Long ReadMar 27 2023

What do the DWP's illiquid asset proposals mean for DC schemes?

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What do the DWP's illiquid asset proposals mean for DC schemes?
The DWP’s aim to remove barriers to illiquid assets investment is welcomed, but the proposals create more regulatory burden. (FT Montage)

Greater investment in illiquid asset classes is something the government is keen for defined contribution pension schemes to actively consider, to benefit both pension savers and to benefit the UK economy, but maybe not in that order.

The Department for Work and Pensions has undertaken consultation to elicit views on its paper "Broadening the investment opportunities of DC pension schemes".

In January 2023 the government published their response for chapters two and three of this paper, in which they provided details of a few changes intended to strengthen the regulations and guidance following feedback to the consultation. 

The DWP’s aim to remove barriers to investment in illiquid assets is reassuring.

The guidance and regulations are intended to encourage trustees to consider illiquid investments by requiring them to disclose and explain their policies on illiquid investment and reflect on whether their current investment policies and asset allocations align with market changes and whether their investments are still in their members’ best interests. 

There is also an expectation that this enhanced communication could help members better understand the investments made on their behalf, which could in turn help drive up overall pensions engagement.

What are illiquid assets?

Illiquid assets are normally assets that cannot be easily or quickly sold or exchanged for cash without a substantial loss in value.

These assets include, but are not limited to: 

  • Direct property investment.
  • Investment in infrastructure projects.
  • Private equity.
  • Private debt. 

As privately held assets, the trading of illiquid assets takes time due to the bespoke nature of the asset and therefore more due diligence is required prior to purchase.

Given the infrequent trading, there may be a lack of consensus on valuation, hence terms of the deal require time-consuming negotiations.

The case for illiquid investments in DC schemes is strong as DC members are long-term investors. 

Therefore, these investments have greater trading costs and greater idiosyncratic investment risks, including that a willing buyer may not be present at a given point in time, creating illiquidity.

The case for illiquid investments in DC schemes and potential challenges

At Buck we believe that the case for illiquid investments in DC schemes is strong as DC members are long-term investors, similar to defined benefit schemes, and therefore can take advantage of the key characteristics of illiquid investments. 

Some of these key advantages from illiquid investments include:

  • The potential for an ‘illiquidity premium’ (that is, additional return received as reward for the risk of tying up capital for a period of time). 
  • Genuinely diversifying away from traditional asset classes like bonds and equities.
  • Opportunity to earn a greater return from the skill of execution of the chosen strategy.
  • Lower pricing volatility than equities.
  • A stable and reliable income.
  • Protection against inflation, where the income generated can be inflation-linked.  
  • An ability to directly implement environmental, social and governance policies, as sustainability and ESG are critical areas of considerations in these types of assets, for example, social housing, wind farms, hydropower plants etc. 

Challenges 

Despite the potential advantages, DC schemes have invested less in illiquid assets compared to DB schemes. This has been due to several factors, which have been constraining investment by DC schemes until now. 

Some of the issues for DC schemes include:

  • Higher costs: the focus for the trustees of DC schemes has been to keep costs low and within the charge cap of 0.75 per cent a year, however investing in illiquid assets tends to be expensive and may take some time to generate value. 
  • Liquidity: DC schemes have focused on daily dealing investments, which has reduced appropriateness of illiquid assets for DC members. 
  • Governance and regulatory challenges: complexity and challenges to transparency with illiquid assets can make it harder for schemes to do their due diligence and can interfere with schemes fulfilling their obligations on costs and charges. Also, the scheme may need to enhance its governance structures, changing processes and reskilling in order to apply the correct level of oversight to investments made. 

What is changing?

The DWP is now moving forward with its proposals for relevant schemes, after receiving broad support for the regulations and guidance proposed in the consultation. The changes are related to DC investment disclosure requirements and the charge cap. 

The key areas of the changes include:

1. ‘Disclose and explain’ policies on illiquid investments within the Statement of Investment Principles for the default arrangement. This applies with effect from the earlier of the first date on which the SIP is revised after October 1 2023 and October 1 2024.

The latest proposals do not solve the problem fully, instead they create more regulatory.

2. Public disclosure of default asset allocations in the annual chair’s statement. All schemes that are required to produce a chair’s statement are covered by this change. This applies with effect from the first scheme year that ends after October 1 2023.

3. The new regulations enable trustees to exclude specific performance-based fees that are paid when a fund manager exceeds pre-determined performance targets from their charge cap of 0.75 per cent a year where this is in the best interests of their members. The exemption of performance-based fees from the charge cap applies from April 6 2023 and from the first scheme year ending after April 6 2023. 

However, the amount of any excluded performance-based fees in relation to each default fund will need to be included in the chair’s statement and disclosed on a publicly available website.

Plans welcomed but regulatory burden grows

We are supportive of the government push on facilitating illiquid investments in DC schemes as we believe it could lead to better outcomes (over the long term) for DC members.

In particular, we are supportive of the governance requirement that requires trustees to put in place formal policies on illiquid assets in their Share Incentive Plan.

There is scope for the DWP to offer guidance on how best to price illiquid assets within the context of a daily traded portfolio.

The DWP’s aim to remove barriers to investment in illiquid assets is reassuring. However, the latest proposals do not solve the problem fully, instead they create more regulatory burden while not delivering additional value to the members.

For example, in our view asset class disclosure reporting in the annual chair’s statement is unnecessary and will add further costs to the scheme, while adding little value to members. In our opinion, it will not improve member engagement with their scheme’s investment strategy, as we have a question on how many members actually read these disclosures.

We believe there is a need to move the emphasis away from cumbersome reporting obligations that add little value to members and focus instead on tackling bigger issues that hinder DC schemes’ ability to invest in illiquid assets. 

Pricing issues for DC schemes

For example, a significant practical challenge for DC schemes, compared to DB schemes for example, is that money is coming in and going out of DC schemes on a daily basis.

To account for fair pricing of these regular incoming and outgoing transactions, the underlying investment platforms and administration systems anticipate ‘daily dealing’ funds where the underlying value of the assets is recalculated on a daily basis. 

By their very nature, illiquid investments often need some form of 'manual' modelled valuation rather than having a visible traded value. As a result, providing a daily price in order to be compatible with daily trading DC platforms can be a challenge.

To date, DC platform providers have been cautious about accommodating illiquid assets due to the costs and operational complexity of the changes required to their systems and processes, and there are few funds available which have packaged illiquid investments in a DC-friendly daily priced option compatible with DC platforms.

Disclosures have a role to play, but it is achieving a positive investment outcome that will ultimately drive better retirement benefits.

So even if trustees want to invest in illiquid assets, they may not currently find many viable options to do so.

DC infrastructure will require significant investment in order to hold and deal in illiquid assets and must have a commercial incentive to do so. This is central to the government’s desire for consolidation of DC schemes, so a smaller number of bigger schemes will have the economies of scale to undertake the work needed to integrate illiquid investment into DC schemes in an efficient way.  

In the meantime, there is scope for the DWP to offer investment managers, platform providers and trustees guidance on how best to price illiquid assets within the context of a daily traded portfolio, to reconcile the model-led valuations that are not frequently or immediately priced in order to ensure fair and equitable treatment between investors irrespective of what day of the month their contributions are invested or they access their benefits. 

From a pure investment perspective, we believe there is a strong case for including an allocation to illiquid assets as part of a DC scheme’s investment strategy.

However, there is a need for regulatory clarity on how this can be done without negatively impacting member outcomes through high costs or inconsistent pricing.

Disclosures have a role to play, as does encouraging greater member engagement, but it is achieving a positive investment outcome that will ultimately drive better retirement benefits.

We look forward to the pension and the investment industry working together to make it easier for DC schemes to access illiquid assets.

Mayank Agrawal is an investment consultant at Buck