Will economic conditions accelerate DC allocation to alternatives?

After decades of economic stability, the past three years have brought challenges and uncertainty that will define the economic landscape for years to come. Pragmatism and a long-term focus have served defined contribution (DC) schemes well so far, helping members’ savings to weather the storm of high volatility and significant declines in the stock market during the early period of the pandemic.

But more recent bouts of turbulence seem likely to be a longer-lived trend, representing a fundamental shift in the economic landscape.

While a pragmatic, hold-steady approach worked well in response to short-term market shocks, long-term challenges that could produce a ‘new normal’ for the way our economy functions will require a more proactive approach.

The traditional passive equity/bond split worked well under the economic status quo of the past three decades, so it’s unsurprising that it continues to dominate DC investment.

But evolving challenges require innovative solutions.

Challenging economic times have re-emphasised the importance of a well-diversified portfolio. Schemes appear increasingly focused on evolving and improving investment strategies and demonstrating value for money.

There is more focus than ever on alternative assets and the role they could play in delivering better outcomes.

The government’s productive finance agenda aims to facilitate and encourage greater investment in alternative, particularly illiquid, assets.

DC scale continues to grow, and the introduction of new investment vehicles, such as long-term asset funds (LTAFs), should help to alleviate availability challenges.

With current economic challenges leading investors to look beyond traditional investment strategies, there could be a longer-term re-evaluation ahead for DC schemes and a subsequent acceleration of investment into alternative assets. But this will depend on how effectively we can overcome the challenges that remain.

While scale has grown across the DC market, it continues to be a challenge – particularly in relation to illiquid alternatives. Greater scale allows for larger upfront investments, as well as diversifying across sectors and investment horizons.

Smaller schemes are less able to access the potential diversification benefits and are more dependent on the offerings of external platform providers. As the DC market grows, these challenges should become less relevant.

Assuming current trends continue, the aggregate value of workplace DC assets could grow to around £1.03trn during the next 20 years.

Shorter term, if larger schemes find ways to work through operational challenges (e.g. liquidity, governance and structuring of contracts), then scale should become a less significant issue, with smaller schemes able to learn from the implementation of larger schemes leading the way.

Some DC scheme trustees are likely to need greater support to build their knowledge on alternatives.

With such schemes having historically invested primarily in equities and bonds, expertise on the details and nuances of alternative assets is not as developed as in the defined benefit market.

Even among trustees who may have a good understanding of alternative asset classes, there can be a reluctance to engage, whether because of risk or cost.

Some schemes, particularly at the smaller end of the market, may need to rely more heavily on the expertise of external consultants and advisers if they are to increase their engagement with alternative investments effectively.

It’s also important to recognise the dynamics of the DC market – one of the key challenges being the way in which DC schemes, and especially master trusts, are expected to compete primarily on cost, often on small margins.

Shifting towards a more holistic approach to value for money is a key priority, with The Pensions Regulator/Department for Work and Pensions framework on metrics, standards and disclosures consulted on between January and March this year.

It’s hoped this will lead to a greater focus on the value that investments can add, rather than an over-emphasis on low costs, and improve member outcomes by enabling more diversified portfolios that better mitigate risks in an uncertain economic landscape.