The government has announced a loosening of the pension charge cap which will be implemented in October 2021.
Pension schemes will be allowed to smooth their performance fees over five years. This means a scheme will be able to invest in longer term assets and will give funds a bit more flexibility. This suits investment in private equity which will often have years where returns are concentrated, for example, if several startups from an investor’s portfolio exit in lucrative IPOs in a short space of time. If that were to happen under the new rules, a pension fund would be able to exceed the cap in one year.
However Mark Fawcett, the chief investment officer at Nest, says that this modest liberalisation is insufficient to persuade DC schemes to invest and told the Financial Times that:
The total level of fees levied by most private market funds will remain too high for many DC pension schemes to access [them].
This is an important topic and we have written about it before. Liberalising pension schemes could transform the UK venture capital market and would thus greatly increase the amount of money going to entrepreneurs. In the UK pension funds only contribute 12% of the funding in the VC market, by contrast, in the US they contribute 65%.
TIGRR, the Government’s taskforce on innovation, growth and regulatory reform, recommended reform arguing:
With sensible changes to pensions and insurance regulation that preserve the highest standards of consumer protection and uphold financial stability, the Government could unlock over £100bn of investment in small and scaling-up businesses across the UK, green projects, infrastructure and a range of other areas.
The UK’s total pension market value reached £2.2 trillion at the end of 2019, of which DC schemes made up £146 billion thanks to the introduction of auto-enrolment. In 2028 the UK’s DC pension pot is expected to reach £1 trillion, if the UK is able to unlock just 5% of this figure by then, that is a staggering £50 billion in additional investment. The charge cap (0.75%) on the fees and administrative expenses that can be borne by savers is a sensible investor protection measure in principle, but in practice has driven many schemes towards passive investment to keep the charges well within the cap. UK savers therefore have limited exposure to high-performing ‘illiquid’ assets, including private equity and venture capital that tend to outperform public markets.
The largest obstacle for DC schemes accessing private equity and venture capital (PE/VC) funds is the calculation method for the 0.75% charge cap. This currently treats profit-sharing models such as carried interest as a performance fee and includes them in the cap (unlike other countries such as Israel). Whilst we understand the rationale for the cap, it is also a key barrier. It does not accommodate long-term incentive models such as carried interest that benefit both investors’ returns and the growth trajectory of the companies the industry invests in.
We have called for the cap to be lifted before. In our report Unlocking Growth, Sam Dumitriu says
“Venture Capital funds typically charge a 2% management fee and take a 20% share of the uplift when the fund closes. Unlike traditional investments in stock markets, VCs invest smaller amounts and take a hands-on approach.”
There are reasons to keep fees low. Pensions are difficult for people to understand, and often they will just accept whichever pension their employer enrolls them in. We don’t want people to be taken advantage of by having their retirement in the hands of people who charge unjustified high fees.
As part of these reforms, the Government is also going to implement new regulations which will challenge small defined contribution pension schemes to demonstrate that they offer value for their members. There are about 1,800 pension schemes which will come under this scope, with less than £100m in assets, and it will largely impact employers who run their own pension instead of choosing to join established pension funds.
If these measures manage to ensure that pension schemes are providing value for members, then that could provide the government and the people investing with the security they need to loosen the charge cap further.
One way to protect people from excessive fees would be to only increase the cap on carried interest. This means managed pension funds would still be restricted by the 0.75% charge as a management fee, but then they could charge a more standard 20% on the extra money they make.
That would lead to more money for private equity, intangible assets, and venture capital, which would mean more money for entrepreneurs, and a thriving startup ecosystem. For young people just starting to contribute to their pensions now, it may even mean about 7-12% more savings in their pension by the time they retire, as their money is put into more lucrative investments.
It’s a tough problem to crack but one which could help to make the UK a richer and more innovative place. Let’s hope the government can get this right.