At the start of June, the US Department of Labor confirmed that defined contribution pension plans could incorporate certain private equity products without violating the Employee Retirement Income Security laws. The announcement was in direct response to a request for guidance from Partners Group and Pantheon – the two firms with illiquid DC offerings.
More than 100 million Americans are covered by DC pension plans with assets in excess of $7.5 trillion, according to data from Vanguard. DC plan managers have proved reluctant to incorporate private markets for fear of failing to comply with their fiduciary duty under federal law.
Several schemes outside the US have successfully incorporated PE in recent years. These are the three main challenges they faced.
Unlike the UK, the US doesn’t have a fixed charge cap. Still, the DoL recommends pensions consider whether private markets products fall within the “appropriate range of expected returns net of fees”. The methodology of how fees are calculated has not yet been outlined and has proved an obstacle in other countries.
Private Equity International is aware of two pension funds in the UK that tried to negotiate a success fee with the private equity firm – a base fee plus additional profit share – seeing it as a way to align the manager with its members.
Under UK regulations, unknown costs such as performance fees have to be accounted for retrospectively. For example, if a person has been a member of a pension plan for a single day, on which they paid one basis point in profit share to the PE manager, that figure would have to be multiplied by 365 days. The charge cap of 0.75 percent is very quickly surpassed.
Even with just a fixed fee, administrative costs mean it is not easy to keep costs low, said a retired portfolio manager from one of the largest UK corporate schemes: “For pensions with less ability [than us] to negotiate down the price of other funds in your blended default, it’s hard to have more than 10-15 percent in the illiquid fund [without costs getting too high]. And there comes a point where you have to ask whether the benefits are worth the trouble.”
Pension plan members want to be able to access their money if needs be. The DoL letter recommends that pensions choose private equity products that have a “liquidity component to manage the participant directed deposits and withdrawals from the fund.”
The existing products on the market don’t guarantee liquidity but do allow for a proportion of redemptions, calculated as a percentage of the total size of the fund, on a monthly and yearly basis. The liquidity comes from an allocation to assets such as cash, syndicated loans, and listed PE and infrastructure.
The chairman of a £4 billion ($5 billion; €4.4 billion) private pension fund based in the UK, which incorporated alternatives into its plan three years ago, told PEI that thus far the liquid component of the PE vehicle has gone relatively untouched. The pension has a default scheme and a self-select option and has generated its own liquidity via transfers between the two.
“Even if the fund gated and we couldn’t get liquidity on a given day, we could effectively create liquidity ourselves by trading between members who had self-selected but wished to sell into the default fund,” he said, adding that liquidity was also created by retirees selling their stakes down to the next generation.
The DoL letter doesn’t explicitly say whether PE can be incorporated into self-select schemes as well as default plans in the US.
While the DoL doesn’t specifically advise pensions to seek illiquid offerings with daily price reporting, it suggests they ensure PE investments are independently valued in accordance with FASB standards and that they request “additional disclosures” about the current value of investments.
The methods used to value holdings in these DC schemes will be familiar to readers. One PE firm alters the valuations of its holdings in line with an index of comparable public companies then asks the business whether recent events, good or bad, are likely to affect their end-of-month valuation. It will then tweak the next day’s valuation accordingly.
According to the pension chairman, some members require convincing of how a security can hold a certain value even if it’s not actively traded on an exchange: “I tell them there are plenty of property funds that provide daily pricing and have methodologies for calculating it – yet the assets aren’t repriced on a daily basis,” he said, adding that a long-term programme of education has turned a majority from passive participants into active investors.
According to managing director with a PE firm in the DC space, there has been a “frenzy” of competitors either restarting initiatives focused on DC or exploring new ones. This is agreeable to the retired portfolio manager: “We’re pleased with our decision [to invest in alternatives] but it certainly hasn’t been cheap. I would love to have had more options.”