Review of the Productive Finance Working Group’s recommendations to the FCA on long term asset funds (“LTAFs”)

• United Kingdom

• Investment funds and asset management
• Pensions
• The future of funds
• Financial services - Asset managers and funds

05-01-2022

Prior to the FCA publishing its policy statement PS21/14 on LTAFs “A new authorised fund regime for investing in long term assets”, the Productive Finance Working Group published its recommendations on the promotion of LTAFs and to encouraging defined contribution (“DC”) pension scheme trustees to invest in longer-term and less liquid assets in its report “A Roadmap for Increasing Productive Finance Investment”.

The working group, comprising of industry representatives convened by the Bank of England, HM Treasury and the FCA is a forum to receive industry feedback on the FCA’s LTAF proposal, especially in relation to the operational ecosystem necessary for the success of the LTAF regime.

The working group’s roadmap highlights the importance of making capital available for the transition to a net-zero carbon economy and to fund infrastructure as part of the UK Government’s levelling up agenda in the post-COVID recovery phase. In particular, it stresses the importance of making alternative longer-term and illiquid investments available for individuals, particularly through DC pension schemes. A key focus of the working group is to find practical solutions which lower the barriers to DC pension schemes investing in less liquid assets.

For further background on the development of LTAF, please also see our client briefings:

• UK FCA policy statement on long term assets funds

• FCA consults on its long term asset funds (LTAFs) proposals

• FCA feedback statement on liquidity mismatch and open-ended property funds

Recommendations

Shifting focus from “cost” to “long-term value”

The working group recommends trustees and investment consultants of UK DC pension schemes shift their focus from lowering costs to creating long-term value for scheme members and calls on trade bodies, legal professionals, asset managers, DC pension scheme trustees and investment consultants to work together to raise awareness of the benefits of DC pension schemes investing in less liquid assets. The report urges these stakeholders to develop operational guidance, host forums and develop resources to help trustees of DC pension schemes navigate investing in less liquid assets, which is often a complex and resource intensive exercise.

Currently administration charges for the default funds into which DC pension schemes may invest are capped at 0.75%. The charge cap has been a constraining factor on investment into less liquid assets, where fees and expenses are typically higher than in other asset classes (due in part to the ownership structure, active engagement and value creation initiatives within private markets). While the charge cap applies at the level of the default fund, so that individual investments within the default fund could cost more, there has been a reluctance on the part of DC funds to make investments that, individually, exceed the charges cap. The working group considers the current charge cap encourages DC pension schemes to compete by minimising costs rather than by delivering long-term value for scheme members. The working group proposes performance fees be excluded from the charge cap, to permit DC pension schemes to invest in higher fee infrastructure investments which typically provide performance related remuneration for managers.

While the working group provides a rationale for this change of emphasis, for many years the FCA’s focus has been on driving down costs on the basis of research which shows that the single biggest determinant of pension fund performance is the size of the fees charged. It is unclear whether DC pension scheme members will acquiesce to this change of direction and the higher fees they will pay as a result. Note that the proposals only relate to default DC funds, which means that in self-selected schemes, individual investors will be able to move their funds into investments with lower fees.

Scale of DC pension schemes

The working group believes that the small size of some DC pension schemes is a reason why they are more focused on costs than long-term value creation. It recommends considering consolidation and pooling of DC pension schemes to create schemes of the size and scale necessary to make investment in less liquid assets such as infrastructure viable. The consolidation of local government pension schemes and the creation of local government pension scheme investment pools is a possible model for DC pension scheme consolidation and pooling.

The Working Group recommends that the LTAF be used to create fund structures pooling multiple schemes into a single fund vehicle.

Widening access to less liquid assets

The permitted links rules in COBS 21 restrict unit-linked funds from investing more than 25% (permitted links) or 35% (conditional permitted links) of their gross assets in less liquid assets, which would have been a barrier to DC pensions schemes investing in infrastructure and other illiquid assets. The working group recommended the FCA consult on removing the cap if the underlying investor is part of a defined contribution default arrangement, which the FCA has accepted. Investments in LTAFs will not count towards the 35% cap on investments in permitted links under COBS 21.3.19R(2).

The working group wanted LTAFs to be promoted to all retail investors, subject to adequate consumer protection provisions, and recommended the FCA review the application of financial promotion rules to LTAFs and reconsider the classification of the LTAF as a non-mainstream pooled investment. The FCA did not adopt these recommendation but is planning to consult on making LTAFs available to retail investors in 2022.

Liquidity management

Under the FCA’s policy statement, LTAFs redemptions may not occur more frequently than monthly, and there is a mandatory redemption notice period of at least 90 days. The working group noted that DC pension schemes tend to invest in daily-dealing funds. To accommodate investment in longer-term assets, DC pension schemes will need find a way to manage liquidity at the fund level (rather than at fund unit level). The working group thinks these challenges are not insurmountable, and trustees of trust based DC schemes might use funds of funds to obtain indirect exposure to illiquid assets. The working group stresses that DC pension schemes must understand their risk tolerance and scope of temporary deviations from their target asset allocation when investing in less liquid assets. Trustees of trust based DC schemes should employ stress testing and scenario analysis tools to understand how to source liquidity in the event of macro shocks or policy changes.

The working group recommends that the work of trade bodies, the FCA and the Bank of England on liquidity classification for open-ended funds should include: (i) guidance and toolkits for liquidity management; and (ii) products which facilitate longer-term investments. It asks the FCA to provide information to trustees of trust based DC pension schemes on how asset managers should price units in the context of LTAFs.

Review and next steps

LTAFs have been available since 15 November 2021. The FCA’s policy statement removed the regulatory barrier to DC scheme investments in illiquid assets posed by the permitted link rules, which is key to encouraging DC pensions to invest in infrastructure and other illiquid assets. The FCA is planning to consult on LTAF distribution rules and the potential extension of LTAF distribution to certain retail investors in the first half of 2022.

How can Eversheds Sutherland help?

Our team have been advising on regulatory interpretation and product development for the fund management industry since the 1980s and we have been at the forefront of new products under European and UK regulation in the period since then. Our in-depth understanding of the sector and experience with the practical implementation of new product categories mean that we are very well placed to guide you in complying with the changing product and regulatory environment.