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Alternative investments for pension schemes

October 6, 2021
clock 7 MIN READ

The challenge for pension schemes

In the last few years, defined benefit pension schemes have become increasingly strained due to a combination of factors. By and large, schemes are suffering from widening deficits as a result of increased member longevity as well as lower returns from the volatile performance of traditional asset classes (equities, fixed income, and cash). Investing only in traditional asset classes means that schemes’ portfolios may not be as diversified as they can be. Pension schemes that want greater diversification, and the potential for higher yield, can look to alternative investments to solve both of these issues. Alternative investments fall outside of the three standard asset classes and are often (but not always) private, illiquid, and longer-term investments.

Alternatives within a scheme's portfolio: Features and benefits

To really understand what alternatives can do for a portfolio, trustees of DB pension schemes should consider the role of each alternative within the context of a broader portfolio (as when investing in traditional asset classes). This is crucial in appropriately constructing a goals-based investment portfolio they can stick with for the long term. Broadly, alternatives can provide return generation, risk management/diversification, inflation hedging, and allow investors to take advantage of emerging opportunities and dislocations (thematic investing).

  • Return/liquidity premium: Alternative asset classes can tend to offer a fairly high rate of return compared to their traditional counterparts. However, this can come with higher levels of risk and with capital tied up for much longer. Therefore, there is also a liquidity premium: the extra compensation you would expect for the risk of locking up your capital for a long period of time.
  • Risk management/diversification: Alternative asset classes tend to reduce overall portfolio volatility due to less volatility on a standalone basis, lower or no correlation with other traditional asset classes and potential outperformance relative to other investments in the event of an economic downturn.
  • Inflation hedging: Certain alternatives are meant to outperform other assets when inflation is unexpectedly high. Since income is linked to inflation, investing in this type of alternative can benefit investors.

Solving the illiquidity conundrum 

Institutional investors, especially defined benefit pension schemes, are long-term investors and as such may wish to consider including illiquid asset classes in their portfolio. However, as of 2020, around 82% of defined benefits pension schemes are experiencing negative cashflow1. Thus these schemes are increasingly reliant on the assets held to meet their cashflow needs and would therefore prefer that the assets are liquid rather than illiquid.1

2020 in particular presented challenges for schemes without ample liquidity in their portfolio. Why?

  • Some of these schemes had fewer contributions coming into their accounts as sponsors were given the option to take contribution holidays.
  • There was additional demand for cash as transfer values increased and in some cases experienced demand of 2-5x normal volume.
  • Collateral calls reduced leverage on liability-driven investment allocations as long-term interest rates spiked.
  • Finally, cash calls for commitments previously locked into for alternative asset classes.

Meanwhile, equity markets, where investors usually seek liquidity, fell dramatically and unexpectedly.

To meet these challenges, and ensure that none of our clients were impacted, we used our liquidity framework to first analyse the specific needs of each scheme. The asset classes in any scheme’s portfolio are classified into different liquidity and transaction cost levels ranging from those easily realisable on any given day with low transaction costs (1) to those that are daily liquid with increasing transaction costs (2 and 3) to those that are locked up for 5-10 years (5).

Many advisers stop short at the above. We take this analysis further in our second step, which is shocking the portfolio. The scheme’s assets and liabilities are stressed for economic scenarios that are expected to pose a liquidity challenge to investors, such as higher interest rates and significant drawdowns in equity markets. The stress test ensures that allocations to illiquid assets are sized to levels that are suitably robust to withstand a range of market stresses.

This gave our clients comfort that even in extreme scenarios, they were likely to have ample liquidity in their portfolio to meet their scheme’s cash needs. It is important for schemes to have access to the latest opportunities within alternatives, but to balance that opportunity with managing their liquidity needs appropriately.

Unique considerations when investing in alternatives

Though alternative investments can bring several benefits to a pension scheme, there are some additional considerations when deciding whether to include them in a portfolio, such as:

  • Level of transparency
  • Level of fees
  • Regulatory reporting such as Competition and Markets Authority Cost and Charges of MiFID II requirements

As a scheme’s investment partner, a fiduciary manager can significantly reduce some of the challenges of investing in alternatives, helping schemes to reap the benefits from these investments.

Technology - The technology and experience to carry out operational due diligence on alternative investments is key in this space. Within alternative asset classes, whereby operational risks are potentially more pronounced, SEI has a dedicated operational due diligence team that has veto authority over manager appointments. For illiquid assets where we do not have daily transparency in the underlying holdings, we have in place a continuous monitoring platform where the service scrapes various databases for legal matters, bankruptcy and changes in regulatory filings; this informs us in real time whether further assessment of the manager is required.

Scale - Our scale means that we can directly negotiate terms for managers on our platform, including potentially lower fees. We give our clients access to specialised managers that might not be accessible in standalone investments, providing them with multi-asset expertise in a diversified, tactical portfolio.

2020 highlighted to many trustees and fiduciary managers the need to balance competing liquidity needs with appropriate diversification and opportunities for enhanced return. A robust liquidity framework, can help schemes understand their appetite for illiquidity clearly and simply to ensure that potential additional return is not left on the table.

To find out how a fiduciary manager can help your scheme achieve this balance, do not hesitate to contact us.

1. "European Asset Allocation Insights 2020", Mercer, mercer.com. 

Important information

This document contains marketing material about our fiduciary management service. This document does not represent impartial advice on this service. In certain cases, you are required to conduct a competitive tender process prior to appointing a fiduciary manager. Guidance on running a tender process is available from the Pensions Regulator. 

This material is not directed to any persons where (by reason of that person’s nationality, residence or otherwise) the publication or availability of this material is prohibited. Persons in respect of whom such prohibitions apply must not rely on this information in any respect whatsoever. Investment in the funds or products that are described herein are available only to intended recipients and this communication must not be relied upon or acted upon by anyone who is not an intended recipient. While considerable care has been taken to ensure the information contained within this document is accurate and up-to-date, no warranty is given as to the accuracy or completeness of any information and no liability is accepted for any errors or omissions in such information or any action taken on the basis of this information. Investments in SEI Funds are generally medium- to long-term investments. Alternative Investments involve a high degree of risk and can be illiquid due to restrictions on transfer and the lack of a secondary trading market. They can be highly leveraged, speculative and volatile. The value of an investment and any income from it can go down as well as up. Returns may increase or decrease as a result of currency fluctuations. Investors may get back less than the original amount invested. This material represents an assessment of the market environment at a specific point in time and is not intended to be a forecast of future events. This document is not intended for and does not constitute investment advice. The opinions and views contained in this document are solely those of SEI and are subject to change. The information expressed is provided in good faith and has been prepared using sources considered to be reasonable and appropriate. This document is issued by SEI Investments (Europe) Ltd (SIEL), 1st Floor, Alphabeta, 14-18 Finsbury Square, London, EC2A 1BR. SIEL is authorised and regulated by the Financial Conduct Authority (FRN 191713). This document and its contents are directed only at persons who have been categorised by SIEL as a Professional Client for the purposes of the FCA Conduct of Business Sourcebook.

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