Not just a short-term strategy: short-term alternative finance in DC defaults

Short-term alternative finance is a catch-all term for a range of short-term funding opportunities for investors and companies (our previous blog covers this in more detail).

In our view, the asset class has the potential to suit scheme members’ different retirement choices, when forming part of a wider multi-asset portfolio. Below, we explore why.

Destined for DC defaults?

Traditionally, scheme members have switched to cash and very short-dated paper as they approach retirement. But we think the characteristics of short-term alternative finance warrant its consideration for inclusion into the default strategy as members stop working.

Why? Although past performance does not guarantee future returns, historically, the asset class has generated a return premium above cash. This premium has been driven by the complexity of the asset structures, their relative illiquidity against cash and the current structural supply demand imbalance in the capital call market (a key component of short-term alternative finance).  

So, in the future, when we expect a greater proportion of members to engage in income drawdown, an allocation to this asset class may support median and upside member outcomes over the long term relative to holding assets such as cash.

The here and now

But the asset class may have useful applications for those retiring now, too. Currently, we expect a significant proportion of members to cash out their DC pots in future, but the timing of this is uncertain. The short maturity of the underlying loans means that the available cash in short-term alternative finance is rapidly recycled, which can provide investors with more flexibility than is often associated with truly ‘illiquid’ investments (e.g. property, which cannot be sold quickly).

This may mean greater flexibility when DC scheme members’ exact retirement dates are unknown, while still harnessing a return premium over cash.     

A default strategy, for example a lifestyle or target-date approach, could allocate to short-term alternative finance at varying levels across different points of the glidepath, or in diverse cohorts. Compared with some other illiquid strategies, the assets are historically low duration and of a short-dated maturity.

These characteristics may make an allocation to this asset class suitable when approaching retirement or indeed having stopped work, because they allow the asset to be sold down relatively quickly, compared with other illiquid assets.

Drawing down exposure to drawdown

A greater focus on capital preservation than higher growth or public market strategies may reduce scheme members’ exposure to market drawdowns. It goes without saying that after retirement, it’s very important to preserve scheme members’ savings.

Short-term alternative finance has the potential to help, owing to its low historical correlation to traditional asset classes. This is combined with lower volatility versus ‘higher risk’ asset classes such as equities (by way of the floating rate nature of the assets and short maturities) and relatively low default rates versus traditional fixed income assets.¹

Short-term alternative finance may also have the potential to provide diversification in issuers versus public markets, making it an allocation to consider for a multi-asset portfolio. Its investments in private markets might allow a return premium to be harvested at a different part of the investment cycle to other multi-asset holdings, without taking as much credit or market risk as other alternatives. These characteristics could make it a useful diversifier.

Getting comfortable with the cost

When thinking about any potential investment for DC schemes, we believe it is very important to think about member outcomes, including the ‘all-in’ costs when investing in private market strategies. Private market allocations can be significantly more expensive than public market solutions.

Short-term alternative finance is no exception, and the costs of available strategies can differ significantly. We believe, subject to selecting an appropriate provider, when compared with typically ‘high risk’ approaches such as equities, short-term alternative finance may offer a lower return volatility with potentially diversifying features, which should be weighed up against the greater cost of the asset class.  

Short-term investing, long-term outcomes

Short-term alternative finance can play different roles in a DC investment strategy. So long as DC trustees are comfortable that the cost is appropriate for their scheme, the asset class may provide an attractive premium above cash and flexibility.

Additionally, the uncorrelated return drivers may offer valuable capital preservation benefits, which can be an attractive tool for default DC strategies as members approach retirement, no matter what they choose to do with their retirement savings.

1. Source: Private Equity International, 10/03/21 “sub line market shaken by fraud”; credit losses 25 years ending January 2023.