DB vs DC pensions: narrowing the gap with illiquid investments

20 July 2023

As the pensions industry unpicks the Mansion House pension reforms, a look at what some of the planned changes may have in store.

There is a wide gap between the defined benefit (DB) generation and the defined contribution (DC) generation, in terms of the standard of living they are heading to for in retirement.

Narrowing this gap was identified as a key driver by pensions minister Laura Trott in her keynote address to Onward which she delivered the day after the Chancellor’s Mansion House speech.

But whilst many who represent pension providers are clamouring for this gap to be filled by additional contributions, Government believe we can be smarter than that by squeezing more out of the contributions that are already being paid. For a long time now, this has meant a relentless focus on costs and charges. Until the Mansion House Compact, which articulated a new direction.

The Chancellor identified “that some defined contribution schemes may not provide the returns their pension fund holders expect or need”. And he attributed the lowly investment returns to “UK institutional investors are not investing as much in UK high-growth companies as their international counterparts”.

Value for Money - Investment Performance

The drive to increase holdings in private equity and un-listed illiquids is on. And whilst several of the large fund managers have signed up to increasing the allocation to 5% of their default funds by 2030, the DWP is introducing a slew of changes that will facilitate and encourage the less willing converts.

The new focus of Value for Money is now moving away from containing costs and in the direction of investment performance. This will expose pension schemes that are delivering sub-parreturns to increased sanctions.. Regulators are to be given beefed up powers to close down underperforming schemes. The drive to consolidate Britain’s pensions into fewer larger schemes is being given added impetus on the premise that it is more realistic to expect larger schemes, where cashflows should be more stable, to make meaningful allocations to illiquid investments. There are several ways that DC pensions may be able to do this:

Long-term Investment For Technology and Science (LIFTS)

Jeremy Hunt is putting his money where his mouth is, with a prize fund of £250m for a competition to find new ways to unlock DC investment in illiquids. This initiative – Long-term Investment For Technology and Science (LIFTS) – specifically supports UK-based science and technology-led firms with a heavy research base. The idea is to stimulate DC schemes to invest in UK start-ups and scale-ups which need funds for research and development to get them to the next level of growth. The programme has an ambitious set of targets and the winning propositions that will get this Government seed capital to bring their ideas to fruition will be announced in the Autumn Statement.

Keep your eyes peeled, there could soon be a LIFT near you offering fresh investment opportunities for your clients.

Long Term Asset Funds (LTAFs)

Then there are Long Term Asset Funds or LTAFs. The UK Government green lit DC pension schemes to invest in LTAFs back in November 2020 and the first two gained FCA approval earlier this year.

Putting DC funds into illiquids can be like putting a square peg in a round hole, with the daily danger that DC members can ask for their money back at one day’s notice. For anything but large listed equities, that entails the risk of a dreaded fire sale, and assets being quickly disposed of at a fraction of the value once attributed to them.

LTAFs deploy two techniques to get round this. Their main line of defence is a series of measures to slow the withdrawal process, like minimum holding periods and lengthy notice requirements. But they also have been given the power to borrow, so to a limited extent withdrawals can be facilitated by the LTAF taking on debt and postponing the sale of illiquid stock until an opportune moment arises.

LTAFs found favour with nearly a quarter (24%) of representatives of leading occupational pension schemes, master trusts, platform providers, IGCs, asset managers, pension consultants, member organisations, insurers and official institutions which attended the DC conference I spoke at earlier this summer. LTAFs came equal first in a non-scientific poll of the audience in which I asked the audience to vote on one of the six options I presented for delivering greater DC savings performance.

Blending retirement income and drawdown

Indeed, the only other option which grabbed just as many votes in my poll (24%) was Blending Income Drawdown and Annuity. This innovation for optimising retirement income is gaining ground - with several major adviser platforms and discretionary fund managers launching blended retirement options over the last couple of years.

Sometimes called Secure Lifetime Income, blending annuity and drawdown income offers the option to swap out low performing corporate bond holdings in income drawdown portfolios, for example, into an annuity. The adviser then applies their risk-rating process to the whole portfolio of annuity and drawdown combined, which noting the absolute security of the annuity will recommend a slightly higher risk for the drawdown investments. This can make diversification into more illiquid investments, for longer, a safer option.

Longer Pathways Needed

For the non-advised DC member, Investment Pathways will be offered to steer would-be retirees to adjust their investment mix as they prepare for decumulation. Pathways help pension holders to confirm what they will be doing over the next five years. The provider should then offer a suitable investment mix for each of the four Pathways. I’ve always argued that it’s not just about the first five years after starting decumulation but considering what’s happening after that. Let’s take a look at this below:

First 5 Years	Beyond Year 5
Option 1: I have no plans to touch my money in the next 5 years	Any of the four options are possible in the next five years.
Option 2: I plan to use my money to set up a guaranteed income within the next 5 years	No need to plan further, the annuity purchase has set the consumer up for the rest of their retirement.
Option 3: I plan to start taking my money as a long-term income within the next 5 years	After some years of income drawdown, many consumers will decide to buy an annuity, finding annuity rates better once they are older.
Option 4: I plan to take out all my money out within the next 5 years	This consumer may have gone, or they may have seen the light and found a better way to raise the cash they needed, preserving their tax-favoured pension vehicle for longer than originally anticipated.

So, although The FCA expects that the central focus in determining asset allocation is that first five years, it would be no bad thing to have one eye on the longer term. Taking a longer view into retirement, at say age 60, enables you to think in terms of longer term investments which enables more illiquid investments to be considered in the investment mix. Why not, as many of these investments may be in search of growth over a 20-30 year time horizon? The obsession with getting ready to cash it all in is only really relevant for those determined to stay in the Option 4 camp.

Collective Defined Contribution (CDCs)

Next, there’s the option of the decumulation Collective Defined Contribution (CDCs) pensions which naturally de-risk savings because they are pooled investments. Multi-employer CDCs should be offered during the next year.

Minister of State for Pensions Laura Trott said of CDCs: ”By extending our secure and dependable CDC framework, more members will be able to benefit from the opportunities of sharing risk. This means their pension savings work harder for them and provide, on average, a better outcome for their retirement than might otherwise be available.

“It is an opportunity to help shape the next stage in one of the most significant developments in UK pensions and I encourage all interested parties to respond and play their part in helping improve outcomes for tomorrow’s pensioners.”

CDC will invest to and through retirement, giving the fund manager a longer time horizon. This, combined with the collective nature of the scheme, will enable CDCs to hold more private equity, more infrastructure and more illiquids than ordinary DC schemes. As CDC schemes get underway, I expect they will make the Mansion House target of 5% appear rather low.

A key pillar of CDC is that the pension income seeks to keep pace with the cost of living, something which this year anyone on a level annuity will have found very painful. It was last year’s seminal research by the Institute for Fiscal Studies (IFS) that finally de-bunked the myth that a level pension will be OK as pensioners slow down and spend less through retirement.

They simply don’t! Pensioner’s annual expenditure goes up at CPI plus one per cent until around age 80 and increases more modestly thereafter at around CPI minus 1%. So, the investment managers of a CDC scheme will seek investments that offer the best prospects of inflation-plus returns, and if they see those happen to be in private equity, funding small growing companies, infrastructure and others then they have the mandate and ability to seize the opportunity.

In summary, there are many routes that the pensions market can go down to help diversify DC pension savings and to secure improved investment returns.

Whilst the Chancellor has positioned this as all in the interests of savers, I do see something of ‘Growth Agenda Mark II’ in this. However, whereas his predecessor in 11 Downing Street discovered that chasing economic growth through un-costed tax cuts is just too painful in the short term, this is an altogether more gradual affair. Pensions money will be utilised to support the growth of our brightest companies. These in turn will be the wealth generators of the future. And it’s that future wealth that today’s pension savers need to support them when their time comes to retire from the productive side of the economy and have others support them through their retirement.

Previous Article Dunstan Thomas Products Contact Us