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Defined contribution (DC) pension schemes need to deliver the required returns for cost-conscious members. But this is highly challenging to achieve in a complex market and with pressure on yields. So, in response, many schemes are looking beyond traditional markets to the potential diversification benefits of private markets.

Looking beyond traditional markets

We live in an increasingly volatile world of risks. Markets are difficult to navigate, there’s wide dispersion between winners and losers, and yields are under pressure. Yet, even in this environment, a successful DC investment strategy needs to find differentiated and sustainable growth opportunities.

After many years of a declining outlook for the performance of traditional market assets, there’s a strong case that DC investors need to look beyond these. And this is where private markets come in. These assets offer three key characteristics that can substantially benefit existing DC portfolios:
  • Potentially higher returns
  • Enhanced portfolio diversification
  • Protection against inflation
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Private markets tend to be more costly and illiquid in nature than traditional markets – so it’s important for schemes to consider the impact of using them in portfolios, something we look at later in this article. But for the increasing number of DC schemes using these assets, the extra cost and considerations seem to be worth it to help minimise risk while generating sufficient return.

What do we mean by private markets?

Private markets can include a wide range of investments – real estate, infrastructure, private equity and private credit being the main ones. What these investments have in common is that they are businesses, ventures or projects that are not traded on the stock exchange.

Real estate

Real estate is the land, buildings, systems and services on which our cities and countries depend. It’s the largest and most developed private market asset class. And for most investors, it’s already a component of their wealth – whether held personally or through pension funds.

The breadth of real estate opportunities for DC investors has expanded over the last 10 years. For example, DC investors could specialise beyond core asset allocations to achieve more specific investment goals, eg by investing in student accommodation, residential housing, logistics and development assets. These different sectors allow DC investors to invest in specific assets for accumulation or perhaps to seek rental income as they phase into retirement.

Infrastructure

Investment in social and economic infrastructure has become a key part of institutional investor portfolios. Opportunities have increased as governments involve retail investors in large-scale infrastructure programmes and help lift economies out of the Covid-19 pandemic. And DC schemes can also access these investment opportunities.

Infrastructure investments are long term in nature, so can match the long investment horizons of DC investors. Investing in infrastructure can also allow schemes to target particular sustainable investment goals. Investing in wind turbines or hydro-electric power to accelerate the decarbonisation of the global economy are just a couple of examples.

Infrastructure investments typically have the ability to generate secure inflation-linked cash flows throughout a market cycle – a big benefit for DC investors.

Private equity

There’s a world of company ownership beyond the listed markets. In fact, 98% of UK companies are privately held. It’s these companies that are innovating and growing. Which makes them an important component in many institutional investor portfolios.

Private ownership has many growth advantages over public companies. Private companies can focus on long-term decision-making, rather than on quarterly earnings being presented to city analysts. Private ownership is also able to align incentives of management to ensure transformation of a business, maximising revenue and increasing profits.

With private equity, DC investors can access fast-growing companies that are not available on the stock exchange – and this means greater diversification.

Private credit

Since the global financial crisis, private credit assets have become increasingly important for many institutional investors. A key reason for this growth is that banks’ appetite to lend to businesses and projects has been reduced, so borrowers have turned to private lenders.

Private credit offers DC investors a diverse array of strategies - from investing in infrastructure projects to direct lending in fast-growing private companies. Typically, private credit offers a higher yield when compared to public equivalents.

What do DC schemes need to consider when creating a private markets portfolio?

Like investing in public markets, these different asset classes have different levels of risk and return expectations. In addition, DC investors need to consider:

  • The long-term nature of these investments and how they affect the portfolio mix
  • Their illiquidity relative to traditional assets
  • The costs for accessing them
  • The impact on schemes’ existing administrative and governance processes
Looking at the first point, holding periods can be substantial. For example, real estate typically involves a five to 10-year holding period. Private equity investments tend to have similar holding periods. Infrastructure opportunities are typically even longer – some as long as 20 years.

Allocation to private markets can help to improve the risk-adjusted return potential of a long-term investment portfolio.

Investors’ potential reward for locking their capital away comes in the form of illiquidity premia and risk diversification. Allocation to private markets can help to improve the risk-adjusted return potential of a long-term investment portfolio. In particular, it offers low correlation of returns to traditional asset classes.

The third element, cost, is a key challenge for DC investors investing in private markets. They can come with high fees and differing fee structures to traditional assets (eg split between management fees and performance-based fees). It means that it’s critical to conduct robust due diligence during the portfolio construction process to ensure that fees are (and remain) worth paying for the best-performing investments.

Finally, schemes also need to measure the impact that opening up their portfolios to private assets will have on existing administrative activities. In particular:
  • Valuation, risk management and oversight processes need to reflect the different characteristics of these assets
  • Given their nature, market prices tend to be harder to evaluate and subject to significant smoothing effects owing to infrequent valuation points
  • Suitability and end-investor education for these assets, particularly as regulators push for greater investor protection and overall transparency in the way these investments are sold to clients
  • Risk and governance functions will need to adapt to the increased complexity of portfolios.

This may seem like a painful exercise. However, the increasing number of DC schemes joining this space, to access the potentially considerable benefits to their portfolios, suggests that the hassle may well be worth it. Some DC schemes willing to enter this area of the market choose to outsource the burden. Asset managers, including Aberdeen Standard Investments, offer tailored DC solutions that can incorporate the diverse universe of private markets to help meet a scheme’s specific objectives.

You can find full details of our DC solutions and fund range, including our latest DC insights on our DC Solutions page, or keep an eye out for our regular newsletter to clients.