Individuals who are automatically enrolled into defined contribution ("DC") schemes without making any choice as to what they want to do with their pension will be put into a default arrangement. There is a charge cap on these default arrangements. The charge cap was introduced to protect these members from excessive charges and to provide a straightforward offering to those new to financial services.
The charge cap is 0.75% of the funds under management each year, or an equivalent combination charge, assessed over a calendar year, referred to as a "charges year". There are two methods of measuring charges for funds under management that trustees can choose to use.
Both of these methods require that the maximum permitted charge is prorated where the cap applies to a member for less than a full charges year e.g., if a member leaves or joins during the charges year.
In February 2019, the Department for Work and Pensions (the "DWP") ran a consultation titled 'Investment Innovation and Future Consolidation' (the "February 2019 Consultation") which highlighted issues with the interaction between performance fees and the charge cap, notably that prorating of performance fees which can significantly vary throughout the year can cause difficulties. Funds that offer greater returns often involve managers who charge performance fees. The DWP therefore questioned the extent to which the charge cap compliance mechanism is a barrier to accessing such funds which charge a performance fee, and asset classes associated with performance fees.
The February 2019 Consultation was then followed by 'Improving outcomes for members of defined contribution pension schemes' which ran until 30 October 2020 (the "September 2020 Consultation"), and now the latest consultation, titled 'Incorporating performance fees within the charge cap', from 19 March 2021 to 16 April 2021 (the "Charge Cap Consultation"). It contained the DWP's proposals in response to the performance fee section of the September 2020 Consultation, which are set out below.
The DWP's Performance Fee Proposals
1. Performance Fee Prorating
The DWP noted it received a good level of support to its proposed measure to provide an easement to the requirement to prorate performance fees when assessing compliance with the charge cap.
Some respondents did highlight that this easement would make the charge cap more difficult to explain to members, and therefore there is the potential that the complexity could discourage trustees from these sorts of assets.
There has also been a view that this could be insufficient to meet its objective of encouraging DC investment in illiquids since some asset classes like private equity and real estate may not be valued any more frequently than annually anyway.
2. Multi-Year Smoothing Option
The DWP intends to introduce the option of a five year moving average of the performance fee being included in the charge cap. Many respondents stated that five years was an appropriate timeframe as it coincides with the usual period over which many fund managers measure the performance of their assets, and also the minimum period to measure performance of private markets.
Notwithstanding the above, there is a concern for trustees that if the fund were to have high outperformance in the first year, then the trustees could breach the charge cap for that year.
It does not appear that the measures proposed will go far enough to give comfort to DC trustees that the charge cap will not be breached as a result of investing in assets that charge performance fees, and there is therefore likely still to be too much complication for members to understand the impact of performance fees.
Impact on trustees and managers of occupational pension schemes and scheme members
The easement on prorating and five year smoothing could add a layer of complexity when explaining to members the default charge cap in schemes' chair's statement. Trustees will have to consider how best to communicate this to members.
If the proposals give trustees of DC schemes the confidence to invest in illiquid assets and/or other asset classes with performance fees, members sitting within default arrangements could benefit from better performance than at present. However, the pensions industry, for example the Pensions and Lifetime Savings Association, consider that the proposals are unlikely to lead to a material change in the volume of investment in illiquids.
Look-through on Charge Cap Compliance
The Government has previously made it clear that, when calculating the charge cap, 'look-through' should apply when investing in all open-ended funds, all UK listed closed-ended investment funds and international equivalents. The Charge Cap Consultation includes a call for evidence on the current position on look-through, to establish whether it is a barrier to investment in alternative asset classes. This is a complex area and there is likely to be much debate before a change in Government policy.
Timetable for implementation and next steps
The DWP aims to publish a response to the Charge Cap Consultation, including final draft regulations and final statutory guidance, in June 2021. The DWP's intention is that regulations on performance fees would come into force in October 2021.