DC members and illiquid assets – a perfect match?

Providing all of those things is possible – but not all at the same time. There is a balance to be struck between these conflicting objectives. 

An area the industry should focus on is the point of immediate access, and if daily liquidity is really a requirement for DC schemes. Is this an area that could be hampering the potential investment returns of our DC pension members?

We have to make investments work harder for members. Accessing the illiquidity premium is one obvious, as yet underutilised, solution

Investments in illiquid assets, such as private credit or private equity, might be expected to deliver additional growth above and beyond those of more liquid asset classes. 

In simple terms, the investor expects greater returns in exchange for giving up immediate access. So why are DC schemes leaving the illiquidity premium untapped?

For most DC members, especially those who have only recently been auto-enrolled, immediate access to pension savings is unnecessary to the point of irrelevance. 

A 22-year-old today will probably not receive their state pension until they are well into their 70s. Why should they be concerned about daily liquidity? 

Surely, in an environment with a UK bank base rate of 0.25 per cent, they should be more concerned about maximising their return and obtaining real growth over that 50-year investment horizon. 

Small progress to date

The fact that DC members have a long-term timeframe puts DC schemes in a perfect position to take on the disadvantages of illiquidity, just as we have already seen defined benefit pension schemes do.

More recently we have seen some, admittedly small, progress being made whereby a few, typically larger, DC schemes have been including an element of illiquid assets within the default strategy. 

For example, illiquid funds with weekly or monthly liquidity can be ‘wrapped’ with more liquid daily dealt funds to give DC schemes access to less liquid asset classes while still providing liquidity and, crucially, a daily price. But why is this not more popular?

Well, firstly, the trustees of the DC scheme have to believe in the illiquidity premium. 

Furthermore, they have to accept the potential inequity caused by certain operational constraints in providing a daily price. For example, how will it be calculated? By using stale prices for the illiquid part of the fund, or by attempting to calculate a proxy for the illiquid part?

When is liquidity important?

I do appreciate that liquidity can be and, in some cases, always will be important. Those members nearing retirement age or, more accurately, the age at which they can withdraw funds (currently age 55) will want to know that at least a proportion of their assets can be tapped at short notice. Even among this group many will be prepared to trade higher returns for liquidity.

But realistically it is only if you are about to take 100 per cent cash, buy an annuity, or in terminal ill health that you need total liquidity. 

Arguably, it would also be of value to ‘day traders’, but we already know that they represent a tiny minority and use the ‘self-select’, typically liquid, fund range anyway. 

In this day and age, we now expect to be able to access valuations online on a 24/7 basis. But there is a world of difference between daily pricing and daily dealing, and it is possible to access some illiquid investments with infrequent dealing cycles and still have a daily price.

However, in an environment where value for money is increasingly important, where long-term growth prospects are constrained and shorter-term gilt yields are falling into negative territory, we have to make investments work harder for members. Accessing the illiquidity premium is one obvious, as yet underutilised, solution.

Laura Myers is a partner in consultancy LCP