Patient capital in DC: Worth the risk?

Despite the sense that this was old news, changes resulting from the government’s forthcoming consultation could shake up pensions more than any of the other pensions announcements in the chancellor’s plans.

This is because the consultation will seek to effect a wholesale reshaping of the portfolios typically used for defined contribution scheme investment, tilting them towards long-term illiquid assets. Venture capital is mentioned as a key target, under the more politically palatable moniker of “high-growth, knowledge intensive firms”.

But to do so the government will consider whether changes should be made to the limit on the amount that can be charged to a DC member, currently set at 0.75 per cent of assets each year. This is because many patient capital funds charge performance-linked fees, where charges go up significantly in good years.

The DC charge cap was introduced in 2015 and was reconfirmed in late 2017. While many in the DC industry have clamoured for access to illiquid assets, the potential for saver protections to be diluted will spark concerns in some quarters.

Pensions Expert asked two industry figures to break down whether greater access to patient capital will be a boon or a burden to DC savers’ retirement outcomes.

A fund manager fightback?

By Tim Sharp, policy officer, Trades Union Congress

This smacks of a successful lobbying effort by the more reactionary end of the asset management industry after a string of recent initiatives aimed at protecting savers’ funds from opaque and often excessive costs and charges.

The government seems concerned that the current 0.75 per cent charge cap on DC defaults stops fund managers levying performance fees, effectively bonuses when they beat their targets.

Opening a loophole for performance fees would be an unwelcome reversal of the direction of travel in investment costs in recent years, which has sought to protect savers.

It is more than a decade since the Pensions Commission concluded that auto-enrolment pensions should have fees of some 0.3 per cent.

The charge cap only captures a portion of the costs borne by savers. But it is important because the full costs incurred by consumers when saving are not fully understood by members or employers, and because costs have an enormous direct impact on the savings amassed by defined contribution savers.

Department for Work and Pensions figures show that over a working life, a 1 per cent annual charge would consume nearly a quarter of a DC saver’s pension pot.

Members unable to control costs themselves

The competitive mechanisms that might limit costs and charges in other sectors are absent from pensions investing due to factors such as complexity, disparities of information and the distance between the end pension saver and the decision to invest.

This situation is exacerbated by the UK’s fragmented pensions sector, with tens of thousands of DC pension funds in existence. This weakens schemes’ buying power.

The result is bumper profits for fund managers. The Financial Conduct Authority's Asset Management Market Study found that companies had an average operating profit margin of 34 per cent to 39 per cent.

There has been particular scrutiny and criticism of high costs and poor returns in the very areas, such as private equity, that the government is so keen to direct savers’ money towards.

It is also notable that there is substantial evidence that performance fees do not work. Fund managers bank the cash in the good years but do not have to hand it back when things turn sour.

The focus should be a concerted effort to bring costs down to the Pension Commission’s target to ensure that savers’ money works as hard as possible for them. It should not be on providing asset managers a new route to lay their hands on members’ funds.

Is the wait for illiquids finally over?

By Maria Nazarova-Doyle, head of DC investment consulting, JLT Employee Benefits

The Treasury’s announcement of plans to facilitate DC schemes’ access to illiquid investments was potentially one of the best pieces of news the industry has had in a long time.  

It does not make any sense that DC schemes are precluded from utilising the variety of asset classes that defined benefit schemes enjoy access to, particularly when it comes to searching for alternative sources of returns in the low-yield environment that we are now faced with.

These assets require a long-term investment horizon, which nicely matches up with the investment horizon of the average DC member –  pension investments are effectively locked in until they are 55.

The industry has been lobbying for years on behalf of DC savers, and over the past couple of years we have seen a lot of progress, particularly since a Law Commission review found no legislative barriers to DC schemes investing in alternatives and the government pledged to clarify the rules in this area.

Venture capital not the right patient asset

However, the wording of the announcement clarifies that at this stage the government is only prepared to look at linking DC funds specifically to “patient capital” opportunities and is not going further to include other types of illiquid investments.

Patient capital is understood to be capital provided to support the UK’s innovative start up companies with high growth potential or, in other words, domestic venture capital.

This type of investment can be considered at the higher end of the risk spectrum. Investment is typically made at an early stage of a company’s development, when a company may not yet be profitable and there are still significant hurdles for it to overcome.

Anecdotal evidence and various research suggest that between 70 and 90 per cent of start-ups fail. I have to question whether this is the right kind of component for DC defaults.

While venture capital could play an important role within a broader alternatives allocation, a patient capital investment in a default fund could only be considered prudent at a very low proportion, in which case the benefit will be insignificant and far outweighed by costs.

Importantly though, the Pandora’s box of illiquid opportunities is now open. The industry must make its voice heard by lobbying even more for any new rules and developments to cover the wide variety of alternative investments and responding to consultations on performance fees and permitted links rules for platforms.

Savers need all the help they can get – and diversified illiquid investments could be a big missing part of this happy retirement equation.