That the Grand Committee do consider the Occupational Pension Schemes (Administration, Investment, Charges and Governance) and Pensions Dashboards (Amendment) Regulations 2023.
Relevant document: 30th Report by the Secondary Legislation Scrutiny Committee. Special attention drawn to the instrument.
My Lords, these draft regulations were laid before the House on 30 January. Good investments are central to well-run pension schemes and decisions made by the trustees of those schemes have a significant impact on growing savers’ pension pots. Subject to approval, these regulations will help occupational defined contribution pension schemes—the so-called DC schemes—make greater use of performance-based fees, which are payable to investment fund managers when they deliver healthy returns on their investments. This will put DC schemes on an even playing field with other institutional investors such as insurers, investment companies, defined benefit pension schemes and overseas investors when it comes to accessing the same range of investment choices that come with fees.
The regulations also place new duties on the trustees of most DC schemes to disclose additional information about their investments. They are designed to ensure that trustees reflect on the investment decisions they make, as part of their ongoing fiduciary duty to create a diversified investment strategy that delivers for savers. These regulations continue the Government’s commitment to ensure that millions of hard-working savers in occupational DC pension schemes are receiving the best possible value. I am satisfied that these regulations are compatible with the European Convention on Human Rights.
Let me take a step back and put this in a bit of context. Over the past decade, there has been a significant increase in the use of illiquid asset classes such as infrastructure, real estate and private equity within institutional investment portfolios globally. Meanwhile, DC schemes in the UK have relied on public markets to generate returns and diversify portfolio risk. Pension scheme trustees’ primary focus must always be on delivering an appropriate return to members. But by investing almost wholly in liquid investments such as publicly listed equity and debt, pension savers can miss out on the potential to achieve better returns from being invested for the long term. This is a particular concern in DC schemes, where decisions which reduce long-term returns will affect member incomes in retirement.
My Lords, as the Minister has said, this statutory instrument contains seven regulations. The first is to do with timings and commencement. We have no comment on this, except to ask why there will be a delay of 21 days in bringing the correcting dashboard regulation into effect.
Regulation 2 excludes specified performance-based fees from the charge cap, and the Explanatory Memorandum sets out the rationale. In paragraph 10.5, the Explanatory Memorandum speaks of
“sufficient safeguards for schemes and members to protect them from excessive charges”
consequent upon this regulation. This is clearly a critical area. The possibility of excessive charges is an obvious concern and was highlighted in the recent SLSC report on this instrument. Can the Minister set out what these safeguards are and on what basis and by whom they were judged to be satisfactory?
Regulation 3 will require schemes to include an explanation of their policy about investing in illiquid assets in their default statement of investment principles, as the Minister said. The taxonomy of asset classes is explained in detail in paragraph 25 of the statutory guidance and is given in Regulation 4(5). This has eight categories and does not attempt to define “illiquid”. In fact, I could find nothing in the instrument and its accompanying documents that approaches a definition. Of course, it may be that I have overlooked it somewhere; I would be grateful if the Minister could guide me on the matter, point to a definition and perhaps explain how it was arrived it and by whom. The chief purpose of this instrument is to remove barriers to investments in illiquid assets, and it would be rather odd if there were no criteria for assessing whether an asset was to be counted as illiquid.
Regulation 4 also requires trustees or managers to report on specified performance-based fees incurred by the scheme.
My Lords, I hold pension trustee positions, and refer to my interests as set out in the register.
These pension scheme regulations are being introduced for two reasons. First, the Government believe that they will facilitate greater investment by pension schemes into private markets, securing better returns for savers. Secondly, the Government want to increase DC pension fund investments in UK start-ups, infrastructure, green investment and illiquid asset classes in private markets.
Of course, this is to be welcomed if beneficial alignment is achieved between the best interests of the ordinary citizen and their pension pot, and investments that benefit the UK economy to achieve the win-win. However, there are barriers to be addressed in getting there. The problem with these regulations is that the exclusion of performance fees from the DC charge cap will not be the driver of significant changes of investment in illiquid asset classes, but consumer protections will be weakened where money is invested without the security of that cap. The charge cap was introduced to protect millions of people investing through inertia under auto-enrolment. To achieve the diversification of investments which would benefit the UK economy, the complexities of other barriers to investment in private markets need to be addressed. Overreliance on removing consumer protections from pension savers will not do it.
I will reflect on some of those complexities. The pension regulatory environment, which is in perpetual change, is driven by endless policy initiatives without certainty as to the Government’s underpinning strategy. Recent regulation enabled performance fees to be smoothed over a five-year period, but before even testing the efficacy of those changes the Government proposed reversing them in favour of these. Trustees need greater consistency when considering long-term investment decisions—consistency between not only one Government and the next but one Minister and the next. Also, the complexity of regulation means that government contradicts itself. For example, the Government asked the Productive Finance Working Group to make recommendations on increasing private market investments, while TPR was consulting on prohibiting the schemes from holding more than 20% of assets in unregulated investments.
My Lords, I thank the Minister for introducing these regulations and those noble Lords who have spoken. As we have heard, these regulations cover two distinct issues—one minor and the other rather less so. I will do the minor one first; it is a change to correct a drafting error in the Pensions Dashboards Regulations 2022, amending the line in Part 1 of Schedule 2 that specifies which master trusts are required to connect to the pension dashboard by 30 September this year. I do not want to kick a project when it is down, but, to me, that is not the most pressing problem attached to the Pensions Dashboards Regulations 2022. In fact, the Minister recently announced that the entire timetable, which is hard-wired into these regulations, is being scrapped, so the regulations will presumably need to be either repealed or amended. Could the Minister tell us whether the intention is to repeal them or if they are simply going to be amended and when we will know more about that?
On the major provisions in the regulations, the objective behind them is clearly to push pension schemes into investing more of their members’ money in illiquid assets. As we have heard, they will use two basic levers to do that. First, they will require all pension schemes with more than 100 members to explain their policy on illiquid assets and to disclose their schemes’ investments in them; and, secondly, they will exclude specified performance-based fees from the list of charges that fall within the 0.75% regulatory charge cap.
Just to be clear, these Benches would like to see greater investment in ways that will help the transition to net zero and in infrastructure projects that support economic growth, but we have heard today some important questions about the detail of these regulations, and I hope the Minister has some answers ready. First, the question of risk was raised. The noble Lord, Lord Sharkey, is right: I could not find a definition of illiquid assets either, but they clearly cover a wide range of investments. They are not just buildings or infrastructure but, as the Secondary Legislation Scrutiny Committee pointed out, could include art or intellectual property. Some illiquids clearly carry significant risk. This legislation also targets venture capital investments, which often have a high failure rate.
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The Minister mentioned that some two-thirds of defined contribution occupational pension schemes have no direct investment in illiquid assets in their default funds and that meeting the cap on charges is a significant barrier to such investment. I am with my noble friend Lady Drake: I would like to see some hard evidence that the charge cap is the primary barrier to such investments. Can the Minister say how many of those two-thirds were small schemes? If they are small schemes, is not this issue more likely to be addressed by consolidation than by addressing the charge cap?
The noble Lord, Lord Sharkey, said that he would like to see the impact of the charge cap, but the Government are pursuing consolidation for small schemes. If they end up consolidating into much larger schemes, how will the Government know that they can separate out the impact of that from, for example, the impact of any changes to the charge cap? As my noble friend Lady Drake pointed out, some large DC schemes are already holding illiquid investments within the existing charge cap, some without paying performance fees; they are basically leveraging scale to avoid putting higher costs on to savers. It really matters that the Government can provide the evidence that the removal of some consumer protections is necessary to persuade others to go where some schemes have already gone within the existing charge cap arrangement.
I also have some questions about how the Government will ensure value for money for savers when performance fees are outside the cap. I would be interested to hear the Minister’s response to my noble friend Lady Drake on this issue, as well as on her question about how higher costs can be fairly distributed across members in different circumstances, including those who are close to retirement or those who leave a scheme; that was a really interesting question, I thought.
Regulation 2 clarifies what counts as “specified performance-based fees”, which would be excluded from the cap. I gather that they are, roughly, fees or profit-sharing arrangements that one pays only if investment performance exceeds a certain rate or the value of the managed investments is above a certain amount. However, as the noble Lord, Lord Sharkey, said, the regulations do not prescribe either the rate or the amount—or, indeed, any cap at all. The statutory guidance simply says that it
“is for the trustees or managers of the scheme… and the fund manager to agree based on the nature of the investment proposed.”
When the SLSC raised this matter, it was quite clear that this is an issue. DWP came back on that and said that, if people are investing
“without the full security of the charge cap, trustees and managers are … advised to seek professional advice on, for example, what is an appropriate hurdle rate”.
The department also said that they should consider using
“a high-water mark or a fee cap”.
However, that is only advice. Can the Minister tell the Committee whether he is confident that this will not erode the protection for savers that was provided by the introduction of the charge cap in the first place? If he is confident that trustees can be relied on to make judgments of this complexity now, why was the charge cap needed in the first place? If they cannot be relied on, why is it safe to exclude these fees from the cap? I look forward to the Minister’s reply.
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Currently, less than 10% of UK DC investments are estimated to be in illiquid assets. The Pension Charges Survey 2020 evidenced that two-thirds of DC schemes had no direct investment in illiquid assets within their default fund arrangements. This is at a time when the UK DC market is growing in scale and in ambition. DC pension schemes currently hold over £500 billion of assets, a figure that is set to double to £1 trillion by 2030. The Australian DC market, in comparison, invests somewhere in the region of 20% of assets, on average. This includes investment in major UK assets such as the King’s Cross redevelopment project and Manchester, Stansted and East Midlands airports.
The DWP has run several consultations to understand the reasons why DC schemes have largely avoided investing in private markets. The feedback received highlighted concerns that performance fees, typically associated with illiquid assets and levied by fund managers, would put schemes at risk of breaching the existing 75 basis-point regulatory charge cap. While the charge cap has successfully reduced costs, it has arguably led to more focus on costs than on the returns that different asset classes can provide. In January, the Minister for Pensions launched a consultation on proposals for a value-for-money framework, which aims to address this. These regulations continue that value-for-money theme. The essence of what we are trying to do here is to make it easier for DC schemes to access a broader range of investment opportunities that could generate higher return outcomes.
I will now say a bit more about the issues highlighted during the consultation. We listened carefully to earlier concerns raised during the consultation that this change to the cap could weaken existing saver protections, and we have acted on this feedback. Regulation 2 of this instrument sets out the criteria that “specified performance-based fees” must meet to be considered outside the charge cap. These include a requirement that fees must be paid only once returns to the scheme have exceeded a pre-agreed rate or amount agreed by trustees and the fund manager prior to investment.
The criteria include additional safeguards that trustees must also agree in advance, and that performance-based fee structures include mechanisms to guard against excessive risk-taking or fund managers being paid repeatedly for the same level of performance. The regulations provide for the use of high-water marks and fee caps, for instance, which are commonly applied in the investment market to give investors this extra level of protection.
The regulations are purposefully silent on what rate of returns or type of fee structure mechanisms must be applied. This is to allow trustees and fund managers to develop and negotiate terms that are in the best interests of savers. Provided that trustees and their advisers apply these terms, such performance fees will not erode retirement pots because they should arise only when savers have received a favourable return on their investments.
The DWP received positive responses to this change, particularly from larger DC pension schemes which said that the ability to remove these fees from their charge cap calculations will make it easier for them to consider new asset classes. The DWP has published statutory guidance to assist trustees with determining the criteria for performance-based fees that can be considered outside the charge cap. The guidance is very clear that trustees should seek professional advice on their investments where performance-based fees are prevalent.
To ensure transparency to members, performance-based fees incurred are required to be disclosed, and the value to members assessed, in the scheme’s annual chair’s statement. To be clear, these changes place no obligation on schemes to agree to investments that come with performance-based fee arrangements if this is not in their members’ best interest.
With any investment there is no guarantee of higher returns. In accordance with existing legal requirements, trustees must invest in a manner calculated to ensure security, liquidity and profitability, and have regard to the need to diversify investments. This provides that trustees are guided on assessing the risk of portfolios and, with this, managing the risk of lower as well as higher returns.
Regulation 3 of this instrument sets out new duties on DC trustees to include an explanation of their policy on investing in illiquid assets in their statement of investment principles. These explanatory statements, covered in the regulations, include whether investments in illiquid assets are held, the types of illiquid assets and why this policy is of advantage to members. Where investments will not include illiquid assets, trustees are expected to give reasons why, along with whether they have plans to invest in the future.
While some of our bigger DC schemes already provide this information, this is not the approach taken by all. Some master trust schemes also disclose information on the asset classes in which the scheme holds investments, but this is not commonplace and most members are not in receipt of this information. The regulations address this by placing a duty on trustees to disclose the percentage of different classes of assets held in the scheme’s default funds. Asset classes covering liquid and illiquid are prescribed in the regulations.
Greater understanding and accountability of the investment decisions made by trustees on behalf of their members will be key to improving value for members across all schemes. The industry’s response to these new duties was that the regulatory burden is reasonable and proportionate while still retaining the wider benefits these changes will bring. It is worth noting that asset allocation disclosure is already mandatory for Australian pension schemes.
The DWP will work with the Pensions Regulator to ensure that trustees are supported with the new duties. Information contained in chairs’ statements and statements of investment principles are monitored by the Pensions Regulator as part of its wider strategy on regulatory compliance.
We will also look closely to monitor the impact of our changes on investment performance. In addition, Regulation 7 of these regulations requires that a review of these regulatory provisions must be undertaken and published within five years of the regulations coming into force.
These regulations also correct a drafting error at cohort 1(b) of the staging profile in Part 1 of Schedule 2 to the Pensions Dashboards Regulations 2022. The error relates to the staging deadline for master trust schemes that provide money-purchase benefits only. While we are not aware of any schemes being affected by this minor error, it is none the less appropriate to amend the Pensions Dashboards Regulations 2022 to resolve this issue as soon as practically possible. With that, I commend this instrument to the Committee and beg to move.
Regulation 5 requires such disclosures to be made public. This all seems very sensible, but nowhere is there any sense of an upper bound on these specified performance-based fees. In its report, the SLSC made this point.
Since the EM was produced, the DWP has published extensive statutory guidance—22 pages—which states that the rate or amount of these fees is for the trustees and managers of the scheme with support from their advisers and their fund manager to agree based on the nature of the investment proposed. At first reading, this seems a bit like an invitation to a fleecing. The Government were happy to install the charge cap in the first place. What consideration was given to capping these special performance-based fees? Paragraph 76 of the statutory guidance, “Volatility of returns and performance based fees”, states:
“The 2023 Regulations require that specified performance-based fees structures must include mechanisms that offer protections to pension schemes and their members. This is so fund managers are not taking excessive risk or being paid twice for the same level of performance or for performance which turns out to be impermanent.”
I cannot see where that is spelled out in the instrument as a must, and I would be grateful for the Minister’s help in clarifying the matter.
Regulation 6 corrects an error in the pensions dashboard, and we have no comment on that.
Regulation 7 provides for a review of the impact of Regulations 2 to 5 every five years, which seems sensible. We are particularly interested in seeing whether the modification of the charge gap and the disclosure requirements lead to an increase in investment in illiquid assets. The SLSC made this point in its formal recommendation to the House:
“As the fee changes made by these Regulations aim to encourage pension schemes to increase their investment in illiquid assets, the House may wish to ask the Minister how schemes’ subsequent exposure to an increased risk of lower, as well as higher, returns is to be monitored and how trustees are to be properly guided on assessing the risks to the portfolio.”
Those are very good questions, and I would grateful if the Minister could address them.
There is also the need to strengthen confidence in government economic policy and governance, a sentiment captured by the noble Baroness, Lady Lane-Fox of Soho, president of the British Chambers of Commerce, in the FT yesterday, where she warned policymakers that
“businesses are holding off making big investment decisions given the UK’s recent political and economic upheaval”
and that,
“People just don’t feel like taking risks”
in the UK.
Inefficiencies from pension freedoms are weakening the long-term private pension system and the approach to illiquid assets. For example, as savers get to 55 or 57, they can take their pots as cash in a series of lump sums and draw down funds in any combination of timing and amount that they choose. Small pots are growing exponentially. People change jobs more frequently. Pension transfers are increasing, including out of workplace schemes. Trustees have to implement these freedoms, which in turn impact on investment decisions.
Higher costs incurred with illiquid assets need to be borne fairly across the members of the scheme, as they would impact members differently. Those close to retirement or who choose to exit the scheme are at greater risk of paying higher fees without the additional returns.
Then we come to the issue of how to ensure value for members and higher returns when performance fees are outside the charge cap and inert citizens directly bear the investment risk. Achieving that higher value will be very challenging, as will measuring it for the Government to see it, as it is with securing standardised disclosure of performance fees. There is a lot of history here about making fees and charges work effectively for ordinary savers.
Ensuring that fees are payable only for realised outperformance is to rest on a tighter definition of performance fees and the discipline of negotiated agreements between trustees and asset managers. Those are the two big levers that are relied on. The Explanatory Memorandum states that excluding pension fees will encourage innovation on fees, but where is the evidence? It is an assertion, and lots of people assert it in their submissions, but it is difficult to find hard evidence. Exclusion of performance fees might set a precedent for removing other charges. Having removed that hard-fought security for consumers, the gate is open. It can disincentivise innovation because the cap has been removed. It can inhibit the evolution of fee structures and private market products that better accommodate DC pensions to the benefit of the UK economy.
Testing the impact of negotiated agreements between trustees and asset managers needs to be assessed much further before weakening the charge cap, given the challenge of achieving member fairness on performance fees. It is an assertion that those negotiated agreements will produce that beneficial result, but that should be really tested before such a critical consumer protection is removed.
The Government have set up a long-term asset fund, the Productive Finance Working Group is considering recommendations and the FCA and TPR have commenced consideration of value for money. This is work in progress, yet the Government push ahead with amending the cap, increasing the risk to the saver.
Investments that help with transition to net zero, environmental protection, housing or infrastructure which support economic growth and savers’ best interest are to be welcomed. Indeed, ESG and TCFD reporting and governance requirements are nudging schemes more and more in that direction. Several pension providers have indicated that they would no longer agree to traditional performance fees but remain committed to investing in private markets. Some large schemes hold illiquid investments within the existing charge cap. Some fund managers are indicating innovating on growth equity funds, and fee and product structures will evolve from the high-growth prospects of the UK automatic enrolment market—agreements achieved through scheme scale, not by weakening consumer protection.
One of the policy options in the impact assessment was government mandating investment in illiquid assets by pension schemes. Although rejected, this is the second hint at mandation after the joint December 2021 letter from the Prime Minister and the Chancellor. These DC savings are citizens’ private assets. Mandation would replace or undermine the fiduciary duty on trustees, require private assets to be harnessed and directed to meet government policy objectives, and probably risk market distortions. It would risk imposing inappropriate risk appetites on savers and increase uncertainty on liability, consumer protection and duty of care. It would certainly weaken employer engagement, and it could seriously risk undermining public confidence in auto-enrolment. Those are big consequences from mandation.
I have four questions to ask the Minister. Can he confirm that the Government have no intention to mandate how pension schemes must invest? How will value for members assessments be altered in light of the new risks arising to pension savers from these regulations? How will the Government ensure that savers close to retirement or who exit a scheme do not pay higher fees without additional returns from illiquid investments? What new measures will be introduced to enhance the availability of charges and cost information on illiquid investments? What new initiatives are the Government expecting the FCA to take to regulate for fairness and consumer duty in all the private markets that these regulations cover? I am sure that the DWP will say that it is not within its remit to know what the FCA is doing, but to make a decision that lifts such a hard-fought-for and fundamental consumer protection on the level of evidence that is before the Government, without knowing, having considered or having discussed with the FCA its approach, is an omission. It would be helpful to leave those questions.
The noble Lord, Lord Sharkey, mentioned the 30th report from the Secondary Legislation Scrutiny Committee, which drew these regulations to the special attention of the House. It expressed concern that, without limits on the proportion of illiquid assets in a pension scheme, the scheme may not be able to deliver the returns that members anticipate. It pointed out that many of those members, of course, have been auto-enrolled by their employer and therefore had no involvement in the choice of their pension scheme investments.
As the noble Lord, Lord Sharkey, pointed out, the committee asked two specific questions that it thought Members of the House might like to put to the Minister. One was about how schemes’ exposure to increased risk of lower returns would be monitored, and the other was how trustees would be guided on assessing the risks to the portfolio. I may have missed this in the Minister’s comments—I heard him talk about advice to trustees on charges, but I am not sure that he talked about advice on assessing risks—so it would be helpful if he would address that.
I want now to look briefly at the proposal specifically to exclude certain specified performance-based fees from the list of charges that fall within the regulatory charge cap. As my noble friend Lady Drake has reminded us, the charge cap was introduced to protect the millions of people who are saving and investing through inertia, so surely there must be a compelling case for the Government to do anything that might weaken that. It is worth pausing briefly to remember that, in 2013, DWP research showed the impact of higher fees on pension savings. An individual who saves throughout their working life via a scheme with a 0.5%—50 basis points—annual charge cap on the value of their pot could lose 13% of their savings to charges. Push that to 1% and they could lose almost a quarter; push it to 1.5%, the figure is around a third. These basis points may sound small but their impact on the value of a fund is really quite significant.