UK government efforts to encourage pensions funds to invest more in infrastructure, venture capital and private equity are at risk of failing because scheme managers fear the move will leave retirement savers worse off.
Popular pension schemes, with tens of billions of pounds in assets, largely steer clear of these less liquid sectors owing to the higher costs and the complexity of investing in these areas, but no guarantee of higher returns.
The government believes tapping pension cash for more so-called illiquid investments will help supercharge the nation’s post-pandemic recovery.
Tensions between the government and sections of the pension industry began to rise in March when, as part of Downing Street’s plans to “build back better”, ministers proposed giving defined contribution schemes (DC) — which do not promise a guaranteed savings pot — more flexibility to invest in illiquid sectors. Some 10m people in the UK save in auto-enrolment DC workplace pensions.
Two-thirds of DC schemes have no direct exposure to “illiquids” in their main funds, according to a government survey published this year, while the others mostly allocate a maximum of 7 per cent.
“Never has there been a better or more important time for a defined contribution pension scheme to consider innovating their investment strategy,” said Guy Opperman, pensions minister, in a recent consultation.
“Investment in emerging sectors like green infrastructure or innovative British companies fits well with the long-term horizons of DC schemes, and are vital to helping sustain employment, our communities and the environment.”
The key change is a proposal, which the government wants in place by October, to loosen an annual cap on the fees charged by asset managers on pension schemes of 0.75 per cent of assets under management
Under the government proposal, scheme managers could adopt a moving average for performance fees over five years, to reduce the risk of annual cap breaches.
This would enable trustees to invest more in sectors, such as private equity and venture capital, which in turn provide seed finance to start ups and other innovate businesses. But these funds levy performance fees, or “carried interest”, in addition to annual management charges. These extra charges would usually make them more expensive than fixed fees on listed assets such as shares.
Fund managers’ charges are passed on to savers but many pension scheme trustees fear that since returns are not guaranteed savers risk losing out from the higher charges.
The Pensions and Lifetime Savings Association, a trade body representing more than 1,300 workplace pension schemes with 20m members and £1.3tn in assets, told the government in a consultation that it did not believe the changes would “lead to a material change in the volume of investment in illiquids”.
“A focus by trustees on securing low charges in a competitive market; the prudent person principle, which requires schemes to take careful consideration of risk and reward; and operational barriers, such as the flexibility to move pots when requested and daily dealing, are likely to always result in only a very low proportion of scheme investment in such assets.”
Department for Work and Pensions analysis from 2013 found increasing fees levied on pension schemes from 0.5 per cent to 0.75 per cent would see a saver lose an extra £40,000 to charges over their working life. The analysis was based on a consistent 7 per cent annual rate of return.
The average fee for alternative investment managers is roughly 1 per cent to 1.5 per cent for the management fee and 15 per cent to 17 per cent for the performance fee, according to research published in a 2019 paper by the all party parliamentary group on alternative investment management.
Nest, the state-backed workplace pension plan, refuses to pay performance fees and says these managers should reform their charging structures.
The British Private Equity & Venture Capital Association, an industry body. argues that performance fees are justified and that pension funds are missing out on higher returns by avoiding illiquids.
“The carried interest model for private equity and venture capital is the longstanding global market standard for aligning PE/VC managers’ interests with their investors,” it said. “It is only paid out after strong performance is achieved and investors make their returns.”
Some figures in the pension industry said the government was pandering to asset managers by loosening the charge cap, instead of forcing asset managers to lower their fees.
“The government appears to be pushing trustees to invest ‘patriotically’ in order to help the UK economy to recover from the Covid pandemic,” said Andrew Warwick-Thompson, former executive director of regulatory policy with The Pensions Regulator and now a professional trustee with Capital Cranfield, a firm of trustees.
“That objective conflicts with the fiduciary duties of trustees to consider all investable opportunities and choose those which they think will be in the best interests of securing their members’ retirement benefits.”
Warwick-Thompson said he did not believe the government would force schemes to invest in a particular way if its reforms were not effective, saying the political damage would be too great “if things went wrong”.
The government said it was not its role to advise pension schemes of the merits of particular asset classes nor would it seek to do so.
“We know many defined contribution schemes are looking to access a more diverse portfolio of assets, including illiquid assets, and our policy is that trustees of these schemes should be at liberty to consider what investments are best for their members,” it said.