When it comes to improving Britain's workplace pension schemes, one of the biggest areas of prospective change is the type of assets in which defined contribution pension funds can invest.
They have typically invested in quoted stocks, usually low-cost passive trackers, although some multi-employer funds have the scale to do something much more ambitious – that is, if other factors permit it.
For example, Scottish Widows' largest default fund, the Balanced Pension Investment Approach, is £45bn in size yet its head of policy, Peter Glancy, says it is "frustrating" to be held back from investing into something more long term and less liquid.
In his Mansion House speech last year, chancellor Jeremy Hunt outlined his desire to have default DC pension funds – by signing a 'compact' with nine large pension providers – to increase their allocation to a certain type of illiquid investment: unlisted equities.
He said at the time: "The compact commits these DC funds, which represent around two-thirds of the UK’s entire DC workplace market, to the objective of allocating at least 5 per cent of their default funds to unlisted equities by 2030.
“If the rest of the UK’s DC market follows suit, this could unlock up to £50bn of investment into high growth companies by that time."
In fact many pension funds already invest in illiquids.
Defined benefit funds have invested in them for a long time; last year, for example, the West Midlands Pension Fund, a local government scheme, had 24 per cent of its £19.4bn fund allocated to private assets.
Broken down: 8 per cent was in private equity; 3 per cent in private debt; 5 per cent in infrastructure; 7 per cent in property; and 1 per cent in 'special opportunities'.
| Pension fund types, membership and assets, today and beyond | ||||
|---|---|---|---|---|
| Type | Number of members | AUM 2020 | AUM 2030 | Typical maturity of the scheme |
| DB | 12mn | £1.5tn (closed £1.2tn, open £300bn) | £1.5tn | 10-15 years |
| DC | 20mn | Master trusts and PF £435bn GPPs £170bn | £955bn | 30-100 years |
| LGPS | 6mn | £270bn | £500bn | 30-100 years |
| Source: Pensions and Lifetime Savings Association | ||||
The challenge is how much DC schemes are restricted by the charge cap, and whether the potential downsides are manageable.
Allocating to illiquids brings certain risks, notably their illiquidity, their costs and potential volatility, but they are able to pay out at different stages and also come with the 'illiquidity risk premium' – that is, the compensation investors receive for locking up their capital for a long time.
Private equity
Taking private equity, for which there are collated statistics, the overall internal rate of return for private equity funds since 1980 was 14.7 per cent in 2022, according to the British Private Equity & Venture Capital Association (BVCA).
Nest, the default scheme for auto-enrolment, is a£36bn master trust and allocates 14.7 per cent of its pension fund to illiquids.
Stephen O'Neill, head of private markets at Nest, says they do this: "Because we can. It's very difficult to get the same kind of economic exposure [that you get from] long-term infrastructure in anything you get in public markets.
"The volatility of people buying and selling index funds tends to determine your risk profile,but if you're buying an illiquid with long-term cash flows, it's a very different economic model.
"In the public equity markets, a lot of risk and return comes from the top 100 stocks, and out of that top 100, a lot of the return comes from the top 10.
