Funds of funds: Opening up the defined contribution world

Funds of funds have a key role to play in opening up private markets to defined contribution pension plans.

Defined contribution pension plans are waking up to the reality that they will need to start allocating to private markets, some way, somehow. Funds of funds will be key to making it happen.

DC assets have just overtaken defined benefit assets in the seven largest pension markets, according to Willis Towers Watson’s latest Global Pension Asset Study. In the last 10 years DC assets have grown at 8.9 percent, compared with 4.6 percent for DB assets.

A rising public market over the last decade has meant DC plans haven’t had to look elsewhere for returns. But when the market turns – flashes of which we saw in December – it’s likely the motivation to move into alternatives will increase.

And the numbers add up. A study by Georgetown University in conjunction with Willis Towers Watson found including alternatives in target date funds “can improve expected retirement income and mitigate loss in downside scenarios”.

Washington State Investment Board, which has a hybrid DB and DC pension plan, with DC assets representing around 10 percent of the total, is working to include alternatives in its DC TDF. It already offers private markets exposure to DC plan participants as an opt-in option through a commingled trust fund, but that is not dynamic or age-specific in the way a TDF is.

However, that commingled fund, which WSIB has been offering since the 1990s, gives the pension plan long-term data on the benefits of a private markets allocation.

“We’re the example of why this works, we’ve got 20 years of history with it,” Theresa Whitmarsh, executive director of WSIB, said at a media roundtable hosted by fund of funds manager Pantheon – one of the first in the market to create a product for DC pension plans – in October.

“A lot of the barriers… we think are illusory, we don’t think these are real, and we would love to see policymakers take these issues on and the marketplace take it on.”

Mercy of the market

The challenges for DC investing in private equity are well-documented. Investors, at the mercy of the market, value the ability to dynamically rebalance their portfolios, and have a greater desire for liquidity. DC members also expect to be able to see what their holdings are worth daily.

Fees are also an issue, and the threat of class-action lawsuits makes DC plan sponsors very-risk averse – particularly as they are not on the hook for performance in the way DB plans are.

But it can be done, and funds of funds will, by and large, be the ones to facilitate it. Not only does it make sense for investors accessing the asset class for the first time to gravitate toward the diversification offered by funds of funds, but these managers are also the best placed to create the kinds of bespoke products needed to allow DC plans – typically through TDFs – to access the asset class.

Of course, recent fundraising numbers demonstrate there’s plenty of capital available for private equity without DC plans in the mix. But funds of funds – whose share of traditional private equity capital has been shrinking – are perfectly positioned to take advantage of this future capital source, without competition from the vast majority of the primary funds market.

“I don’t know when it’s going to happen, but it’s going to happen,” says Lee Gardella, head of investment risk and monitoring and investment committee member at Schroder Adveq, which is not currently operating in the DC market.

“As the number of public companies gets smaller by the day and private equity becomes more and more institutional and prolific every day. To me, to not have some element of private equity in defined contribution [plans] at some point becomes a mistake by the fiduciaries of those plans.”