For many of us, our Defined Contribution (DC) pots will be the main source of income when we retire. The amount of income that we receive in retirement depends heavily on the investment returns achieved throughout our lifetime.
One method of achieving a higher return is to invest in longer-term, less liquid assets. According to the theory of risk-return trade off, the potential to achieve a higher return is greater with increased risk. There are many differing types of risks that exist for investors but, in this article, we will be focusing on liquidity risk – which in essence is not being able to sell an asset in a reasonable period without significantly impacting the price. Such assets are traded privately, not via a stock exchange.
Historically, Defined Benefit pension funds have benefitted from the diversification advantages and attractive returns that less-liquid, long-term investments can offer. Illiquid investments include infrastructure, private equity, private credit and real estate. However, these investments can be expensive and subject to minimum investment criteria making them difficult to access for the majority of DC schemes.
With the dual aim of developing practical solutions to the barriers to investing in long-term, less liquid assets for DC schemes, and providing greater access to capital to support economic growth, the government convened an industry working group comprised of the Bank of England, the Treasury and the Financial Conduct Authority (the ”FCA”). This working group developed a “new” fund structure, Long-Term Asset Funds (“LTAFs”).
LTAFs are exactly what their name depicts, in that they are open-ended authorised funds that are specifically designed to allow DC investors to invest efficiently in long-term, less liquid assets. Therefore, they can help provide exposure to asset classes that have until now been inaccessible to the majority of DC schemes, at a comparatively lower cost than accessing these investments directly. Because LTAFs are open ended they have the ability to grow to accommodate investor demand by issuing new “shares”. Also, they tend to be ESG tilted/focused, and most LTAFs launched to date have particular focus on the climate transition and net zero.
Pros and Cons
When looking to invest in LTAFs there are obvious risks, such as liquidity risk. Private investments and longer-term investments are characteristically less liquid, particularly during times of heightened market stress. Many LTAFs impose a minimum lock-up period, which means that you have no access to monies invested for a specified period. They also usually require notice prior to subscription, impose redemption limits and have minimum investment sizes which can limit who is able to invest. This can make administrating LTAFs for DC schemes operationally difficult but not impossible, particularly for larger schemes with more resourcing and flexibility.
Another concern is that there are not many options available at present, and the LTAFs currently on the market are new so there is little to no historic performance to determine how a fund has performed relative to its objective.
Despite the risks LTAFs face, they can provide DC investors with a diversified return stream which exhibits a lower degree of correlation to traditional asset classes (predominantly equities and bonds) and can offer illiquidity premiums i.e. higher returns for locking up capital.
Conclusion
To conclude, the notion of long-term investing aligns very well with the investment horizons of DC investors and LTAFs can offer accessibility to a wider choice of assets with the prospects of higher returns, which could be considered very attractive.
However, despite encouragement from the government to increase private market allocations in DC Schemes, there are still operational and accessibility challenges associated with LTAFs and these risks should be carefully considered prior to investing.
It is worth noting that regulation came into force from 1 October 2023 which requires that all trust-based DC schemes to state a policy on illiquid investments in their Statement of Investment Principles (“SIP”). Specifically, the SIP has to state the trustees’ policy on the default arrangements investing in illiquid assets. This applies to any SIP produced after 1 October 2023 and must be in place by 1 October 2024 at the latest.
Isabelle Ewah – Investment Analyst at Quantum Advisory