The crucial debate about pensions has intensified over the past week, and rightly so. There is much change needed to unlock Britain’s full potential and to connect savers with a broader array of assets.
Critically we must create the right ecosystem. To begin, we need a change in our whole investment culture so that more pensions savers see the merits of real asset investment both for Britain’s wealth and their own wealth. This requires perseverance and education. We are all used to medical health checks but financial health checks should be promoted by Government and not left until retirement when it is too late. Secondly, we need to ensure their pension managers are not inhibited in selecting these investments on their behalf.
The right reform - in terms of regulatory adjustments, incentives, and industry restructuring – could bring both these things. It should help foster a stronger, rejuvenated investment ecosystem; one where individual savers are more connected with their assets. You might be a saver in Liverpool looking out to sea, knowing the windfarms dotting the horizon are part of your pension.
We’ve seen a deluge of negative headlines about London losing its lustre as a global centre for capital-raising. In fact, a lot of work is underway on many fronts to bring about widespread change. Earlier this month the Financial Conduct Authority proposed an overhaul of the UK’s listing regime, making it easier for firms to raise money on London’s market. Other reforms, including those involving the so-called “Solvency II” rules for insurers, are also progressing. New investment vehicles, such as Long Term Asset Funds, are being developed and launched. Overall there are strong forces of change from government, regulators and the finance industry working together.
With pension assets it’s useful to distinguish between the large – but declining – pot of defined benefit (DB) pension money and the increasingly popular, and growing, defined contribution (DC) pot. Private DB schemes currently oversee assets of about £1.5 trillion. They have divested significantly away from UK equities in recent decades, with our research suggesting DB allocation to UK company shares has fallen from over 50% in the 1990s to less than 2% in 2022. This shift is not surprising: DB schemes’ responsibility is to pay specified benefits to retired workers and take no unnecessary risk. However, many of these schemes are now in healthy positions and are able to pass the responsibility for future payments, along with the assets, to insurers. This is why insurers’ ability to invest more freely in risk assets forms such a crucial part of the wider picture of necessary reform.
The DC pension world is in stark contrast. Here, workers’ ultimate retirement benefits are directly linked to the performance of their investments. A different risk dynamic applies. The DC pile of assets is also growing rapidly, rather than declining, and it belongs to a far wider group of people. As of 2022 there were 18 million DC members compared to an estimated 960,000 DB scheme members. A total £670 billion is forecast to be contributed to DC by 2030, bringing total DC assets to an estimated £1.3 trillion.
Modernising these schemes is vital. Sweeping away decades of structural inefficiency and policy muddle would release deep pools of risk capital. Risk capital is the oxygen of growth. The UK’s comparative lack of this type of capital is the fundamental problem which all reforms should join in addressing. If we get this right, we can move toward ending the persistent problem of UK companies lagging at lower valuations than their US counterparts – which in turn is what makes UK companies such attractive targets for overseas buyers.
What steps to take? To start with, the proliferation of tens of thousands of small pension schemes needs to be consolidated. There are close to 27,000 DC schemes, more than 25,000 of which are micro-schemes with less than 12 members.
Small, fragmented schemes are hugely hindered in the breadth of available investments. They cannot access many of the most promising growth assets. Once consolidated, however, schemes can develop the specialism and scale necessary to invest more widely, including in fields such as life sciences and technology where the UK wants to lead. The government could also introduce structural incentives to attract pension capital into those sectors.
As has been argued in these pages in the last few days, a smaller number of larger schemes should result in investments in a greater array of assets. Experience elsewhere suggests this can generate higher returns. The Canada Pension Plan Investment Board, for example, one of Canada’s largest pension funds, invested $300m in a single UK energy business in 2021 – more than the entire UK pension system invested in private equity and growth capital combined for that year. This Canadian scheme is also the one, it’s worth noting, whose annual returns over ten years were an average 69% higher than the returns of the UK’s private-sector DB pensions.
Behind all this lies the complex question of risk – and society’s ability to understand and accept it. The decline of DB pensions and the rise of DC makes brutally clear how younger generations are being forced to shoulder more risk. What they manage to save during their working life, and how successfully it is invested, will determine the quality of their retirements. We want to aim for that point where savers clamour for their money to back the projects that both work for the UK – and deliver personal returns.
This article first appeared in The Daily Telegraph.
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