Tweaking the charge cap will not solve DC illiquids conundrum

Tapping DC schemes for investment in the post-Covid recovery and the Build Back Better agenda has long been a government priority. Pensions Expert reported in November 2020 on calls from Andrew Bailey, governor of the Bank of England, for regulatory changes to expand schemes’ access to illiquids, though the industry has been consistently sceptical, citing a number of structural hurdles to be overcome. 

In the October Budget, chancellor of the exchequer Rishi Sunak announced that the government would look at changes to the charge cap, and the Department for Work and Pensions launched its consultation in the same month with a view to removing performance fees from that cap.

In his foreword to the consultation, pensions minister Guy Opperman wrote: “We are proposing to increase the flexibility trustees have to access a range of assets while ensuring members are protected from predatory charges.

Trustees need to be better convinced of the illiquidity premium and of the overall risk-return versus cost balance, while discussions need to shift from one of cost to value

Phil Duly, Barnett Waddingham

“We believe that this change will give schemes the flexibility and freedom to pay performance-based fees, if they think this will be in the financial interest of members. At the same time, it is essential that members continue to be protected. As I reaffirmed in January 2021, the charge cap continues to serve an important role.”

Performance fees ‘not a silver bullet’

The consultation explained that performance fees were frequently cited as a barrier to increased DC investment in illiquids, though the Productive Finance Working Group acknowledged “mixed views” on the subject in the industry.

The government proposed adding to the existing list of exemptions from the charge cap, currently set at 0.75 per cent, to include “well-designed performance fees that are paid when an asset manager exceeds pre-determined performance targets”.

Industry experts were unconvinced, however. Joe Dabrowski, deputy director of policy at the Pensions and Lifetime Savings Association, said: “The PLSA sees no case for the exclusion of performance fees from the DC charge cap. We believe that this risks diluting an important protection for automatic enrolment savers, without sufficient evidence at this time to demonstrate a change is needed or higher fees will improve member outcomes.

“Given the various other developments in this area over the past year — including the introduction of a mechanism to ‘smooth’ the calculation of performance fees over five years, and the introduction of a new fund framework to help investors make long-term investments — industry needs time to implement, develop and review their effectiveness before making further changes.

“The underlying structural dynamics of the current [auto-enrolment] market are also unlikely to result in the proposed changes succeeding in its intended goal.”

Reuben Overmark, senior policy adviser and investment platforms specialist at the Association of British Insurers, was similarly cautious, arguing that removing performance fees was not a “silver bullet” that would increase investment in illiquids.

“For pension schemes to increase investment in illiquids there needs to be a cultural shift on how price is perceived in the pensions industry,” he explained. 

“While the pensions charge cap is an important protection for members, it has led to price becoming an almost exclusive driver of many pension providers and trustees’ decisions rather than considering the value a scheme offers overall, including the investment return.”

Overmark added that evidence from Australia and Canada, “where these types of investments are more common”, show “a focus on investment return over the price of investments”.

“To change this and to increase investment in less liquid assets, government and industry need to foster a culture of value for money where investment returns are as important as the price of the pension scheme,” he said.

Darren Philp, director of policy and communication at Smart Pension, also pointed to the fact that DC schemes are judged primarily on price rather than value. He told Pensions Expert that small-scale changes might not “do any harm”, but they “won’t seriously move the dial”.

“Change will come when we can demonstrate significant and consistent value from illiquid assets to the market — ie, trustees would likely be breaching their fiduciary duty by not investing in illiquids, and by platforms increasing capabilities to manage illiquids in a way which provides the required liquidity,” he said.

The move could be counterproductive

Some experts warned that the move would in fact be counterproductive, with Phil Duly, associate and head of DC research and technical at Barnett Waddingham, telling Pensions Expert that removing performance fees could mean that “guidance is needed on performance fee design to protect members from unduly high charges”.

“This needs to be balanced by managers being prepared to change existing fee structures in line with any forthcoming guidance,” he said.

He also pointed — as others have previously — to the fact that defined benefit schemes do not face many of the hurdles commonly blamed for poor take-up among DC schemes, yet lack substantial allocations themselves.

“Trustees need to be better convinced of the illiquidity premium and of the overall risk-return versus cost balance, while discussions need to shift from one of cost to value,” Duly explained.

“In addition, a long-term view is necessary and, with the government’s encouragement of DC schemes to consolidate, perhaps only the larger DC schemes can take a long-term view. It would appear that, with diminishing own trust DC schemes, the government needs to get master trust schemes on board to see a marked take-up by DC schemes.”

Jury’s still out on LTAF

In May 2021, the Financial Conduct Authority launched a consultation into a new type of fund designed specifically for illiquid investments.

It confirmed in October that DC schemes would have access to the new arrangement, the Long-term Asset Fund, to invest mainly in long-term illiquid assets, with at least 50 per cent of the assets being unlisted securities or other long-term assets.

The FCA introduced  a rule that will require an LTAF to redeem units “no more than monthly”, thereby getting around daily dealing requirements.

Overmark told Pensions Expert that the new fund addresses one of the more significant barriers to DC illiquids investments, “the permitted links rules’ 35 per cent cap applied to illiquids”.

“In the FCA’s final rules on the LTAF, it removed the 35 per cent limit for LTAF-linked funds that form part of the default arrangements of a pension scheme, which we welcomed,” he said.

“Broader permitted links reform, where the underlying investor is not self-selecting investment strategies, would more comprehensively remove barriers to productive finance assets and ensure better consistency in the rules across asset classes.”

Brenda Kite, DC provider and platform solutions lead at Hymans Robertson, said there was a case for prohibiting performance fees in the LTAF, but also noted that, “given that larger and engaged master trusts are already investing in illiquids successfully, the impact an LTAF can offer to the market which it is still not available is reducing over time”.

Daily dealing is still an issue

Daily dealing requirements have consistently been raised as a significant barrier to increased investment in illiquids, and as yet there have been no proposals to address it outside the LTAF.

Philp suggested that it would be useful to explore whether daily dealing is “operationally required”, or whether weekly dealing might suffice. 

“Members are invested for 40-plus years in some scenarios, and while there are liquidity events, such as transfers out and deaths, in general daily liquidity should not be necessary,” he said.

However, Kite countered that daily dealing has been “baked into DC administration for years and so the costs of changing systems would be substantial”. 

“At the same time, an important minority of DC members value daily dealing and pricing, so it would take a brave provider to step away from it,” she said.