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.
Defined Benefit Pension Schemes
of DB schemes open to new members
open to new accrual 2
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.
Defined Contribution Pension Schemes
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:
LiquidityThe long term nature of these funds means that it may be difficult or costly for schemes to sell their holdings, with the industry all too aware of the Woodford Investment Management debacle and the possibility of a run on the fund. Also, while in theory members investing for 30+ years don’t need daily access to their pension savings, in practice some DC investment platforms are unable to offer funds with longer redemption periods without either substantial rebuilds or risky bespoke manual processes – though we are seeing some innovation in this regard.
Higher feesThe UK DC market has been encouraged to focus on low cost solutions, whether due to the charge cap, or in the case of Master Trusts, commerciality.
Limited number of fund optionsThough this is being addressed through the wave of solutions emerging that incorporate private market vehicles, such as newly FCA approved Long Term Asset Funds (LTAFs) which allow DC schemes to access private markets. Although these LTAFs are in the early stages of development, and without proven track records of success, this will hopefully come in time.
SizeSmaller schemes lack the economies of scale and negotiation power to access private markets efficiently. With many of these smaller schemes moving towards master trust consolidation, accessing private markets with initial lock-in periods is not feasible.
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:
RegulationWhile draconian, regulation may be the only way to make pension funds invest more in UK companies. Otherwise it would be difficult to justify increasing exposure to the UK and accepting concentration risk (e.g. the FTSE All Share is dominated by a small number of stocks by global comparisons and there is a much bigger opportunity set for any form of investment outside of the UK).
Tax incentivesTax credits or other incentives for investing in UK companies would add to their returns, helping to match the superior gains that US equities have produced. By contrast tax incentives such as the tax relief, called on Advanced Corporate Tax, on dividends that UK pension schemes enjoyed on UK plc dividends were taken away by Gordon Brown when he was Chancellor in 1997. Annual allowance tax relief for investing in UK companies could also help.
- Infrastructure bonds for DB pension schemes that are attractive in terms of risk and return.
- A pooled fund supporting young UK growth companies could be established for pension schemes and other investors to invest in, backed by the government and executed by professional investment managers to achieve economies of scale and share risk.
- Establishing a Sovereign Wealth Fund would be another option that has served this purpose well in other countries, typically funded from oil and gas tax revenues (according to the Gov.UK UK Oil & Gas government revenues were £1.4 billion in 2022).
(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