Reforming the DC charge cap – DWP consults

What’s been published?

On 30 November 2021, the UK Government’s Department of Work and Pensions (DWP) published a consultation paper, ‘Enabling Investment in Productive Finance’.

The aim of the consultation is to “create a regulatory environment that allows pension scheme trustees to invest where they think they can achieve better value for members and which encourages genuine innovation and competition on fees, including on the part of investment managers”.

To help achieve this, the consultation paper sets out proposals to remove “well designed” performance-based fees from the charge cap – meaning that pension scheme trustees can agree to pay them in addition to capped charges. The DWP believes that this will give schemes the flexibility and freedom to pay performance-based fees, if they think this is in the financial interest of members.

Responses will help inform future policy to ensure that DC schemes can access a broader range of illiquid asset classes.

The work builds on the Report of the Productive Finance Working Group, in which Simmons has taken an active role. It should also be seen in the context of the recent introduction of the Long Term Asset Fund (LTAF) a new vehicle intended to enable DC schemes to invest in longer term assets.

The consultation period closes on 18 January 2022.

If the DWP chooses to place performance-based fees outside the scope of the charge cap, it would look to consult on draft regulations early in 2022, with the aim of the regulations coming into force in October 2022.

What does Simmons say?

We welcome the DWP’s proposals to remove performance fees from the DC pension scheme charge cap.

They would, if enacted, give DC pension scheme trustees more flexibility to focus on delivering real net returns to members rather than simply focussing on cost.

What’s the background to this consultation?

The current charge cap prevents DC schemes from imposing charges of more than 0.75% annually on a member’s pot. Some charges, such as transaction costs and the costs of holding physical assets, are excluded and can be charged in addition to costs falling within the charge cap.

The charge cap applied to DC schemes is widely seen as limiting the ability of DC schemes to invest in long-term, illiquid assets. Although some illiquid assets can be accessed without paying performance fees, access to the most illiquid, higher risk but potentially highest potential gross return investments, like venture capital and other forms of private equity, can currently typically attract a performance fee.

At the same time, the DWP believes that the interests of DC scheme members need to be adequately protected. One of the reasons for the introduction of the charge cap in the first place was to protect them from overly high and unfair performance fees.

The DWP has consulted twice before on the charge cap – in September 2020 and again in March 2021 and these have helped shape the DWP’s policy approach for the current consultation.

What does the consultation paper say?

• Changing the list of exemptions to the charge cap

  The DWP is proposing to take “well-designed performance fees”, paid when an asset manager exceeds pre-determined performance targets, out of the charge cap.

  This would apply only to fees related to performance and other current investment administration charges (such as the 2% fee of the standard ‘2:20’ carried interest model) would remain in scope of the cap.

• Smoothing

  The DWP’s most recent amendment to the charge cap, effective 1 October 2021, was designed to allow trustees to smooth performance fees within the charge cap. The DWP now acknowledges, however, that smoothing has only a limited impact in this area and would aim to remove the smoothing mechanism if it decides to proceed down the route proposed above.

• Would this meet trustees’ concerns?

  The DWP, however, wants to understand how far the proposed exclusion of performance fees from the charge cap might allay concerns of DC trustees about the practicalities of performance fees. Previous feedback has highlighted that combining variable fees in a flat cap regime is seen as a factor that limits trustees’ confidence when it comes to investment in private markets. The DWP hopes that, while not a panacea, the proposal to change the scope of the cap, combined with smarter regulation of performance-based fees, should address practical concerns linked to the flat cap regime.

• Would this lead to changes to existing fee structures?

  In addition, the consultation seeks views as to how far the proposed change would trigger private equity and venture capital managers to make changes to existing fee structures and, if they did so, whether this would increase DC investment in such assets.

  On the other hand, mindful that asset managers could reform existing fee structures for other asset classes to fit within the proposed easement, the DWP notes its commitment to designing any change to the treatment of performance fees to protect against such “abuse”.

• When would the performance fee be payable?

  The DWP wants to ensure that members of DC schemes only end up paying fees when genuine outperformance is achieved, so that the members’ savings and best interests are protected.

• Limiting asset classes?

  A further consideration might be to specify to which asset classes the performance fee exemption would apply – the consultation identifies the following:

  • venture capital
  • private equity
  • infrastructure and/or
  • private credit.

• Defining performance-based fees

  To enhance investor protection, the DWP raises the issue of creating a tighter definition of performance-based fees than the current one under Regulation 2 of the Charges and Governance Regulations 2015.

• Hurdle rates

  The consultation paper calls for feedback, in particular, on whether the DWP should require a given hurdle rate, for each asset class, with a view to preventing arbitrage and/or unfair practices emerging.

  (By way of example, the consultation paper flags that, “without tight regulation”, a manager could decide to change its fee structure to charge 0 and 50 with a 0% hurdle rate, which would mean that schemes would sacrifice 50% of all positive returns.)

• Unbalanced nature of performance-based fees

  The DWP is also considering whether it should add additional criteria to the definition of ‘performance fees’, in particular to address DC schemes’ concern about the unbalanced nature of existing structures (where it is felt that the 20% performance-based fee kicks in on out performance but trustees are not reimbursed if performance then drops).

  The consultation notes that while “the Government is considering several options to ‘remedy’ some of these concerns, there is a need for large schemes to exert their buyer power on both the level and structure of such fees”.

• Other design considerations

  The DWP asks for comments on a number of other conditions which could be applied to the types of performance-based fees excluded from the list of charges subject to the charge cap (should the DWP go down that path). These include:

  • principles for typical hurdle rates for performance fees across different asset classes
  • accrual methodologies for performance fees
  • linking performance fees directly to realised profits
  • circumstances when caps on performance-fee-incurring assets within the portfolio might be appropriate
  • incentivising the development of alternative fee methodologies such as ‘1 and 30’
  • requirements for a high-water mark; and
  • banning the practice of clawback.

• Transparency

  If the DWP’s proposals were to be pursued, the DWP notes that it would intend to require performance-based fees to be disclosed to pension scheme members in the Chair’s Statement.

• Pro-rating for members with less than a full charges year in the scheme

  Current regulations include an easement which removes performance fees from the requirement to pro-rate charges under the charge cap where a member has spent less than a full charges year in the scheme.

  If performance fees are removed from the charge cap as proposed, such fees will no longer be classed as “charges”, so would fall out of the overall requirement to pro-rate charges. As a result, the pro-rating easement would be redundant and the DWP would remove it from legislation.