U.K. effort to bring illiquids to DC faces hurdles

The U.K. government's latest attempt to encourage defined contribution plan investment into alternative asset classes is missing a major issue: DC executives are unlikely to allocate to illiquids unless managers reduce their fees.

The government wants DC plans to help rebuild the U.K. economy in the aftermath of the coronavirus pandemic. It also wants to improve plan participants' retirement outcomes — something it has been consulting on with the industry over recent years. The problem is, plans must invest in a way that does not breach a 0.75% charge cap on default funds under management and administration — meaning pricier alternative assets are usually out of reach. Broadridge Financial Solutions Ltd. estimates that the proportion of U.K. DC assets allocated to private markets or illiquid investments, excluding real estate, is currently below 1%.

So in March, the government proposed that DC plans could spread the costs they incur from investing in private equity, venture capital and other alternative investments over five-year periods rather than looking at them on an annual basis — potentially allowing them to invest in more alternatives without breaching the charge cap. The new method would give plan executives the option of using a five-year average calculation for performance fees as an alternative to the in-year performance fees accrued, consultants said. Currently, plans can either look back at the year's data to determine charges or look at the planned charges to ensure they are compliant with the cap.

But despite the government's efforts, DC plan executives and consultants said an increase in alternative allocations by DC plans is unlikely until managers back down on 2-and-20 charging structures — where 2% refers to management fees and 20% to performance fees.

Sources also said that unpredictable returns of alternative asset classes will keep executives away from launching meaningful exposures without being "nervous" about breaching the cap regardless of fee spreading. And single-employer DC plans won't lock assets into a seven-to-10-year illiquid strategy if their sponsors have already decided to outsource retirement arrangements to multiemployer plans, known as master trusts.

"I think the smoothing of performance fees is a bit of a red herring," said Nico Aspinall, CIO of the £14 billion ($19.3 billion) defined contribution multiemployer plan The People's Pension, which is sponsored by B&CE, West Sussex. "One of the big problems of the government's approach … is this sense that 2-and-20 (fees) are acceptable and (the) DC industry has to … work with it. That's not the page we are on," he said.

Mr. Aspinall, who said that master trusts themselves are under pressure to keep costs and charges far below the charge cap, expects to see the 2-and-20 structure "massively reduced" before he invests. Mr. Aspinall would like to see managers give a discount of 70% to 80% on performance fees. But he noted that private equity managers prefer buyers that can afford their charging structures and he hasn't come across managers that would offer such a discount.

During investment periods, private equity managers running European-domiciled funds on average charge management fees above the DC charge cap. According to data by Preqin Ltd., these managers charge between 1.58% and 1.95% depending on the fund size. Venture capital fees during investment periods, depending on the fund size, can range from 1.33% to 2.14%, while infrastructure fees can range from 0.84% to 1.35%, Preqin data showed.

Mr. Aspinall hopes that The People's Pension, which does not currently allocate assets to illiquids, will see progress on the fee front so that his master trust can include alternative investments in its default fund in the next few years.

And even the £1.6 billion Smart Pension Master Trust, London, one of the U.K. master trusts that recently ventured into the illiquid assets space for the first time by adding a £100 million private credit allocation into its default fund, will not be quick to use the proposed calculation method if the proposal is enacted. Darren Philp, director of policy and market engagement at Smart Pension, which invested with Natixis Investment Managers U.K. Ltd., said the government's proposal may remove a regulatory barrier, but it doesn't mean that DC funds will rush into illiquids as there are bigger barriers to overcome. He agreed that cost and the structure of alternatives charges is one obstacle, but the nature of the investment is another barrier.

"We will continue to develop our investment proposition to both improve the climate credentials of our funds and to ensure we are generating long-term risk adjusted returns. So we think illiquids will definitely be part of the mix, but they need to be structured in the right way and meet the scheme's needs, very much like we have already done through the private credit solution we recently introduced, developed in partnership with Natixis IM," he said.

Mr. Philp said the Natixis strategy addresses some of the key barriers such as access to private credit markets, including that it comes in at a price point and price structure that the trustees are comfortable with and consider value for money. It also blends an MV Credit Partners LLP strategy, which provides access to private credit, with liquidity provided through a multiasset credit strategy through Loomis, Sayles & Co. LP. Both firms are affiliates of Natixis IM.

Paul Herbert, senior investment consultant at Willis Towers Watson PLC in London, agreed with Mr. Philp that the government proposal on its own is a positive development, but noted that alternative investment returns can differ greatly from year-to-year in practice.

"The top-quartile managers are achieving very strong returns. And therefore, the uncertainty around the potential performance of the fund and hence the fee that you end up paying means that you end up constrained in terms of what sorts of exposure you can have without breaching the charge cap," he said.

In order to benefit from the returns that alternative investments can offer, Mr. Herbert said DC executives may want to invest more than 5% or 10% of their portfolios in illiquids. But they would then likely breach the charge cap if the manager performs well, he said.

Other sources said that the proposal could pave the way for DC plans to negotiate alternatives fees with managers. Mark Fawcett, CIO of the £17 billion National Employment Savings Trust, London, which invests about 3.5% of its assets in private credit and will initially invest £900 million in unlisted infrastructure, but does not invest in private equity, is hopeful about the proposal helping investors to start a conversation with managers about fees. "Typical fees in the private equity industry are clearly too high to be affordable for DC schemes. We hope this is the start of a conversation that gets private equity managers to reflect hard on fees and fee structures in their industry. If we get this right, millions of U.K. savers stand to benefit," he said.

A study by the U.K. Pensions Policy Institute conducted in 2019 showed that a global diversified private equity allocation in a DC portfolio can return 13.5% net of charges over 20 years, while private debt could add 8.8% over the same time period. Global infrastructure equity could add 7.1% in the same period.

Consultants also noted that the proposal isn't compatible with market trends such as outsourcing single-employer plans to multiemployer arrangements.

Sonia Kataora, partner and head of DC investment at Barnett Waddingham LLP in London, added that smoothing the performance fee calculation over a period of, for example, five years doesn't address the issue that plan participants would have joined and left the fund over that period. "It's difficult to ensure that members who paid that fee benefited over that period," she said.

WTW's Mr. Herbert added that while DC plan participants are long-term investors, they are not necessarily going to be invested in the same plan indefinitely as they may change jobs.

Such consolidation — which the government is also encouraging — means trustees have shorter investment horizons, "making it difficult to commit to these sorts of asset classes," Mr. Herbert said.

There were 38 master trusts in the U.K. with a combined £52.8 billion in assets as of Dec. 31, according to The Pensions Regulator. This compares with 38 master trusts that had £38.5 billion in combined assets as of Dec. 31, 2019.

And master trusts are not necessarily keen on taking on investments started by single-employer plans due to the additional governance burden it would create.

Mr. Aspinall said his master trust wouldn't offer different investments to different employers, adding that The People's Pension is also unlikely to include investments of an acquired plan into its default fund. "That gives us all of the governance headache and new set of managers without the scale. We wouldn't go down that route," he said.