25/01/2012 Author: Kirstie Brewer

D.C. World

This year the UK ushers in auto-enrolment, the pension reform which will see millions of British workers automatically signed up to a Defined Contribution (DC) pension scheme without any active decision on their part. The new reforms, designed to tackle the retirement savings crisis in the UK, have given rise to a growing and steadily more prevalent DC market – a market which hedge funds currently have almost no exposure to.

Hedge funds will need to take stock of the fact that auto-enrolment, together with a number of other pension reforms, has become the catalyst for a shift in the dynamic between Defined Benefit schemes (DB) and DC schemes, with the latter set to eventually become the bigger investor of the two. Defined Benefit (DB) schemes, a mainstay source of capital for hedge funds, are either closed or closing to new members, and, as they begin to de-risk, their allocation to growth assets is decreasing and the pool for investment is getting shallower. All of the pensions for companies listed on the FTSE100 are now closed and only 19% of the overall market is open to new members, compared to 88% ten years ago, according to the National Association for Pension Funds (NAPF).

Meanwhile, DCs are slowly swelling in member numbers – and in assets; but securing investment is not without its obstacles for hedge funds. Of the nine million UK employees currently without a pension, six million are expected to be automatically enrolled into The National Employment Savings Trust (Nest); a national DC scheme, which has already seen some 100 companies sign up. With Nest set to secure a large slice of the nation’s savings and a number of other private pension providers also entering the marketplace as a result of the reforms, hedge funds are presented with an exciting opportunity from the DC world; if they are able to meet its many challenges.

Governance and education
The UK Pensions Regulator, in conjunction with the Investment Management Association (IMA), launched its Investment Governance principles for DC schemes last year, which places emphasis on ensuring that ‘inappropriate’ investment choices are avoided. “Trustees should look carefully at their scheme’s investment strategy, consider the risks specific to their approach, and ensure that they are satisfied with the risk exposure. Trustees should not place unnecessary gambles on members’ retirement funds,” Darran Burton, The Pensions Regulator’s DC policy manager, explained.

Governance at DC funds is not as extensive as it is for DB schemes, meaning trustees are less likely to have access to alternatives investment tutoring, explains Mark Jaffray, senior investment consultant at Hymans Robertson. “There is a huge educational barrier that hedge funds have in getting directly at members and the people making investment decisions,” he says. “I would be engaging with packaged players and trying to become part of a packaged fund – because that is what is being appointed for DC schemes; diversified growth funds would be where I would focus my efforts.”  

Brian Henderson, head of DC for Mercer’s investment business Europe, agrees: “Hedge funds tend to need a fair amount of governance – you need to keep an eye on them, and trustees in DC schemes don’t normally have the appetite to take this on. Better governance of existing arrangements is clearly something that is topical at the moment but the extent to which trustees want to micro-manage the assets is a different matter.”

Diversified growth funds – a popular type of ‘packaged fund’ – blend together alternative asset classes alongside equities to generate a less volatile return stream and a better risk and return profile. For the DC market, the two most popular diversified growth funds are the Standard Life Global Absolute Return Strategies Fund (GARS) and the Schroders Diversified Growth Fund (DFG), the latter of which allocates around 5% to a combination of direct hedge funds and fund of hedge funds and is a mixture of internal Schroder capability and external managers.

DFG, which had an AuM of £4.2bn ($6.51bn) as of the end of December, has secured around 40 DC clients since its inception in 2006, the majority of which use the fund as their default option. “Traditionally the DC default option has been passive equities, which are now seen by many to be too volatile. As a DC investor you need a smoother return profile and diversified growth funds offer equity-like returns but reduce volatility, which is seen as attractive in the DC market because it helps members plan for retirement,” explained Robert Bee, head of UK institutional business development at Schroders.

“The very largest DB funds can go and select hedge funds themselves; a DC investor doesn’t typically have the governance budget to go and do that. DC schemes employ us to research the hedge fund universe and access the best hedge fund strategies on their behalf within a diversified multi-asset solution. We have ranges for each different asset class and allocations vary depending on what is most attractive to fund managers at the time. Hedge funds could therefore go into double figures and it is unlikely they will go much below the current figure of around 5%.”

Fees and liquidity
Fees remain a bone of contention for UK pension funds, particularly for DC schemes facing greater pressure to keep costs down. “There is a real downward pressure on fees”, explains Henderson. “We encourage schemes to think from a value-add perspective rather than fixating on low fees, but hedge funds fees are still too high; paying 2/20 is not realistic in the DC space and performance fees won’t work at a member level with members joining and leaving on a regular basis,” he says.  

Another recurrent issue, raised by trustees and investment consultants, is liquidity, as DC schemes require daily dealings, or weekly at the very least. Members move in and out of DC funds at high frequency, which limits the number of eligible hedge fund strategies. However, this could largely be an issue of scale, and as assets increase may not be as much of a stumbling block for hedge funds, particularly if they can be slotted within a large default fund which can afford to use other assets for its daily liquidity needs.   

“There needs to be an element of patience in the hedge fund market,” says Hymans Robertson’s Jaffray. “For me, it is all about scale, in terms of investment. As the DC market matures and you get greater assets going in and default funds particularly get much bigger in size, you will find that they begin to resemble DB schemes in the way that they invest money, and we may see a greater allocation to hedge funds.”

The sentiment is echoed by Robert Gardner, co-chief executive of pension consultancy firm Redington, which has assets under consulting in excess of £200bn ($310bn). “A critical mass of assets is what is needed in order to justify the resources and costs to invest in hedge funds; as DC schemes grow in size, and with it governance capacity and capability, there will be a more compelling case to move away from plain vanilla liquid investments into higher alpha, more illiquid vehicles like hedge funds,” Gardner says.

Australia’s long-standing DC schemes, which largely come in the form of multi-employer ‘superannuation funds’ that allocate generously to hedge funds, demonstrate that hedge funds do have a place within the DC world. The UK’s private pension market may just need some time to grow and evolve.