The Productive Finance Working Group has published its recommendations to UK policymakers to remove barriers to investment by retirement savers in long-term and illiquid assets.
The Working Group was established by the Bank of England, HM Treasury, and the FCA as a result of the Government’s 2017 review of patient capital and, more recently, to help achieve the Chancellor’s ambition for the first Long Term Asset Fund (LTAF) to be launched by the end of 2021. The Working Group’s membership comprises asset managers, insurers, trade associations and other investment management stakeholders.
The report, "A roadmap for increasing productive investment", details a series of proposals for policymakers and the industry to increase long-term investment by pension savers and to ensure the success of the LTAF.
The recommendations in summary:
- Shifting the focus to generating long-term value for pension investors
The report encourages a shift in mindset for defined contribution (DC) scheme trustees, and investment consultants from a sole focus on achieving the lowest costs of investment to generating better and more sustainable returns for investors. This is important in the context of an ageing society and chronically low interest rates. Recent data from the Pensions Policy Institute shows that DC schemes’ investment in illiquid assets are small, but steadily growing, albeit mainly in listed alternative assets that are relatively liquid and less likely to generate higher returns as a result of the market determining prices.
The Working Group also acknowledges that policymakers will need to undergo the same shift. Specifically, the Department for Work and Pensions (DWP) should find ways to accommodate investment managers’ remuneration structures within the DC charge cap (which caps costs within the scheme’s default option at 75 basis points), and that the trade associations should help them by developing proposals. This is important for all types of alternative funds in which managers typically charge performance fees or carried interest to align their interests with the fund’s investors. These changes would ensure that asset classes such as private equity, private credit, infrastructure and real estate can be included in the LTAF – a benefit for DC scheme members because these asset classes have generated better returns on average than publicly listed equity and debt.
- Building scale in the DC market
The report does not entirely ignore the issue of costs. The Working Group points to the need for DC schemes to have sufficient scale to have better bargaining power on fees and to draw on the necessary skills and knowledge to make sound private market investments. The DWP has already actively promoted DC pension scheme consolidation and the Working Group encourages the continuation of this work.
- A new approach to liquidity management
DC schemes have pressing liquidity needs: the schemes receive a steady flow of contributions as salaries are paid, but also members withdraw their funds on retirement and may move between schemes. At present, DC schemes mainly invest in daily-dealing funds. Investing in the LTAF, or similarly long-term and less liquid investments, demands a different approach to managing the DC schemes’ liquidity.
The report suggests that this issue needs to be addressed at the investee fund level, where the management of the assets takes place, to give DC scheme trustees the confidence to invest in less liquid assets. The trade associations should develop guidelines on good practice for fund liquidity risk management. This would need to be done in the context of, and in a way that is consistent with, the UK authorities’ planned new regime for liquidity risk classifications (which we previously wrote about). In turn, the FCA should provide information to DC trustees about how fund managers should price units, and in particular units in the LTAF.
- Widening access to less liquid assets
Importantly, the Working Group suggests broadening the ability of certain types of retail investors to access alternative assets. Partly this means the creation of new, appropriate vehicles such as the LTAF. But the report also acknowledges that this means a change in distribution rules to facilitate DC schemes’ and financial advisers’ permissions to choose alternative investments, while still ensuring sufficient investor protection.
Specifically, the report recommends removing the 35% cap on illiquid investments for permitted links, rules that ensure insurers’ investments are appropriate for retail investors. Also, the FCA should review the application of its financial promotion rules to the LTAF once the LTAF is established. The Working Group suggests that more sophisticated, advised retail clients should be accommodated.
These changes are essential to enabling the democratisation of private asset ownership. In Macfarlanes’ response to the FCA’s consultation on the LTAF, we argued that there are few risks and some benefits to allowing wealth management clients to invest in the LTAF. We proposed a new distribution model based on a series of objective tests to determine that a retail investor is both advised and able to bear the risks of illiquid investments.
What happens next?
The Working Group’s recommendations are positive and helpful if the UK is to develop a regulatory regime that facilitates long-term investment by pension savers. The specific proposals in relation to the LTAF are, in our view, necessary to ensure that the vehicle is viable and desirable for investors, DC scheme trustees, and asset managers.
There is a lack of prescription in some of the proposals; for instance, in relation to liquidity risk management and in relation to the LTAF’s distribution rules. This poses risks, firstly, that sub-optimal rules might be created. However, the Working Group typically suggests collaboration between policymakers and the industry, and the feedback to the FCA’s consultation on the LTAF also addressed some of these issues.
The second concern is timing. The FCA is expected to publish its final rules for the LTAF in October or November 2021. The hope is that the rules address most of the outstanding issues and in a way that breaks down some of these market barriers to the LTAF’s success. However, we understand that considerations about broadening retail investors’ access to the LTAF will not happen until 2022 (not ideal, but welcome). Furthermore, clarification on liquidity risk management will be somewhat dependent on the Bank of England’s and the FCA’s work on the classification of asset liquidity.
Finally, we await HM Treasury’s work on the LTAF’s tax treatment, expected around the same time as the FCA’s rules. This latter piece could be a significant driver of decisions to invest in the LTAF versus comparable vehicles in other jurisdictions.