The days of savers being left in small defined contribution schemes offering some benefits but little value are over, says David Fairs, TPR’s Executive Director of Policy, Analysis and Advice. Instead, it’s time for trustees to take advantage of available support and guidance to increase their skills in relation to investment decisions and take action to enable pension savers to access the investment opportunities that best support good outcomes — whether in their existing scheme or through consolidation.
We welcome the publication of a suite of guides by the Productive Finance Working Group (PFWG). These have been prepared to support trustees and advisers when considering the opportunities offered by illiquid investments. We applaud the work done to bring industry together, with a common aim, to try to overcome barriers and improve opportunities for trustees to invest through fund structures that may lead to better member outcomes.
This work is timely. The defined contribution (DC) market is characterised by 36 DC Master Trusts (MTs) and around 1,300 DC occupational pension schemes. Consolidation in the DC market has already created opportunities, through asset and organisational scale, for greater innovation in DC investment to be considered.
The DC universe, like the defined benefit (DB) universe, has a long tail of small schemes. However, unlike for many DB schemes, the governance budgets that many of these DC smaller schemes have access to is often very limited and constrained by ‘members pay the cost’ considerations. That often means proactivity and creativity are also constrained.
Better governance equals better outcomes
Research shows better governance leads to better outcomes. In the absence of effective scheme sponsor support — and we acknowledge some small DC schemes are well supported, particularly when linked to larger DB sections – something needs to change.
Under new regulations introduced in 2021, trustees of most DC schemes with total assets of less than £100 million must carry out a detailed Value for Members (VFM) assessment every year. This is unless they have notified us that the scheme has commenced winding up. In completing their VFM assessment, trustees must carry out a relative value assessment against three comparator schemes.
If, having completed their assessment, trustees decide their scheme is not offering value, they should seriously consider whether better member outcomes could be achieved by transferring members’ benefits to another scheme and winding up. If they decide not to wind up and transfer members’ benefits, they should make any improvements necessary to ensure the scheme does offer value and will need to explain their approach in the scheme return.
This year we expect around 1,100 DC schemes, with around 400 linked with DB arrangements, to produce a detailed VFM assessment and explain the outcome in their chair’s statement and scheme return.
This assessment process should drive significant change. However, while the detailed assessment requirements will impact many DC schemes, they will only impact around 15% of the assets invested by DC schemes and a negligible amount of the assets invested by DC MTs.
Larger schemes will, however, have to continue to assess the extent to which member-borne costs and charges represent good value for their pension scheme members. Additionally, from 1 October 2021 they are required to calculate the return on investments earned by assets in the scheme, after deduction of any charges or transaction costs, and to both record that information in their chair’s statement and publish it on a publicly accessible website. This too in time should drive change.
The proposals in DWP’s recent consultations on Broadening the investment opportunities of defined contribution pension schemes and Draft statutory guidance: Disclose and Explain asset allocation reporting and performance-based fees and the charge cap also have the potential to drive change.
Around 60% of schemes have a scheme year end date around the end of quarter one and around a further 20% at year end. Many trustees will therefore have already assessed or will be in the process of assessing the value their scheme provides to members against a much more benign investment environment than the current environment. However, this year the economic backdrop has been grim. Prior to this year, since the launch of automatic enrolment in 2012, DC MT providers have only ever known consumer price index (CPI) inflation of up to around 2.5% and for most of that period, significantly less. This year, CPI has breached 10% and investment markets have been challenging. DC scheme (investment) trusteeship just got a lot harder.
This year, trustees have already had to respond to geopolitical risks, inflation risk and market contagion risks. Recessionary risk rapidly appears to be crystallising as high inflation and the increased cost of capital take their toll. In the real world, members can be impacted in a variety of ways: increased lending rates, high inflation, real income contraction and reductions in non-contractual hours or unemployment can lead to an increase in opt-outs and early or flexible retirements. Liquidity risk, though much less an issue for DC than DB, also needs to be considered. In addition, trustees also need to consider whether the governance structure they have is best placed to deal with emerging systemic risks including climate change and wider sustainability issues.
Valuation of some illiquids can be challenging, even in benign markets, and the process can often be more of an art than a science for some illiquids. In current markets and other incidences of stressed markets, with volatile investor sentiment, transaction activity drying up, and significant uncertainty around some key valuation inputs, valuation of some illiquids may be impossible. For others, it may be little more than a conditional best guess. While many of the underlying illiquid assets may eventually come out the other side of the period of economic and market challenge and deliver the long-term value and outcome expected, the valuation of those assets along the journey can be problematic for trustees.
The true market value of an illiquid asset can only be established on sale. However, trustees will need valuations on many different dates, as members join, leave, transfer to other options within the scheme or externally, and die at different dates. In practice, trustees need to be able to settle members accounts, offer valuations and allocate fees and investment performance to member accounts. Where performance-related fees are involved the challenges for trustees increase and where the valuations of illiquids lag the market and are artificially high (from not being realistically ‘marked to market’), VFM concerns arise as members pay fees based on the artificially high value attributed to those investments.
However, the real world is complex, and trustees need practical solutions to invest in a wider range of investment opportunities, that could have the potential to lead to improved outcomes for their members over the longer term. Ultimately, these challenges should not be a barrier to investing but they should give rise to a ‘pause for thought’ for trustees when they are considering opportunities and doing due diligence. In practice, we believe that trustees who are considering investing in illiquids should:
- ensure that rigorous valuation governance processes are in place and the proposed valuation data points meet the administration requirements for their scheme
- obtain appropriate advice from their investment adviser and their legal adviser and also, potentially consult their scheme auditor
- understand the difference between the use of stale and modelled prices and in which circumstance either may be acceptable or necessary
- undertake some member movement scenario analysis to understand the practical implications in relation to valuations and attribution of fees and performance
- undertake some downside valuation scenario analysis to understand the operational issues that would arise, in stressed markets or when (fund) assets invested in are subject to, for example, an audit qualification
Trustees of DC schemes are now at a fork in the road on their DC journey. However, the direction of travel is clear: trustees need to either upskill or up sticks. The recent suite of guides published by the PFWG will be very helpful, but the days of small, subscale DC schemes offering some benefits, but not much value to members, are over.
Climate change and wider sustainability issues have the potential to generate material systemic risks, however, they also have the potential to generate tremendous opportunities for investment. The scientific evidence is clear: the transition has to happen and has to be financed. Trustees therefore need to think about whether companies and investee entities have taken this into account when making their investment decisions. Investment stewardship and engagement for pension scheme trustees are also becoming increasingly important. Trustees need to consider whether their governance structures are fit for the future investment environment, and if they are not able meet the challenge, they need to think again.
More generally, even where trustees believe their scheme offers value for members, they should consider whether their members might be better served by consolidation with larger scale providers if they believe these have the potential for better member outcomes, for example because of greater governance resourcing and access to a wider range of investment and risk management opportunities.
By David Fairs, Executive Director of Regulatory Policy, Analysis and Advice