Recently, the government rejected the suggestion from the British Business Bank (a state-owned bank that helps finance new and growing businesses) to reform the current 0.75% cap on annual charges that defined contribution pension scheme members pay for the default investment strategy. Maintaining the current charge cap can reduce members’ ability to invest in more alternative (and also more expensive) asset classes such as venture capital (VC).
No entry to the dragon’s den
Venture capital involves investing into early stage companies, as in the premise of the BBC show Dragons’ Den. VC investments can grow from minor beginnings into hugely successful companies, e.g. Facebook and Uber. It offers investors the opportunity of significant returns. The government’s rejection denotes that members may find it difficult to get access to a potentially rewarding area of the market which would help diversify and increase their pension pots. However, it will save them from paying high management fees, and also from the risk of their capital being locked away for a long time due to the inherent illiquid nature of the asset class.
Allowing VC and other expensive and illiquid funds to be accessible to DC members would increase member potential returns, but also increase risk. Selecting any investment manager that outperforms net of fees is notoriously difficult and there is little evidence to suggest retail, or even institutional investors, can do this successfully over time. The performance of VC managers varies considerably and there is no way of knowing which would be successful – this would put members’ capital at risk.
What’s the alternative?
A key challenge to changing the charge cap is in answering the question ‘what do we change it to?’. VC fees can become complicated as they charge carried interest, similar to a performance fee. This could result in the member paying many multiples of 0.75%. Carried interest could encourage the VC manager to take excessive risks to get their very lucrative carried interest fee. Perhaps having a higher base fee could be a solution i.e. some funds have two share classes, one with a performance fee, the other with no performance fee but a higher standard fee.
An alternative to VC could be investing into small or micro-cap passive indices as these are more correlated to VC than traditional large cap indices. This may help members achieve higher growth but will increase the volatility of returns. As most members are likely to be invested for an extremely long time (e.g. 30-40 years), many listed and passive funds could provide a similar return to their illiquid active peers without the need to allocate to expensive and illiquid VC funds.