Report encourages more UK pension investment in illiquid assets

The Productive Finance Working Group is made up of industry representatives and co-chaired by the Bank of England, Financial Conduct Authority (FCA) and UK Treasury. It was asked to report on barriers to investment in longer-term assets such as private equity, real estate, research and development, technology and infrastructure. Its recommendations (27-page / 2.9MB PDF) focus on supporting investment by DC schemes and developing the long-term asset fund (LTAF) structure, recently consulted on by the FCA.

The working group said that, with appropriate risk management in place, illiquid assets have the potential to generate better returns for those saving into DC pension schemes for the longer term, given their typically long-term investment horizons. The potential sums available to invest – around £500 billion, which is expected to double by 2030 – are such that this type of investment could support the UK’s long-term financial stability and transition to a ‘net zero’ carbon economy.

However, this would require a shift in focus from the DC pensions industry to long-term value, despite potentially higher fees and costs in the short-term, according to the report. The working group is also seeking better guidance on liquidity management from regulators, along with changes to the regulatory rules around investment in illiquid assets.

Pensions expert Tom Barton of Pinsent Masons, the law firm behind Out-Law, said that the working group had provided some useful recommendations, although there were no concrete implementation plans or timescales.

“The recommendations clearly signal the need for action from the industry and regulators to enable DC schemes to invest in long-term illiquid assets, and provides a helpful indication of how the barriers to illiquid investment may be resolved in the longer term,” he said. “Of course, these opportunities will need to be balanced with any potential risks to pension fiduciaries – in particular, any risk of claims against trustees or managers for selecting investments at a higher cost when cheaper investments of equal merit are available, which is currently a live issue in the US.”

According to the working group, DC schemes tend to focus on low costs to members rather than value, partly because of the 0.75% cap on member-borne charges. Scheme trustees should be encouraged to actively consider how to increase their allocations in illiquid assets, including through the LTAF, by looking at the likelihood of higher returns despite potentially higher fees and costs. Consultants should integrate allocations to less liquid assets in their investment recommendations; while the industry and professional advisers should find ways to accommodate performance fees within the charge cap.

Smaller schemes, which currently make up a significant proportion of the DC market, can find it more difficult to invest in less liquid assets. The report recommends that the current drive towards scheme consolidation where smaller schemes are not providing value for members should continue; while the government should continue to monitor the charge cap and consider how best to reconcile performance-based charges and the charge cap rules.

Better guidance on liquidity management at investee fund level should be produced, giving a broader range of DC schemes more confidence to invest in less liquid assets as part of a diversified portfolio. This guidance should build on the FCA and Bank of England’s wider work on liquidity classification of open-ended funds. Currently, most DC schemes invest predominantly in ‘daily dealing’ funds, giving them the flexibility to sell at short notice, according to the report. However, the working group said that a full overhaul of this system was not necessary.

Finally, the working group recommends that the FCA consult on removing the 35% cap on investment in illiquid assets through unit-linked funds by underlying investors who are not self-selecting their investments. The FCA, which will shortly confirm its policy on LTAFs in response to an earlier consultation, should ensure that these products can be promoted to appropriate retail clients, while asset managers are encouraged to develop LTAFs and similar products to suit the needs of DC schemes. The LTAF structure is aimed at allowing wider access to long-term assets which are not regularly traded, including infrastructure and private companies.

Investment funds expert Elizabeth Budd of Pinsent Masons said: “The LTAF is clearly a major building block not only for long-term value investing for pension schemes and potentially in the longer term for retail investors, but also for raising funds for national infrastructure projects”.

“However, the working group’s report also highlights concerns about understanding liquidity risk that is associated with these long-term assets, and the importance of educating all those in the value chain,” she said.

Asset management expert David Young of Pinsent Masons said: “We have seen significant interest from alternative investment managers based in a number of jurisdictions in using the LTAF to enable access to renewables and other illiquid assets for DC pension schemes”.

“An open-ended vehicle of this nature aimed at alternative assets has long been an industry goal, but I do think there is now the political will and industry support to finally make this happen through the LTAF,” he said.