The Financial Conduct Authority (FCA) has proposed lifting the 35 per cent cap on illiquid investments that can be held in workplace pension funds where a Long-Term Asset Fund (LTAF) forms part of the default defined contribution (DC) arrangement.

The proposals are intended to address the “market failure” that DC default pension schemes do not invest in long-term illiquid assets, despite having the investment horizon to do so.

Indeed, the FCA warned that scheme members are missing out on the opportunity to benefit from any illiquidity premium, suggesting that the needs of members are not being met.

The consultation has proposed integrating the LTAF into the regulatory framework for the investment by DC pension schemes in unit-linked long-term insurance products, via amendments to the permitted links rules.

In particular, it noted that DC schemes may wish to allocate a proportion of their default funds to such assets, but may seek to do so by investing in an individual LTAF that is largely illiquid.

“We want to ensure that our rules enable schemes to think of their default investment proposition holistically,” it stated.

In light of this, and as part of the wider work on productive capital, FCA has confirmed that it is considering amendments to the permitted link rules where the unit-linked contract forms part of the default arrangement of an occupational or workplace DC pension scheme.

It stated: “We understand from industry feedback that in practice the 20/35 per cent cap on illiquid investments within any unit-linked fund means that firms find it difficult to market such a fund to DC schemes, which typically construct their default arrangements from a number of funds and so prefer to use a fund which is 100 per cent illiquid as part of a wider portfolio, in combination with funds consisting of more liquid assets."

Considering this, the FCA has proposed removing the 35 per cent limit on illiquid investments where an LTAF fund forms part of the default arrangement of a pension scheme, while retaining requirements on insurers to provide risk warnings and ensure that the fund is suitable for the ultimate investors.

This would be achieved for current purposes by allowing links to an investment in LTAF but carving out LTAF from the definition of QIS for COBS 21.3 purposes, making LTAF available as a conditional permitted link only in respect of default arrangement, and not for retail investors investing outside of the pension environment.

The FCA also emphasised that it would clarify in relevant rules that investment in these LTAFs does not count towards calculation of the 35 per cent limit.

"In this scenario, responsibility for deciding the proportion of the default arrangement which was invested in illiquid assets falls primarily on the trustees (of an occupational scheme) or on the operator of a workplace scheme (an insurer or SIPP operator)," it stated.

"However, we will include guidance clarifying that the insurer is expected to consider the concentration risks associated with the inclusion of LTAF in a default arrangement when complying with the conditions for the use of LTAF investment."

The regulator also stressed that the LTAF unit-linked investment will only apply to default arrangements in occupational or workplace pensions, and will not extend to self-select options available to pension scheme members, or non-workplace personal pensions.

It also acknowledged that some potential investors in LTAFs, like the default arrangements of pension schemes, will need to use the price of the LTAF to calculate a fair price for units of their own scheme.

In light of this, it proposed requiring that the LTAF’s assets should be valued at least monthly, and the price published in line with rules for NURS, predicting that this will provide transparency to investors.

In addition to this, the FCA noted that LTAFs will invest a significant proportion of their portfolio in inherently illiquid assets, stating that to address the liquidity risks stemming from this managers may need to make additional agreements with investors to deal with liquidity events.

“Whilst this goes beyond the management of the fund, we would be interested in views of how pension funds and managers could contract to deal with these complex scenarios, and whether there is merit in a cross-industry solution or standard,” it stated.

The FCA's consultation paper confirmed that the Productive Finance Working Group, launched in November, is also considering how to address barriers to illiquid investments, including a focus on costs of investing and an investment culture that favours investment in daily dealing funds.

Alongside this, the FCA flagged the DWP’s recently proposed changes to regulations around the pensions charge cap, which were designed to enable DC schemes to invest more easily in illiquid asset classes, despite industry concerns to the contrary.

Commenting on the consultation, Pensions Minister, Guy Opperman, said: “As part of the Productive Finance Working Group, I am proud of the work we have done with the FCA and others to launch the new fund structure, the LTAF, which has begun its consultation.

“I am passionate about ensuring pensions schemes have the necessary information, and a broad range of options, to improve member outcomes. The LTAF will provide wider access to alternative investments which will help pension schemes to diversify their portfolios.”

The consultation, A new authorised fund regime for investing in long term assets, is open to feedback until 25 June 2021.

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