Debating the pros and cons of illiquid assets in DC

However, in the UK the benefit of giving members exposure to asset classes such as commodities, infrastructure, private equity and hedge funds is rendered problematic by their relative illiquidity.

Schemes should recognise the trade-off between favourable return and unfavourable liquidity

The main hurdle facing DC schemes in accessing illiquid assets is operational: the requirement for daily dealing. While it is being said increasingly that schemes do not need to deal on a daily basis, the problem is that in this country in particular the current trend is to have pooled funds on platforms.

It is therefore not simply a case of one individual scheme being invested in one fund, rather there are multiple schemes investing in single funds, with each having a daily dealing point.

Does one fund need a daily dealing point? Probably not, but they are all in unitised vehicles on a platform that requires daily dealing.

The upside

From the investment perspective, it is wholly understandable why DC schemes are desperate to get exposure to illiquid assets.

Benefits range from higher returns and lower volatility to wider diversification and lower correlation. But the trade-off to these advantages is the danger that funds themselves become illiquid and have to close.

We just have to look at the various crises suffered in recent years by hedge funds, property funds, and to some extent credit funds and cash-plus, funds to be reminded of the risks of giving DC members exposure to assets with liquidity that cannot be guaranteed.

So what are the possible solutions? One option is to employ a diversified growth fund with set allocations, perhaps using investment trusts as a convenient liquidity wrapper. Another could be a halfway house where you would have indirect access to illiquid assets.

But in both cases you need to be mindful that if there is a run on the underlying assets, you are going to suffer serious liquidity issues. Investing in an open-ended investment company, for example, could offer relatively liquid exposure to the property market, as many funds run high cash positions and derivative overlays as buffers.

But the protection is limited if circumstances dictate that underlying properties have to be sold.

Some of the bigger schemes have the ability to have their own unitised fund, which allows them broader asset allocation scope. But this still fails to overcome the fundamental problem in that investing in illiquid assets is not a one-way bet.

The downside

While illiquid assets can give you benefits, there are also drawbacks.

One of the disadvantages is that they prevent investors from rebalancing their portfolios. When assessing these assets, an investor should comprehend that one loses the capacity to rebalance a portfolio in case other investment opportunities occur. The other drawback is stale pricing. The basis of these assets’ costs may rely on old costs.

Therefore, if you use unadjusted historical information to compare illiquid and liquid investments, you may not obtain a true representation of the fundamental financial association between the two.

Nest is a potential model of what can be achieved through economies of scale once the UK’s highly fragmented DC market starts to consolidate. The scheme is currently looking at a whole range of illiquid assets but they are going to be cash generative for the future.

It will also benefit from greater clarity of people’s retirement date because it is the state-sponsored scheme, and that gives it the scale and ability to manage its liquidity internally.

Overall, DC schemes need to be careful what they wish for. Liquidity is always needed, particularly in times of market stress. Write it out of the equation and you create the potential for major structural problems in your scheme.

DC schemes taking reasonable exposure to illiquid assets is an important and desirable goal, but we need to consider carefully how we get there.

These assets may provide diversification benefits and an opportunity for some schemes to leverage off their existing investment expertise, but in striving to surmount the challenge of the daily pricing requirement, schemes should recognise the trade-off between possible favourable return characteristics and unfavourable liquidity characteristics.

Above all, the DC landscape needs to consolidate before illiquid assets can play their full role in helping scheme members reach pension goals.

Julian Lyne is head of global consultants and UK institutional business at F&C Investments