News | November 23, 2022

Defined Contribution Schemes – Can scheme trustees prudently invest part of their Default Funds in illiquid investments?

Key points

• DC Scheme trustees will have to report on their illiquid investments (and other investment holdings) in their Statement of Investment Principles/Annual Chair Statement.

• An exemption from the fee cap on default funds may be available to DC schemes for certain performance – based fees.

• DC Trustees should always prioritise members’ interests when deciding how to invest.


On 6 October 2022, the Department for Work and Pensions (“DWP“) launched a consultation on draft Regulations which would require trustees of defined contribution (“DC“) schemes to disclose and explain their investment approach to illiquid investments in their default fund within their Statements of Investment Principles and also provide a yearly breakdown of their investment asset classes in the annual Chair Statement. The draft Regulations also amend the relevant existing Regulations so that certain performance-based fees charged by investment managers are out of scope of the charge cap that applies to default funds.

What is an illiquid investment?

Under the draft regulations, an illiquid asset is defined as an asset “which cannot easily or quickly be sold or exchanged for cash“. The definition is extended to include any assets held in a collective investment scheme.

In its current form, this definition is quite vague and open to interpretation. This may result in inconsistent disclosures from scheme to scheme. The government is considering expanding on this definition, presumably in the form of guidance, to allow trustees properly to consider what is and what is not an illiquid investment and therefore would need to be disclosed.

Why are the regulations being introduced?

Automatic pension enrolment started in 2012. There has been a rapid increase in the assets invested by DC schemes, which look set to further double before 2030. The DWP are keen to allow schemes to invest in illiquid assets as they regard them as potentially offering better returns for pensioners and certain investments may have wider beneficial impact for the UK economy (eg. Investment into renewable energy). Many overseas pension schemes operate in this manner. However, while opening up these avenues for investment, the DWP is keen to ensure transparency as to these investments.

The transparency is aimed to standardise the approach of default funds within the occupational pension market and also to allow members to see what investments are being made with their contributions, the outcome of these investments and the impact it may have on their potential retirements.

What will trustees have to do by way of disclosure and reporting on their default funds ?

Under the draft Regulations:

  • Statements of Investment Principles for default funds-trustees will be required to disclose and explain their policy on illiquid investments on the first occasion on which their SIP is updated after 1/10/2023 and in any event from 1 October 2024; and
  • Annual Chair statement – for the first scheme year ending after 1 October 2023, must specify their asset holdings within their default fund, on a percentage basis per specified asset class. Such classification will ‘see through’ collective money purchase schemes and need to incorporate the underlying asset. The asset classes proposed are:
  • cash;
  • bonds;
  • listed equities (i.e shares listed on a public stock exchange);
  • private equity (i.e shares not listed on a recognised public stock exchange);
  • infrastructure;
  • property/real estate;
  • private debt/credit facilities; and
  • other.

The structure of asset allocation disclosure will be a matter for trustees to decide how best to present the data to their members. A recommended approach will be included in (at present draft) statutory guidance but the approach will not be a requirement.

Some have questioned whether the Chair’s statement is the appropriate place for this information and DWP are considering this further.

Exempting performance-based fees from the default fund charge cap

Simultaneously, the government has been looking at exempting certain DC scheme performance fees from the charge cap. Currently, DC scheme performance fees are subject to a regulatory charge cap of 0.75% charged to members auto-enrolled into the default fund. It is hoped that by exempting certain performance based fees from the cap, it would further encourage illiquid investment and therefore potentially allow a greater return on investment. Scheme trustees must consider whether the additional incentive for fund managers provided by additional performance fees will provide additional value to members that outweighs the expected extra performance fee costs.

The Government aims to finalise the draft regulations issued by way of consultation on October 2022 swiftly in time for them to take effect on 6 April 2023. The exemption for relevant performance – based fees would then be available from 6 April 2023.

The trustees (with support from their advisers) and the investment manager will need to agree the terms of the performance fee prior to the investment. No classes of assets are excluded from performance based fees.

It is for trustees to decide whether to include performance fee based investments in their default fund. Trustees are not bound to do so and should obtain advice both from the investment and legal perspectives.

Would such investments be consistent with trustees’ legal duties? Each case will depend on the specific circumstances but, broadly speaking providing the trustees obtain and consider appropriate advice including legal advice, such investments may be in order.