Update on DC Schemes' Ability to Invest in Illiquid Assets

Related Author:   Charlotte Tarr, Trainee Solicitor

On 30 March 2022 the Department for Work and Pensions (DWP) published a combined consultation which:

• set out the responses to a November 2021 consultation on the exclusion of certain illiquid assets from the regulatory charge cap for DC default funds;
• consulted on a potential requirement for the Statement of Investment Principles (SIP) for a DC scheme to both disclose and explain the trustees' policy on illiquid investments and, for schemes with over £100 million in assets, to provide an asset allocation disclosure in the Chair's Statement;
• consulted on changes to Employer Related Investment (ERIs) regulations which apply to certain Master Trusts; and
• evaluated and reported on evidence collected from previous consultation on the potential need for greater consolidation of DC schemes.

DC schemes' ability to invest in illiquid assets

Exempting performance-based fees from the regulatory charge cap

The DWP responded to its November 2021 consultation on whether removing performance fees from the DC charge cap for default funds would incentivise DC schemes to change their current approach to investing in illiquid assets, such as infrastructure and private equity. Perhaps unsurprisingly, a mixed response was received.

Some welcomed the proposal believing it would "open doors to pension schemes", and also that it would help to shift the focus of pension schemes from keeping costs as low as possible to instead focussing on the value of the investments i.e. the potential for higher costs contributing to higher returns.

The majority of responses were less positive, seemingly because they were not convinced that excluding performance fees from the charge cap would be enough to encourage investment in illiquids. One explanation being that "even with this change most DC schemes would still lack the economies of scale, expertise and resource required to access and manage more complex investments".

A mixture of consumer and trade groups strongly opposed the proposal, concerned that the exclusion of performance based fees would dilute the charge cap which so far had been effective in protecting members from the higher charges. Consensus was found however in that nearly all respondents agreed that any regulatory changes needed the necessary safeguards to provide effective protection to members.

The DWP has highlighted the importance moving forward that the government carefully considers and understands the wide range of concerns raised, and that it should continue to engage further in order to explore fully how these concerns might be best addressed in any proposed changes to draft guidance and regulations. The DWP will therefore consult on principle-based draft guidance alongside any proposed consultation on draft regulations.

Consultation on a requirement for a SIP to disclose and explain the trustees' policy on illiquid investments, and to provide an asset allocation disclosure in the Chair's Statement

The DWP has also proposed to amend the Statement of Investment Principles (SIP) requirements to "ensure that relevant defined contribution (DC) pension schemes disclose and explain their policies on illiquid investment". The DWP wants to encourage further diversification and investment in assets that bring higher returns, and believes that this requirement to explain is more appropriate than any attempt to force private pension schemes to invest in specific asset classes or sectors as that would cut across trustee's fiduciary duties. Some Master Trusts already voluntarily provide this information setting a precedent for such disclosure.

The DWP would like such SIP policies to include:

• what illiquid assets are;
• whether trustees choose to invest in illiquid assets;
• which members will be holding illiquid assets (does the scheme lifestyle members in and out of illiquid assets and at roughly what age?);
• a description of these allocations, including whether the investment is direct or indirect and under which asset classes the investments fall;
• why trustees decided to make an allocation to illiquid assets (this should include their assessment of the benefits to members of such an allocation);
• if trustees do not decide to make an allocation to illiquid assets, why;
• what factors they consider when deciding whether to invest in these assets;
• any current barriers to investment in illiquid assets; and
• any future plans for investment in illiquid assets.

In addition to the above, the DWP is proposing that relevant DC schemes with over £100 million in total assets should be required to publicly disclose and explain their default asset class allocation in their Chair's Statement. This would mean disclosing the percentage of assets allocated in the default to each of the following seven main asset classes: cash; bonds; listed equities; private equity (including venture capital and growth equity); property; infrastructure; and private debt.

These proposals will be watched with interest to see if the perceived hurdles for DC schemes to access illiquid assets can be overcome. The pensions industry seems unconvinced that they will achieve their goal in isolation, but it is encouraging to see the DWP working to allow members (for whom such investments would be appropriate) to be able to invest in what could be an advantageous asset class.

Consultation on potential amendments to Employer Related Investments (ERI) to reflect recent developments to the wider pensions landscape
ERI restrictions aimed to protect members from misappropriation of scheme assets by restricting the extent to which a scheme could invest in its sponsoring employer. The pensions landscape has evolved in the last 30 years from when these restrictions were introduced, including with the emergence of multi-employer DC Master Trusts. The current regulations result in such Master Trusts spending significant time and money ensuring compliance with restrictions which do not recognise their particular structure, and also may have the effect of restricting the asset classes available to the Master Trust.

The Government has proposed numerous changes that would recognised the structure of Master Trusts and assist them in expanding their investment strategies. In summary, they amend the current ERI regulations such that, in their application to Master Trusts, they will apply only to the scheme funder, the scheme strategist and persons connected to the scheme funder and scheme strategist. The DWP has asked for feedback on whether the amendments achieve its policy intent, therefore it will be interesting to see whether the industry feels that these changes will help to remove the restrictions on Master Trusts.

The need for greater DC scheme consolidation?
Lastly, the DWP reviewed its call for evidence from June 2021 regarding greater consolidation for DC schemes, particular focus being on smaller DC schemes (under £100 million in assets), and how they could show they offered comparable value to larger schemes.

The evidence received was mixed, and the DWP concluded that while the government was still concerned with members who were suffering in poorly performing smaller schemes, unable to access the full range of available investments, the DWP was "encouraged by the data published by TPR", which suggested consolidation was continuing at a healthy pace, seeing a year-on-year decline in the number of schemes. The DWP concluded by saying, "We will therefore not be introducing any new regulatory requirements with the sole purpose of consolidating the market in 2022".

If you would like to discuss any aspect of this, please contact Duncan Watson or Edward Jewitt from our Pensions Investment team, or your usual Mayer Brown contact to discuss how we can help you.