U.K. investors question 20% illiquids cap proposal

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Corporate pension funds are concerned that the U.K. regulator’s plan to limit illiquid investments to 20% of portfolios could force them to alter their current strategies.

The Pensions Regulator proposed in March that illiquid assets should not make up more than 20% of portfolios — a big departure from current regulations that state investments should “predominantly” be held in assets traded on regulated markets.

The current rules are interpreted to mean that pension funds should not invest more than 50% in illiquid assets rather than 20%, Tiffany Tsang, London-based head of DB, LGPS and investment at the Pensions and Lifetime Savings Association, said in a telephone interview.

With the change proposed under its new code of practice, which will be introduced to replace 10 existing codes for pension governance and administration, the regulator wants corporate and public pension fund executives and trustees to ensure they carefully manage liquidity risk and exposure to illiquid assets. The comment period on the proposal ended May 26 and pension funds are now waiting on the regulator to reveal any changes, sources said.

“The PLSA and its members are really concerned about this proposal,” Ms. Tsang said. “This is quite a major step change,” she added.

Large pension funds that are major private market investors also reacted to the proposal.

“We are concerned about the illiquid threshold and believe it would be unhelpful to have a cap on illiquid investments,” a spokesman for the £57.3 billion ($81.3 billion) BT Pension Scheme, London, said in an emailed comment. BTPS’s illiquids exposure is just below 20%.

A spokesman at the £68 billion Universities Superannuation Scheme, London, added in a separate emailed comment: “We understand TPR’s intentions here but the unintended consequences are potentially significant. We believe we would not be able to invest in ways we consider to be in the best interests of our members, and the options available to access investment returns consistent with our liabilities would be reduced.” USS invests £18.2 billion in real estate, private credit and private equity.

Sources said that the potential change drums up quite a lot of different problems particularly for larger pension funds, and would require them to rethink their investment strategies.

Hemal Popat, director, investments at Mercer Ltd. in London, said the vast majority of U.K. DB plans has 30% or less invested in illiquid assets. “Those over the 20% figure proposed by TPR tend to be the larger funds with more in-house resource,” he said.

Tim Giles, head of investment for U.K. and Ireland at Aon PLC, added that the regulator is looking for a clear management of liquidity by pension funds. “Schemes do need to make sure that the allocation they make to illiquid assets is appropriate for their cash flow and duration of their liabilities,” he said.

But while Mr. Giles thinks that it is not a major restriction for smaller U.K. pension funds, he agreed could be limiting for larger funds.

If the proposal is enacted, it would mean that some pension funds would have to reduce their illiquid investments and would have to regularly monitor allocations to ensure that they don’t exceed the new limit.

Mr. Giles, who thinks that larger pension funds have appropriate capabilities to manage their own liquidity and thus don’t need to be limited to 20% illiquids, said that executives at these funds would potentially have to sell their assets down, which “if done at a wrong time could be at a cost.”

In response to the proposal, the spokesman at BT Pension Scheme said: “BTPS has strong liquidity measures, which help when investing in illiquid assets. We feel we understand the implications well and we have enough contingency so that we should not be in a position of being a forced seller.”

As U.K. DB funds increasingly mature and derisk their portfolios, illiquid investments can actually enhance their liquidity position.

Mr. Giles said that many illiquid assets can generate cash for pension obligations. For example, infrastructure debt could be fairly illiquid, but it could be throwing out a dividend yield of 5% per year, he said. “If you use illiquid assets to pay cash flow towards your pension (obligations), it is helping with your pension rather than hindering it,” he added.

TPR’s proposal did not define what type of investments will be considered illiquid.

Other challenges include administration headaches. PLSA’s Ms. Tsang said that small market movements don’t currently force investment changes because the parameters are set to be wide. But if they are narrowed to 20%, the constant evaluation of going over it could cause an administrative burden to pension funds, she added. The proposal did not include any details of how investors should handle excess exposure to illiquid assets or if they will be permitted to hold extra illiquids temporarily.

Ms. Tsang also added that the proposal contradicts the U.K. government’s intention to have pension funds participate in the recovery from the coronavirus pandemic through infrastructure and other alternative investments. “The way things are set up now can speak to a wider government objective to invest in the green recovery and infrastructure,” she said. But a 20% cap “ties people’s hands,” she said.

USS executives agree with the contradiction. “We believe a return to the longstanding interpretation of rules around investing in unregulated assets would be the best outcome for our scheme members and would also enable us to meet wider government policy objectives,” the spokesman said in the email.

Sources said the decision on the proposal is not expected before the end of the year. A TPR spokesman did not provide a timeline for any changes to be implemented.

“It will be interesting to see if what revisions, if any, TPR proposes to this part of the draft code based on consultation responses,” Mercer’s Mr. Popat said.