The Pensions Regulator has warned of the challenges posed by attempting to value illiquid assets, as the government seeks to incentivise defined contribution to increase these investments.
The government announced in December that it would soon remove fees from the DC charge cap, in a bid to spur investment in “UK innovation”.
On December 9, TPR published a blog penned by its executive director for regulatory policy, analysis and advice, David Fairs, in which he warned that the valuation process for illiquids “can often be more of an art than a science”.
“In current markets and other incidences of stressed markets, with volatile investor sentiment, transaction activity drying up, and significant uncertainty around some key valuation inputs, valuation of some illiquids may be impossible,” he said.
The valuation of those assets along the journey can be problematic for trustees
David Fairs, TPR
Illiquid market value can only be established on sale
The government has worked to channel pension fund investment towards domestic initiatives, consulting on DC illiquid investment in March and agreeing to remove performance fees from the charge cap.
In November, the Productive Finance Working Group – convened by the Bank of England, HM Treasury and the Financial Conduct Authority – published a series of guides aimed at helping trustees to better understand investing in illiquid assets.
The guides emphasised the importance of focusing on value over cost when considering illiquid investments. It said that charges were used too regularly as a “proxy for value”, with investment decisions based on “a handful of basis points”.
In his blog, Fairs endorsed the publishing of these guides, lauding the attempt to help trustees invest in illiquids in a way that would also benefit members.
Warning that valuing some illiquids would be impossible, “for others, it may be little more than a conditional best guess”, he said.
“While many of the underlying illiquid assets may eventually come out the other side of the period of economic and market challenge and deliver the long-term value and outcome expected, the valuation of those assets along the journey can be problematic for trustees,” he continued.
“The true market value of an illiquid asset can only be established on sale.”
Fairs cautioned that trustees will need valuations on many different dates, while trustees need to be able to settle members’ accounts, provide valuations, and allocate fees and investment performance to these accounts.
“Where performance-related fees are involved, the challenges for trustees increase and where the valuations of illiquids lag the market and are artificially high (from not being realistically ‘marked to market’), value for money concerns arise as members pay fees based on the artificially high value attributed to those investments,” he said.
Value over cost emphasised in new DC illiquid investment guides
Defined contribution scheme trustees are being encouraged to shift their focus on illiquid investments from cost to value, in a series of guides published by the Productive Finance Working Group.
TPR wants to see “rigorous” valuation governance, while trustees should also consult their investment advisers, legal counsel and even in some cases their scheme auditor, Fairs added.
They should also understand the difference between the use of stale prices – an old price of an asset – and modelled prices, while also carrying out some member movement scenario analysis.
Schemes should also conduct downside valuation scenario analysis “to understand the operational issues that would arise in stressed markets, or when (fund) assets invested in are subject to, for example, an audit qualification”, he said..
