The UK government has proposed consolidating defined contribution (DC) schemes into £25bn megafunds; however, industry commentators say this could lead to unintended consequences.
In her first Mansion House speech last week, chancellor of the exchequer Rachel Reeves pointed out that DC schemes are set to manage £800bn worth of assets by the end of the decade.
She said the government will consult on measures to facilitate the consolidation of schemes into megafunds, including legislating to allow fund managers to move savers more easily from underperforming schemes to ones that deliver higher returns.
However, David Snowdon, head of master trusts at SEI, said that while he is in favour of market consolidation, the way in which the chancellor is looking to achieve consolidation is “questionable”.
“Scale appears to be everything – if a multi-employer scheme isn’t at £25bn or more by 2030, then that’s that. The scheme could potentially be wound up or acquired,” he said, adding that while this makes sense, it does not consider member outcomes.
“Presently, the biggest schemes aren’t necessarily generating the best net investment returns. And if a scheme is generating exceptional investment returns, but fails to meet the £25bn threshold by 2030, then it’s hard to argue that winding up said scheme is in the best interest of members,” Snowdon explained.
Operational challenges
Snowdon added that in order to consolidate, most providers will face “serious operational, legal, and regulatory challenges” in achieving the scale Reeves is looking for.
He said: “The process needs to be streamlined – for example, the regulatory side of things would be simpler if something like a due diligence process confirming ‘no worse terms’ and/or broadly comparable benefits were used to determine whether a merger or acquisition–taking place between what will already be very highly regulated and heavily supervised master trusts–really benefits members. However, changes like this need to happen now if they are to support the chancellor’s 2030 deadline.”
Laura Myers, head of DC at LCP, agreed this would be challenging. She pointed out that different master trusts serve very different types of membership, which will limit their ability to offer a single default approach in a consolidated environment; the government should remain mindful of these complexities.
She said there is also a danger of introducing additional bureaucracy that could hinder the consolidation process.
“Overly burdensome requirements, such as consolidation plans and incremental targets for reducing default options, could divert valuable governance time away from making the actual transition.
“Governance resources should be focused on ensuring a smooth and effective shift, not on meeting excessive administrative demands.”
“Governance resources should be focused on ensuring a smooth and effective shift, not on meeting excessive administrative demands”
Laura Myers, head of DC at LCP
While Alison Leslie, head of DC investment at Hymans Robertson, believes that scale helps provide the ability to access a wider range of asset classes to generate higher returns for members she added there must be a clear governance process to ensure decisions are made for member benefit.
“There are many well-performing, well-governed smaller schemes in existence. There is also the risk of stifling innovation if the scale of the megafund is too high and smaller providers, who are currently innovating, are crowded out,” she noted.
Competition and innovation
Snowdon agreed that pushing the market to consolidate by 2030 could have a number of unintended consequences.
“If only schemes of more than £25bn are to survive past 2030, then we could see consultants starting to recommend providers now based on size alone. We may also see consultants recommending defaults with a significant allocation to UK assets, given everything that’s been said to date about using pension funds for productive finance.
“What’s good for the economy isn’t always good for member outcomes. Ultimately, this kind of herding could mean members are exposed to less diversified and lower quality investments, which could seriously impact their retirement outcomes.”
“What’s good for the economy isn’t always good for member outcomes”
David Snowdon, head of master trusts at SEI
The second unintended consequence, according to Snowdon, could be an innovation stall as providers rush to reach the £25bn+ threshold.
In slashing their total expense ratio in order to win new business, he pointed out that providers could have less to spend on administration, technology and investment proposition.
The Society of Pension Professionals (SPP) president, Sophia Singleton, agreed the move could stifle innovation and lead to a “herding mentality”, removing choice for both employers and savers.
This could also lead to the closure of some very good but smaller pension schemes, which may not be in the best interests of savers, she said.
“Whatever changes are made [they] must deliver for savers from a risk and return perspective and we are committed to helping the government to make these proposals work in practice,” she said.
Mandating
Snowdon warned that the government’s focus should be on delivering better member outcomes rather than unlocking private sector investment.
“The assets held by UK workplace pension schemes far outstrip the capacity of UK private markets. If these schemes start chasing that limited capacity, two things are likely to happen: the market would become oversaturated, and an investment premium would be created. In practice, this means money is either left unallocated, or that it’s allocated to opportunities that are lower quality. Neither of these scenarios lead to better retirement outcomes for members,” he stated.
Snowdon added that current pensions legislation does not require working people to save adequately for retirement, and mandating investment into any one asset class “misses the point”.
He said: “Such investments won’t generate retirement income for those who are currently saving too little – only higher contributions will. If the industry wants to meaningfully change retirement outcomes for today’s working population, it will need to increase the minimum mandatory contribution levels for individuals and their employers.”
Mark Searle, partner and head of DC investment at XPS Group, added that it is already “feasible” for schemes of £30m and above to invest up to 20% in illiquid markets however, there is a need for a mindset change from focusing on minimising costs to maximising long-term performance.
“Using Australia as an example, one reason their DC schemes have such large allocations to these assets is because there is clear evidence that achieving strong risk-adjusted returns will win them new business,” he noted.
However, he added there isn’t the same dynamic in the UK currently but the introduction of some type of performance-based league tables would help change that mindset.
LCP’s Myers agreed that comparators such as Australia have implemented a broader set of measures, such as franking credits, that actively promote domestic investment.
She said: “The UK government should consider similar measures alongside consolidation to foster increased investment in the UK economy.”
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