Pension Fund Reform

Today’s post looks at proposals to reform DB pensions in the UK, and in particular at a paper from the Tony Blair Institute.

Context

The UK has a large pension industry (around £3 trn of assets) but not much of it is invested in UK stocks.

• This process of disinvestment has been underway for at least a couple of decades, but politicians have suddenly noticed an opportunity to boost growth in the UK economy.

The allocation to UK equities was close to 50% in 2000 but is now less than 2%, with noticeable effects on the UK stock market.

• Most pension funds are currently invested in low-risk low-yield bonds.

If some of this money could be diverted to growing UK firms and infrastructure projects, it might be possible to boost productivity.

• Both main parties have hinted that they might back compulsory allocations to UK stocks, though it might be better to allow schemes to opt in.

In theory, this means increasing the risk level of pension funds, but there are two caveats:

1. Over the life of a pension fund, stocks and infrastructure are likely to outperform bonds, so the pension fund should end up better off
2. DB pensions underwrite the payment to the pensioner – and are themselves underwritten by an industry insurance scheme – so the risk to individuals is negligible.

There are diversification issues to be considered, but a 20%-25% allocation to UK stocks (as proposed by the Blair Institute, rather than 2% as at present) would probably be defensible on investment grounds.

• Strictly speaking, the UK only makes up 4-5% of global equity markets, and perhaps that should be the starting point for the debate (but even that is much higher than 2%).

Pension deficits

The move away from stocks was triggered by accounting changes in 2004 which forced companies to show pension deficits or surpluses on their balance sheets.

• This began a shift into long-duration bonds, designed to better match the liabilities of the company DB scheme (payments stretching a long way into the future).

As interest rates fell so did the projected returns on these bonds, and many schemes fell into deficit, making further reform difficult.

• But now higher interest rates mean that the UK’s 5,000 DB schemes are in aggregate £300 bn in surplus.

This means that there is an opportunity to change the rules to favour stocks once more.

• The risk could further be reduced by consolidating many small schemes into a handful of larger ones.

DC schemes

Most DB schemes (outside the public sector) are now closed, and retirement contributions are now funnelled into DC schemes.

• These are smaller (forecast to pass £1 bn in assets by 2030), and the moral situation is less clear.

DC schemes usually invest in what their pensioners (who hold individually allocated pots, rather than rights to a share of a pool) request.

• This means that they hold more equities already, and also that forcing people to hold a certain level of UK stocks could cause problems.

Many will be able to compensate by lowering their UK exposure outside of their DC pensions, but:

1. This is a chore they have not asked for and
2. Some people’s savings may be dominated by their DC pension, leaving them with no escape route.

Again, pooling many small schemes into fewer, larger ones would make implementation more straightforward, but wouldn’t affect the moral issue.

• The charge cap on DC schemes would also need to be lifted to allow investments in alternatives and early-stage funds.

Blair proposals

The Blair Institute (TBI) paper is called “Investing in the Future: Boosting Savings and Prosperity for the UK”.

• We’ll go through the contents in more detail in a future post, but the key proposal is to pool public and private sector DB pensions into a number of “GB Superfunds” with up to £500 bn in assets each, similar to funds that already exist in Canada and Australia.

The Pension Protection Fund (PPF) – a £39 bn lifeboat scheme for UK pension plans – would become a fund consolidator.

• At the moment a pension scheme needs to fail in order to be taken over by the PPF, but under the TBi plan, small schemes would be tax-incentivised to merge with the PPF.

The PPF would grow to £400 bn, be renamed “GB Savings One” and would invest 25% of its assets in UK infrastructure, listed firms and start-ups.

The report notes that overseas pensions invest 16 times more into British venture capital and private equity than domestic pensions.

TBI director of policy, Jeegar Kakkad said:

We need these reforms to benefit pensioners and light a fire under the UK economy. The UK’s entrepreneurs and innovators shouldn’t have to look abroad for the capital to match the ambition of their ideas.

Industry reaction

The Pensions and Lifetime Savings Association, which represents 1,300 workplace schemes serving 30mn investors, said the proposals were radical and impractical. PLSA director Nigel Peaple said:

There are much simpler and quicker solutions. The government and pensions industry are already working intensively together on these issues and, provided they always put the interests of savers first, they should result in better outcomes for everyone.

Mick McAteer of the Financial Inclusion Centre warned that the UK did not have the collective risk-sharing mechanisms to support the TBI approach.

PensionBee thought that the plans would work for DB pensions. CEO Romi Savoya said:

There are huge benefits to removing the management of these pension plans from companies and placing them together in a ‘superfund’ – especially for the UK economy. A bonus of using the Pension Protection Fund for this, is that there is some level of security for savers, as well as a strategy for long term investment growth.

But she was less keen on DC pensions (which PensionBee operate) getting involved:

Defined Contribution pensions are a different story as there is no promise to savers to pay them a pension; the pension income in retirement depends on the investment return. So there is already a huge incentive to seek the best returns.

Unfortunately over the last decade or so, the UK has been a poor return environment. If the change in Defined Benefit investment works to kickstart the UK economy, then Defined Contribution funds will naturally invest here for returns. Where individuals are responsible for their own retirement pots, it’s not possible to have a mandated investment strategy.

I take her point, though it might be possible for DC pensions to allow investors to opt-in to a SuperFund as part of their pot.

Writing in the FT, Martin Wolf came out in favour of superfunds:

The UK has ended up with a pensions system that is incapable of generating the supply of long-term risk capital on which development depends or of providing the population as a whole with adequate and secure pensions.

Symptoms include a moribund stock market, under-invested companies, an undue dependence of foreign capital and even a stagnant economy. In particular, the narrow focus on making pension promises absolutely safe made them unaffordable.

Conclusions

This is a bit of a chicken-and-egg situation:

• DC investors will only invest in the UK if they think that the returns will be good.
• The TBI (and others) think that the investment from pension funds is what will make the UK grow, and improve its returns.

But (retail) investors are a largely performance-chasing mob, and 15 years of out-performance from the US (plus the lack of sexy tech firms in the UK – this year’s flavour being AI) mean that it might take a long run of outperformance to convince them.

• This means that it’s more likely that DB pension scheme members will have to play the guinea pig.

The offer to invest in a SuperFund can be made available within DC schemes.

• But whether many will take them up on it is another question.

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The second issue is the conflict between the “fiduciary duty” of pension scheme trustees to invest in the way they think makes the eventual payment of the pension most likely, and those who think (1) that stocks will deliver higher returns than bonds and (2) people will want to retire to a more prosperous country, for which we need growth capital.

• Getting the trustees to accept a new (in reality, the old) way of investing will not be easy.

I was arguing for DB pensions to invest in growth assets many years ago when DB pension deficits were still a big deal.

• I’m still in favour, but I don’t think that a majority of those in the pension industry (for which, read “on the gravy train”) agree with me.

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That’s it for today.

• It’s an interesting idea, and I’ll be back soon with a closer look a the TBI paper, which includes a lot of stats on the UK stock market and UK (and foreign) pension funds.

Until next time.