The change of course will not happen overnight. Kelly-Scholte notes it will take several years for pensions to develop programmes and establish processes that make full use of the credit spectrum, particularly when it comes to more illiquid assets.
“The emphasis needs to be valuation-based rather than time-based,” she adds. “If you have an illiquid portfolio, you can’t be overly precise about defining the exact combination, but you do have to manage at an overall level to ensure it is aligned with your liability structure.”
The good news for pension schemes is that the list of illiquid investments is expanding while old favourites such as infrastructure debt – where yields compressed to unattractive levels – are expected to come back into fashion. This is mainly due to the fiscal stimulus programmes both Prime Minister Theresa May and US President Donald Trump have promised to embark upon. The potential rise in inflation is also expected to benefit commercial real estate debt as well as ground rents and long lease properties because they act as a hedge plus generate higher risk-adjusted returns than mainstream assets.
Other opportunities can be mined in non-bank finance where an asset manager provides long-term capital for projects, according to Jo Waldron, director for alternative credit at M&G Investments.
“The money is lent through private structures and can be for commercial real estate, leasing or direct company lending,” she says. “They are split into short term – three to 10 years – and can offer Libor plus 5% to 6% or longer dated which looks more like an insurance annuity. They are typically 10 to 40 years and offer returns of gilts plus 150bps to 250bps.”
There is no doubt that in a yield-starved world pension schemes are becoming braver when it comes to allocating outside the traditional trident of equities, bonds and property. But while asset classes such as infrastructure, alternative credit and private equity provide a convincing case for fulfilling this need for income, and are currently attractively valued, some trustees still require convincing of the merits of taking on illiquidity.
While 20% in alternative assets is a realistic and sensible target, each investor will have their own specific portfolio requirements. Therefore, the need to fully understand exactly what an increase in illiquidity means for their portfolio, and ultimately the ability to pay members’ benefits, is essential before making investment decisions.