U.K. eases path to DC illiquids but challenges remain for plans

While U.K. multiemployer defined contribution plans are boosting default funds with new private equity allocations, they don't expect to benefit from the latest efforts by the U.K. government to reduce regulatory barriers.

In addition to an initiative approved Oct. 1 to allow multiemployer DC plans to spread performance fees over multiple years, the U.K. government is creating two new ways intended to make it less expensive for DC plans to invest in illiquid assets such as private equity.

In October, the U.K. Financial Conduct Authority approved new long-term private markets funds that will permit longer redemption periods so that investors don't have to sell assets at unfavorable prices. Earlier this month, the government said it will be reviewing the 0.75% charge cap on DC funds under management and administration.

But executives at master trusts, as multiemployer DC plans are known in the U.K., said that challenges such as the level of the charge cap and redemption periods aren't DC plans' main barriers when it comes to investing in private equity. For example, average DC charges were found to be around 0.46%, well below the charge cap, according to the Pensions and Lifetime Savings Association.

Instead, DC plans more frequently struggle to find managers that can invest large enough allocations at a reasonable cost, to convince plan sponsors to spend more on investments and get into strategies with established assets that can help spread returns among plan participants fairly.

Still, a few U.K. master trusts did manage to break down these barriers and have launched or are launching private equity allocations.

“The charge cap is irrelevant,” said Julius Pursaill, an adviser responsible for the asset allocation of the £740 million ($1 billion) Cushon Master Trust, Poole, England. That’s because largest master trusts that have been successful at growing their AUMs are charging way below the charge cap, he added. “The issue is whether we can persuade the market (employers and consultants) that the 15% allocation to private markets represents good value for members,” he added, noting that allocations below 10% would cause a lot of “aggravation” from a governance perspective with minimal benefit in terms of performance.

Mr. Pursaill added that master trusts can also struggle to find strategies that would be compatible with DC requirements. “Some managers understand the attraction of positive cash flow that would last 60 years. Other managers said they have limited capacity, and some were able to charge 2 and 20 and see no need for this new deal,” he said.

Also, TPT Retirement Solutions, London, which recently allocated £54 million to private equity-like investments from its £2.3 billion DC multiemployer plan is not waiting for the new funds or the revision of the charge cap.

“I’m less concerned with charge cap limiting (opportunities) to invest in these type of assets because I think the average charge is sub-50 basis points,” said Philip Smith, London-based director of defined contribution at TPT Retirement Solutions. “For bigger plans, there is a race to the bottom on price. There is more than enough room to accommodate private assets within the existing charge cap.”

Instead U.K. DC master trusts are taking different approaches to incorporate illiquids into the default funds such as declining to pay performance fees and working with managers that can offer discounts.

After a new allocation of 15% to private markets was approved in October, Cushon's total investment expense ratio in the growth phase is 15 basis points with no performance fees. "There is a lot of resistance from clients and other providers to increase the price. Investors are slow to implement private markets because it implies increase in their costs," Mr. Pursaill note, adding that his search took a year to complete and only five managers out of 17 participating met the master trust at its price point.

Cushon's new allocation is funded from bonds and equities and will feature investments in private equity managed by multiasset manager Schroders Capital through collective investment funds and through direct joint allocations. Schroders Capital will also select third-party managers.

"We will be investing in more than one existing unitized vehicle that holds private equity," Mr. Pursaill said. "We will (also) move into direct co-investment opportunities with Schroders," he added. While the size of the allocation solely to private equity is not yet decided, Mr. Pursaill said it will grow over time. For example, Cushon will invest in companies creating new battery technology, green hydrogen companies and in companies that build wind farms.

The £20 billion National Employment Savings Trust, London, which is currently searching for private equity managers, is also negotiating fees with managers directly to avoid performance fees.

Stephen O'Neill, head of private markets in London, said: "We've said on many occasions that typical fees for illiquid assets are too high to be affordable for many DC schemes and that NEST won't be paying performance fees. We've challenged private equity managers to reflect hard on fees and fee structures in their industry and consider ways to work with DC schemes like NEST."

In Europe, according to data by Preqin Ltd., private equity managers charge between 1.58% and 1.95% depending on the fund size.

NEST aims to invest £1.5 billion in growth and midmarket private equity companies and by 2024 wants to have a 5% allocation to private equity. Speaking about the role that private equity will play in its portfolio, Mr. O'Neill said: "With public equity markets becoming more concentrated, we want to develop our investment strategy so we can access other areas of growth."

Private equity investments could boost the returns of DC default funds more than equity returns can. The Cambridge Associates LLC US Private Equity index returned 22.3% over a five-year ended June 30, compared to 15.2% for the MSCI All Country World index in the same period. Over a 10-year period also ended June 30, the private equity index returned an annualized 16.7%, while the MSCI ACWI index delivered a 10.5% return.

NEST is currently reviewing submissions and will announce the outcome of its manager search in early 2022. As NEST already holds illiquid assets such as commercial real estate, private credit and unlisted infrastructure equity, private equity is the logical next step that can offer strong returns to help participants grow their savings, Mr. O'Neill said. Over the next decade NEST, which currently has about 5% of its assets in illiquids, plans to increase its overall private markets exposure to 15%.

TPT's 3.5% allocation to investment trusts and stocks of private equity companies is managed by AllianceBernstein Ltd. and is included in target-date funds to avoid high costs. Investment trusts list the shares of ownership in the fund company onto a registered stock exchange with daily pricing, which provides similar investment exposures to private equity but is more liquid because investors trade fund company units amongst themselves, rather than through a private equity manager, to meet investor cash flow needs.

"Maintaining liquidity and operational efficiency is key for us. We were looking for private equity which is efficient and would fit operationally with our model," TPT's Mr. Smith said.

Ensuring that private equity investments have daily liquidity has been a challenge for DC plans globally. For example, in June 2020, the U.S. Department of Labor permitted the use of certain private equity strategies in DC plans, allowing implementation of certain private equity strategies into target-date and target-risk or balanced funds, while complying with the Employee Retirement Income Security Act. But U.S. DC plans haven't been quick to adopt new strategies, either.

Because liquidity risk stops investors from making significant allocations to private markets and investors want an option to redeem investments at net asset value, the FCA's new U.K. long-term asset funds will have longer redemption periods, high levels of disclosure, and specific liquidity management and governance features to help investors manage the risk.

Still, Cushon's Mr. Pursaill said that liquidity is not generally problematic for U.K. DC plans that have predictable monthly cash flows.

Sonia Kataora, partner and head of DC investment at consultant Barnett Waddingham LLP in London, agreed with Mr. Pursaill. "Large DC schemes have more options as they can adopt a segregated approach and influence their own illiquid investments — exactly as NEST have recently started to do — but this is clearly much more resource-intensive to run," she said. "We do expect to see more of this approach over the coming years, though, particularly as more schemes and providers reach a large enough scale helped along by consolidation," she added.

Ms. Kataora noted that some managers improved their DC offerings, but the number of daily priced, daily traded funds is limited. "We have seen the introduction of funds providing illiquid asset exposure in a 'DC-friendly' way through pooled offering, which is both charge cap and platform compatible. This has relied on the use of a flat fee structure including an in-built premium in place of the performance fee," she said.

Mr. Pursaill added that DC master trusts need managers that can offer funds with established assets.

"If you are a DC scheme, you need to think about the J-curve," he said, because if plan participants leave master trusts before the investment has started to generate returns, they would have no benefit.

"That is a fairness issue. … One of the ways, is to buy into an established set of assets to spread the J-curve fairly," he said.