Is it value for money or money for nothing? In a bid to tap into the investment potential of U.K. pensions, the Treasury and regulators are embarking on a major shift in the concept of value – from near-term cost and performance to long term growth. It is just the latest government policy that will have a profound effect for the billions invested in default pension funds. Has the notion of Value for Money been distorted by Rachel Reeves’ big picture strategy of productive finance? In this, his latest blog for IFA Magazine – a particularly deep dive into this very topical debate – JB Beckett explores the potential dire straits and poses ‘what exactly is long-term value?
Governments do love to tinker with pensions, typically Labour have intervened; Tories have sought to liberalise.
Both have meddled and not always for the better and there is always one eye on the tax pot. Recall that the Tories introduced the Pensions Act 1995 triggering mass DB scheme transfers into DC; (and later millions of mis-selling claims). Labour then reversed much of it with the Pensions Act 2004 that also introduced The Pension Regulator (TPR).
In 1997 Labour’s Gordon Brown reportedly raised £5bn a year from U.K. pension funds owning U.K. stocks by removing tax credits that put into motion a two-decade pension divestment from U.K. equities.
In 2013 the Tory-LibDem coalition introduced auto-enrolment increasing minimum contributions into DC schemes and later the Tories introduced ‘pension freedoms’ in 2015 making drawdown accessible sooner, to name but a few.
Pension legislation has been a ‘yo-yo’ for the Left and for the Right. Governments seem to either succumb to short-term policies to win the next election or ambition to radically change the country over the next 100 years. The value of either is… complicated.
The latest political swing?
Widely anticipated, the recent Rachel Reeves’ Mansion House address proposed a radical growth agenda for the U.K., one that will centralise and mobilise pension pots to deliver infrastructure finance, green transition and greater domestic U.K. investment.
There was more than a whiff of the Johnson-Sunak era deregulation agenda belying this, Reeves stating “The U.K. has been regulating for risk, but not regulating for growth.”
With memories of the GFC fading, the lessons learned around systemic risk have abated. Together with the IHT pension bomb, it is fair to say that the industry reaction to these plans has been, err, mixed! Advisers too will feel rightly nervous what it all means for their clients.
This strategy also marks a continuing change in the trajectory for the Value For Money (VFM) regime for workplace pensions. One we have seen creeping over the last couple of years. Recall that back in 2013 it was the Office of Fair Trading (OFT) that conducted a market study and identified competition problems in the market. This was the catalyst. 2015 first saw the introduction of a cost cap for default pension funds of 0.75% per annum. To which we also have had; the FCA 2018 Asset Management Market Study (AMMS), subsequent Competition Markets Authority (CMA) investigation into Investment Consultant market and the original guidance that created ‘VFM’, Independent Governance Committees (IGC) from 2015 and Master Trusts from 2017. Smaller pensions were permitted to operate Governance Advisory Arrangements (GAA) outsourcing to third parties as an alternative to IGCs. In 2019 workplace providers were required to offer Investment Pathways for non advised members (PS19/21) and in 2020 this remit was also added to the existing governance frameworks. At the same time Environmental Social Governance (ESG) oversight criteria was also added. The FCA then conducted an IGC effectiveness review in 2020 (TR20/1). Following which decumualtion outcomes were also added to IGC remits to more align with Master Trusts (PS19/30). In conjunction they created a complex but definable overarching formula of value for money, one of; reducing costs, improving service levels and assessing investment outcomes commensurate to cost, drawdown and ESG.
Deregulating Value
Behind the VFM regime there were larger changes afoot. The then Chancellor, Rishi Sunak, published the Future Regulatory Framework (FRF) in 2021 to commence what was, in effect, a deregulatory agenda post Brexit. This introduced “competition” as a key objective for regulators. It kicked off a shift in VFM through the Department of Work and Pensions (DWP) and The Pension Regulator (TPR) resulting in a policy response by the FCA. With it, we have seen a shift away from that original formula for VFM. For example, we saw new rules that relaxed the default fund use of Long Term Asset Funds (PS23/7) by allowing increased exposure and by exempting LTAF performance fees from the default fund cost cap (PS21/14).
In 2021, the TPR-FCA jointly published a VFM discussion paper and further issued FS22/2 in which they stated “an excessive focus on cost may result in other key elements of value not being given appropriate consideration, which is why we want to encourage a shift to long-term value for pension savers”. FS23/3 set out to review the VFM framework. The heart of the latest FCA consultation (CP24/16) outlines a new VFM regime outlining to “drive better value for money across the workplace DC market through greater scrutiny and competition on long-term value rather than predominantly cost”. This shift to a longer-term narrative in turn facilitates a more flexible approach to asset allocation and much greater latitude towards cost, and risk, opening up the opportunity set of investable assets.
The Value of Big?
Meanwhile; echoing Reeves’ plans to pool local government schemes together, there is now a clear drive to concentrate Defined Contribution assets into fewer default funds than the myriad that exist today. This will purportedly be done without member consent in order to expedite and negate certain fiduciary constraints. We know that many members default into their chosen fund with limited or no advice. Member engagement levels in workplace remains stubbornly low and there is a large reliance on advisers into drawdown. When you add up perennially poor member engagement, defaulted investment choices and now non-consented scheme restructuring and significant allocation changes then it may leave IGCs, GAAs and Master Trust boards feeling some level of discomfort, given trustee responsibilities and consumer duty, and I can hear the legal challenges brewing.
Why consolidate? Fewer larger pensions are arguably easier to regulate, govern and steer allocation policy than a myriad of smaller schemes. There is a large universe of default funds out there and I have seen first-hand that the quality of those portfolios and competences can and do range widely. There may be economies of scale to pooling more schemes together into vast default funds, the government asserting funds make more “productive investments” once they have reach £20-50bn in size.
Certainly, size matters when bidding for lot sizes, larger properties and illiquid projects. The assertion that these assets will outstrip liquid assets is more challenging, certainly if we only relied on long-term actuarial models. Irrespective, the notion that such a concentration of supertanker “megafunds” will also boost value, competition and growth is vexing to many. This is the opposite to the trend we have seen in asset management more laterally.
What is more assured is that you end up with a smaller spectrum of outcomes be they good or bad. You also increase systemic risk from that concentration, such as when more pension schemes bid for and become invested in the same infrastructure projects. Of course, that can be beneficial too if those investors prove stable and hold for the long-term. For example, we have already read the announced investment into the new British Growth Partnership by NatWest-Cushon and Aegon and we can expect many more to join it, as well as increased investment into LTAFs more widely.
This strategy then is laudable stuff but it also pools the outcome of these allocations across more pension members. There are known risks that arise such as liquidity and financial risk. Allocators will also need to balance these illiquid investments against the remaining portfolio and make it work in accumulation and possibly even into drawdown.
Consolidation of smaller defaults plausibly provides megafunds with cash flow to make new investments without need to divest existing assets. In principle, long-term assets like infrastructure should work for long term portfolios and capture a liquidity premium that is appealing, one away from the daily noise of public markets. Either way there is a trade-off that the Treasury clearly sees as justifiable.
Exactly what is “long-term value”?
To the Treasury, ‘long-term’ probably equates to a 25 year and beyond strategy to invest in U.K. infrastructure. To a young accumulation investor, long-term typically means buying riskier assets today and cost-averaging and compounding that growth over 25-30 years through their working lives. To an older member in drawdown, it may mean drawing income sustainably against a portfolio that minimises sequencing risk for 10, 20 even 30 years through retirement. Previously, before the budget tax changes, ‘long-term’ may have even conjured up inheritance and multi-generational wealth. The point being that ‘long-term’ may mean something quite different depending on your perspective.
Thus, any allocation of a portfolio over the ‘long-term’ is neither consistent scheme to scheme or member to member. This has always been the challenge for pooling members into default funds over bespoke portfolios. It is for this reason that workplace providers offer life-styling and glide-paths to try and make that journey more consistent over time. However; like default growth portfolios, these glide-paths differ from provider to provider both in terms of; asset allocation, how quickly they begin to rebalance ahead of the selected retirement age and how rapidly they rebalance.
The traditional perceived value of ‘life-styling’ has always been one of reducing volatility and increasing liquidity. To incrementally change an allocation over time (usually monthly) from one set of assets to another, against the ongoing contributions of the member. The value of this is derived from minimising the uncertainty of the end value at drawdown. There have been arguments that life-styling de-risks a member too early and the effectiveness of life-styling more generally is moot across the industry.
This is before any reallocation of private assets or infrastructure set out in Reeves’ maple syrup blueprint. The issue is the lumpy nature that illiquid projects and private assets return capital to the pension. This can create an inconsistent return for members invested today, and entering drawdown in say 5 years, compared to those who may not enter drawdown for another 10 or 20 years. These liquidity issues can be far greater and opaque than we have seen in commercial property, which is a far larger mature market than the developmental aspect of infrastructure projects. Experience in managing infrastructure and property funds effectively will certainly help the default. I have also read some exuberant projections for return of capital from infrastructure and the headlines often overlook the maturity of that cash flow and rely on some capricious assumptions given the long maturity of these projects.
Meanwhile public markets generate volatility leading to what we know as ‘sequencing risk’ for drawdown clients. Illiquid assets have low quoted volatility in their reported valuation but illiquid assets rarely return capital on day 1, or even day 100, it can take years and so they can prove a drag on overall portfolio returns in the short to medium term with no liquidity to offer against sequencing risk. Thus, even if your client’s valuation statement appears stable you have to look through to see how much of the portfolio is realisable as sustainable income. Illiquid assets will prevent simple vertical slicing for drawdown income and instead assets will need to be tranched. This has a bearing on sizing and rebalancing allocations into and around LTAFs and illiquids.
Providers will need to work hard to model drawdown rates including for impact of Tax Free Cash (TFC) and ad hoc income. Many have observed that ad hoc income rates increased as inflation rose and this, with higher market volatility, led to poorer income sustainability. Ah hoc income continues even if inflation has slowed. Additionally many non-advised Pathways members are also mapped back to default funds pointing to an advice gap for the proposed changes.
Questions for VFM?
The Reeves plan will be disruptive in the workplace market both structurally and competitively. If the proposed consolidation of defaults occurs then it could lead to the largest single cash and churn of workplace assets, since the 1990s, assuming it does not lead to the single largest in-specie transfer migration. Scheme transfers create cost and exactly who picks up that unknown cost is not clear but it will not be the Government.
It may also give rise to new innovation in default funds and I can see some merits to the use of Collective Defined Contribution (CDC) to enable more efficient risk transfer of illiquid assets between scheme members than afforded by typical glide-paths. We may also see a return of quasi With Profits funds to apply ‘smoothing’ buffers, third party risk sharing, new annuity products, revamped target date funds or even the use of asset-liability investing techniques keen to pay penance for their disastrous 2022!
There is a positive side to these significant changes for they may indeed deliver a positive benefit for the long term U.K. economy, infrastructure and return long-term value to pension members. The challenge ahead will be implementation in a way that does not impact the riskiness of portfolios across the member populous; or erode value, even if Reeves herself has overtly signalled that she is less interested in risk than she is in growth. Consequently, there may be unintended consequences ahead from consolidation and crowding in allocation that we have not seen since the days of the 60:40, CAPS or Lipper median surveys. Competition between workplace providers will also drive a race to invest in the new Reeves utopia and something committees and boards will need to be vigilant of.
Questions. How can we assess the cost and value of DC consolidation? Are IGCs, Master Trusts or GAA’s best placed to govern value? Given the relaxed LTAF limits what is the right level of infrastructure exposure? How should illiquids be managed into drawdown? What are acceptable costs for default funds? How do we present and manage for risk? What is the new VFM formula for members?
Dire straits for Value?
Whatever the answers we can assume cost is being assimilated into long term value, and assumptions of risk have been upended to accommodate new assets. Even the way portfolio risk (itself a component of value) is managed and reported may have to change. For an advised workplace sector so dogmatically obsessed with volatility bandings, and benchmark performance, then some adaptation and adviser support is needed.
Pensions have become politicised rightly or wrongly. Rachel’s Reeves’ “Megafunds” aspire to emulate pseudo Superannuation and sovereign funds to invest at a national level. A sense of public purse and greater good now pervade your clients’ pensions. There may be long-term value too for members from this upheaval. Either way, we now have a combination of deregulation initiated by the last government combined with the interventions of the new one. With it the very inputs to the VFM regime will change.
Yet, to deliver value over the long-term is not a default outcome. It will still require good governance today to deliver value for your clients tomorrow. Along with my fellow cohort of independents I will do my best for members as workplace makes that transition.
About JB Beckett
Across 30 years, JB Beckett has delved through the contentious and taboo of our industry, speaking around the world. In 2015 JB wrote “New Fund Order” and “NFO 2.0” in 2016 and co-wrote a number of books on digitalisation of asset management. Since 2020 JB has hosted the New Fund Order podcast – NewFundOrder.Buzzsprout.com. A multi-asset allocator for over 20 years, until 2018 JB was a fund gatekeeper at Lloyds and Scottish Widows. Today, JB is a member of Royal London’s Investment Advisory Committee and remains Emeritus of the Association of Professional Fund Investors and external specialist for the CISI.
