Tapping DC schemes for growth fund raises industry concern

As first reported by This is Money, Treasury officials have supposedly met with senior industry figures to discuss freeing up part of the UK’s £2.2bn pension pots to invest in the government’s ‘build back better’ agenda.

The government hopes to have DC schemes, in particular, investing part of their members’ pots in the LTAF, a fund specifically designed to boost access to property, infrastructure and other long-term illiquid assets for those who might otherwise be unable to invest in sectors.

Though members would have the right to opt out, the fact it is intended to be an investment within the schemes’ default strategy could see most members continuing to contribute to the fund solely by virtue of signing up to a workplace pension scheme, boosting it by billions of pounds a year. 

I fundamentally believe that if you’re going to introduce anything into a DC default strategy, it has to be because it’s going to be better than what you have there already. And it’s going to provide a better long-term, risk-adjusted return for members

Rona Train, Hymans Robertson

Though several industry figures were cautiously optimistic about the plans, they nonetheless called to mind the dramatic end of Woodford Investment Management’s Equity Income fund, wound up in 2019 and since the subject of a Financial Conduct Authority investigation that is expected to report early next year.

It is widely believed the cause of the fund’s collapse was an over-reliance by fund manager Neil Woodford on illiquid assets, which could not be sold quickly enough when investors began demanding their money back.

Natalie Winterfrost, member of the Society of Pension Professionals’ investment committee, told Pensions Expert: “In the context of the Woodford collapse, it is understandable that concerns persist around investing in illiquid assets.

“However, while younger DC investors need access to attractive long-term returns, they don’t necessarily need liquidity given they are investing for retirement in the distant future. This means they are in a prime position to benefit from an illiquidity premium.”

Winterfrost added that the obligation on trustees is “to act in the fiduciary interests of members”, and that this “should ensure they only invest if it makes sense for their members, not because doing so is a political priority”.

“Where the expertise is there, particularly in the very large DC schemes and master trusts, it should be possible to manage illiquid allocations prudently as part of defaults,” she continued. 

“However, saying this, trustees can see that the global opportunities of illiquids, and the areas into which the government is hoping to see investment, may or may not be the best use of any illiquid allocation – the commercial rationale will need to stack up before any decisions are made.”

Challenges to be overcome

Rona Train, partner and senior consultant at Hymans Robertson, agreed that member interests rather than regulatory pressure or government policy needs should determine whether and how heavily DC schemes move into illiquids.

“I fundamentally believe that if you’re going to introduce anything into a DC default strategy, it has to be because it’s going to be better than what you have there already. And it’s going to provide a better long-term, risk-adjusted return for members,” she said.

She cited the closure of DC property funds last year as an example of some of the problems that can arise in that space, in this case due to the fact that “valuers couldn’t get in to value properties, so they couldn’t price the funds”.

Meanwhile, the traditional problem of holding illiquid assets in a scheme whose members are used to daily trading also needs to be addressed.

Alan Collins, director and head of trustee advisory services at Spence & Partners, doubted whether investment into the LTAF could successfully be made part of a default strategy.

“The very nature of default funds is that they attempt to be ‘suitable for all’, and this is unlikely to be the case for illiquid funds. As such, if it was going to be viable, it is likely that illiquid funds would only make up a very small proportion of a default fund, say up to 5 per cent,” he said.

He added that the question of whether workplace pension pots should in fact be used to remedy the £2tn in debt the government has accrued with its lockdown policy.

“As is often the case, an idea like this that looks good at first sight has many challenges associated with it, including, for example, pot follows member if members move between illiquid funds.”

Pensions Expert asked the Treasury for comment and was directed to the Department for Work and Pensions and the FCA, which has been approached for comment.

A DWP spokesperson said: “We are passionate about making sure people can get the best outcomes from their pension investment, and alongside the FCA and others we are gathering views to deliver this.” 

Daily dealing problems ‘not insurmountable’

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, 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.

An FCA consultation on the LTAF closed on Friday, and made mention of work being done to smooth the entry of DC schemes into illiquid markets.

“The Productive Finance Working Group is considering how the ‘default’ investment options of [DC] schemes might invest part of their assets into an LTAF, consistent with their investment horizons and risk appetite,” the FCA’s consultation stated. 

“This consultation also, therefore, proposes amending the permitted link rules to enable pension schemes to consider the proportion of illiquid assets across their investment portfolios, rather than to restrict the proportion of illiquid assets in each underlying fund in which they invest.”

It continued: “DC default schemes need to cater for member or employer-driven liquidity events. Governance bodies of DC schemes will therefore have to work out how the relatively lower liquidity offered by the LTAF can be accommodated within liquidity management across the wider portfolio of the default scheme.”

Darren Philp, director of policy at Smart Pension, said DC schemes “will need to get their heads around the different constraints and risk-reward structures as they move away from passive trackers. There are challenges, such as the move away from daily pricing and liquidity considerations, but these are eminently solvable”.

Stephen Budge, principal in LCP’s DC practice, added: “The issue of daily trading is a platform-level issue rather than a fund-specific issue.

“The platform must be able to deal with non-daily dealt funds before the LTAF can be considered. We already have clients using this method, but only across a small number of platforms.

“The downturn risk is a key risk for members – more specifically, fairness to members, as illiquid assets will behave differently to liquid assets particularly due to frequency of pricing. This is not insurmountable but should be considered carefully by trustees.”