Investing in less liquid assets - key considerations for DC investors

Executive summary

UK workplace defined contribution (DC) pension schemes are an increasingly important vehicle for saving for retirement. Ten years since the launch of automatic enrolment in 2012, there are 18 million active savers in UK workplace DC schemes¹. Over this period, their assets have increased from around £200bn to over £500bn, and are expected to double to £1tn by 2030.

As UK DC schemes have developed and grown in size, the range of investment opportunities available to these schemes has increased significantly. And this is likely to increase still further in the years to come. For example, UK DC schemes currently invest relatively little in less liquid assets, compared to UK Defined Benefit (DB) pension schemes and DC schemes in other countries, such as Australia. This reflects several factors, one of which is the important focus of the UK DC pensions industry – across the entire supply chain – on keeping costs low. Investing in less liquid assets tends to be more expensive and they may take some time to generate value; some of them may fail to do so. However, some UK DC schemes are now starting to consider whether and how allocating to less liquid assets as part of a diversified portfolio within a default arrangement could improve member outcomes. This can be for a variety of reasons including improving the potential risk-adjusted return on member savings, net of costs and charges, reducing risk through greater portfolio diversification and assisting net zero transition and sustainability objectives.

These considerations could be particularly pertinent in the context of relatively slow economic growth by historic standards, demographic trends and growing concerns around adequacy of savings for retirement. While investment in less liquid assets by itself cannot ensure adequate savings in retirement, it could help close the gap. For example, estimates suggest that a 22 year-old new entrant to a default DC scheme with a 5% allocation to venture capital / growth equity could achieve a 7-12% increase in total retirement savings².

Reflecting the importance of this issue, the Productive Finance Working Group was established to develop practical solutions to the barriers to investment in less liquid assets. The Group has identified the barriers faced by the DC pension schemes as the main areas of focus. In 2021 the Group published a report³, setting out the key issues and recommendations for industry and the official sector that could create an environment in which DC schemes and other investors could benefit from investment in long-term, less liquid assets, where appropriate. One of the Group’s early deliverables was also to consider what is required to ensure the Long Term Asset Fund (LTAF) – a new FCA-authorised fund structure for investment in less liquid assets – is operationally, commercially and legally viable, alongside other existing structures.

In response to the recommendations in that report, the Group has been taking concrete steps to remove barriers and raise awareness of the key considerations around investment in less liquid assets and to give decision makers the necessary tools to consider investing in such assets, when in members’ interests. To facilitate this, the Group has produced this series of guides for trustees, employers and other key DC scheme decision makers,covering key issues around investment in less liquid assets within default arrangements, including:

• Value for money: To help shift the focus from minimising cost to a more holistic value assessment, this guide outlines a process for assessing value for members from investing in less liquid assets and provides case studies on how that could work in practice for different types of DC schemes.
• Performance fees: To help DC schemes select, negotiate and co-create performance fee structures that could meet their members’ needs, the guide sets out key principles and maps them to specific features of performance fees to highlight their implications for DC schemes.
• Liquidity management: To support robust liquidity management and give DC scheme decision makers the necessary tools, the guide outlines how DC schemes can meet the liquidity needs of their members, while investing in less liquid assets, by managing liquidity at two levels – the DC scheme and underlying fund levels.
• Fund structures for less liquid assets: To help DC schemes select a route for investing in less liquid assets that meets their specific needs, the guide provides an overview of the key features and considerations around the fund structures potentially available to UK DC schemes.
• Legal guide to the Long Term Asset Fund (LTAF): To help DC scheme decision makers become more familiar with the LTAF as a new fund structure, the guide highlights the key features of the LTAF, including its legal structure and a summary of the key terms. The Group is also currently finalising model constitutional documents for the LTAF, to be published later this year. In the meantime, a draft is available on request from the Secretariat of the Productive Finance Working Group.
• Due diligence: To facilitate high standards around investment in less liquid assets, this guide highlights the key considerations around due diligence on the investment managers and products.

To support implementation in practice, investment and employee-benefit consultants have published a joint commitment to shift the focus from cost to value when advising DC decision-makers, and an accompanying list of considerations for consultants on how to incorporate less liquid assets successfully in client solutions, when appropriate. Consultants have also issued a call to action for DC investment platforms to evolve their processes and systems to support investment in less liquid assets, and will engage with platforms, as appropriate, to set out the business case for such investment.

Implementing and embedding the solutions outlined in these guides in practice will require actions from across the entire ecosystem involving employers, trustees, consultants, platforms and fund managers.

How to use these guides

The purpose of these guides is to raise awareness of the key considerations around investment in less liquid assets. These materials are not intended as a promotion of these asset classes, any specific investment propositions or their features. Each pension scheme, considering investment in these assets, should make their own assessment of whether such investment meets their members’ needs, and seek appropriate advice as needed. Any examples provided in the guides are illustrative only and not meant to set any particular standard or benchmark.

The guides are aimed at a broad audience, with a varying degree of expertise in investment in less liquid assets. Therefore, these guides cover both the first principles (which might be more helpful for those at the early stages of considering less liquid assets) and some of the more technical issues (to help assist those further forward in this journey).

There are different ways to read these guides. Each of them focuses on solutions to a specific issue, identified as a real or perceived barrier in the Working Group’s 2021 report, and could therefore be read on its own as an introduction to each of these topics. In practice, these issues are interrelated and a decision to invest in less liquid assets is an iterative process, involving three steps – making the case, designing solutions, and implementing and operationalising them. From that perspective, the value for money guide could be particularly helpful at the first of those steps, the guides on performance fees, liquidity management and fund structures at the second step, and the LTAF legal guide and due diligence at the third step.

These guides have been produced by industry for industry. Therefore, they do not constitute regulatory guidance. The regulatory environment continues to evolve. LTAF rules came into force in November 2021, and at the time of writing (September 2022), the official sector has been taking forward a series of policy initiatives. Among them are: the work on performance fees and disclose-or-explain requirements for exposures to less liquid assets by the Department for Work and Pensions (DWP); the value for money framework by the FCA, The Pensions’ Regulator (TPR) and DWP; and the FCA’s work on the appropriate distribution of LTAFs to retail clients, valuations and unit pricing for LTAFs.

We hope you find these guides useful and welcome feedback. The trade body members of the Working Group have planned a series of actions to continue raising awareness of the key considerations around investment in less liquid assets and disseminate the findings from these guides, including through teach-ins for broader industry, conferences, publications in trade media, and other channels.

¹ See Corporate Strategy Pensions Future | The Pensions Regulator
² See Oliver Wyman BBB The future of defined contribution pensions
³ See A Roadmap for Increasing Productive Finance Investment | Productive Finance Working Group September 2021

We also assisted the Group with producing model constitutional documents for the LTAF and the first of these, the version for an investment company with variable capital (ICVC) is being published alongside the LTAF legal guide. The other versions, for an authorised contractual scheme (ACS) and authorised unit trust (AUT), are currently being finalised and will be published soon.