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These new VFM regulations will require schemes to benchmark themselves against competitors on three key metrics: costs and charges, investment performance, and quality of services.
At a recent roundtable event hosted by Corporate Adviser, advisers and providers discussed the potential impact on investment strategies, and whether this would deliver better overall outcomes for savers.
While charges and quality of services may be easier to benchmark, many at the event said the picture was far from straightforward when it comes to assessing investment performance. While all agreed some assessment was needed, given this is a key driver of member returns, concerns were raised as to whether this could create unintended consequences, if these VFM tests are not structured appropriately.
The VFM regulations will require schemes to disclose a red, amber, or green rating for these metrics, indicating whether they deliver value for money (green), are close to the benchmark but with room for improvement (amber), or are lagging behind (red).
As proposed regulations stand, an amber or red rating will force schemes to close to new business, potentially having a significant commercial impact.
Many questioned the practicality of these RAG tests for investment performance, with concerns that they could negatively influence future strategies. Paul Armitage, who leads Muse’s DC and employee benefit support said these VFM regulations, combined with moves to drive wider consolidation in the DC sector could lead to ‘herding’ around investment strategies, with providers following similar and more conservative investment approaches rather than risk becoming an outlier in performance terms and having to close to new business for a period of time.
“We’re going to see a lot of consolidation you would think in the next two to three years. What’s left will be a very strong pool of providers. You can certainly see the likelihood of a concentration of different investment strategies around accepted norms in order to achieve and retain a green rating. This is likely to narrow the dispersion of returns significantly.”
In such conditions, “it’s going to be increasingly hard to deliver above-average performance,” he added. “By definition, not everyone can be above average, and for those that aren’t, there could be significant commercial ramifications.”
Many of the consultants attending the event said herding was unlikely to benefit members if it led to more defensive investment strategies. Some cited Australia’s more stringent VFM tests which require schemes to notify members if performance dips just 0.5 percentage points below their benchmark. This has resulted in a narrower range of returns, with the best-performing schemes delivering less than the best-performing schemes in the UK. However it should be noted that the converse is also true, with the worst-performing schemes delivering better returns for members.
Aon DC Solutions chief investment officer and senior partner Jo Sharples noted that anecdotal feedback she has heard from Australia is not to follow their model too closely when it comes to benchmarking investment returns, which by their nature can be cyclical. But she acknowledged that “net performance is really important, and this is something we should be looking at and making available” as part of a wider assessment of the value of DC schemes.
Consultants also pointed out the current wide divergence in returns for UK workplace schemes. Aon market development lead and associate partner Nigel Aston said: “If you look at the top and bottom performers in the workplace DC market over five years, there’s a huge gulf, meaning some UK employees are on track for poorer retirement outcomes.”
This is partly due to different investment strategies. PwC director, DC pensions and benefits lead, Roshni Patel said: “This change has been needed.” She points out that a decade ago the differences in investment strategy were so significant it was difficult to compare schemes. But convergence has increased recently, she said, with many providers now moving to higher-risk 100 per cent equity strategies in the growth phase.
Another area of concern is around the benchmarks that may be used to grade this performance, particularly as schemes can essentially select their own, and pick which other providers to compare themselves against in this VFM comparisons. Hymans Robertson partner and senior DC consultant Mark Jaffray said: “It can seem as though providers are marking their own homework due to a lack of standardisation.”
However, he pointed out that this is where the consultant would play an important role, when it comes to assessing the more basic traffic light ratings. “It comes back to people like us who are in a position to read across the market, understand different scheme objectives, and how well they are being met when it comes to delivering for members.”
Sharples said schemes need to think about what is an appropriate benchmark. “You might have an inflation-plus benchmark, which essentially ignores the market cap and what this is doing.
Then there are benchmarks [that monitor performance against an index like] the MSCI World.” This may not necessarily be appropriate for schemes going forward though she said, with many workplace pension providers looking to diversify into private markets.
Another potential area of concern is the number of default schemes now offered by providers. Nigel Dunn a partner in LCP’s defined contribution team, stressed the importance of ensuring providers don’t ‘game’ the system by closing underperforming defaults and launching new ones.
Barnett Waddingham principal and senior investment consultant Gareth Doyle added that recent launches of new default options needed careful monitoring to ensure schemes weren’t essentially running a number of ‘shadow defaults’ in the background. He said though consolidation might mitigate this.
The consultants on the panel all agreed that investment performance should be ‘chain-linked’ between newer and older defaults to provide a clearer and more accurate picture of DC savers’ returns; an approach Corporate Adviser takes with its CAPA data.
Broadstone senior consultant Richard Sweetman also commented that VFM metrics focus solely on the growth phase, and ignore post-retirement investment performance, which means they are unlikely to give a view of overall value. “This stage is completely ignored,” he said. He added that the assessment on quality of services will also not take into account services offered at retirement. This is an oversight he said as poor decisions at this stage can destroy value.
Sharples also pointed out that regulators routinely seem to overlook the post-retirement phase — as this is also excluded from the charge cap. She said she hoped VFM assessments would eventually evolve to include this.
Forward projections
Some attendees were surprised that VFM regulations focus solely on past performance, without forward-looking projections on investment performance. Armitage said: “I was struck by how difficult it will be for a provider who has changed their investment strategy. Even if they’ve made improvements, they can’t demonstrate this in the VFM assessment until historical data improves.”
This raised the prospect he said that some poorly performing schemes will already be “sunk” when these new regulations come into force. Even if they have improved their default, it may take a number of years for this to be show in performance data — and in the meantime their commercial activity could be hit by an amber rating.
Others were less enthusiastic about forward-looking assumptions. Sharples says it can be “very irritating” when schemes change their investment strategy, but then project backwards what this new strategy would have delivered.“ This just feels like a hindsight strategy. I think we need to avoid that because it risks looking like you are trying to game the system.”
She added that forward projections are highly sensitive to assumptions, so there would need to be very careful consideration about how they should be used in any VFM assessment.
Redington managing director and head of DC Jonathan Parker cautioned against turning this into an “assumption competition” where providers all claim their models are superior, when it comes to predicting future returns. “The TPR and the FCA had this debate when the rules around SMPI (Statutory Money Purchase Illustrations) assumptions were changed to a backward looking measure.” He doesn’t think regulators wanted to have two different approaches between the SMPI assumption and new VFM rules.
Jaffray emphasised the importance of balancing past and future performance when assessing schemes, and said consultants will obviously take a view on both, and look at more than just to VFM RAG assessments when recommending schemes to a client. “Past performance does matters, it shows what a provider has delivered. But the forward look is also a key indicator of whether this is likely to continue in future. I think you can find a balance that includes both.”
Patel said that all these figures have to be considered in context. She added: “There’s nothing stopping providers giving this information to the market in a different way, it does not have to be part of the formal reporting. And it’s up to us as advisors to scrutinise this information carefully, as if this is outside the framework it might not all be presented in the same way.”
Private markets
Delegates’ surprise that VFM rules exclude forward-looking performance metrics was in part down to the government’s other big pensions initiative: to get DC schemes to boost investment into private markets.
The Chancellor’s Mansion House proposals call for industry consolidation to drive investment into real assets, infrastructure and private equity, with a view to boost the UK economy and improve pension outcomes.
However, the panel debated whether private markets necessarily deliver superior returns in the DC sector.
Armitage noted that while this asset class is new to DC, it has been used successfully in DB schemes for decades. “The investment case has been made in the DB world,” he said. Isio director Sukhdeep Randhawa agreed, pointing out that the Local Government Pension Schemes (LGPS) have high allocations to private markets, which have delivered strong returns.
Jaffray added that Australian and Canadian DC schemes have invested in private markets successfully for decades. “It may take time to see results in DC. Listed markets have done spectacularly well over the past 10–15 years, which might be a hard target to beat, but this is unlikely to last forever.”
However, Patel highlighted potential complications. “We’ve worked with a provider offering two defaults, one with private equity exposure. Unfortunately, the private equity option has underperformed.” She also noted challenges in accessing clear-cut private market performance data.
Doyle also cautioned against ‘survivorship bias’ in the data available, where success stories in the DB sector may create unrealistic expectations for DC schemes. “Not all private market investments will outperform listed markets,” he said.
Sharples agreed this was an issue, particularly given the cost constraints of DC schemes. “The best private equity and venture capital funds are oversubscribed, with high fees. If you don’t pay the premium, you may end up with lower-tier options that may not deliver superior returns. I think if you have to go down to the dregs you’re probably better off not doing it at all, and may be better off sticking with listed equities instead.”
Delegates pointed out that many DC schemes will access private markets through new Long-Term Asset Funds (LTAFs). Doyle highlighted the diverse underlying assets within these LTAFs. “You look at what is currently available and can see how little exposure some have to private equity. And you look at what other asset classes are in there, and you can see some will struggle to match let alone exceed listed equities.”
Dunn agreed this is a potential issue, and said there was a need for consultants to scrutinise individual LTAF holdings. “Some are single-sleeve, investing in private equity or private credit, while others are multi-asset.” Aston drew parallels with Diversified Growth Funds (DGFs), where performance varied significantly depending on underlying holdings. “LTAFs like DGFs will be no universal panacea for better returns,” he added.
Performance concerns
While most agreed that private markets offer long-term potential, they cautioned that returns may not be immediate, particularly given the time it can take to deploy capital into these strategies.
Those at the event raised concerns about whether these VFM metrics might disadvantage schemes that are early adopters of private markets when it comes to shorter-term performance. However, the panel largely felt this would not deter schemes from investing in private markets, given the regulatory and legislative push in this direction. Many pointed out that moving as an industry made schemes more likely to adopt this approach.
Sharples said this might influence the debate about whether private market are accessed through closed or opened-ended fund structures. “There’s a debate at present about whether you look at traditional closed-ended funds, or got down the more opened-ended route.
“There are pros and cons to each, in terms of capital being drawn more quickly, which means there shouldn’t be quite the same impact on short term performance But with more open ended structures you might not get the very best deal, as these often get locked up in those closed structures, but you might get a more transparent portfolio for your clients.”
Overall those on the panel agreed that in principles the VFM regulations should lead to greater transparency across the DC sector.
But as regulators fine-tune the more detailed rules, consultants said care needs to be taken, particularly when it comes to how the assessment of investment performance to ensure schemes don’t retreat from innovation, or find themselves unduly penalised as a result of wider market movements.
