Multi-Asset Allocation, Risk Parity and Illiquidity
A £1.2bn multi-asset fund for a corporate pension scheme targets CPI+4.0% over 10 years, with CPI assumed at 2.5%. The current strategic allocation is 45% global equity (expected return 7.5%, volatility 16%), 25% gilts (3.5%, 6%), 10% property (6.0%, 12%), 10% infrastructure (6.5%, 9%) and 10% cash (3.0%, 0.5%). The investment committee proposes moving to 35% equity, 15% gilts, 10% property, 15% infrastructure, 15% private credit (expected return 9.0%, reported volatility 10%) and 10% cash. Private credit is marked quarterly and has a five-year lock-up; infrastructure has a ten-year lock-up. The scheme has 12% of liabilities due to be paid over the next three years. The consultant advocates a risk-parity approach because it 'diversifies risk better'.
1. Calculate the expected nominal return of the current and proposed allocations. Assess whether either is likely to meet the target, stating any assumptions.
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The target is CPI + 4.0% = 2.5% + 4.0% = 6.5% nominal. Current expected return is 45% × 7.5% + 25% × 3.5% + 10% × 6.0% + 10% × 6.5% + 10% × 3.0% = 3.375% + 0.875% + 0.600% + 0.650% + 0.300% = 5.80%. Proposed return is 35% × 7.5% + 15% × 3.5% + 10% × 6.0% + 15% × 6.5% + 15% × 9.0% + 10% × 3.0% = 2.625% + 0.525% + 0.600% + 0.975% + 1.350% + 0.300% = 6.375%.
Both fall short of 6.5%, although the proposal is closer. The current allocation is about 70bp short; the proposal is about 12.5bp short before fees and expenses. After investment management fees, the shortfall is likely to be larger. The arithmetic assumes expected returns are realised, no rebalancing premium and no tax. The committee should not assume private credit will deliver its 9% expected return with certainty; if the return is lower, the shortfall widens. Either the target, contribution rate or risk budget needs revisiting.
2. Analyse the risk and diversification implications of the proposed allocation, including the reliability of reported private credit volatility and the scheme's liquidity needs.
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The proposal raises illiquid assets from 30% to 40% of the fund: property 10%, infrastructure 15% and private credit 15%. That is £480m of illiquid exposure against a scheme with 12% of liabilities (£144m) payable over three years. Liquid assets would be 60% (£720m), which looks adequate in normal conditions, but equities can fall sharply and gilts may be sold to meet collateral calls. The lock-ups mean private credit and infrastructure cannot be relied on for near-term benefit payments.
Reported private credit volatility of 10% is likely to understate economic risk. Quarterly marks smooth returns, and the true volatility may be closer to 18-20%, with higher correlation to equities in a stress. Risk parity would allocate more to gilts and cash because of their low measured volatility, but that may not protect the scheme against inflation or liability risk. It also ignores the scheme's liability profile and liquidity needs.
A better approach is liability-aware risk budgeting: stress test a simultaneous equity fall, credit spread widening and inflation shock; measure risk contributions using stressed correlations; and cap illiquid assets at a level consistent with benefit payments and collateral needs. The committee should not treat private credit as a bond substitute.
3. Recommend a revised strategic allocation or conditions for approving the proposal, with governance and monitoring safeguards.
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The committee should not approve the proposal as presented. A revised allocation could be 40% equity, 15% gilts, 10% property, 15% infrastructure, 10% private credit and 10% cash. Its expected return is about 6.3%, still below 6.5%, so the committee should either accept a lower target, increase contributions or take more equity risk consciously. Private credit should not be increased to 15% simply to fill the return gap.
Conditions should include: a cap on illiquid assets of 35%, a minimum 10% cash plus 10% short-dated gilts, and a liquidity stress test covering three years of benefit payments and collateral calls. Private credit should be valued independently, with monthly monitoring of marks, covenants and defaults. Rebalancing bands and a pacing plan should be agreed. The trustee should review the target return and the scheme's funding plan, and monitor fees and illiquidity premia. Risk parity can be used as a diagnostic, not as the sole allocation framework.