Watching the Great British Bake Off is always entertaining – but every now and then the judges are left wondering whether the final bit of icing on top was really necessary when the rest of cake was already so good!
So should we think of illiquid investments within DC schemes as the flour and eggs in a good cake, or the icing that might be an enhancement but may also prove to be an unnecessary addition?
The idea of including illiquid investments in DC schemes is generating plenty of industry and press attention. The rationale for doing this is fairly straightforward. A wider range of asset classes can increase diversification, which can lead to improved returns without adding risk. Most DC members, particularly those who are less engaged and invested in default strategies, are long term investors who do not need short term liquidity. Putting these two factors together it appears obvious that DC default strategies should include a material allocation to illiquid assets.
However, is there too much focus on these positive points, and not enough consideration of the other issues to address before deciding if illiquid assets are appropriate for a particular DC scheme?
I should point out that I am not against DC schemes investing in illiquid assets in principle (I enjoy icing on most cakes!). An allocation that has well thought out plans to react to adverse circumstances should improve DC member outcomes, which is what all of us within the pension industry are trying to achieve.
A primary concern of mine is the widespread use of the phrase “illiquidity premium” to describe the additional return that may be derived from illiquid investments over similar liquid alternatives. Contrast this with the term used to describe the additional return that equities are expected to deliver over risk-free bond assets. That is called the “equity risk premium”, in recognition of the risk that this additional expected return might not actually be achieved.
Why do we not make the same recognition for illiquid assets? Are we suggesting they will always give investors a premium over liquid equivalents? Investors in the Woodford Equity Income Fund, which collapsed in 2019 holding a large proportion of illiquid assets, may not agree! Even before the CIO of Amundi recently likened the private equity industry to a Ponzi scheme, the jury was still out on whether the excess returns historically generated can be explained simply by leverage and size and sector biases rather than actual illiquidity (see, for example, A Bottom-Up Approach to the Risk-Adjusted Performance of the Buyout Fund Market, L’Her et al, 2016). The difference in the terminology that the industry uses for equity and illiquid investment may seem like semantics, but could convey the false message that illiquid investment has no downsides.
There is also the possible impact on efficient transfers. There has long been a concern that transfers between DC schemes take too long. It is vital that any investment into illiquid assets does not make this an even bigger issue for members to contend with. While it is not necessary for DC schemes to trade illiquid assets regularly (as that would defeat the objective even if feasible!), it is essential that reliable daily valuations are available. To do this, there has to be a robust way of updating stale prices for actual market conditions, particularly in periods of high volatility.
It is also worth noting illiquid investment creates different challenges for DC schemes that are growing (primarily the Master Trusts) and those that are mature (primarily single employer trust-based). Growing schemes looking to maintain an illiquid allocation have to source suitable investment opportunities and avoid overpaying for these in a competitive market. Mature schemes, which even if not shrinking will need to de-risk away from growth assets including illiquids. They will therefore need to manage a reducing portfolio of illiquids either through a well-planned maturity profile or finding suitable buyers at the appropriate time.
It is clear to me that DC schemes should be considering potential investment into illiquid assets as part of a diversified portfolio. However, this consideration needs to encompass all of the positive and negative factors before a decision is reached. And always remember, cakes can be created with all the flavours needed to please the GBBO judges without always having icing on top!
Paul Black is a Professional Independent Trustee with over 30 years’ experience in the pension industry. A qualified actuary, prior to moving into trusteeship, he was an investment partner with LCP and has recently led the development of the Hargreaves Lansdown DC investment proposition. He is therefore well placed to help in leading Trustee Boards of both DB and DC schemes through complex investment strategies.
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