Defined Contribution Schemes in Britain: Encouraging a Broader Portfolio

Defined Contribution Schemes in Britain: Encouraging a Broader Portfolio

Britain’s All-Party Parliamentary Group on Alternative Investment Management has published a paper on the country’s pensions. It’s focus is defined contribution schemes especially and the demographic strain they face, and the prospect of their moving more heavily into alternative assets and strategies in response.

Defined benefit schemes “have some freedom in their investment decisions and have accordingly, invested in alternative investment,” the paper says, but defined contribution schemes “are subject to specific regulatory, cultural, and operational pressures” that keep them out of the alternatives space. That is worrisome to the APPG, since defined contribution is a rapidly growing percentage of the total pension assets in the United Kingdom. Accordingly, the DCs are the focus of this paper, which cites estimates that defined contribution assets will amount to 15% of UK net wealth by 2030.

Under existing regulations, the managers of defined contribution plans “are obligated to specifically justify any allocation made to an investment that is not traded on public markets.” This obligation has had a chilling effect, and the APPG suggests that it be reconsidered.

In 2012 the UK moved to a system of automatic enrollment, under which eligible workers are enrolled in their employers’ pension funds unless they actively opt out. This change invoked what some have called “the power of inertia” to raise the numbers. It worked. By 2013, the percentage of the workforce participating in pensions had doubled, reaching 66%.

In further testimony to inertia, the paper tells us, the vast majority of workers keep their contributions in their employers’ default fund.

As a retiree comes closer to retirement, the default funds typically transfer capital from riskier to safer assets: which means, generally, away from equity, toward bonds and cash.

The Horizon of Alternatives

There are two main respects in which alternative investments could assist defined contribution schemes, including the default funds: diversification and access to the illiquidity premium. Typically, the plans now are run on 60/40 lines, where the 60% represents public equity and the 40% represents bonds. Less than 5% of the defined contribution managed assets in the UK are anything other than equities, bonds, or cash. This is much smaller than the analogous number in other jurisdictions. And it may not represent an adequate level of diversification.

Return on both bonds and equities could be lower in the UK in the coming years than the pensioners expect.

The paper’s authors accordingly tour the horizon of alternatives. They see private equity as a way of avoiding the principal/agent problem that can arise when pension funds invest in public equity. The interests of a public corporation’s managers don’t necessarily align with the interests of the pensioners who have an interest in their performance, and there is no easy way to make them align: contested directors’ elections, for example, are expensive and the outcome is always unreliable. However, with private equity, the fund manager owns the corporation outright.

The authors of the APPG paper see private credit, or non-bank lending, as a way of deriving “new sources of return by providing financing to underserved segments of the economy.”

Private credit looks for the most part to the mid-sized enterprises, which are too small for either equity listings or access to the public bond markets.

Hedge fund managers, in the paper’s brief description, are fund managers who pursue absolute returns, freeing themselves from the benchmark indexes that define traditional investment managers.

Each of these three, and other alternatives can offer something very valuable to pension schemes and the pensioners: low correlation with public equities and bonds.  Relatedly: “our evidence sessions made plain that, contrary to public perception, alternative investment managers are not inherently ‘riskier’ than traditional assets.”

A Premium and a Conclusion

The paper also discusses the matter of the illiquidity premium, described as “one way that alternative investments can deliver superior returns.” Since pension schemes have long horizons, they positioned to take advantage of this phenomenon.

Also important from a public policy point of view: “Increased allocations to illiquid assets by pension funds would not just potentially benefit their beneficiaries: it could also theoretically increase the amount of long-term ‘patient capital’ invested in the broader UK economy. Many infrastructure projects, for instance, require years—or even decades—of steady investment, which can be difficult to source from conventional investors.”

In sum, the report concludes: “Given that the goal of DC pension schemes is the maximization of a beneficiary’s outcomes, it seems logical that such schemes should allocate to investments that offer the chance of superior returns.”

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