The Department for Work and Pensions (DWP) has launched a consultation on draft regulations to exclude performance-based fees from the regulatory charge cap, in an effort to drive defined contribution (DC) illiquid investment.

The requirements were initially consulted on in November 2021, with the government since confirming plans to “accelerate” charge cap reforms as part of its economic growth plan.

The DWP suggested that schemes in scope will be able to apply the exemption to exclude ‘specified performance-based fees’ from the charge cap calculations as soon as the regulations come into force, which is currently expected to be 6 April 2023.

However, transitional arrangements are to be put in place for trustees or managers of schemes that are making use of the current option to smooth the incurrence of performance fees over a five-year moving average when assessing compliance with the charge cap.

In particular, the draft regulations would repeal the previous description of ‘performance fee’ contained in Regulation 2(1) of the Charges and Governance Regulations.

This would instead be replaced with a "tight conditions-based" definition of what can be considered a well-designed, “specified performance-based fee” structure that trustees or managers of DC and collective money purchase (CMP) schemes that are covered by the charge cap must follow if they want to exclude these performance-based fees.

The proposed new definition of ‘specified performance-based fee’ will relate to a fee paid when returns from investment exceed a specific rate/benchmark or a specific amount, which may be variable or fixed, but "crucially" must be agreed upon between the trustees or managers of the scheme and the fund manager prior to investing.

Under these changes, performance-based fees would join a list of ‘charges’ that can be considered out of scope of the charge cap, alongside transaction costs, costs of winding up the pension scheme and costs solely attributed to holding physical assets.

However, the exemption would not apply to components of a performance fee structure that are not linked directly to investment performance, such as any fixed rate management fee or other costs.

The DWP suggested that the change will "incentivise" trustees and managers to link payment of fees directly to the net benefit that their scheme members receive, in an effort to provide trustees with greater flexibility.

It also suggested that the change could facilitate the development of fee structures, with lower base management fees, which may be more appropriate for use in relation to DC schemes, if there is sufficient investor demand.

Indeed, although the DWP acknowledged that performance fees are not the sole barrier to greater DC illiquid investment, they can discourage many trustees from considering investments that would require them to allocate otherwise unused charge cap ‘headroom’ to such payments.

It therefore suggested that the changes could be an "important enabler now, and in the future, as the DC market continues to grow, gains scale and considers investing in a broader range of investment opportunities".

The DWP also clarified that schemes are under no obligation to enter into arrangements where the investment comes with a performance fee if this does not fit with their investment strategies, or the arrangement is not in their members best interests.

Draft statutory guidance has been published alongside the regulations, to ensure that trustees have a fuller understanding of what conditions/elements make up a specified performance-based fee.

It also includes information on measurement and payment periods to help explain the timing of performance fee deductions from members’ pots, taking account of fair apportionment to scheme joiners and leavers.

Commenting in the ministerial foreword, DWP Secretary of State, Chloe Smith, and Parliamentary Under Secretary for DWP, Alex Burghart, stated: “Enabling our occupational schemes to take advantage of long-term illiquid investment is one of this government’s key priorities.

“Whilst we realise performance fees and their relation to the charge cap is not the sole challenge that DC and CMP schemes may face when looking to invest in certain illiquid asset classes, it does remove a potential barrier. Removal has the capability to help facilitate greater levels of investment in private markets, which may not have been previously considered.

“The performance-based fee measure removes a barrier for trustees when considering whether or not to incur performance-based fees, if they believe the investment provides value for their members.

"It is intended to provide an opportunity for fund managers and DC schemes to work together to ensure investment products work, and in equal measure protect, the interests of members.

“We have listened to industry and refined our policy in light of the feedback we received. We want to ensure that the regulatory burden is reasonable and proportionate whilst still retaining the wider benefits that changes in this area could bring.

“The proposed measures emphasise the key role that trustees of DC and CMP schemes, and their advisors, have in ensuring the impact of different investment arrangements on long-term outcomes are appropriately considered.

"The role which illiquid assets could play in improving pension outcomes for members should not be overlooked.”

Alongside these changes, the government is also consulting on draft regulations requiring trustees to disclose and explain their policies on illiquid investments in their Statement of Investment Principles.

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