DC pensions: incorporating performance fees in the charge cap

As large DC pension schemes increase in size, particularly in the master trust sector, the government's focus is unsurprising in seeking to provide DC savers with the same investment opportunities as DB members.

The Department for Work and Pensions (DWP) consultation sets out proposed measures to allow occupational DC pension schemes to ‘smooth’ performance fees over multiple years within the charge cap, as well as a call for evidence on ‘look-through’ of investment funds for charge cap purposes. The government intends to respond to the consultation in June, with regulations coming into force in October 2021.

The consultation is the latest step in the government’s drive to encourage DC investment in private markets and provide savers with access to higher returns from long-term assets. It follows the DWP’s recent charge cap review; HM Treasury’s review of the UK funds regime; and the government's establishing of the Productive Finance Working Group to investigate ways of reducing barriers to private markets investment.

For an overview of the hurdles to DC schemes investing in private markets, see our recent Out-Law article.

The issue with performance fees

Managers offering access to certain private markets, such as venture capital and private equity, tend to levy performance fees. Fee structures vary, although the most common is a combination of a fixed annual management fee – paid regardless of return – and a performance-related element. As an example, a ‘2-20’ fee structure would include a fixed annual management charge of 2%, and a 20% performance fee on returns delivered above a ‘hurdle rate’.

A fee structure along these lines causes uncertainty for trustees needing to assess compliance with the charge cap, particularly when returns are high.

The most common type of performance fee is ‘carried interest’. This crystallises at the end of the life of a fund when all investments have been realised, but accrues at intervals across the investment period and is notionally deducted from members’ pots. The total performance fees crystallised will be the sum of accrued fees over the fund’s life.

What is multi-year performance fee smoothing?

The government has confirmed that, from 5 October 2021, it will allow trustees to exclude performance fees from the pro-rated charge cap where members are invested for only part of a charge year. This is known as the ‘in-year adjustment’. It seeks to provide headroom within the charge cap and 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.

Trustees will also be able to use an alternative ‘multi-year approach’ to assess charge cap compliance, which allows them to ‘smooth’ performance fees over multiple years. This new method supplements the existing retrospective ‘looking back’ and prospective ‘predicting’ methods of charge cap assessment, allowing trustees to use a five-year moving average of performance fees incurred over the previous five years.

Do the proposals work?

The smoothing option appears to be a positive step in providing more headroom within the charge cap and giving trustees greater assurance that investment in private markets would not risk breaching the cap. However, in our experience, the ‘carry period’ of funds investing in certain assets, such as venture capital, tends to last longer than five years, so there is a risk that the proposed smoothing period is too short for certain types of investment.

In addition, the smoothing option requires trustees to calculate aggregate performance fees over a five-year period, taking the average over the previous charges years. This implies the method may be more practicable for schemes with an existing private markets allocation. Given trustees are unable to use indicative performance fees in the current proposals, this raises questions of how trustees exercise the easement for new investments.

Finally, we expect the multi-year approach will place greater emphasis on investment managers to provide regular information on returns and on the level of performance fees. Although this is positive from a transparency perspective, and aligns with the requirement to report net investment returns from October 2021, it would increase the levels of reporting and information flows required of managers at a time when the industry is already grappling with the extent and scope of climate-related disclosures for TCFD compliance. Trustees will need to lean on their intermediaries, in particular their investment advisers, to ensure that they receive the information that they need to assess compliance and report in line with their statutory requirements.