While the nation is braced for potential tax changes in the upcoming Budget, many in the pension world are contemplating other longer term reforms to defined contribution pensions that could see savings invested in more illiquid stocks.
The Pension Review being undertaken by the chancellor and pensions minister is looking at new ways to get more money into UK listed and unlisted equities – especially ‘high growth’ businesses – and infrastructure, where capital is apparently lacking.
At the same time they hope to achieve better long-term returns for people’s DC pension pots, which many fear will not cover savers in retirement.
There are likely to be further reviews of default fund DC saving, including contributions and additional consolidation, but the urgency of investing in illiquids and UK assets has been compounded by the government’s desire to get the British economy firing again.
Many, especially professionals in the City and pension consultants, believe such a move is a no brainer, citing defined benefit pension funds and DC funds in Australia as success stories.
James Roe, UK equity capital markets co-lead at law firm A&O Shearman and an IPO specialist, is strongly in favour.
He says: “The government is struggling with a number of economic and social problems. One is people not saving enough. When people reach retirement, will they have enough money to live off? Will they be able to provide for their health needs? This depends on the amount they save and the return they get on their savings.
“Our economy is struggling; there is a real concern with growth and productivity. To support growth, you need investment. Investment requires capital, and one source of capital is people’s savings. In an ideal world, you would help match peoples’ need for investment opportunities with businesses’ need for funding.”
Others, however, are worried that we could be opening up DC pension savers to more risk, greater charges, and the possibility that it could all blow up and lose savers money.
The drive to invest DC funds into illiquids first became official just over a year ago, when then-chancellor Jeremy Hunt announced the Mansion House compact, whereby nine DC pension businesses promised to allocate 5 per cent of their default DC funds to unlisted equities.
A year on, chancellor Rachel Reeves has picked up this baton and is carrying it further, with the Pensions Review and statements suggesting DC investment should go into ‘growth companies’ (that is, those which have survived their early stages and are just about to turn a profit), and also private equity and infrastructure. Yesterday HM Treasury and DWP announced a call for evidence on a number of issues, including whether DC funds should increase investment in UK assets, both listed and unlisted, and infrastructure.
Reeves said a few weeks ago after visiting Canada: “I want British schemes to learn lessons from the Canadian model and fire up the UK economy, which would deliver better returns for savers and unlock billions of pounds of investment.”
Some of Canada’s pension schemes are among the largest institutional investors in the world and take a distinctive approach to their investments, with each scheme managed in-house and making direct investments in often illiquid asset classes like private equity or infrastructure.
The Ontario Teachers’ Pension Plan is £140bn in size and owns Bristol Airport and Birmingham Airport as well as recently buying wealth manager 7IM, while the Caisse de dépôt et placement du Québec, which manages the assets of the Québec Pension Plan, is £250bn in size and owns significant stakes in Eurostar, Heathrow Airport and platform technology provider FNZ.
This desire to emulate Canada is also the thinking behind the creation of the national wealth fund, which is allocating £7.3bn to infrastructure projects, and is assisted by the British Business Bank, which would also like DC money to go into a new growth fund it is developing.
In the private sector, new funds are being launched, most recently the Future Planet Capital co-investment fund for DC schemes.
However, mention the prospect of investing into illiquids – at this stage, mainly unlisted equities – and anyone in the retail financial space immediately thinks of Neil Woodford. As is well known, he came unstuck after taking substantial stakes in small, early stage, unlisted equities.
While some of them failed, big investors wanted to take money out when his equity income fund started to underperform and the fund was suspended because it could not meet redemptions.
Even in the accumulation stage, pension savers should still be wary of holding an investment that they can’t readily sell or whose value is unknown.
While many in the retail world baulk at any further talk of investing people’s savings into unlisted equities, the venture capital world sees Woodford-style behaviour as very much an outlier.
The view there is that he invested heavily in firms that he loved and kept piling in when there was no support from other investors; in addition he had no experience or track record in the sector, and was trying to run long-term VC investing in a fund with daily liquidity.
The proponents of investing in (theoretically more sensible) illiquids argue there would be a substantial uplift to DC pensions offered by these investments. In the UK it is currently difficult to ask people to increase their contributions, and with private sector savers now all investing in a DC scheme, pension funds are being asked to look at other countries where it is common already to invest in private markets.
Investment returns from Australian Super funds, which allocate 21 per cent to alternatives (including infrastructure and unlisted property) made investment returns of 9.2 per cent for the year to the end of June last year, and 7.4 per cent for the 10-year period, according to the Association of Superannuation Funds of Australia.
There is currently little consistent data for UK funds, but three-year annualised returns on master trusts hover around the 3 per cent to 6 per cent mark.
XPS Pensions, a pension consultancy that advises trustees, is so positive on the prospect of investing in illiquids that it wants a greater allocation than the 5 per cent suggested by Hunt last year.
Simeon Willis, chief investment officer at XPS Pensions Group, says: “The premise of the Mansion House compact [unveiled last year] was a 5 per cent allocation to a member’s pot. But if you drill down to the analysis, the 5 per cent will have a very miniscule impact. Most of the impact will come from other changes like reducing fees through consolidating schemes, or people saving at an earlier stage.
“We think 5 per cent isn’t enough to make a big difference; for any individual scheme, we think it’s more like 20 per cent allocation, which will give you an 0.5 per cent expected return; when you compound that over a time horizon, that does give some significant improvement.”
He adds that it could contribute a 14 per cent uplift to DC assets.
However, those whose business is risk are more cautious.
Jonathan Herbst, global head of financial services at law firm Norton Rose Fulbright, says: “If you’re going to invest in smaller companies, you are increasing the risk [profile], which is why we’ve see concerns from the Financial Conduct Authority. They are worried about [everyone saying], ‘This is all going to be OK’, until it’s not going to work.”
This is articulated also by Harvey Knight, UK head of financial services at law firm Withers. “It’s a classic widows and orphans; most people don’t understand how to take risk and they take the view that it’s regulated and the only way is up, while even the most conservative strategy assumes the markets go up and down.
“The FCA are naturally going to be super cautious, they think in terms of primary regulatory objectives. The last thing they want is Mrs Widow writing to them saying, ‘This product has gone south, what are you going to do about it?'”
Nike Trost, head of asset management and pensions policy at the FCA, says: “We see the debate about investing in private assets and investing in the UK through the lens of how people ensure good returns are generated for consumers because in the DC space consumers are really dependent on the default investment proposition delivering good returns. It’s well known most consumers are in auto-enrolment default schemes.
“All investments involve risk, and the risk in different asset classes differs. This is why it matters that firms have the right governance in place to oversee different types of investments.
“Every firm or trustee will have to decide what’s right in terms of the asset mix and also what’s right in terms of what they are able to oversee. Some types of investment will require more active oversight and governance.”
Members have flexibility that they don’t use and don’t need, you might as well put that flexibility to good use.
A big aspect of concern with private markets is the private nature of the assets themselves. The fear is that investors do not know the details of what they are investing in, and would not necessarily have a chance to challenge the management of the company directly, depending on which kind of investment route they take.
This can either be via an long-term asset fund (LTAF) – an open-ended vehicle that invests in private markets on behalf of DC funds, offering more liquidity than investing direct; a private market fund such as a private equity fund; or co-investing directly into a private market asset, which requires an in-house investment team.
However, anyone involved in deals in the private market space insists that they do their due diligence, and they know what their client’s money is invested in.
Herbst at Norton Rose Fulbright says: “You have to disclose what you are required to disclose. Disclosure for private equity buyers is just as great as in a public deal. The difference is that it’s private.
“On a large transaction there will be an investment bank who will produce a detailed investment analysis, and put an auction up and approach three or four houses.
“In any large transaction, there will be an investment bank on the other side who will produce a thorough due diligence analysis, and then you will have interviews with management and that will feed into the due diligence.”
David Ramm, partner in the corporate group at law firm Crowell & Moring, who has worked on both IPOs and private deals for small tech firms, says: “VC and private equity lawyers have a good history of knowing where to look and find the problems.
“We will send a full due diligence questionnaire and we expect a company to supply the data on that. It’s got pretty much everything on it. We will go through it with a fine-tooth comb. You can try to hide things but most good lawyers can spot it.”
Douglas Hansen-Luke, founder and executive chairman of Future Planet Capital, which manages $500mn (£380mn), has a specific process when it comes to the early stage investments.
“We look at whether or not it’s impactful,” he says. “Our default impact categories are climate change, education, health, society and sustainable growth – they need to meet a global challenge. If you can solve a global challenge you’ve fixed a high-cost problem and are creating true value.
“Sequioa Capital is one of the most successful venture companies – they look for people; they look for market; and they look for technology. Of these three things, they look for market first. If the market is big enough, somebody will find the right product and people and to us at Future Planet, global challenges are synonymous with markets.
“For us the market and the change you’re going to make is far bigger than anything else; the next two are technology and people.”
Another big area of contention is the issue of charges. The private equity and VC world follows the model of 2 per cent management fee and a 20 per cent performance fee after a certain hurdle.
This latter has been allowed to fall outside the 75 bps default charge cap by Hunt in the last government, but the 2 per cent will still have an impact in the fund’s charges, even if it is just a 5 per cent allocation.
Willis of XPS Pensions says: “The sort of increase is from 15bps up by 40 bps, based on 20 per cent allocation with a 2 per cent fee.” He is quite relaxed about this, and adds that the whole market needs a “mindset shift” away from lower costs to a more expensive portfolio that will deliver a better return.
Flexibility issues
The other area is liquidity. DB pensions, mainly in the public sphere, are able to invest in illiquids because savers leave their savings alone and look forward to the pension promised to them. In the DC space, the burden for performance is on the saver and they have more control over which fund they are invested in, and can move funds if they wish.
However, most people do not tend to bother, either through inertia or through lack of advice (or both), staying in the default fund, and the pension industry would like to take advantage of that aversion and use it to invest in longer-term assets.
XPS would like to see changes to the rules that allow savers to move funds frequently. “The larger trusts have the scope to invest a bit in closed funds [that is, private equity funds] but not at large scale because it causes a problem with the running of their portfolio.
“Members have flexibility that they don’t use and don’t need, you might as well put that flexibility to good use.”
The frequent issue cited around flexibility, is that savers have the ability to move regularly to a different fund if they so wish, such as an ESG or Sharia fund, but very few use that capability, and this according to the pension sector is holding illiquid investing back.
If we’re going to put 10 per cent of our assets into private markets in the UK, we’ve got to satisfy [ourselves] it’s the right thing to do.
James Batchelor, a chartered financial planner at Progeny, says it may not be that straightforward: “This degree of flexibility is particularly important when dealing with DC pension funds in decumulation, where access to capital is vital for funding ongoing income.
“If an asset cannot be realised punctually, it can at best represent a source of anxiety for the investor, and at worst can risk an actual loss.
“Even in the accumulation stage of pension saving, where investors may not have to sell assets to generate income for many years, pension savers should still be wary of holding an investment that they can’t readily sell or whose value is unknown because the fund manager can’t put a definite price on the assets.”
Tom McPhail, public affairs director of the Lang Cat, says perhaps there could be a compromise found: “There’s a balance to be struck there. The problem is that most people don’t exercise a right to transfer, but when they do they’ve got be able to take that decision.
“Should the government allow pensions to have some kind of exemption, with a private market transfer given a six month window on those assets?”
So, for example, a person could move 95 per cent of their money straightaway but the remaining 5 per cent invested in private markets they would have to wait a while.
Fundamentally, private markets are seen as the next big area of investment and there is a huge shift away from public markets.
Mark Woolhouse chief executive of Treble Peak, says: “There’s much more DC money now. If you look at all of the sources of capital in the world it’s the biggest pot and it’s one of the smallest allocations [to private markets]. If [private equity] can get access to the biggest pot of institutional, they can increase their percentage.”
Crowell & Moring’s Ramm says from the investors’ perspective, there is simply less opportunity. “IPOs are too expensive and too time consuming and there’s too much burden on the management, even if you’re looking at Aim. That’s an issue that needs to be addressed because IPOs should be able to raise this capital.
“There’s a demand not just from the pension funds who are under pressure and would prefer to invest on the stock exchange; there’s also retail investor demand who would like to invest in some of these more exciting companies that are primarily invested in by venture capital and private equity.”
Ultimately, according to McPhail, the country needs the money to grow its fledgeling businesses. “I do have some sympathy with the government, but that’s not what trustees are paid to care about. They have to take an objective view of the risk tolerance of their scheme, on behalf of their members
“There’s a reason pension schemes don’t invest in the UK, but instead are invested outside the UK, because that’s the way to get risk-adjusted returns. Now if we’re going to put 10 per cent of our assets into private markets in the UK, we’ve got to satisfy [ourselves] it’s the right thing to do.”
One way of making life a bit more comfortable for trustees would be to create tax incentives for pension funds to invest in UK private assets.
McPhail says: “They could say, ‘We will make some of your tax breaks conditional on investing in a particular sector’, because that way the pension schemes could rationalise it to their members.”
Another way would be to reinstate the dividend tax credit on UK equities, which theoretically would not have much Treasury impact, given investment in UK business is so limited.
Either way, there is enormous pressure on pension funds to make the shift. The question is, can it be managed safely?
Melanie Tringham is features editor of FTAdviser