Our first article on lessons from overseas for UK DC pension funds looked at key issues when building private market allocations including developing internal capabilities and building relationships with asset managers.
This second article looks at lessons on private market illiquidity, finding suitable investment opportunities and supporting member outcomes, particularly in terms of decumulation as more DC members approach retirement.
Managing and monitoring illiquidity
Illiquidity is a key characteristic of private markets; traditionally, investors have had to be prepared to commit capital for a number of years in venture capital or private equity funds. This is a potential issue for DC funds, where individual member accounts are valued on a daily basis, with members often able to switch their investment options while still in accumulation.
In Australia, members can easily move from one super fund to another or change their investment options within a fund via an app, meaning accurate valuations are crucial.
At one of Australia’s larger superannuation (super) funds, the Australian Retirement Trust (ART), Michael Weaver, general manager mid risk assets & UK, commented: “We take our liquidity concerns very seriously; we get valuations on any major asset every quarter. All the managers we appoint need to have robust valuation policies, and if there is some sort of market event, we can take overriding action and make sure our members are treated equitably.”
And at MLC Super, one of Australia’s largest retail super funds, Steve Gamerov, head of diversified portfolio management, said liquidity is carefully managed with the knowledge that private markets are a long-term investment. “We have a budget set by our trustee on how much of the portfolio can apply to illiquid assets, given the membership profile of the portfolio. If the average age of the membership is 40 and retirement is 65, that’s a 25-year investment timeframe and having a long-term timeframe is very important.”
In addition, liquidity is monitored on an ongoing basis, with modelling and forecasts of future cashflows across the underlying private market investments, along with regular stress-testing of the portfolio.
While there is a strong argument that large and well-run DC funds can tolerate the illiquidity of private markets for part of their portfolio, Pieter Regnery, founder of due diligence consultancy, Pro-Diligence, said that this view is not accepted by all in the Netherlands. “Managing highly illiquid assets, capital calls, and lag-valuations within a strict individual DC lifecycle framework creates massive operational and administrative headaches. Far from stimulating private equity, the transition to DC is actually causing pension fund investment boards in the Netherlands to approach these assets with greater caution.”
A deep pool of UK assets
One issue for UK DC pension funds is that under the Mansion House Accord, half of their agreed allocation of 10% to private markets by 2030 should be in UK assets.
“There is a clear geopolitical desire within Europe and the UK to mobilise pension savings to fund domestic innovation and venture capital to compete with the US and China,” said Regnery. “While the macroeconomic logic is understandable, pension trustees must remain vigilant. A forced home bias driven by political agendas directly challenges the cornerstone of pension investing; the absolute fiduciary duty to deliver the best possible risk-adjusted return for the individual beneficiary, not the state.”
Can UK pension funds invest sufficiently in UK private market assets while fulfilling their fiduciary duty? If there is a sizeable pipeline of suitable opportunities, this may be possible.
Weaver’s investment responsibilities at ART include its UK investments, where it owns 11% of Heathrow airport, as well as stakes in Edinburgh, Bristol and Birmingham airports. He believes that the UK has a deep pool of suitable assets for investors.
“If I was a local UK investor and told to invest in the UK, I would not have a problem with that, from both an infrastructure and a real estate perspective, but it might be a little harder in private equity to make large allocations,” said Weaver.
Investors in a new asset class often start with a domestic allocation before diversifying overseas, but this is not always the case. MLC Super’s Gamerov said: “It really depends on the opportunity set and that varies for each of the different segments in private markets. In commercial property, we started with primarily domestic property and then we diversified globally and moved towards a 50:50 mix of domestic and global. Whereas with private equity, the opportunity set is a lot larger globally than in Australia, so we have closer to a 70:30 mix of global to domestic assets in infrastructure and even higher globally for private equity.”
Looking at the availability of assets and opportunities in the UK, the CFA paper, UK pensions into private markets and the Mansion House Accord, points out that this is an area where government support may be needed. It stated that “more can be done by Government departments through active creation of a viable opportunities pipeline and ensuring certainty of regulation to protect the economics of investments.”
Private markets and decumulation
At DC funds in both the UK and Australia, there is growing focus on decumulation, or retirement income solutions, as increasing numbers of DC fund members reach retirement age.
If these individuals have built up a substantial DC pension fund, they may want to remain invested and draw an income over time. In this case, the diversification and return potential of private market assets means they can play a role if individuals want to stay invested post-retirement. Weaver said that approximately 16% of ART’s funds under management are with members in their retirement phase. “They still have a healthy allocation to illiquid assets because once someone has made the decision to stay with us at 65, they are often with us for another 15 or 20 years or so,” he said.
Gamerov commented: “There is a big focus on retirement income solutions now and typically, investment time horizons are shorter and liquidity demands are greater. A number of different solutions have been developed to cater to members in the decumulation phase, but usually there is some element of liquidity, such as a cash bucket, to meet the demands of drawdown from the pension.”
He added that this means private market exposure needs to be calibrated appropriately for the liquidity demands but said there are attractive features of private market assets in the decumulation phase. “The stability of returns is attractive and so is very strong income generation from these assets. The yield, or income, that we get is higher single digits in many cases.”
Pension funds, patient capital and productive finance
Pension funds with sufficient scale that are able to manage liquidity should consider investment in private markets. This applies to DC pension funds and there are valuable lessons for the UK from pension funds in Australia and elsewhere showing how this can work in practice.
If the UK’s major DC pension funds increase allocations to private markets in line with the Mansion House Accord, this will create a significant source of capital for the UK economy. In turn, this should further activity on two related and worthy financial concepts: patient capital and productive finance. Both involve investments that boost economic growth in the UK, for example by increasing funding for innovative start-ups, or financing much-needed infrastructure projects.
As a result, it is easy to understand how UK policymakers see growing DC pension fund assets as a potential national asset to be utilised in pursuit of wider economic and financial goals. But mandatory, or forced, investment, in UK private markets could, if implemented, do more harm than good, if it undermines the integrity and governance of pension funds. Nevertheless, if UK DC pension funds can extend their investment portfolios to encompass private market assets – as other countries have done – it could improve returns and diversification, helping members achieve their goals in both accumulation and decumulation.
Matt Craig is a senior consultant at CoreData Group, a global specialist financial services research and strategy consultancy. To find out more about our industry insights and research programmes, you can reach him at [email protected]