Focus on value over cost as UK pensions given pathway to greater illiquids exposure

Defined contribution schemes in the UK are forecast to grow to more than £1trn in assets by 2030.

A focus on net returns is a feature of new guidance published by a UK government working group aiming to help as many as 18 million pension savers in defined contribution pension schemes benefit from greater illiquid assets exposure.

A group convened by the Bank of England, the Financial Conduct Authority and HM Treasury that includes 20 large DC pension schemes, investment managers and consultants released the new guidance on Thursday. The guide outlines the key principles such schemes should adhere to when considering increasing exposure to alternative asset classes such as private equity.

“As UK DC schemes have developed and grown in size, the range of investment opportunities available to them has increased significantly, and is likely to increase still further in the years to come,” the guide noted.

Compared with defined benefit pension schemes in the UK, and DC schemes in other countries such as Australia, UK DC schemes invest relatively little in illiquid assets.

Assets managed by UK DC schemes are forecast to grow to more than £1 trillion ($1.2 trillion; €1.2 trillion) in assets by 2030 as result of automatic enrolment, up from £340 billion in assets in 2015, according to the FCA.

The guide comes as the UK government looks to make it easier for DC schemes to invest in illiquid assets.

In October, the Department for Work and Pensions published a consultation which recommended removing performance fees from the charge cap applied to DC schemes, which are constrained by an annual 0.75 percent charge cap on assets under management and administration. This has acted as a barrier to accessing certain asset classes that charge a performance fee, including private equity, growth equity and venture capital.

DWP noted in the paper that the draft regulations are not intended to reduce the bargaining power of DC schemes to demand alternatives to performance fees. Instead, it seeks to “ensure open dialogue between the trustees and the fund manager on the appropriateness of the performance-related fee structures and their value to scheme members”.

Such changes could unlock meaningful amounts of capital that may be invested in private markets. One source familiar with the working group told Private Equity International that typical ballpark allocations to private markets by these schemes could be anywhere from 5 percent to 15 percent, with some advisers pushing for such schemes to allocate as much as 20 percent.

A typical ballpark ticket size for a multi-employer DC pension pot to a private markets fund could be £500 million, while single-employer workplace DC schemes could deploy tickets of around £50 million, the source said.

Thursday’s guide outlines six areas that have until now prevented DC schemes from investing more capital in illiquids, including a focus on performance fees and liquidity management.

On the former, the guide recommends that DC schemes ensure performance fees are linked to value and that there are “clear links between the costs and charges and the superior returns received by members”. Additionally, schemes should ensure that performance fees are attributed “as fairly as possible” between different scheme members.

Private equity’s two and 20 model has historically been a barrier against more DC scheme participation, such as the UK’s largest DC scheme, the National Employment Savings Trust. In a 2021 interview with the Financial Times, NEST’s chief investment officer Mark Fawcett said the pension fund wouldn’t pay the industry-standard two and 20 to access private equity. The pension has since elected Schroders Capital as its first-ever private equity manager, as part of its £1.5 billion push into private equity by early 2025, and is understood to not be paying two and 20.

On liquidity, the guide outlines ways in which DC schemes can invest in less-liquid asset classes and still meet the liquidity needs of their members by understanding expected future cashflows. Schemes should ensure their broader portfolios are sufficiently diversified; determine their risk appetite for illiquids and take practical steps to manage liquidity; and ensure assets are held within appropriate fund structures.

“Compared to investing in public companies, transacting in less-liquid assets such as infrastructure projects or private equity requires significant resource and time, so regular transactions in such assets are best avoided,” the guide notes. Schemes considering exposure to less-liquid asset classes via listed investment companies, for example, should consider issues such as discounts and premiums and the longer period of time it may take to dispose of shares without materially impacting the price of the assets.

Partners Group, a member of the working group, “firmly believes private markets investments have a place in defined contribution pension portfolios, as has been the case in defined benefit portfolios for decades”, Joanna Asfour, managing director of UK client solutions at the firm, said in a statement on the back of the guide’s release. “A growing willingness amongst various stakeholders over the last 18 months to align DC capital with long-term investment opportunities has therefore been very encouraging.”

On guidelines addressing the need for DC trustees to look at value over cost alone, Asfour added it was Partners Group’s view that “an excessive focus on cost could result in a missed opportunity to secure long-term value for members in the future”.

“The guides also encourage a change in mindset to support investment in less-liquid assets, although collective action by the industry will be required for this shift to truly happen.”

– Carmela Mendoza contributed to this report.