U.K. multiemployer funds prepare for infrastructure

U.K. multiemployer defined contribution plans are taking their first steps to incorporate direct investments such as infrastructure into their default funds after a sharp increase in assets over the past few years.

Increases in the combined employee and employer contributions rates in both 2018 and 2019 have given sponsors more money to diversify into new asset classes. Assets of U.K. master trusts increased to £29 billion ($36 billion) as of January 2019 vs. £16 billion in January 2018 and £10 billion in January 2017, according to data from The Pensions Regulator, which regulates U.K. schemes.

But greater scale isn't the only thing that's working to their advantage.

Operational and liquidity challenges, which had stopped DC plans from investing in private markets directly, are subsiding and making it possible for executives to embrace illiquid investments, much as superannuation plans in Australia have done, sources said.

"In Australia, alternative investments are much more common – on average, super funds allocate around 20% to illiquid or less liquid investments like infrastructure, property and private equity," said Maria Nazarova-Doyle, principal, DC and individual wealth at Mercer LLC.

"As the U.K. DC market develops and grows, it is only reasonable to assume that we will follow in the footsteps of this more mature DC market," she added.

One U.K. plan has already made the leap.

The £7.5 billion National Employment Savings Trust, London, started its first illiquids program Sept. 12, adding a joint 5% real estate debt and infrastructure debt allocation to be managed by Amundi and BlackRock Inc., respectively.

"We will start deploying capital (in) October. We are targeting about 5% by committing £500 million over the first 12 months, but we will probably be investing more than that next year as (NEST's AUM) will probably be at £13 billion (then)," CIO Mark Fawcett said at a news conference.

"One of the attractions for infrastructure debt is that we can help finance wind farms and renewables. There are some positive environmental, social and governance opportunities," he said.

Mr. Fawcett said NEST also plans to include infrastructure equity in its default choice. "Probably toward the end of the year, we will announce a search for a fund manager," he said. "We are warming the market up."

Other large master trusts are set to follow. Nico Aspinall, CIO of The People's Pension, a £7 billion multiemployer DC plan based in West Sussex, England, said: "As our scale increases — we are currently taking (in) £250 million per month in contributions — we expect to be able to access more illiquid investments at a price which makes them attractive."

The fund realizes it will need £500 million to invest efficiently in illiquid asset classes and are "keen to engage with the industry," Mr. Aspinall said.

For other multiemployer DC plans, which might be invested in assets via investment platforms and can only access listed alternative assets, U.K. regulators are gearing up to remove further obstacles. In the U.K., a proportion of DC assets are managed via funds on investment platforms that are run by record keepers and some master trust providers. Because of liquidity constraints imposed by the platforms, the funds were limited in their ability to access illiquid assets.

Mercer's Ms. Nazarova-Doyle added that the U.K. Financial Conduct Authority is looking to remove restrictions on the types of funds being offered on platforms.

Emma Douglas, head of defined contribution at Legal & General Investment Management in London, said: "I don't feel that liquidity is much of a barrier anymore. It was harder when auto enrollment began (in 2013) and contributions were low ... These are large master trusts with a strong cashflow."

Ms. Douglas added that the workplace master trust of LGIM, the Legal & General Mastertrust, with £8 billion in assets, has a 14% exposure to alternatives that include real estate investment trusts, private equity and global infrastructure already. But the master trust is not directly investing in illiquid asset classes yet.

One hurdle many plans still struggle with are cost and charges associated with investing in illiquid asset classes. Plan executives agree that manager fee structures are preventing a number of DC plans from investing in illiquid assets since U.K. DC plans are constrained by a overall 0.75% mandatory fee cap on all assets, sources said.

DC plans need to understand charging structures of managers' funds especially fund of funds structures as there could be many layers of charges, said Raj Shah, head of DC investment consultant Hymans Robertson in London.

"When illiquid assets are wrapped in investment trusts, only the top-level charges are taken into account," Mr. Shah said in relation to charge cap calculations.

Additionally, investment options offering access to illiquid asset classes currently available in the market are incorporating private equity, private credit and other illiquid elements. Particularly, private equity tends to push up the cost above 100 basis points and add a performance fee. In contrast, private credit on its own would cost a plan between 80 basis points and 110 basis points, sources said.

"We are keen to add exposure to illiquid assets as a means of further diversification, but only at the right price," said Mr. Aspinall at People's Pension.

Brian Henderson, partner and director of consulting at Mercer LLC, said illiquids also are on the radar of the £2.2 billion Mercer Master Trust. But he noted that fees are north of 100 basis points.

Ms. Nazarova-Doyle said existing investment options have not really been optimized for DC plans and are more suited for defined benefit funds. Such funds don't work well with in DC because as default assets grow on a monthly basis, the benefit of illiquid allocations locked for years is diminished. That's because the overall allocation will fall unless new illiquids are added, she said.

But the market is changing. Constantly growing DC plans have better negotiating power because the amount of the allocation that could be invested in illiquids is higher, she said. "And more managers are open to discussing a different fee arrangement."

The U.K. government is also looking to facilitate illiquid investing for DC plans following a consultation in February on needed regulatory changes that would allow plans to incorporate illiquids.

"While I believe the government is not going to amend the charge cap to carve out an exception for performance-related fees (found in private markets investment options), it is expected to supply plans with guidance on how to account for fees and calculate costs," Ms. Nazarova-Doyle said.

Smaller DC master trusts need to work out how to manage cashflow to be able to access illiquids through open-end structures, Hymans' Mr. Shah said, because more direct exposures require getting advice, choosing a manager and doing detailed analysis, sources said.

But the benefit is larger than through daily managed investment options offered by firms, which are only partly illiquid, Ms. Nazarova-Doyle noted.

"In a decade we will see illiquids in all master trusts. It's really a question of size and business model to allow (plans) to have the practical side of such investments, said Alex Pocock, head of DC investment at consultant Barnett Waddingham in London.

A plan needs to set aside 5% to 10% allocation for illiquid investing to be worthwhile, Mr. Pocock said. "(Only) master trusts with billions can do it."