Pension Megafunds and Mandated Asset Allocation – The Government Confirms its Plans

The government has published the Final Report of its Pensions Investment Review, together with a response to its consultation on unlocking the UK pensions market for growth. These confirm that the government will proceed with its plans to introduce so-called pension “megafunds”. However, rumoured plans to mandate a minimum level of investment by schemes in certain UK asset classes have not materialised – for now.

Pension “megafunds”

The Interim Report of the Pensions Investment Review stated that fewer, bigger, better run DC workplace pension schemes would provide better returns for members and boost investment in the UK. The accompanying consultation therefore sought views on achieving consolidation by requiring DC multi-employer schemes to have a minimum size, and a maximum number, of default funds. The Final Report and the consultation response confirm that the forthcoming Pension Schemes Bill will contain provisions to:

• Require contract-based workplace pension schemes and multi-employer DC trust-based pension schemes to have at least one default arrangement with £25 billion in AUM by 2030 (a “main scale default arrangement”). A transition pathway will give smaller schemes additional time to meet this requirement. Where a scheme can demonstrate that it will have a default arrangement with at least £10 billion in AUM by 2030, it will be able to apply to be on the transition pathway and will be required to provide its regulator (i.e. the Financial Conduct Authority (FCA) for contract-based schemes and the Pensions Regulator (TPR) for trust-based schemes) with a credible plan to have £25 billion in AUM by 2035.
• Require schemes to demonstrate that they have (or in the case of those on the transition pathway, are building) an investment capability commensurate with their scale. This will require schemes to have suitably qualified in-house investment expertise as well as strong governance.
• Prevent new default arrangements from being created and operated, except in certain circumstances with regulatory approval. However, the government has decided not to set a limit on the number of default arrangements for any given scheme.
• Provide for a “new entrant” pathway. This will allow new market entrants with innovative products to seek authorisation, where they are offering something significantly different that could benefit members or employers and have plans to reach scale in the longer term.

The requirements will apply to contract-based workplace pension schemes and multi-employer DC trust-based pension schemes that are being used for automatic enrolment. They will not apply to DB schemes or single employer DC trust-based schemes. In addition, although the Final Report and consultation response refer to multi-employer DC trust-based schemes, the inclusion of multiple references to master trusts leads us to believe that the requirements will only apply to DC master trusts (i.e. non-associated multi-employer DC trust-based schemes) and that non-master trust DC multi-employer schemes will not be within scope. Lastly, the requirements will not apply to CDC schemes, hybrid schemes which are only available to a closed group of employers related through their industry or profession, or to default arrangements that serve protected characteristics, such as religion.

Schemes that are within the scope of the requirements, but which cannot reach the scale requirements (by 2030 or 2035) or access the transition pathway will no longer be able to participate in the automatic enrolment market. These schemes will be expected to consider wind-up or consolidation.

Without consent contract-based transfers

To help address fragmentation, the Pension Schemes Bill will introduce a contractual override to enable providers of contract-based schemes to transfer members to another scheme without their consent. (A without consent transfer option already exists for trust-based schemes.) A transfer will only be permitted where it is in members’ best interests, certified by an independent expert. The detailed rules on the use of the override will be developed and consulted on by the FCA.

2029 market review

The government expects the introduction of the new contractual override and the new value for money (VFM) framework for DC schemes to go a long way to reducing fragmentation and the number of poor value arrangements. However, the government is concerned that, even within schemes that are providing VFM, there is still potential for significant differences in outcomes. It therefore expects schemes to take proactive steps to assess whether their members should be moved into a main scale default arrangement.

In addition, in 2029, a ministerial-led review involving the FCA and TPR will assess the market impact and operation of the contractual override and the new VFM framework to examine why any default arrangements are continuing to operate outside main scale default arrangements. The review will start from the presumption that members’ assets and underperforming default arrangements will have been consolidated into a main scale default arrangement unless there is demonstrable evidence that such a move would not be beneficial to members. The government plans to put in place a legislative underpin to enable it to tackle any remaining fragmentation if required.

Cost vs value – employer and adviser duties

A key objective of the Pensions Investment Review is to promote a focus on value in relation to DC workplace pension schemes rather than their cost. The Interim Report noted that the new VFM framework is intended to address some of the government’s concerns in this area, but also considered the role of employers and advisers. The consultation sought views on various proposals to support the shift to a focus on value. These included creating a new employer duty to consider the overall value of their chosen automatic enrolment scheme (both at the point of selection and/or on an ongoing basis).

However, the government has concluded that there was limited evidence that the proposals would support its objectives and concerns were highlighted about increasing burdens and costs on employers. The government will not therefore proceed with its proposals.

UK investment

The government believes that investment by DC schemes in a fuller range of asset classes, including specialist private markets such as venture capital, infrastructure, property and private credit, particularly in the UK, will benefit both members and the UK economy. Earlier this month, 17 of the UK’s largest workplace pension providers signed the Mansion House Accord. Signatories committed, subject to their fiduciary duties and the FCA’s Consumer Duty, to the ambition of:

• Allocating at least 10% of their DC default funds to private markets by 2030.
• Within that, allocating at least 5% of the total to UK private markets, assuming a sufficient supply of suitable investible assets for providers.

In light of the Accord, the government has decided that it is not currently necessary to mandate investment in any specific asset classes. However, the Pension Schemes Bill will include a power for the government to mandate investment if necessary. The government does not anticipate exercising the power unless it considers that the industry has not delivered the change on its own and would only exercise it following a thorough assessment of the potential impacts on members and economic growth. The power will include safeguards to protect members’ interests, and any requirements imposed under the power would be consistent with the principles of fiduciary duty.

Asset allocation transparency

The government will need access to data on asset allocation to monitor the impact of the reforms. While the disclosures required under the new VFM framework will provide this data, based on the framework's expected implementation timetable, these disclosures will only start in 2028. TPR and the FCA will therefore conduct a market-wide data collection exercise. The exercise will request asset allocation information from major DC schemes, broken down by asset class and sub-asset class, and with UK/overseas splits. The first exercise will start later this year and will continue annually until the VFM disclosure data becomes available.

Boosting UK investment opportunities

The government acknowledges that if pension schemes are to invest in a wider range of UK asset classes, there needs to be a strong pipeline of investment opportunities across the UK. The Final Report sets out details of how the government plans to boost the depth and volume of investment opportunities, underpinned by a competitive UK investment environment; and increase the visibility of these opportunities for investors.

Phase 2 of the Pensions Review

The Pensions Investment Review represents phase 1 of the government’s review of the UK pensions system. Phase 2 will look at retirement adequacy and will be launched “in the coming months”.

What does this mean for trustees and employers?

These reforms will have a significant impact on the shape of the DC pensions market in the UK. However, while the legislative framework will be included in the forthcoming Pension Schemes Bill, the reforms will not come into force for some years. Whether they will have the desired impact on member outcomes and the UK economy will take even longer to become clear. Nonetheless, once the Pension Schemes Bill is published, providers of contract-based workplace pension schemes and trustees of in-scope master trusts should start planning for the new requirements.

While the focus of the proposals is contract-based workplace schemes and DC master trusts, given the government’s clear emphasis on consolidation and facilitating investment in the UK, we can expect to see further reforms with those aims that may affect other trust-based schemes. In particular, the government has also published further details of its proposals to make release of surplus from ongoing DB schemes easier. For more information on these proposals, please see our legal update.