The risks of private markets for DC should not be underestimated

I have looked on with interest as this government's pension investment review consultation suggests that the drive to lower member charges may no longer be entirely seen as a positive as it has stifled innovation. This is quite the reversal given governments of all shades have for many years looked to push down pension costs for the end user, as Steve Webb so memorably stated.

And it's true that charges in the UK are, internationally, very competitive. On average, much lower[i] than the circa 61 basis points[1] Australians pay.

Given we see regular comparisons between UK DC and Australian superannuation schemes, does the extra cost offer huge outperformance Down Under?

Not really. On average, an extra 0.24% per year[2], compared to UK defaults during the growth stage is noteworthy but it's not the huge difference that, for me, merits the hype, especially when you factor in different charges.

And it's easy to overlook the reason that the Australian DC system is heralded for good outcomes, is less about accessing private markets and outright investment performance, more about the very high level of employer contributions paid into the system compared to here. Next year, Australian employers will be paying in 12%, something very unlikely to happen in the UK any time soon.

Most UK DC assets are invested in default funds or strategies designed and managed for the majority of members. In this context, the DC sector is approaching this call for private market investment in several different ways.

Some workplace pension providers say they don't see private assets having much, if any, place in their main default strategies in the near future.

For the most part, they're going to be using ‘premium' type funds to access private markets with allocations ranging from 10% to as high as 25%. How does this help with the government's drive to consolidate DC default funds into large asset pools? From where I am standing, it simply doesn't.

Other providers will be slowly expanding private market allocation in their current ‘go to market' default but they seem to be the minority.

Whatever option pension providers take, accessing this asset class will be more expensive and I expect charges potentially north of 0.5% for these premium funds, whilst keeping under the 0.75% cap (unless government intervenes to raise or remove it).

Expectation is building in the private equity industry and also the climate transition business - seen as a likely beneficiary – about the potential wall of DC money heading their way.

And herein lies the problem. It's not the ability of DC schemes to access private markets but rather the opportunity set that concerns me.

The global private asset market may be huge but its already very competitive and the same overseas pension funds our government wishes to copy have already landed in the UK. Canadian funds own a number of our airports – and Thames Water – and the bigger Australian schemes have been opening offices in London.

As it stands, overseas pension funds invest 16 times more capital into UK private assets than UK pension funds do[3], meaning competition for investable opportunities will be fierce, driving up cost and driving down value.

No other market participant will stand aside and let UK DC simply pick the juiciest opportunities. Neither globally nor in the UK unless government mandates some form of home market incentivisation.

Interestingly government has yet to rule this out, but I fail to see how it could work in an open economy like ours. Especially as we continue to court overseas investment.

In the US, private equity has seen the sharp rise in interest rates create a larger-than-normal spread between buyer and seller expectations, leading to fewer deals over 2023 and early 2024, with many holding onto cash for the right opportunity[4].

This cash can't be sat on forever and this pent-up demand from the world's biggest private equity market is now translating into marked uptick in deal activity in the latter part of 2024, which could lead to poor investment outcomes if UK DC, as a late entrant, is crowded out from the best opportunities.

In addition, I would add increasing concerns about the hazards of private equity investing[5] with governance and valuation accuracy, a recurring theme.

Australian supers have written off hundreds of millions in failed private equity ventures[6], bringing increasing regulatory scrutiny[7]. The International Monetary Fund has also warned Australian funds are over-exposed to private markets[8]. This area of investment offers danger as well as opportunity.

And what of the people for whom this is designed ultimately to benefit: members? Have they been consulted? Has this drive been articulated, beyond an untested promise that it will improve outcomes?

There are real cultural differences between how the UK and Australian public view investment risk. How will members react if a UK pension has to write off millions or more in a failed allocation?

But a steady increase in risk seems to be the dominant feature of where we are. Gone are the days when the Department for Work and Pensions was recommending diversification so as not to scare members newly auto enrolled. Now, many providers are now exposing members to 90% to 100% equity in their growth stages, like they did in the late 1990s, in the quest for performance.

Some will rightly point out that private assets act as diversifiers and their lack of correlation with equity markets is a way of mitigating risk. But will the public see it that way should UK DC experience some of the issues highlighted above? The risks might be different but they are still risks.

DC providers will need to act cautiously and patiently to get to grips with this asset class and it will be interesting to see how they navigate what can be deceptively choppy waters.

Ultimately time will tell on how successfully they manage to set their course. I hope the DC sector can use private markets to deliver improved returns for the British public and economic growth for our country. However, the risks should not be underestimated.

Richard Evans is a senior consulting partner at Secondsight