Rule change to promote UK pension fund investment in illiquid assets

The changes (29-page / 606KB PDF) are designed to address any unjustified barriers preventing retail investors from investing in a broader range of long-term assets via unit-linked funds, while maintaining an appropriate degree of investor protection. The Law Commission of England and Wales recommended that the rules be reformed in its 2017 report on pension funds and social investment, with a view to encouraging investment in infrastructure by defined contribution (DC) schemes.

Pensions expert Mark Baker of Pinsent Masons, the law firm behind Out-Law, said that the change was particularly relevant to DC schemes with investments in growth assets.

"Pension schemes are being encouraged to investment more of their assets in illiquids, with the promise of extra return," he said.

"Until now, there's been a misconception that the permitted links rules restrict DC schemes from using illiquid assets through a platform. The rule change will influence the government's consultation on DC investment innovation and strengthen its drive to encourage private markets investment with extra vigour," he said.

In a unit-linked insurance product, the policyholder is allocated nominal 'units' in underlying pooled investments based on the premium paid and unit price on the date of investment. The policyholder then receives returns based on the performance of the fund's investments. Unlike investments in authorised funds, unit-linked investments can only be purchased as an insurance product rather than purchased directly. This 'wrapper' usually takes the form of an insurance-based pension, but can be a standalone life insurance product.

The 'permitted links' rules in the FCA's Conduct of Business Sourcebook (COBS) previously permitted an element of investment in illiquid assets such as property, land and certain narrowly-defined unlisted securities. However, they did not permit investment in infrastructure or unlisted securities more broadly. Both the Law Commission and the UK Treasury's Pension Scheme Investments Taskforce have recommended that these rules be reviewed in order to remove barriers to unit-linked funds investing in infrastructure and other illiquid assets.

The FCA, following consultation, has now amended the rules to allow investment of up to 35% of a fund in a wider range of illiquid assets provided certain conditions are met. The cap does not relate to investment in land and property, to which a separate 10% gearing limit already applies. It has decided against removing restrictions on illiquid investment entirely to ensure an appropriate degree of protection for consumers, citing the collapse of the LF Woodford Equity Income Fund as an example of the need for caution.

The new rules include a new category of 'conditional permitted immovable', which will enable investment in assets such as rail tracks, bridges, roads, runways, wind turbines, hydroelectric plants, solar farms, pylons, gas storage and sewerage plants. A new category of 'permitted loans' has also been created, including loans secured on assets that fall into the conditional permitted immovable category. The FCA has also removed the requirement for investments in unlisted securities to be 'realisable in the short term' and a 20% cap on holding assets through qualified investor schemes and unregulated collective investment schemes. These will now be subject to the overall 35% limit.

Insurers will only be able to take advantage of the extended permissions where they can ensure that the investments are suitable and appropriate for their policyholders' circumstances on an ongoing basis. They must also clearly and prominently inform policyholders of the additional risks. Insurers must also be able to ensure that benefits due to their policyholders will continue to be paid as they fall due without being affected by liquidity issues. They will, however, be able to defer policyholder requests to exercise rights other than the right to receive their benefits as they fall due where this is "reasonably necessary for the prudent management of the fund and in the best interests of the relevant policyholders". This is consistent with the 'notice periods' applicable to other investments in less liquid assets.

The FCA, in a policy statement, said that the new rules reflected the fact that unit-linked funds are generally explicitly long-term investments, in which investors tended to be focused on long-term returns rather than short-term liquidity. Capital requirements imposed on insurers mean that they should be able to continue to meet their contractual and regulatory obligations to investors even if fund assets cannot be cashed in quickly.

Pensions expert Mark Baker said: "There are complications to solve before investment in illiquids becomes common, particularly setting workable fee levels. And, importantly, the largest DC schemes won't always be reliant on platforms, just as big defined benefit schemes can already make these investments direct".

"But the platform-based master trust providers might see some benefit, probably medium term – and the change will support the more widespread use of illiquid assets by DC schemes over maybe the next three to five years," he said.