the DC marketplace.

The National Employment Savings Trust (Nest) — the low-cost DC vehicle set up by the UK government to offer an independent auto-enrolment-ready pension for employers without a provider — have already committed to accessing real estate and are investigating how they could best gain exposure to infrastructure.

And in an innovative twist, Nest is looking into whether it could sell illiquid assets from maturing cohorts of members to the younger cohorts at the point of retirement, thus keeping the assets and ensuring the older members can derisk for a fair price.

The DCIF has called for greater communications on the benefits of illiquid assets, sharing of best practices, and for pension and investment trade bodies to work with the financial services regulator to facilitate access to illiquid investment strategies.

The full DCIF paper can be read here.