New guidance on fund-level liquidity management is required to bolster illiquid investing by defined contribution schemes, the Bank of England has said, despite stopping short of recommending an overhaul of daily dealing requirements.
In a report published on Monday, the Productive Finance Working Group, an industry-led team established by the Bank of England and the Financial Conduct Authority to investigate illiquidity barriers faced by DC schemes, mades four key recommendations, underpinned by 13 action points to facilitate these investments.
Improving DC access to long-term illiquid assets has been a target for both the government and pensions industry, with numerous bodies, including the Pensions and Lifetime Savings Association and the Investment Association, having previously called for a review into liquidity management and regulation.
Pensions Expert reported in November last year on calls by Bank of England governor Andrew Bailey for regulatory easement to increase the uptake of illiquids by DC schemes, but a criticism made then and since was that these schemes typically allow members to see the value of their pension pot and switch between funds on a daily basis, which makes investing in long-term illiquid assets difficult.
Supporting access to different investment opportunities, which have the possibility to provide more diversified returns to members as well as benefiting the wider economy, is important
Nikhil Rathi, FCA
Guidance to lead change
The working group stated that “industry participants and trade bodies should develop guidance on good practice on a toolkit for liquidity management at a fund level, in consultation with the FCA and Bank of England in the context of their broader work on liquidity classification for open-ended funds”.
“This guidance should focus on appropriate ranges for dealing frequency and notice periods for different asset types,” the report stated.
Notably, a rethinking of how daily dealing barriers are addressed by trustees, alongside renewed regulation and guidance, is central to the report’s proposals.
The report outlined how DC schemes can still accommodate illiquid assets by taking “a more holistic view” and create allocations to less liquid assets within its default arrangements. This would mean managing liquidity primarily at a DC scheme level rather than at fund unit level.
Similarly, trustees would need supporting fund structures, including a suitable redemption policy and notice period for open-ended funds.
The report said a radical overhaul of the daily dealing system is not necessary and that new guidance will give trustees greater confidence in investing in less liquid assets without putting their obligations to their members at risk.
“On the surface, the daily dealing nature of the current DC system seems ill-suited to less liquid assets that are not tradable in that timeframe. However, our engagement with a range of industry stakeholders indicates that moving away from a daily dealing format within DC schemes is neither feasible nor necessary in order to accommodate less liquid exposures,” the report read.
More broadly, the report made recommendations to shift trustees, trade bodies and consultants’ focus to the long-term value of illiquid investments, including through Long-Term Asset Funds within DC schemes.
In a consultation published in May, the FCA detailed that the new long-term asset funds would be open-ended and able to invest in assets such as venture capital, private equity, private debt, real estate and infrastructure.
Considering that DC schemes typically construct their default arrangements by combining a number of funds — which means these providers prefer to use a fund that is 100 per cent illiquid as part of a wider portfolio with other liquid assets — the FCA has proposed to remove the illiquid investments cap, currently at 35 per cent.
Recommendations welcomed by industry
While concerns had previously been raised by the industry on the challenges that DC schemes will face, the PFWG report has been broadly welcomed by experts.
Ruston Smith, chair of the Tesco Pension Fund, said: “Many members in DC schemes typically have long-term time horizons and, in delivering good member outcomes, good-quality illiquid assets can contribute towards improved diversification and future net risk adjusted returns.
“Further support from consultants and on trustee education, in this important area, will help provide good informed decisions and the further development of UK DC investment strategies.”
Richard Butcher, chair of the PLSA, backed the proposal, saying that the “work and recommendations of the Productive Finance Group will provide an important launchpad from which we can seek to resolve the detailed operational and systemic barriers that inhibit pension funds who wish to invest in productive finance and illiquid assets.”
Industry bodies to 'develop the case' for DC illiquid investments
Industry bodies including the Pensions and Lifetime Savings Association, the Association of British Insurers and the Investment Association will “develop the case” for defined contribution schemes to invest in less-liquid assets, as part of a push to secure “long-term value” for its members.
Nikhil Rathi, chief executive of the FCA, said: “DC pension schemes have increased in importance over the past 10 years with increasing numbers of people using them to save for their retirement.
“Supporting access to different investment opportunities, which have the possibility to provide more diversified returns to members as well as benefiting the wider economy, is important.”
Meanwhile, chancellor Rishi Sunak noted it was “great to see the industry working group have put forward proposals that will help to overcome the barriers to investing in long-term UK assets and I look forward to seeing them put into action”.
