Minutes of the Productive Finance Working Group - 22 June 2021

Agenda

1. Competition law reminder by Simmons & Simmons LLP

2. Chairs’ opening remarks

3. Stress testing exercise

4. Key questions for discussion

5. Next steps and closing remarks

Minutes

Item 1 – competition law reminder by Simmons & Simmons LLP

1. Simmons & Simmons LLP set out the legal obligations of all members of the Working Group relating to competition law.^{footnote [1]} They reminded members that it is their responsibility to meet their legal obligations and to take their own legal advice.

Item 2 – chairs’ opening remarks

2. The TEG co-chairs^{footnote [2]} thanked members for their work to date and set the objectives for the meeting: in particular, to discuss the results of the stress testing exercise, to discuss some key questions that have arisen, and to give an overview of next steps, including in relation to the final report.

Item 3 – stress testing exercise

3. The chair of the second sub-group^{footnote [3]} gave an overview of the stress-testing exercise, explaining that the intention was to build on the Group’s previous external engagement and get a better understanding of the operational barriers DC schemes face in investing in less liquid assets. Engagement was with people from all the way across the process, including consultants, compliance, operations and investment. The Group had had detailed conversations with five DC schemes and one pensions platform. The following points were noted:

• There are operational barriers, for example in relation to portfolio rebalancing and liquidity management, but they can be overcome.
• Exposure to an LTAF will likely be wrapped through a fund of funds structure or through a platform, not through direct exposure.
• Liquidity isn’t seen as a big barrier as schemes are expecting to manage it at scheme level.
• A bigger issue is the ability to price the units of the LTAF daily to strike the overall default fund daily price. Options are to use a stale price or for it to be indexed. Some trustees called for more guidance on this point.
• Teams will need to be upskilled, which will have cost implications.
• Most schemes want to use a commitment model (where the asset manager calls on investors for cash when the next investment is available) rather than a fund model (where investors are able to subscribe for and redeem fund units at regular intervals).
• There will be some asset allocation drift (where the proportions of investment in certain asset classes are impacted due to market movements), which may take time for trustees to get used to.
• Uncertainty about whether there might be a further reduction in the DC charge cap was raised by several schemes as an impediment to them investing in less liquid assets. Therefore, a commitment from the DWP not to change the cap for a period could be helpful.

4. The chair of the third sub-group^{footnote [4]} spoke about the demand-side issues raised in the stress testing exercise. Four themes had emerged:

a) Cost – there is significant pricing pressure in this part of the market. The charge cap applies on a bundled charge for both investment and administration, which is having a negative impact on the investment budget. If there is a possibility of DWP splitting these out (into separate charges) this would allow for a better allocation of budget toward investments then is currently possible under the bundled approach.

b) Regulations – mixed messages from the regulators makes it difficult for trustees to consider this in a clear way. A regulatory nudge could be helpful.

c) Positioning – it’s very difficult to increase costs to members. Some help with regulatory or broader positioning would be helpful. One scheme also said using something like a value type matrix or framework might be helpful.

d) Perception – all were aware of the value these assets could bring. However, they suggested that trustees would be more comfortable making such investments if DWP, TPR and the FCA were clearer that considering these investments is an appropriate thing to do.

5. The chair of the first sub-group^{footnote [5]} gave an overview of how the different examples of LTAFs that were used during the stress testing exercise were received, noting:

• Lifespan and lock-ups – feedback was that this is acceptable. Potential investors also appeared comfortable with the proposed use of notice periods by LTAFs.
• Valuation frequency –despite asset managers’ preferences for quarterly most schemes thought the more frequent the better.
• Commitment/fund dealing – if the LTAF was illiquid a commitment model would be acceptable, if it could look after liquidity then a fund model would be acceptable.
• Fee methodology – due consideration needs to be given to performance fees, in particular whether operating an LTAF with performance fees might be off-putting to certain DC schemes due to concerns with either breaching the charge cap, or the impact on their charges more generally which might render them uncompetitive.

6. Questions and discussion followed the presentations, including in relation to: the features of the LTAF, as proposed in the FCA’s consultation; the pros and cons of recommending regulatory nudges, around which there was no consensus; bundling of investment and administration charges in the charge cap; and clarity and consistency of regulatory messaging around investment in less liquid assets.

Agenda item 4 – key questions for discussion

7. Nicholas Smith (AIMA) gave a presentation on possible recommendations for industry and regulators to overcome the demand-side barriers to investing in less liquid assets. Recommendations included:

a) Fees – finding an alternative way to regulate performance fees outside the charge cap, which may also act as a stimulus for fee innovation by industry. It was noted that the TEG would need to consider DWP’s proposals to smooth performance fees but it was unclear whether this alone would be sufficient to remove this barrier.

b) Creating the right environment – regulators have a key role to play, as they create the culture. Schemes and their trustees see ‘don’t walk on the grass’ signs around illiquid investment, and a mixture of standards and views across the regulators isn’t helpful. Updating the TPR code of practice, guidance from industry and regulators, and enhanced transparency around longer-term measures of performance and value (e.g. risk-adjusted measures) could be helpful in addressing this.

8. Stephen O’Neill (Nest) gave a presentation on what trustees or pension scheme managers need to think about if they are considering investing in less liquid assets. The presentation covered three topics:

a) Illiquidity risk and capacity – how asset allocations and the risk return profile get distorted through market movements, and how trustees can establish a comfort level with a number of assets that won’t move in price when the rest of the portfolio does. This included by being able to tolerate some flexibility in the asset allocations in the near term.

b) Investment beliefs – how schemes can use their SIP regarding which markets they might want to invest into and asking trustees to look at their foundational beliefs to steer them in that direction. This included by re-engaging trustees on their objectives for the scheme and highlighting how an allocation to private markets might help to accomplish those objectives.

c) How might trustees make an allocation, test the market, find an illustrative price and then going back to the market to deploy a live allocation based on the cost constraint.

9. Ross Hayter (abrdn) – introduced two questions for discussion:

a) Can and should the TEG initiate some industry guidance to support the FCA’s consultation on the LTAF? If so, what kind of guidance could be produced, for example, on liquidity management and notice periods?

b) What are the key barriers for the LTAF being distributed beyond DC investors and what protections should we consider in order to supplement the CP?

10. Questions and discussion followed the presentations, including in relation to: if the LTAF should be opened up for broader retail distribution (some were for and some were against); the difficulties posed by the NMPI rules; the need to shift the focus from cost to long-term value for DC scheme members; performance fees and performance fee smoothing; regulatory messaging; the role of investment companies in illiquid investment; and industry guidance on liquidity management.

Item 5 – next steps and closing remarks

11. One of the chairs set out the next steps on the report, including the plan to engage with the TEG as we start to draft the report. The plan was to share a draft of the report with the SC ahead of its meeting on 28 July.

12. One of the members of the Secretariat talked through a timeline of next steps.