The investment of our workplace pensions is quite literally “front page news” as Jo Cumbo is keen to point out.

Scoop: Pension savers risk fee rises as Sunak seeks billions for ‘levelling up’ agenda. https://t.co/B4FpR0Vg5O

— Josephine Cumbo (@JosephineCumbo) October 13, 2021

And as the picture chosen to accompany Jo’s scoop suggests, it looks like tomorrow’s pensioners are going to be paying the price for a cleaner Britain – wind farms funded by their pensions.

This may be an over-simplification but the current debate over whether illiquid investment performance fees should be exempt from the pension fee cap, needs a better airing than it is currently getting. This blog digs deeper into the subject with help from Con Keating, Chris Sier and Ludovic Phallipou.

This blog is not saying that illiquids should not form a (big) part in workplace pension default strategies, it is saying they need to provide value for saver’s money.

Disquiet

Friend or foe?

There has been concern raised in the UK at the letter to the pensions industry from the Prime Minister and Chancellor , challenging it to accept a much higher allocation to private markets (and especially private equity).

Back in April, I published on this blog, a reasoned paper by Dr. Con Keating, explaining his concerns. He expressed concerns about the capacity of fund managers using illiquids to manipulate returns for marketing purposes.

There is in general a problem with the valuation of illiquid instruments. They are marked to model, not marked to market; the result of this is that their valuations will appear far less volatile than their market traded counterparts. In the case of property, it is common to see wide variation between the performance of a property company’s net asset value, a modelled value, and its market price. The net asset value (model) of Land Securities fell by 9% in the six months to March 2020 while the share price (market) declined by 35%. As volatility is the most widely used measure of risk, this allows the unscrupulous to present, and the uninformed to consider illiquid investments as being less ‘risky’ than their traded counterparts.

With such opacity in performance reporting comes opportunities for managers to take much larger fees than would be deemed acceptable from managing quoted assets.

This experience marries well with the observation here in the UK that the total costs, that is ad valorem and performance fees, associated with private equity are typically in the range of 3% – 5% p.a.

The managers of private market funds are allowed to charge their fees on a “carry basis” where the fee rolls up and are realised in a spike of costs to the scheme. In a separate article in yesterday’s FT, the development of private equity, charted by the progress of KKR is celebrated. The article concludes however that the principal attraction of “carry” to PE managers is the tax-subsidy to them, a tax-loophole that the FT suggests is no longer needed.

“Carry” is treated as a capital gain rather than income, so subject to less tax. That loophole ought now to be closed

Performance fees are not just tolerated, they are encouraged by the global tax-systems. I agree with the FT that this should change.

The Pension Charge Cap was hard won and is precious.

Speaking to Jo Cumbo, Andrew Warwick-Thompson, formerly the Pension Regulator’s DC Executive pointed out..

 “Careful thought needs to be given to any proposal which undermines the consumer protection principle that lies behind the cap.”

But the British Venture Capital Association look set on driving a coach and horses through the charge cap.

The BVCA said it backed a full exclusion of performance fees from the charge cap where it was supported by strong performance over the long term.

I worry there are some in Government, especially in number 10 and 11 Downing Street who are more concerned with the short-term benefit of a raid on pensions than on the long-term impact on DC pensioner outcomes.

Private Market fees aren’t set in stone, but they’re hard to move

Returning to Con Keating’s paper, we are asked to look at the work of the investment team of the NatWest pension scheme which has for some time been investing in illiquids. A fuller analysis of the value NatWest believe they are getting for the money they are paying for differing asset classes is available from Con Keating’s article. But it is clear from this table that fees for private equity are much higher than for other asset classes

And when these asset classes are analyzed for “value retained”, it’s clear that most of the value from alternatives has historically been retained by the fund managers and not by the pension fund

But this is changing as can be seen by this chart showing the percentage of NatWest’s pension schemes’ investment charge spend over time

Assuming that allocations to private markets are being retained, this suggests that the fees paid to the high charging managers are being reduced – albeit slowly.

Can pension funds reduce private market fees by negotiation?

I asked this question of Guy Opperman at the recent Professional Pensions pension event held at the Brewery in the City (where the Minister was speaking in person). His answer was that based on his previous experience he thought this unlikely and that Government intervention would be needed to ensure fair value to the beneficiaries of pension schemes relative to the managers of their money.

If it has taken the NatWest schemes ten years to reduce their fees as indicated, then the wait for workplace pensions could be even longer.

The Government should consider the root problem of high fees, the “carry” and question whether it should be incentivized by tax-breaks. Like the FT, I would like to see carry fees  taxed as income not as capital gain, this would reduce their use.

The Government should resist the calls of the BVCA to exclude these carry/performance fees from the cap. This proposal would drive a coach and horses through the cap.

And the Government should push for much greater disclosure of the fee models employed by private equity managers to trustees and to regulators. The risks of workplace pensions are born by members and experienced in their outcomes. This is different to schemes such as NatWest’s where the risks are born by the employer who picks up shortfalls in funding through deficit contributions.

Do we need performance fees in UK DC pensions?

I side with Con Keating in saying we do not.

There is no reason at all to associate illiquid investments with performance fees. Indeed, performance fees applied to the capital of a firm, and the returns on the instrumental claims on that, are misplaced. Such fees should be applied to and contained within the performance of the firm.

In other words, outperformance is what members pay for and should go to the member, while the costs for generating out-performance should be met from  the declared revenue of the private market manager.

We don’t need performance fees, they are being needlessly encouraged by tax systems around the world- this should stop. The Government has a change to reallocate value from private fund manager to beneficiary by sticking with a tough charge cap. Our workplace pension funds cannot be expected to negotiate value on their own, they need Government help . Workplace pensioners cannot afford current private equity fee scales.