Over the Easter weekend , I continued to question the legitimacy of illiquids in the default funds that dominate retirement saving in the UK. To date these funds have invested in liquid funds which have sought returns by passively investing in stocks quoted on recognized markets. The returns savers have been getting have been well ahead of inflation and with relatively low product costs, workplace pensions have been a good deal- certainly compared to saving into cash (which is what most retail savers are doing).

My fundamental question is “if it ain’t broke- why fix it?” and many of the comments I’ve seen – especially on linked in have not been encouraging. Moving money to private markets cannot just be about feeding active fund managers keen to extract higher rents from the trillion pound savings book created by auto enrolment.

The “value” question is whether people need access to illiquid markets and I will come back to that, but the “money” question is how to pay for that access- and how much to pay. This is what Mark Fawcett, CIO at Nest, is calling the new bargain. This blog explores that bargain further in terms of “value” and “money”.

The fees charged in private markets are characterized by something called “carry”. I had to look this up and it refers to the reward picked up by medieval ship-owners for carrying goods by sea from one continent to another. It was thought proper to share up to a fifth of the profits of a voyage with the ship-owner for the risks taken with ship and men. This was an accepted practice and provides an interesting insight – the men who’s lives were put at risk, were not the ship owners but the seamen, as with DC -rents were being demanded but not paid on to those taking them.

Ros Altmann’s comments

Ros Altmann has commented on this – you can read the original post here. 

I am continuing the conversation by inserting  comments (marked in red).

In my experience, the larger DB schemes don’t pay anything like 2+20% and haven’t done for some years – they negotiate much more reasonable fee structures. 1+10% is more usual for most except the really esoteric or niche funds. For large DC schemes to pay so much more than DB trustees can achieve is clearly not appropriate in my view.

But I still believe that the daily pricing and expected short-term liquidity of DC pension funds does not fit well with optimising long-term returns and members need to understand that if they want the ‘option’ to move their funds within just a few days (which most do not use and could wait longer or transfer in specie, as most are not going to actually withdraw their money for many years) – there will be a potentially heavy cost in lost returns.

A diversified portfolio, including illiquids and assets that are not ready realisable instantly, will usually perform better and is likely to be lower risk in the long-term than just equity/bond assets with a tiny allocation to alternatives.

Not just because of any supposed illiquidity premium but – as John Kay points out in Other People’s Money access to capital has become less and less important to businesses. The finance sector retains two key roles in modern corporate life. One is “search” for companies that need new capital, but this is now most relevant to young businesses looking to fund the period before they become profitable. The other is “stewardship”, supervising incumbent management’s competence and integrity and acting – where necessary -to make changes.

Asset management works best in private markets because in private markets there is most need for capital and stewardship. Which is why more of the £1 trillion of DC assets savings is best deployed diversifying into private illiquid markets

I know that some people want to think of pensions like bank accounts with instant access, but that is not the way to optimise pension outcomes and is a sub-optimal way of thinking about pensions, which actually need to stay invested for the very long-term so you have money into your 80s, not just in your 60s.

I am very pleased that Ros Altmann is taking this view. I am mystified as to why we still think of DC pensions having a hard-stop at an arbitrary “retirement age”. The idea that people need to cash out and spend is nonsense, people do cash out but they don’t generally spend, they just stay in cash. If people were given the confidence to stay invested in pensions they would, that means those designing DC plans being prepared to run investment strategies to and through retirement. 

The question we need to be asking is “what do people want from their retirement savings” and if the answer is a wage for the rest of their life, then investing, not cashing-out, is the best way of achieving that. Putting aside the question of how to organise the return of the money (DC or CDC), money may well be invested longer after retirement than before it. If this lesson is taken onboard, the arguments for “patient capital” make more sense.

We need to help people recognise the risks of instant transferability and daily pricing and be willing to accept that these investments truly are meant to deliver over years, not days.

There are many examples where people have learned this lesson and kept assets illiquid. The housing market is the obvious one but people also see the value in “things” like the heirlooms that get passed from generation to generation, creating no income but providing happiness and a financial longstop. What is different about a pension investment is that it must have sufficient liquidity to meet the expectations of those in receipt of the pension promise.

I’ve seen the success of risk management in DB and I’m afraid it seems to me that most DC schemes have not moved into the modern era yet in terms of asset allocation.

This worries me! If the success of DB risk management is liability driven investment, then “the modern era” won’t work for DC. LDI has worked because of the phenomenal returns achieved from borrowing on the derivatives market to buy more and more bonds – it continues to thrive because of quantitative  easing keeping interest rates low and bond prices high. If DC funds were to start LDI programs (at huge cost in terms of fees and charges), it would be in the face of some strong headwinds in terms of the likely prospect for interest rates and inflation. More fundamentally, the reason for gearing up bond holdings is to protect sponsors of DB schemes from the impact on guaranteed liabilities creating demands on the sponsor’s balance sheet and profit and loss account. This is not a worry for DC savers, their worry is ensuring that their income is maintained for as long as they need it (typically till they die).

If what Ros Altmann is referring to is the management of the growth portfolio within a DB fund, I’m more happy. But I am still far from clear that the bargain on fees between those managing illiquids and the DB trustees employing them, is the bargain we want and need for DC.

The bargain for DB trustees is that the growth portfolio produces stable and predictable returns based on valuations created by the asset managers. This makes for a quiet life for trustees who can show the Pensions Regulator their path towards self-sufficiency or buy-out with the authority of their fund manager’s projections. Understandably, this bargain works well for both sides and allows DB trustees to justify plenty of “carry”. But – as recent events show – the hedge funds do not always get it right and holes in the funding of projected returns can emerge. 

This is why the DC bargain, referred to by Mark Fawcett , needs to be driven a lot harder. There is no sponsor for a DC fund to fall back on but the private investor. The duty of care on DC trustees is directly to the member so the bargain will need to be driven harder and the terms – more transparent.

This is why I am so against granting trustees “favored nations status” in return for a non-disclosure agreement on fees. Such deals take the bargain away from member’s sight and into the collusive deals that are too prevalent between fund managers, advisers and trustees.

The consequences are spelt out in a recent article in Prospect Magazine by John Kay

At private equity’s too-frequent worst, existing businesses are acquired with mountains of too-cheap, tax-favoured debt, assets are sold and short-term profits are enhanced at the expense of the long-term health of the business.

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My conclusion

I no longer see investing in illiquids as a “bad thing” for DC. I see that the burgeoning coffers of the DC defaults cannot be emptied into public markets for ever, quoted companies do not need the capital and private companies – especially young ones do. I also see the role of private equity managers as responsible stewards of the E, S and G of the companies they invest in, as critical to the financial health of British business.

But for illiquids to sit in our retirement funds, we need a hard bargain to be driven with the hedge fund industry. It needs to be a harder bargain than in DB as Trustees and other fiduciaries have no one to take the risk of failure than their members.