What are alternatives?
The term ‘alternative assets’ is one which covers a wide range of asset classes, generally speaking anything excluding equities, fixed income or cash. Although not exclusively, one general characteristic of an alternative asset is the limited liquidity it provides, with very few alternative assets being listed on public exchanges. Examples of alternatives include real estate, private equity, private debt and infrastructure; however this is only scratching the surface of a wide ranging and often esoteric asset class.
Why should alternatives be attractive to DC members?
Two key aspects of a defined contribution pension scheme are:
- Extremely long time horizon of a typical member, potentially stretching as far as 40 years or longer for a young person
- Investment risk is the responsibility of the individual; guaranteed pensions in retirement are a thing of the past
Extremely long time horizons mean that individuals are typically unable to access their retirement savings for many years. This means the assets they hold to provide long-term growth for their retirement pot do not need to be overly liquid - it is often not necessary to trade on a daily, monthly or even yearly basis. By investing in assets that are freely traded, investors give up the potential additional return that is associated with an illiquidity premium. However, the question must be asked, if an individual has an extremely long time horizon, why are they giving up this premium on the assets they are holding to fund their retirement?
Investment risk being the responsibility of the individual, rather than their employer, means that it is imperative individuals have adequate savings to fund the retirement they wish to have. If not, an individual would have two choices: work longer or settle for a lower standard of living in retirement. Equity valuations continue to rise and bonds are already expensive, with this comes a squeeze on their potential return. It’s vital, given what is at stake, that savings for retirement work smarter.
You may rightly ask: alternative assets have been around as long as more ‘traditional’ assets, so why now? Part of the reason is what is described above, to ensure default investments are working as efficiently as possible, maximising retirement savings in order to meet goals and aspirations once working life slows down. However, this is only part of the story.
It has been a long held view by many that it is necessary for defined contribution schemes to hold assets which are liquid, such as equities or bonds, to ensure they are daily priced and daily dealt; something which many alternatives do not offer. This stems from trustees being required to ensure payments into and out of a scheme are processed promptly and accurately.
With this in mind, the Law Commission, under the direction of the government, has been investigating current practices and legislation surrounding assets which pension schemes are able to invest in, and what must be considered prior to investment. They were categorical in their findings released in June 2017 regarding the need for liquidity:
Law Commission report: Pension Funds and Social Investment – “Guidance for trustees states that trustees should seek to balance the liquidity of assets against investment objectives and does not state that daily dealing is a legal requirement.”
It is of course necessary that assets are available to make payments promptly, however trustees need to carefully consider the impact holding only fully liquid assets in the default arrangement is having on members’ savings.
In fact, the government is looking to provide a full response to the Law Commission’s findings this summer which should give DC trustees clearer guidance around the specific rules applicable to DC in relation to alternative illiquid investments.
How can a DC pension scheme access alternatives?
You do not, however, need to wait to allow your scheme members to benefit from the additional sources of potential return.
As with most things, change comes about incrementally. It is unrealistic to assume that there is the capability or willingness for DC schemes across the land to immediately invest assets in a completely illiquid fund. Before locking assets up for a significant period of time, it is not unreasonable for trustees to want to invest in similar assets, but with the flexibility that at least partial liquidity offers. Whether this is to see the idiosyncrasies of the asset class in real time, or possibly to ascertain what impact being unable to access this portion of assets will have on a scheme’s ability to “promptly and accurately” process payments.
Within the market there are a number of innovative solutions. Including funds which offers a “half & half” approach; whereby half of the fund is invested in completely illiquid assets in private markets and the other half in listed alternatives, such as listed private equity firms or listed real estate. Though a fund such as this is not quite as liquid as a listed equity, the impact on a scheme’s default would be slight.
However, if a scheme wished to maintain complete liquidity within its default strategy, whether this be to test the water or provide diversification, there are funds which invest solely in liquid alternatives. Liquid alternatives are assets which can be traded regularly and so do not impact on the ability of an investor to access their funds.
JLT believe that investing in alternative assets will improve the risk/return characteristics for the default investors and thus will drive better member outcomes. However, this needs to be balanced with the need to process transactions promptly and with the understanding that alternative investments introduce alternative sources of risk which may not be present in the traditional asset classes. Solutions already exist in the market to help balance these goals and with regulatory developments on the horizon, there will be even more scope for alternative assets to improve the outcomes for DC members.
If you are interested in finding out whether Alternatives Assets could play a part in your DC Pension scheme, or to discuss your DC pension scheme’s investment strategy, contact Maria Nazarova-Doyle, Head of DC Investment Consulting, Maria_Nazarova-Doyle@jltgroup.com.