While their defined benefit (DB) cousins can take advantage of the premiums offered by holding illiquid asset classes, DC plans have been more limited in their investment scope and ambition. Stephen Budge, principal, DC & financial wellness at consultancy Mercer, says that there has been “little ability or appetite to try and bring illiquid holdings into DC default portfolios.”

And yet, there are good reasons to consider illiquid assets as part of a DC plan. “Greater freedom in the approach to investment and flexibility should improve value to members, considering their long-term investment horizons,” says Budge.

“Members’ investment returns and asset diversification could be improved by allowing access to more illiquid assets, so there seems little argument against their inclusion in portfolios, based on an investment rationale,” he adds.

To date, however, there have been few options available to DC default fund managers that would enable them to build in the greater diversification and added value that Budge describes. Schemes using diversified growth funds (DGFs) might include an allocation to illiquid assets, but use of these vehicles within defaults is still relatively muted; research carried out by State Street Global Advisors in early 2016 showed 31% of UK DC schemes had exposure to DGFs. The use of illiquids within those DGFs is also typically kept to a minimum.

However, there are now signs of increased interest in creating funds that will provide access to illiquids for DC – while still retaining the current requirement for daily liquidity and trading.

Swiss asset manager Partners Group launched the first private markets fund for the UK DC market in June 2016, investing in private equity, private debt, private infrastructure and private real estate. The daily liquidity requirement is met through allocation to listed private markets. The company launched similar funds for the US and Australia markets last year. 

Budge believes that pooled fund structures such as this remain the most likely opportunity for accessing illiquid assets in the UK market. “Hopefully other managers will follow suit in due course,” he says.

Liquidity mismatch

However, using a wrapper of dailydealt assets to provide liquidity around a traditionally illiquid asset class can introduce different risks. The decision by many UK-based open-ended property funds to suspend withdrawals following the European Union referendum showed that while Brexit might mean Brexit, liquid didn’t always mean liquid. Concerns over commercial property prices following the UK’s vote to leave the EU saw retail investors rushing to make withdrawals from these vehicles. Asset managers responded with a combination of outright suspension of withdrawals and price cuts as they sought to make property sales to meet redemption requests.

“Making liquid funds out of illiquid asset classes runs some big risks and in late June, those risks came home to roost,” says Ian Mason, portfolio manager, AEW Europe. “Investors were not protected in any way, as they didn’t get the liquidity or pricing they thought they were going to get.”

Mason believes that building liquid funds from illiquid assets risks creating a solution that favours no-one. “The problem is that you end up with daily traded but poorer quality funds. They may give liquidity – but it comes at a cost. When investors wanted liquidity they couldn’t have it , but they are paying a cost for unused liquidity in lower returns.”

Given the challenges and risks involved in creating liquid vehicles from illiquid asset classes, would a better option be to remove the daily trading and pricing requirements altogether? “There is a general belief that returns could be enhanced if the daily liquidity requirement were removed,” says Budge.

Mason adds: “It would be better to put limits on a default fund of say 5% to 10% of a balanced portfolio, for illiquid assets. That is similar to the way in which DB schemes use illiquids.”

Removing restrictions

Would closed-ended, genuinely illiquid assets work any better for DC if the rules were changed? For example, an infrastructure fund with a 15 to 20-year fixed-term horizon might meet the investment profile of a younger saver – or even possibly work in favour of a 40-year-old aiming to start accessing funds at the age of 60.

While at a high level, this looks like a good fit, Gavin Lewis, head of consultant relations at Vanguard cautions: “From a trustee perspective, the board needs to pay very close attention to the fund’s timing strategy. Closed-ended structures might have a period when the fund manager goes to find assets to match, which causes a drag.” 

Lewis adds that, similarly, funds may roll over by one or even two years rather than the date originally planned. This potentially distorts redemptions. Regulations aside, not all DC schemes will be in a position to invest directly in illiquid assets on behalf of their members. Scale is a consideration and, in that vein, Budge sees some of the larger master trusts as potential direct investors in illiquid holdings “but only when assets have increased in size”.

There is also the consideration of the charges cap of 0.75% imposed on UK DC default funds. “The charges cap would be a huge restriction to say the least,” says Lewis. “Cost restrictions are there to help the end investor, but it would be a big hurdle for illiquid assets.” 

Ultimately, every DC investor has control over their own assets – especially when it comes to accessing and using their pension pot from age 55 onwards. As such, the ability of DC investors to manage more complex and varied investment types with differing risk profiles needs careful consideration. Ankul Daga, senior investment strategist at Vanguard, says: “There are some intangibles here. When you look at the options of what to include , the question is, does this give the investor a better chance of success and peace of mind? A simple solution can enable investors to feel in control and make decisions.”

While the day-to-day performance of a default fund, or the asset classes within it, should pose few concerns to investors with long-term savings horizons, for savers using drawdown, it may be more of an issue. Daga says “it can put an expectation on individuals to make a call on complex investment strategies that even some asset managers struggle with. It can make big demands on inexperienced individuals.”

A potential mismatch between the need for regular income in retirement, typically on a monthly basis, and the long-hold nature of illiquids could also be an issue, adds Lewis. “People expect monthly income, but if you are in an illiquid asset class that doesn’t mature for five years, that causes problems. Yieldgenerating assets such as real estate might be able to assuage some of those issues, but it is still not a perfect match.”

One-off withdrawals are another potential sticking point says Daga. “Savers could be looking at transacting and withdrawing money around a life or market event,” he says, pointing to a “potential nightmare” for investors needing instant access from fixed-term funds. “It then becomes the responsibility of DC plan sponsors to communicate effectively around the assets and members’ ability to access them. People need to be educated and given the responsibility, then the tools and shown how they use them. But pension engagement is so low in the UK.”

Total liquidity is only really necessary for DC investors in a small handful of instances (such as withdrawing the whole pot in cash). However, even if the regulatory requirements for daily pricing and trading were removed, making illiquid assets work in the context of drawdown, delivering vehicles within the charges cap, and protecting potentially unsophisticated investors might suggest that anything other than daily trading is beyond the scope of DC.

But increasing demand for diversity, to help drive better value for DC plan members, means that the debate around accessing illiquid assets is unlikely to be silenced. The real challenge for the market will be delivering default funds that offer the right balance between accessibility for end investors and improved returns through greater diversification.