Hundreds of billions of retirement pounds are locked away doing little for savers, who face lower returns than in other countries due to overly conservative investment strategies, and little for the UK economy, either. A push is under way to hike returns and use the growing defined-contribution (DC) industry to boost valuations on the London Stock Exchange. But will it work?
Chancellor Rachel Reeves, like her predecessor, has talked of a new “big bang”, starting with a pensions bill next year that will shift the industry away from a purely 'value for money' framework and embrace higher-risk assets.
The context is awareness of the fact that pension money has been gradually withdrawn from the UK market over the past two decades, to the point where current low levels of domestic investment may be contributing to a wider lack of interest in UK shares.
This shift was prompted by private sector defined-benefit (DB) schemes closing to new members and began focusing on reducing liabilities. But with the arrival of auto-enrolment over a decade ago and the subsequent ramp-up in assets parked in DC schemes – an extra £33bn put away since 2012 – the government and the City see an opportunity to use some of DC schemes’ £600bn of assets, expected to rise to £1tn by 2030, to both build infrastructure and boost valuations of London-listed companies.
In September, pensions minister Emma Reynolds said there was “clearly much more work to be done in unlocking the full promise of pensions to drive growth across the country – and better outcomes for savers”.
Former chancellor Jeremy Hunt, launching the Mansion House reforms last year, made similar points as part of his push to direct more UK savings into higher-return investments such as private equity funds.
Lobby group and think-tank attention has also coalesced around the dual issue of limited pensions money finding its way into the local market, and existing structures producing poor returns for savers.
“As UK pensions have switched out of UK equities, they have helped feed a doom loop of lower demand, lower valuations, and a less dynamic market,” said William Wright in a report for think tank New Financial in September.
“Pension funds have harmed the valuation, credit rating and access to capital of UK companies to such a degree that a thriving business has arisen within the insurance industry to relieve them of this burden,” said a report from the Tony Blair Institute last year.
There is not a direct link between domestic investments and performance. But it’s hard not to look down the road and see both a weakened local stock market and an even greater burden on the state pension system due to lower savings levels, especially when there are models overseas that show how DC funds can deliver both growth at home and better returns.
Consulting firm Mercer calls low levels of pension savings the equivalent of “climate change” in terms of its financial impact on the UK economy: “Widening gaps in retirement income not only present challenges for individuals but also impose fiscal and political pressures for the government.”
So the situation is set: the government wants change, the system needs improving, and the local exchange and infrastructure need bolstering. Where to start?
Down under
Canada and Australia provide handy comparisons given their established DC industries. In August, Reeves herself went to Canada and met with some of the funds that are globally significant investors, including those in the ‘Maple 8’ such as Omers and Teachers.
“I want British schemes to learn lessons from the Canadian model and fire up the UK economy, which would deliver better returns for savers and unlock billions of pounds of investment,” said the chancellor.
Canadian funds are prolific infrastructure investors but put little into the local exchange, according to New Financial research. Excluding the US, top of the tree for local holdings as a percentage of total equity investment is Australia, at 52 per cent. This amounts to a significant sum: Australia has the fourth-largest pile of pension cash in the world in absolute terms and takes the top spot for savings per head.
Outcomes are better too. Here is the conclusion of fund manager Christopher Mahon, writing in a September report from The Policy Exchange: “Pensions [in Australia] deliver substantially better returns, particularly for older savers. There are much higher levels of transparency. Performance competition is intense. League tables of investment returns abound and moving provider comes easily. But the greater level of performance comes with slightly higher costs.”
A direct returns comparison between UK DC master trusts shows average annual returns of 5.3 per cent between 2017 and 2023, against 6 per cent for industry super funds in Australia. Mahon says there is a “huge difference in the way they are run”, which is down to risk profiles (see below).
Top of the rankings on a 10-year view is a growth-oriented fund from Hostplus, whose annual returns over the past decade amount to 8.3 per cent. Its target holdings are 21 per cent in Australian equities and 22 per cent in other developed market shares, with other assets including 30 per cent in unlisted “growth” holdings such as property, infrastructure and credit.
This kind of asset allocation is one of three big differences between the Australian and UK systems. The others are fewer, larger pension schemes ('super' funds) and a system focused on employer contributions (the legal minimum currently stands at 11.5 per cent, compared with roughly 3 per cent in the UK).
Australia's 1992 superannuation guarantee, which introduced a mandatory 3 per cent employer contribution, funnelled new dollars into a rising stock market, rapidly increasing the scale of the sector.
The country was already starting from a high base, with white-collar employees having been part of super schemes for decades. The real turning point was the government facing an inflation crisis in the 1980s, at which point it convinced major unions to accept retirement benefits in lieu of immediate pay rises.
“By 1985, the government was battling inflationary pressures, relatively high real interest rates, an increasing current account deficit, foreign debt and a decline in the value of the Australian dollar. Employee superannuation [a workplace pension] was attractive to the government in this economic climate because it offered scope for deferred wage increases and improvements in national saving,” says an official Australian Treasury history of superannuation. Coverage rose from 71 per cent of employees in 1991 to 81 per cent by 1995.
As the Hostplus allocation illustrates, equity holdings are just part of the picture. UK chancellors past and present have highlighted the outsized investments overseas pension funds have made in the UK, often in infrastructure.
Some might not be so popular – the main shareholders of Macquarie’s infrastructure fund that filled Thames Water to the brim with debt were Australian super funds, and more recently Canadian pension fund Omers has declined to inject more cash. But therein is the opportunity for such deep pools of capital. The failed Thames Water investment (for Omers at least) barely touches the sides in terms of its overall fund performance.
Leaps and bounds
In the UK, the accumulation of funds through auto-enrolment shows how quickly capital can be built up in pensions. Allocating it in a way that drives good returns and goes into boosting local projects and valuations is only going to become more important as the pile grows.
The Pensions and Lifetime Savings Association (PLSA) forecasts significant growth in DC funds by the end of the decade: the £605bn held across different types of DC schemes could hit £1tn by the end of the decade. These funds have over 20mn members between them. The PLSA forecasts much slower growth in the local government pension schemes (LGPS), from £270bn in 2020 to £500bn by 2030.
However, the average DC pot is still very small in size, with 77 per cent of funds maturing with less £50,000 in assets, as per FCA data. Boosting returns would make a material difference to savers, be they facing decades to retirement or just a few years.
The scheme performance numbers mentioned above, showing better returns in Australia and elsewhere, are not a completely apples-to-apples comparison.
Strip out the far greater number of UK savers who are subject to automatic ‘lifestyling’ processes, whereby those closer to retirement see their assets moved into lower-risk assets such as bonds or cash, and the difference in performance is negligible.
This is the state of affairs for DC scheme default funds, and Mahon is among those who see this as an under-recognised aspect of the UK's pension problem. Savers have the option to change lifestyling settings themselves, but in reality few do so. “It’s the elephant in the room,” Mahon says. “There is little desire yet to shift the needle from the risk-averse regulatory approach today.”
Where there is currently momentum is in a shift from a purely cost-based focus to one acknowledging the wider concept of value. The Financial Conduct Authority (FCA) and the Pensions Regulator have a consultation out on a plan to make DC pensions administration more user-friendly and better-performing, while the government is also examining the issue.
The value for money shift will mean investment performance is factored into the mix, as well as costs. “The cheapest schemes to run will not necessarily deliver the best performance in the long term for consumers,” the FCA said in August. The fact most workers are likely to remain with the default fund offered by the employer will also inform the updated framework.
An approach to disclosure closer to the Australian model, where funds are easily ranked and compared, is also on the way. Sarah Pritchard from the FCA said greater disclosure overall would “prompt some providers to consider if they have the scale and allocations to deliver good value”.
This question of scale is also critical, particularly if pensions are to invest more in risk assets. Separate to DC fund consolidation, the government is also looking at ways to bring together the splintered monolith of the LGPS. Over £430bn in assets are currently split between 99 funds in the UK, meaning the schemes should prove a good test case of the appetite for change.
The industry itself is considering the implications for being encouraged into riskier investment options: “If [higher-risk] opportunities are not in line with the Sharpe ratio [a risk-adjusted return] you could achieve elsewhere, then you’re on dicey ground doing it without some form of support,” said Luke Webster, chief investment officer of the Greater London Authority, according to industry publisher Room151.
Another local chief information officer (CIO) said merging the many different schemes in England could hit long-term returns because “you lose that local specialist knowledge, and that could ultimately affect long-term returns”.
But industry push-back is often a sign a policy is on the right track. The government said in August that progress in pooling would need to be seen by March, from when it would consider mandating it through legislation.
New Financial estimates LGPS cash being withdrawn from UK markets took £25bn out of the London Stock Exchange annually over the past decade, and there is still the potential for further withdrawals: “if the 37 LGPS funds that still use a ‘UK centric’ model switched to a ‘global equities’ approach, it would reduce the allocation to domestic equities across LGPS to just 2 per cent (from 10 per cent today)”.
William Wright at the think tank says volatile DC fund returns emphasise their managers are not perfect investors. “[The argument about avoiding the UK] would also be more compelling if pension funds and their advisers knew which markets were going to outperform in future,” he adds.
Overall, just 4.4 per cent of UK pension holdings are invested in local equities, as per the think tank's data. This is a slide from 50 per cent 25 years ago. The main drag is corporate DB pensions, which are mostly closed and sitting in fixed income or cash to protect against fund deficits.
Wright says this shift has been a driver of so-called de-equitisation, albeit not the only one. “A combination of the internationalisation of the investment industry, the poor performance of UK equities, changes in regulations and higher capital requirements for insurers have contributed to this dramatic institutional shift away from UK equities,” he says.
The contrast with other nations is stark: pension schemes in countries such as Australia, Japan and Hong Kong all allocate more than 20 per cent to domestic equities. Even the average domestic allocation across the globe, at 8 per cent, is almost twice current UK levels.
Radical ideas
The think tank attention has delivered some radical ideas to significantly hike the funds available. They go beyond raising the risk tolerance of DC schemes: pensions expert Toby Nangle, writing for New Financial early this year, said the real elephant in the room was the public sector DB system.
This covers millions of civil servants and other public employees, and effectively works by paying out retired members using the cash coming in from those still working. Nangle says the model is sustainable, but in practice it means over £1tn in assets are effectively left unused because of the current pay-as-you-go system.
“Moving unfunded public sector pensions to a funded pensions model would increase the stock of savings, deepen pools of capital that can be drawn on to enhance the capital stock, boost economic growth, and help finance the transition to net zero,” he wrote.
This would move over £1tn of liabilities onto the government’s books, however, although Nangle argues greater transparency would solidify such schemes' attractiveness to workers.
In the private sector, some think a move in the opposite direction is required. Last year's Tony Blair Institute report said corporate DB schemes should be severed from company balance sheets to allow greater investment freedom: “corporate sponsors’ legitimate risk aversion, together with the accounting treatment of liabilities, has artificially distorted asset allocation towards an extreme overconcentration on low-return government bonds”.
The institute said this shift could be introduced alongside a major roll-up of schemes and the creation of more superfunds. It found that the Pension Protection Fund, which amalgamates failed funds, has managed to boost returns via its scale and broader remit.
Then there is the question of scheme contributions. Increasing these is not a radical idea in itself, but hiking employers' efforts arguably is. Mahon argues it needs to happen. “Now is the perfect time to think about and tackle that challenge,” he says.
UK rules stipulate a minimum contribution level of 8 per cent, with 5 per cent from the worker and 3 per cent from the employer. Mahon said a gradual ramp-up of the latter to 5 per cent would be digestible, and less of a step change than the overall move from 5 to 8 per cent in 2019.
In his report, he said greater contributions are a “key route to living standards in retirement”. "This will help break the inflationary wage spiral the UK has recently been fighting, without negatively impacting total employee compensation,” he added.
Australia's employer contribution level will reach 12 per cent next year, with workers often topping it up to this amount due to tax incentives. Lower disposable income levels in the UK means asking more of workers is not easy, but the lifetime benefits are inarguable.
Extra cash coming into the system, at the same time as a concerted effort to rev up fund performance, could prove significant for UK equities. And if funds' UK allocations rose from their current level of 4.4 per cent to peers' 8 per cent average, that would add £93bn to the local market (which has a total combined capitalisation of £2.6tn).
Pension veterans may shrug at the current push for change, but this is still a system in transition and any major shifts will reverberate for the rest of the century and beyond. Time for an overhaul.
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