Should the government make it easier for trustees to invest in illiquid assets?

The government is encouraging schemes to invest in illiquid assets with higher performance fees. Kim Kaveh asks if this is a good idea.

Illiquid assets rarely feature in the default strategies of defined contribution (DC) schemes. The 0.75% charge cap and daily dealing requirements on many DC platforms being the main hurdles.

The Department for Work and Pensions (DWP) now wants to explore an extension to the way compliance with the auto-enrolment (AE) charge cap is measured, to make it easier for trustees to consider investments which levy performance fees, while retaining the same level of protection for members.

This was set out in the government’s consultation on defined contribution (DC) investment innovation – unveiled earlier this month – which put forward a range of proposals to expand investment opportunities for DC schemes.

The government believes encouraging DC schemes to make greater investments in illiquid assets such as infrastructure, private equity and new technologies, will be good for the UK economy, and boost productivity and growth.

While the industry has broadly welcomed this, there are also concerns that savers may end up paying more fees and being left with a smaller pension pot if such assets generate poorer returns.


Aegon pensions director Steven Cameron says one barrier to DC schemes investing in illiquid assets is that they often charge performance fees, which “makes it difficult to be sure overall charges are within the 0.75% charge cap”.

Now the government is setting out a new means of checking charge cap compliance “shows how serious the DWP is to encourage illiquid investments”, he adds.

The charge cap was introduced in April 2015 to limit the annual amount that can be charged to savers in default arrangements, and applies to all scheme administration and investment costs, including performance fees but excludes transaction costs and a small number of other costs.

But as the DWP points out in its consultation document, the average annual charges for pension schemes which are subject to the charge cap are between 0.38% and 0.54%.

It says this makes it clear that trustees have scope within the existing level of the cap to “consider innovative investment opportunities” which may attract higher charges.

Hymans Robertson head of DC consulting Mark Jaffray agrees there are constraints around what can be invested. “I think the DWP absolutely recognised that and wanted to think outside the box in relation to how they solve that, which is good.”

He notes that one of two things needs to happen from a performance fee perspective: Either the DWP needs to find a way of excluding elements from the charge cap calculations, or investments in private equity and private debt [illiquid assets] should not have a performance fee element to them.

“We have seen private equity and private debt managers change the way they price their fund to be friendly to DC schemes to remove the performance fee element and change it into fixed fee.”

Jaffray argues there is a case for manager to offer a fixed-fee version of their fund so the pension scheme knows how much they are going to pay for that fund and then work with it.

He adds another option is to somehow exclude the private funds [illiquid investments] form the charge cap calculation.

“But I think my concern with this would be that the charge cap has been a good thing and forced providers to provide good value for money to members, and I wouldn’t want to erode that principle.”

Risks to savers

However, if trustees invest more in illiquid assets, there is a danger that members would be paying more in fees, with a potential for lower returns.

Trade Union Congress senior policy officer Tim Sharp says that this policy must not become a free-for-all for the fund management industry.

“For a start, the evidence shows quite clearly that performance fees don’t lead to improved performance. It is utterly inappropriate to suggest that sectors like private equity, with notoriously opaque and inefficient cost structures, should be given access to mass market savers without reforming their practices.

“As AE gathers pace, we should be seeing scheme costs being driven down towards the 0.3% level that the Pensions Commission talked about. We shouldn’t be inventing ways to allow the industry to breach the current cap.”

It must also be remembered that these are members’ funds.

Sharp continues: “Government has no place in attempting to dictate where pension funds put their money, let alone attempt to use scheme assets as a substitute for state action.”

Nonetheless, Jaffray is pretty comfortable that even if you do pay a higher fee [within the current cap], you are getting better returns because of it.

“You only reward a manager if they provide good returns. Performance fees have been in the industry a long time. If the performance fee is fair on both sides, I think it could work.”

Member interests

The DWP has also set out proposals which would require larger DC schemes to document and publish their policy in relation to investment and illiquid assets, and report annually on their approximate percentage allocation to this kind of investment.

But despite this, Cameron points out that whatever the government thinks, “trustees must continue to make investment decisions based on what they and their investment advisers believe is in the best interest of the scheme members and beneficiaries”.

The government’s proposal to change the way the charge cap is measured will inevitably make it easier for trustees to invest in illiquid assets, something which could also boost the UK economy. However, there is clearly disagreement over whether this would generate better returns for savers. It is not easy to predict whether or not this would be the case, but the government needs to bear in mind that there would be a risk that members will be paying higher fees for a smaller pension pot. Member outcomes must be at the forefront of the DWP’s decisions, whatever the result of the consultation may be.

Master trust consolidation
The DWP has also questioned if some or all smaller DC schemes, those with fewer than 1,000 members or less than £10m in assets, should conduct a triennial assessment of whether their members’ may receive better value if the scheme consolidated into a larger scheme with more scale – asking whether government should “encourage or nudge” smaller DC schemes to consolidate.
The government says small schemes will generally be less able to enter more innovative or less liquid investments. The DWP is also proposing to extend the annual Chair’s Statement to cover consolidation, by extending the ‘value for members’ assessment.