By year’s end retirement savers in U.S. and U.K. defined contribution schemes could be investing in leveraged buyouts and distressed-debt deals. In a big change for the world’s two largest pension markets, new structures will let plan participants move money into some of the highest-returning assets around.
Britain’s Pantheon Ventures and Partners Group of Switzerland have spent several years developing private equity–centered investment products that offer daily valuations and liquidity for typically illiquid and quarterly valued assets. It’s the first step in a concerted effort by private equity firms to tap the $15 trillion-plus defined contribution pension market.
New York–based Goldman Sachs Group is also reportedly looking at ways to introduce private equity into defined contribution plans. Others are watching with interest. “For private equity it is the holy grail,” says William Gilmore, senior investment manager for private equity at $504.1 billion, Aberdeen, Scotland–based Aberdeen Asset Management. “How do you get all that DC money channeled into the industry? If we could crack that, we would be happy.”
By dealing with structural roadblocks, private equity firms will give defined contribution plans access to private equity and other alternative assets such as infrastructure and unsecured mezzanine debt. Unlike existing liquid alternatives funds, the new products aim to tap the full illiquidity premium that long-term alternatives can yield. But they face other challenges, including the shift toward low-cost investment options and concerns about risky investments that might blow up and leave savers out of pocket and fiduciaries humiliated.
Defined contribution programs represent 46.7 percent of the $32.9 trillion in pension assets in the top six markets worldwide, according to New York–based consulting firm Towers Watson & Co., making them too big for private equity managers to ignore any longer. For their part, defined contribution plans can’t overlook higher-yielding asset classes as fixed-income returns compress. In the U.S. such schemes posted average annualized returns of 6.85 percent from 1997 to 2013, while their defined benefit rivals returned 7.92 percent, Toronto-based data provider CEM Benchmarking reports.
“If the only retirement assets that an individual is going to have are DC assets, there is no reason they shouldn’t have the same powerful tools as DB investors have had,” says Kevin Albert, global head of business development at London-based Pantheon. “If private equity makes sense in a DB plan, it has to make sense in a DC plan.”
Pantheon expects to have two large corporate pension plans signed up for its new U.S. investment product later this year. The $31.4 billion firm is structuring private equity components for bigger target date funds, which could provide, say, 10 percent exposure to the asset class for plan participants early in their career and reduce it as they near retirement. For that portion of the fund, liquidity will come from listed investments comprising as much as 30 percent; Pantheon will create daily valuations using underlying quarterly private equity valuations and daily movements of the S&P 500 index’s constituent stocks, along with macroeconomic data.
Zug, Switzerland–based Partners aims to attract U.K. and U.S. plans with packages consisting of private equity funds, direct investments, infrastructure and private debt. The firm hopes to satisfy liquidity needs by investing in more-tradeable forms of debt such as senior and mezzanine loans, as well as publicly listed infrastructure. Like Pantheon, it wants to be part of an auto-enrollment option or default selection for savers who tend to go for little else.
“We would love to see an investment structure from the private equity industry that solves the problem of getting into DC portfolios,” says Nico Aspinall, London-based head of U.K. defined contribution consulting at Towers Watson. “That structuring question is the DC challenge to the private equity industry,” adds Aspinall, whose firm has $2 trillion in assets under advisory for pension funds and other investors. “This applies to hedge funds as well. We would love to see more of them in DC.”
But structuring products is only part of the issue. Private equity, like hedge funds, is sticking to its 2 percent annual management fee and 20 percent performance fee as pressure to reduce such costs grows. In April the British government introduced a 75-basis-point charge cap on defined contribution default funds; all funds may eventually have to match the 50 basis points set by the National Employment Savings Trust that it established in 2010 to manage pensions for businesses without their own programs.
“The 75-basis-point cap is very tight, even if you create a diversified portfolio with some more-liquid elements that come at lower costs,” says Steffen Meister, partner and delegate of the board of directors at $45.5 billion Partners. “If it goes to 50 basis points, I think that is probably going to pretty much stop all private markets initiatives.”
Fear is another factor. Even within a corporation with legacy defined benefit pension liabilities and a newer defined contribution plan, opposing forces are at work. A defined benefit plan can ride peaks and troughs in returns, but defined contribution fiduciaries fret about explaining bad deals, which cost participants directly.
Still, with products from Pantheon and Partners close to adoption, private equity, hedge funds and other illiquid alternatives will likely be part of the mix for many defined contribution pension schemes within five years. “We think low-cost beta coupled with sophisticated alpha is the future,” Towers Watson’s Aspinall says.
