How pension funds could be a better source of UK growth capital 

In the fierce debate about how to provide more risk capital for UK companies, pension schemes are attracting criticism for not investing in fledgling businesses particularly in the technology and science industries but also listed equity markets as well as helping to fund UK infrastructure projects. Indeed, the government is under pressure to propose reforms for unlocking pension investments in the coming months.  Labour has identified their intention to establish a “future growth fund” funded partly by defined contribution schemes if they come to power and the Chancellor of the Exchequer is promising announcements on the topic in July’s Mansion House speech.

Creating new avenues for pension schemes to tap into attractive investment opportunities is always welcome. Mercer would support any proposals that led to better outcomes for pension scheme members. However, compelling UK pension schemes to increase their holdings in UK plc, start-ups and new infrastructure projects presents a range of challenges. 

The wording around these issues in the statements being made seem blurred in not differentiating between our mature defined benefit pensions industry and the more immature defined contribution market.  

Perhaps a good place to start then is to consider these two markets separately and identify what these very different types of investors need and whether this can be married-up to the needs and wants of the government and UK economy.

This means they do not have the very long time horizon for making new investments that these schemes used to have as immature, open schemes.  Many DB schemes are now fully or close to fully funded (i.e. they have enough assets to pay all future benefits) and a large proportion are aiming to pass over their assets and liabilities to an insurance company (i.e. transact a “buy-in or buy-out”).  This typically requires assets that can be easily liquidated.  Others are running off their scheme with a limited lifespan left.  The upshot is that fewer schemes need to rely on generating high levels of return to deliver the promised pension payments.  So the proportion invested in risky assets, like equities, are reduced dramatically.  Instead, DB schemes are focused on investing in low risk assets, such as government and corporate bonds, which can generate the cashflows to meet the promised pension benefits.  The fiduciary duty of the trustees managing these schemes is to ensure pension payments are paid out in a low risk way.  Mercer analysis shows that UK DB schemes own c.45% of the index-linked gilt market³ so are already providing significant amounts of capital to the UK government to be able to invest in the real economy.  

So rather than trying to encourage these corporate pension schemes to invest in technology and science start-ups, perhaps the role of DB schemes could be to invest in bonds which help fund some of the UK growth story.  The obvious place would be infrastructure projects.  Bonds would also offer the liquidity many DB schemes are looking for (rather than private market assets). This would fit their investment strategies much better than private equity (i.e. start-up companies).  The government’s focus seems to be on UK listed companies and private equity initiatives but it’s the bonds markets that demand the attention of corporate DB pension schemes.

Those open schemes with bandwidth to invest in equities at a significant level, e.g. the Local Government Pension Scheme (‘LGPS’), need to be provided a robust investment case for doing so to support the UK growth agenda. This will require the UK government to provide significant detail on the competitive advantage the UK holds to ensure decision makers are fulfilling their fiduciary duty to members. 

By contrast, the growing £600 billion DC pension pool is, in theory, a far better source of growth capital as members tend to have a longer-term investment horizon and a higher risk tolerance (certainly among younger members), in order to generate higher levels of pension income at retirement.  

DC schemes could benefit from being able to invest in high growth assets such as private equity and venture capital (that would support tech and science). These higher returns would be readily welcomed, as we calculate that the recent levels of high pensioner spending inflation (up to 18%⁴), with wages not keeping pace, have resulted in DC savers needing approximately 0.5% p.a. extra investment return their whole working life (all else equal) – so either members need to contribute more or investments need to work harder. Recently, private markets have been hailed by many as a way for members to achieve these higher returns needed to retire more comfortably. However investment by DC pension schemes in areas such as private markets have been held back by:

A lot of noise has been made about the Australian and US markets as leading the way in this regard and indeed the Australian market looks like kind of market the UK will want to stride towards. In particular, the UK government and regulators have been keen to promote DC pension scheme investment in private markets to stimulate UK economic growth. However, the Australian DC pension industry is many years ahead of the UK, and has benefited from a much higher minimum contribution rate (12% from 2025 versus a UK rate of 8% of qualifying earnings for auto enrolment), as well as from an earlier focus on DC for pension provision. The Australian superannuation system is 30 years old and a staggering A$3.5 trillion⁵ (£1.9 trillion) in DC assets given a population of just 26 million – more than 3 times the size of the UK for less than half of the population.   

Further consolidation and innovation in the UK market will help DC schemes access private markets faster – and we’re optimistic that private markets will be a feasible option in future DC portfolios. That said, if the UK government really want more UK investment from the DC sector, having a higher contribution rate would certainly go a long way to achieving this and help address the much bigger issue of the savings and pension adequacy crisis that many UK DC members are facing.

All of these issues make any imminent drive to increase pension investment in UK growth part of a wider debate. In addition, much work was done through the 2000s and 2010s to diversify away the UK home bias in (listed) equity investment – especially in DC. Schemes will need to be convinced that investing heavily in the UK instead of taking a more global approach is in the best interests of beneficiaries.

That said, there are three ways that the government could fulfil its investment goals while supporting DB and DC schemes’ objectives:

References

(1) Office of National Statistics estimated total private sector schemes assets valued at £2 trillion as at 30 September 2022, split £1.276 DB and hybrid and £0.69 trillion for private sector DC.

(2) The Pension Regulator’s 2022 annual report.

(3) UK DB allocation uses the PPF total assets (2022 Purple Book), then divides this pro-rata using Mercer’s SAA as well as direct allocations from the PPF Purple Book

(4) PLSA Retirement Living Standards estimated the increase in spending from April 2021 to April 2022 for pensioners living outside of London at the “minimum” level of spending to be 18%

(5) Australian prudential Regulation Authority June 2022