Achieving Liquidity in Private Markets for Defined Contribution Pension Plans

July 18, 2018

In the US, defined benefit (DB) plans have long invested in private markets to earn higher risk-adjusted returns and diversify their portfolios. In fact, private markets continue to grow in DB plans, making up approximately 20% of global portfolios in aggregate, according to Willis Towers Watson. Yet even as pension managers continue to allocate significant amounts of capital to private markets, US defined contribution (DC) plans have remained on the sidelines.

The challenge facing American plan sponsors lies in the fact that the features which enable private markets to generate outsized risk-adjusted returns are also incompatible with how DC plans operate: for institutions that function in a daily pricing environment and support a high volume of participant cash flow activities, it can be difficult to incorporate assets that only provide quarterly valuations and episodic liquidity. However, as private markets have evolved, StepStone believes new investment structures have the potential to overcome these concerns.

The Case for Private Markets

Long a staple in institutional investors’ portfolios, private markets have been an important contributor to attractive risk-adjusted
returns. There are three key reasons why:

1. The illiquidity premium—because private markets are typically less liquid than their public counterparts, investors expect to be compensated with higher returns.
2. Idiosyncratic premia—by investing in private markets, investors can harvest return drivers that otherwise are not accessible. For example, real assets are often viewed as an inflation hedge.
3. Diversification—adding private market investments to a traditional portfolio of stocks and bonds can increase overall diversification and mitigate systemic risk since many investments have low correlations to public markets.

The cumulative effects of these return drivers suggest that private markets can generate higher returns at any level of volatility—shifting the efficient frontier up and to the left. To arrive at this result, we replaced 20% of a traditional portfolio with an allocation to private market investments.

Global demand for alternative strategies continues to increase, with assets under management expected to grow from US$10.1 trillion in 2016 to US$21.1 trillion in 2025, per PwC. Much of this growth will be driven by high net worth individuals (HNWI) whose allocations to alternative investments represented 9.7% of their financial assets in 2017. This cohort is expected to represent approximately 35% of total global client assets in 2025.

Despite attractive reasons to invest and growing global demand from investors for private markets, American DC plans have not been a significant participant in these assets. Two frequently cited reasons are illiquidity and the lack of daily pricing.