Fundraising and pension reform: A slow-burn issue

Uncertainty has become the norm over the past decade for nearly 77,000 people working for Australian universities and research institutes. They represent barely one sixth of the employees whose pensions are managed by UniSuper, but they have been promised lump sums from the fund as they retire. The money is used to buy annuities that generate regular income to see them through their senior years.

The problem for UniSuper is that - due to salaries rising higher and people living longer than expected, plus investment returns coming in under target - it is unlikely to have enough cash to meet future pension obligations.

"The universities don't want to put in more money and members don't want to give up entitlements," says one local fund manager. "You get to a stage where the fund doesn't have enough capital to meet liabilities but if no one does anything about it for 10 years then it is the last guy standing who wears the consequences."

UniSuper can break this stalemate by reducing members and pensioners' benefits. Four times in the last 10 years it has been forced to review its position: the first review resulted in no change; the second, announced in August, prompted a cut in benefits accrued after 2015; the third and fourth reviews will be completed over the next three years. A further erosion of benefits cannot be ruled out.

Australia has gone to great lengths to avoid these situations. The majority of the population is in defined contribution (DC) plans, where responsibility for providing a pension lies with the employee, not the employer. Defined benefit (DB) plans, and the unfunded liabilities that can accompany them, are left out in the cold.

Global shift

While it may be ahead of the curve in terms of developed market pension reform, Australia is certainly not alone. "This shift is definitely happening in Europe and in the US as well," says Luba Nikulina, global head of private markets at Towers Watson. "Over the next 20-50 years existing DB plans will wind down. Many are already not taking new members."

For private equity, the retraction of DB plans from the asset class - either through wind downs or a scaling back of commitments as liability horizons draw nearer - represents a challenge. Firms have grown accustomed to the long-term DB outlook. DC plans, however, are perceived as very different creatures: more portable, more subject to the whims of the individuals they serve, and more inclined to invest in liquid assets.

UniSuper's DB division, for example, commits 10% of its corpus to alternative investments, twice the size of the largest allocation through any of the fund's DC plans.

Bridging the gap between DC and private equity is therefore a concern, albeit not an immediate one. Most of the large US public pension funds that feature on LP rosters are resolutely DB and open to new members. Even where there are pullbacks, these can be offset by new sources of capital such as sovereign wealth funds. In an Asian context, many pension plans are underweight on the region so if they are paring back, it is happening elsewhere.

"It's not so much private equity firms saying, ‘I need to do something today,'" says Mario Giannini, CEO of Hamilton Lane. "But as DB goes down due to withdrawal pressures and DC goes up, every firm that wants to be around in 10 years is either looking at DC access as a strategy or actively doing it. As the big firms begin to penetrate this market all of us will be doing it."

DC plans accounted for 45.5% of assets in the leading global pension markets last year, with growth outpacing DB over the past 10 years, according to Towers Watson.

The largest of these is the US, where DC plans have grown sevenfold to more than 270 over the past decade, a period during which traditional DB plans fell by nearly three quarters to 70. Cerulli Associates estimates that assets in US 401k plans - the most common DC strategy - will increase by 6% a year through 2016 to reach $5.03 trillion, surpassing the $4.9 trillion held by public pension plans.

In Europe, meanwhile, a recent survey of 20 investment firms identified DC plans as the fastest-growing source of business growth this year, with assets expected to reach $2.1 trillion.

Needless to say, the DB-DC debate varies between geographies, which can lead to a misunderstanding of the forces at work. Indeed, Thomas Kubr, executive chairman of Capital Dynamics, doesn't see liquidity as a DB-DC issue at all. Rather, at issue is whether plan members have the freedom to remove their money on leaving the employment of the sponsor.

"People assume that in DB plans members can never withdraw their capital and thus the money will be there forever. The other assumption is that a DC plan is like a bank where members can move their savings to wherever they would like," he says. "That is not always the case."

Kubr contrasts Australia's DC system, which allows members to move their pension savings between providers and therefore requires ample liquidity, with Switzerland's DC system, which is strictly linked to place of employment. Similarly, there are DB plans in the US that allow employees to remove their capital from the system.

Although it offers no perfect comparison with other systems, Australia is an interesting case study by virtue of how far and how fast it has gone in adopting DC. The DB-DC asset split in the US was 42-58 in 2012 and it has taken 30 years of incremental shifts to get there. In Australia, more than 80% of pension assets are held in DC plans.

A movement that began with corporations getting liabilities off their balance sheets gained momentum in the mid-2000s as members won greater freedom to choose plans, prompting a wave of industry consolidation. The number of superannuation funds has fallen from 4,000 a decade ago to around 150. Martin Scott, head of Partners Group Australia, expects the industry to narrow to 50 or so large players.

There is already bifurcation in product offerings - at one end, a niche group of providers that continues to allocate to PE in the belief that returns outweigh costs; at the other, a mass market is committed to reducing management expense ratios. This has been exacerbated by the MySuper legislation, intended to create a range of simpler products that are easier to compare in terms of costs and returns.

"The way superannuation funds advertise to potential beneficiaries is cost," says Marcus Simpson, Head of Global Private Equity at QIC, an investment manager set up by the Queensland government. "Private equity is the most expensive asset class and so funds don't want to put much of it in their portfolios."

Self-managed superannuation funds, the largest area of growth in Australia's pension fund market, in some respects represent the apogee of this evolution - the member takes full responsibility for contributions and earnings.

Roughly one third of the country's A$1.4 trillion superannuation pool is deployed in self-managed funds. However, around 80% of the 12 million Australian who hold superannuation accounts don't opt for a particular plan and are therefore signed up default funds that must ultimately fall in line with MySuper criteria.

Where choice can be exercised, it is often constricted by either the plan's potential liquidity needs - product offerings are public equities and fixed interest heavy - or risk aversion on the part of the individual.

"In a DC world you see an asymmetric risk profile," explains Macquarie's Lukin. "If a fund delivers 14% and the benchmark is 15%, investors are relatively happy. If the fund returns -3% to the market-wide -5%, you have a disgruntled member base. You get rewarded less for excess return and punished more for underperformance in poor markets."

Adaptation options

Assuming DB allocations to the asset class do decline in the long term, the question for private equity firms is how they can adapt to the needs of DC. Global firms such as The Carlyle Group, KKR and The Blackstone Group have rolled out or are said to be planning investment products with a minimum commitment threshold low enough for individuals. Some have spoken publicly of their desire to bring 401k plans into PE.

There are three principal hurdles: providing liquidity; providing daily valuations so a member leaving a plan can be confident the price at which he or she trades out fairly reflects the underlying holdings; and fees. The latter is no longer just an Australian concern. According to David John, senior strategic policy advisor at the American Association of Retired Persons (AARP), providers now have a fiduciary responsibility to ensures fees are appropriate to the market.

A number of groups claim to have identified solutions. In 2011, Partners Group launched a dedicated Australia feeder fund for its Global Value SICAV vehicle.

The product is tailored to the changing priorities of DC programs, offering exposure to secondaries, directs and mezzanine debt as well as primary funds, in keeping with LPs' more opportunistic, j-curve jumping approach. The entry level is set low, A$20,000 for a retail investor, fees are based on net asset value, and there is a liquidity option in the form of monthly applications and redemptions.

"We are trying to offer a solution to that end of the market so they have something to invest in that is different from publicly listed alternatives," says Partners Group's Scott.

Pantheon is also working on a product designed to bridge the liquidity gap. It does this by taking a traditional fund-of-funds pool comprising an assortment of US PE vehicles and carving off 30% of the portfolio, which is then invested in exchange traded fund (ETF). The ETF focuses on the S&P500 and is designed to replicate the typical US buyout and growth fund portfolio, with a view to correlating the liquid and illiquid portions as closely as possible.

According to Pantheon, the fee will be slightly higher than the level for a typical equity mutual fund under 401k, while the target return is 2-3.5% above the S&P500, net of fees, expenses and costs associated with the liquid tranche. This tranche will not only be used to fund redemptions but also to cover draw downs made by portfolio GPs over the life of the product.

"We are already engaged in some very interesting conversations with large sponsors in the US and we hope to be in a position to bring in clients in the next year or so," says Rob Barr, a partner at Pantheon and head of the firm's DC initiative. "A big part of this is reassuring the consultant community that we have something that makes sense for their clients."

Part of the solution

It remains to be seen whether these products gain significant transaction in the market, but some industry participants are skeptical, suggesting that liquidity shouldn't be a priority for investors who are truly committed to the asset class. Questions are also asked about these products' ability to withstand a downturn.

If, for example, there was a surge in members seeking to leave the plan - in situations where they are entitled to exit at short notice - would the liquid balance be sufficient to placate demand?

It is worth noting that Partners Group's fund assumes a minimum liquidity level of 20% per year and retains the ability to gate redemptions if insufficient liquidity is available.

"What are the two things that are perfectly correlated in finance? Illiquidity and crisis. When people are heading for the door in a crisis everything goes illiquid," says Capital Dynamics' Kubr. "None of these schemes people are dreaming up will work when they really need to."

Hamilton Lane's Giannini is more generous. He doesn't see these products working on a standalone basis but rather as the minority private equity component of a long-term horizon target-date fund. Another factor is the maturity of the secondaries market: with more transparent pricing the better the chance of developing a liquid market for private equity positions, so a DC plan that finds itself under pressure from members who want out wouldn't have to jettison its illiquid assets at fire sale prices.

Getting into target-date funds, which effectively seek to create a DB outcome via DC model, is Pantheon's principal objective; it wants to provide the private equity sleeve in a broader plan. The approach suggests that, while PE firms must adapt to DC, DC will simultaneously try and adapt to them.

"The type of sponsor that will be involved in putting PE into these qualified default funds are likely to be those with positive experiences of PE in their DB schemes," Barr adds. "They know the asset class and they want to give access to their participants to private equity."

Target-date funds don't represent a panacea for private equity but they are able to accommodate the asset class, provided the employer and consultant are willing to accept the added cost and complexity. Rather than a one-size-fits-all approach, a likely retirement date and a desired pension pot are identified for an individual and the investment portfolio is designed to meet these goals. The end result may resemble a final salary pension.

Allocations change over time but for someone who is 40 years from retirement the liquidity of different investments shouldn't be a major concern - it is estimated that a 2060 target-date fund would be comfortable with a 5-8% private equity weighting. Customization is also seen as sticky; there are less likely to be wholesale shifts between providers.

A similar phenomenon is apparent in Australia. Many of the larger superannuation funds are now offering members a deferred annuity structure that delivers a guaranteed income stream for the rest of a member's life or for a set period of time.

"They ask people where they want to be in 20 years' time and then tell them they need to lock it up or allow some level of longevity to their investment," says Partners Group's Scott. "What this would actually mean is a full circle back to where we were - just without the liability resting on the corporate or government balance sheet."

Performance issues

Comparing the performance of DB versus DC plans can be problematic: a fully funded DB plan might only require a 4-5% return to meets its target and therefore opt for a defensive strategy while an underfunded plan is likely to be more aggressive. Furthermore, private equity and other illiquid assets are only one part of the puzzle. However, most studies have found that DB is superior DC.

Analysis released by Towers Watson earlier this year shows that DB plans in the US have outperformed DC by an average of 76 basis points per annum since 1995. The gap halved for 2007-2011, in part due to strong public markets in 2009, but Towers Watson also noted that it reflects DB plans adjusting allocation strategies to better match assets to liabilities and DC plans assuming certain DB characteristics.

Rebalancing achieved through the use of professionally managed target-date funds was cited as an example of this.

The target-date fund remains a work in progress. Fiduciary burdens mean the world of 401k is slow moving, but the general expectation is they will become more sophisticated in line with members' demands.

Alternatively, the product that comes after the target-date fund may go in another directly entirely. "You could in theory have a lot of customization but recent discussions have focused on something that is more of a one-size-fits-all," says AARP's John. "It is being discussed in terms of a large plan that covers employees of a small business that wouldn't be able to afford a more customized 401k system."

This might still appear close to a DB portfolio in composition, but members would be bundled together and assigned to a particular investment category based on risk tolerance.

Another scenario offered by John sees the concept of placing all the risk on members could lose favor in political circles and replaced by a cash balance plan, where the DC-style individual account is hypothetical and the employer is responsible for ensuring the lump sum available on retirement meets an agreed minimum level.

Hamilton Lane's Giannini accepts there will be nuances in most pension systems, but he argues that the trend towards individuals having a greater say over investment across a wider array of asset classes - including PE - is irreversible.

"With pressure from investors as they become increasingly sophisticated, it's hard to see this not happening," he says. "More DC plans will bring in private equity but it won't be all of them; the ones that go first will have less liquidity pressure than your normal mutual fund-type plan. The question is not whether they do it, but the speed with which they embrace it."

For the PE firms, too, it is in part a matter of necessity, with any compromises made in the interests of securing a portion of the pension market that is exhibiting substantial growth. While DB plans still have long enough horizons to make new commitments to the asset class - indeed, some with unfunded liabilities are becoming more aggressive in alternatives - it cannot last forever.

"That's why you see these new models emerging, PE firms trying to tap the DC market and diversify their investor base by attracting sovereign wealth funds and and high net worth individuals," says Towers Watson's Nikulina.

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