DC pension default funds: investing in private markets

The UK government has been encouraging private markets investment for several years. However, only a small number of DC schemes currently invest in private markets because of governance, regulatory and operational challenges preventing widespread uptake. Typically, schemes investing in private markets are those which have the scale, resources and capability to invest directly in illiquid assets or through segregated mandates with single managers.

As the DC market consolidates and DC schemes grow in size and buying power, the landscape is starting to shift. We are seeing improvements in platform offering; managers offering innovative fee arrangements; and further movement towards direct investment. But this is the tip of the iceberg, and there is still a lot of work to be done to make illiquid assets commonplace for DC default funds and give DC savers the same range and diversification of investment as their counterparts in defined benefit (DB) schemes.

Pinsent Masons, the law firm behind Out-Law, has been closely involved in industry developments and working with several investment managers in this space, including Partners Group. Antony Esposito, head of UK DC client solutions at Partners Group, points out that the benefits and advantages of private markets investing have been available to other institutional investor segments for decades - including DB pension funds, high net worth individuals and sovereign wealth funds.

He says: "We firmly believe DC pension members should also be able to access private markets investments as they can provide both additional investment options and potentially significantly improved member outcomes".

The government recognises these challenges and announced its intention in the 2021 budget to consult further on the barriers to DC schemes investing in private markets and accessing the “largely untapped pool of capital" in venture capital and growth equity assets.

Charge cap challenge

The first hurdle to overcome is the charge cap for qualifying auto-enrolment schemes at 0.75% of a member's funds under management or an equivalent combination charge, which must include managers' performance fees. Trustees have been cautious to diversify into private markets amid uncertainty around the calculation and frequency of performance fees.

The structure and frequency of performance fees depend on asset class and fund type and vary by manager. Generally speaking they are based on investment returns; vary significantly throughout the year; and are typically event-based, instead of being valued at regular intervals. They do not fit neatly with either the prospective or retrospective method of charge cap assessment, particularly for members joining or leaving the scheme during the charges year in which case the charge cap needs to be pro-rated.

The Department for Work and Pensions (DWP) proposes to address this issue from 5 October 2021 by allowing trustees to exclude performance fees from the pro-rated cap where members are invested for only part of a charge year, known as the 'in-year' adjustment. This prevents a situation where a scheme member joins the scheme after an investment has increased in value and ends up paying a performance fee for growth incurred before they joined.

Although helpful, the proposed easement would only apply where trustees use a single charge structure; there is a partial year membership; and performance fees accrue each time the value of investments is calculated. Schemes using a contribution charge or flat annual fee structure cannot use the additional method for calculating performance fees, and regular calculation of performance fees does not address the full range of fee structures and rates in private markets.

The DWP recognises that a multi-year approach to calculating performance fees within the charge cap may be necessary to enable access to assets with performance fees spread over multiple years - typically a 'carry' period of 5-7 years. Trustees will be able to adopt the in-year adjustment or use a multi-year approach. In its latest consultation, the DWP has asked for industry feedback on how a multi-year approach may work and we expect this to be a focal point of the further consultation announced in the 2021 budget.

Whilst it is possible to develop a well-diversified portfolio without paying performance fees, in our view trustees need further flexibility in the additional method to cater for all ranges and types of charging structures and to fully alleviate charge cap issues. Fortunately, the DWP has recently confirmed in its charge cap review that the current cap will remain and transaction costs will not be brought within the cap. This is helpful, and prevents managers from having to go back to the drawing board to reconcile charges and transaction costs with a revised cap.

There is also a commercial challenge to consider. DC master trusts and the largest employer-run schemes are setting themselves scheme-specific charge caps, sometimes 40 base points below the statutory charge cap. These lower caps are the result of competitive pressures to provide low costs in tender processes, leading to a 'race to the bottom' culture where trusts are reluctant to increase their charging basis for fear of competitive disadvantage. While most schemes will have sufficient, and sometimes significant, headroom on the cap, for others, there is often little wriggle room due to internal and commercial pressures.

The industry needs to work harder to encourage investment approaches that justify higher costs as part of the overall value for money assessment, to resolve the misconception that low costs mean good member outcomes.

Roberto Cagnati, co-head of portfolio solutions at Partners Group, says: "Most DC schemes prioritise low investment costs above all else, including net returns. However, we believe 'value for money' should be focused on improving member outcomes through increased net of fees returns, rather than disproportionately focusing on the lowest cost investment options".

Unit-linked funds

The ability of schemes to access private markets fundamentally depends on the structure of investment.

It is far easier for those large DC schemes with FCA-authorised capability to invest directly or which appoint single managers to access private markets. However, most DC schemes, including vertically-integrated master trusts, invest through investment platforms by purchasing unit-linked long-term contracts of insurance.

This form of investment is potentially a bigger challenge to private market investment than the charge cap. By investing through unit-linked policies, trustees hold investments indirectly and there is a high degree of delegation to the provider. Often, the provider sets the default investment strategy across its book of business, including group personal pensions (GPPs) - which typically means the trustees' role is limited to oversight and monitoring, rather than actively setting investment strategy and strategic asset allocation.

Because unit-linked funds must be purchased within an insurance wrapper, they are subject to Financial Conduct Authority (FCA) permitted links rules on insurers, which specify the types of investments that insurers can make. The FCA has recently revised its permitted links rules to include 'conditional permitted' links, which allow the liquidity of individual investments to be viewed in the context of the whole portfolio of the fund. The FCA has also removed some of the restrictions on the type of illiquid assets, allowing investment in infrastructure (e.g. immovable assets such as rail track, bridges, roads and wind turbines); and removed a requirement that unlisted securities must be 'realisable in the short term'. This is subject to an overall limit of 35% on the proportion of the fund that may be invested in illiquid assets (excluding permitted land and property).

In theory, this is a significant shift to allowing greater access to private markets through platforms, but there are still operational issues. The existing permitted links rules, which remain in force for insurers who do not elect to apply conditional permitted links, mean that platform providers have set up their operations for liquid assets and to daily pricing, resulting in ongoing residual issues with integrating illiquid assets.

The complexity of assessing and monitoring private market assets can also make it difficult for providers to do their due diligence and to satisfy the 'prudent person' rule. Retail investors, including pension schemes, must only invest in assets and instruments where the associated risks can be properly identified, measured, monitored, managed, controlled and reported.

The FCA needs to do more to distinguish between types of retail investors in order to overcome these operational and governance challenges. Pension schemes have a long-term horizon for their investments and do not require as much liquidity as other retail investors. According to Partners Group, the long-term nature of private markets investments aligns well with the long-term investment horizons of many DC members - and yet the current DC landscape disincentivises a longer-term investment approach, to the ultimate detriment of member outcomes.

Trustees' statutory duties

Trustees must exercise their powers of investment to ensure the security, quality, liquidity and profitability of the portfolio as a whole. They are also required to ensure the default investment strategy is in the best interests of members and investment returns from the default arrangements are consistent with the trustees' aims and objectives.

Typically, the aims and objectives of a default arrangement will be to provide an investment return in excess of inflation and to shift strategic asset allocation so that as a member approaches retirement, the exposure to growth assets is reduced in favour of more defensive, less volatile assets.

In the 'growth' phase, trustees should set expectations of their managers to invest in a broad range of growth and return-seeking assets - this type of strategy reflects the investment profile for private market investment. But there is still reluctance amongst trustees, and managers acting on their behalf, to look beyond short-term returns in favour of longer-term sustainability.

Recent developments around climate governance requirements and TCFD reporting will bring the long-term benefits of private market investment back into focus. Partners Group tells us that as a result of these policy developments, DC schemes are increasingly looking to their investment managers to understand the impact and engagement exercises undertaken within their portfolios. Antony Esposito says that private markets managers are often better able to achieve positive and measurable impact on behalf of their investors, given the long-term nature of this type of investment and the typical controlling equity stakes investment managers have in these businesses and assets.

Climate change risk is a financial factor and risk matters just as much as return in the sustainability and suitability of a portfolio. Trustees should focus on long-term outlook and embrace a wider range of investments to ensure they are acting in members' best interests.