Defined contribution trustees investing in illiquid assets should "do it big and do it right”, one pensions expert has said but warned of operational challenges and the need to consider other asset classes. Others have pointed to nervousness among trustees about fund gating. 

Many pension funds have sought exposure to illiquids in pursuit of the so-called illiquidity premium, particularly when yields on fixed income fell to historic lows over the past 15 years. Since then, yields have risen but a government agenda of incentivising pension investment in private markets and the growth in DC assets has kept the illiquids debate alive. 

“There's a lot of talk about illiquids,” said Ian McKinlay, director of investment services at Pegasus, speaking at a webinar organised by the firm on Friday.  

 

These do not form a single asset class, however, and partly for that reason he feels there is no clear view in the pensions industry on how to get access to illiquid assets. 

However, "my own experience tells me that if you're going to do this, you do it big and you do it right,” he said. 

This means having the right governance and understanding of what the trustees are getting into, he argued, particularly for private equity. He advised to think about four things: the cost of leverage; fees; the skill of the manager; and how to implement it. 

 

“To do it right, you need to have some sort of comparative advantage that enables you to say in each of those components, I'm better than the other one down the street, or I've got some sort of advantage that enables me for the flows of the returns to go through to my members,” he said. 

 

For this reason, aggregation is important as it enables the better governance and expertise, as well as gives the pension scheme negotiating power, he said, and added: “For smaller schemes, I put a big question mark over how you can create that comparative advantage.” 

McKinlay is also sceptical about “bolting on a fund to something that already sits there”. 

Implementation is key in DC. “Operationally, I'd be almost testing it to destruction to ensure it works,” he said. “The operational challenges around managing private assets – it's for grown-ups.” 

The discussion around illiquid assets comes against a big shift in the economic and geopolitical backdrop of the recent past that has led to higher inflation, interest rates and yields which has put fixed income back into the game for return-seeking investors.

"Looking as a prospective investor and what the opportunity says, there is much more on the table that is now offering attractive returns than there once was even two to three years ago,” he said. 

McKinlay said there was “a lot of talk about aggregation, a lot of talk about illiquid assets, a lot of talk about ESG, not enough talk about perhaps the credit markets and the opportunities that are available in the credit markets”. 

Sub-investment grade corporate bonds are now offering “a very attractive yield”, he argued. “So if private equity is attractive, I would say that credit of that nature is probably more attractive because you got more security. It also throws off income which to me is an attractive asset.” 

Speaking on the same panel, LawDeb trustee director Samantha Pitt argued in favour of illiquids in DC default funds based on their long-term nature, diversifying qualities and higher risk-adjusted returns. 

“I'm not sure it would work as a self-select fund, but certainly in the default,” she said, noting that many investment consultants now suggest exposures of 5-10% in the early growth phase of the default option.

While master trusts are likely to be the ‘leaders’ when it comes to DC investing in illiquids, she warned that given the current low levels of fees in master trusts, investing in these assets could push fees up. 

“I do hope that people, when they are looking to move to a master trust, do think that it’s not just about costs and charges. It is about the overall value for members,” she stressed. 

Having illiquids in the investment mix nearer retirement would be more problematic for own-trust schemes than master trusts, she said, given that assets will need to move for the decumulation phase. 

“The own trust will then have to sell the illiquid funds to get into the master trust for drawdown, so that’s definitely more challenging,” said Pitt. 

She agreed with McKinlay on the importance of the operational aspect: “If you're a DC plan, you've got to be on an investment platform and many of the platform providers are still undertaking their operational due diligence on these funds.” 

Given recent events with illiquid assets funds, including property funds having barred investors from selling and the Woodford debacle, trustees want to have certainty they will not be caught out. 

“As trustees, we're all aware of the gating of the property funds, so we are nervous. We want to make sure that these funds are really going to work from a liquidity perspective,” she said. 

“In theory there should be more money coming into a DC plan through contributions than going out, but we do need to check and stress-test that before we introduce them.”