The gloomy outlook for the economy coupled with the burden of an ageing population appears to be increasing the frequency of calls for the UK’s pension schemes to step up and improve the country’s growth prospects.
In 2015 George Osborne asked LGPS funds to pool to bolster investment in infrastructure; last year the then-Prime Minister and Chancellor Boris Johnson and Rishi Sunak called for an investment ‘big bang’; and this March Baroness Ross Altmann called on the current Chancellor, Jeremy Hunt, to require pension schemes to invest a minimum in UK growth assets.
In recent months, there seems to be a shift in the political argument about pension scheme investing.
Matt Gibson, head of investment research at LCP, says: “Individuals are given a tax break on their pension investment so they can accumulate enough not to be a burden on the state in later life.”
But now politicians appear to be arguing that the state should see some advantages too. Gibson continues: “There are signs of a growing pressure on pension schemes to invest in the UK in order to justify the tax break.”
These calls for UK pension schemes to invest in the country’s growth assets represent, at best, confused thinking – and at worse a lack of understanding of the regulatory and market constraints which shape schemes’ investment strategies.
Joe Dabrowski, deputy director of policy at the PLSA, says: “The fundamental challenge is finding the sweet spot which matches pension schemes’ needs with the government’s requirement for investment into certain types of assets.”
Pension schemes must ensure any potential investment meets a trustee’s fiduciary duty, provides value for money and gives the best possible outcome for members.
Dabrowski comments: “Recent calls for pension schemes to provide more capital have lumped all schemes into the same bucket.”
Which schemes should invest?
Adam Saron, founder of Clara-Pensions, agrees: “It is very unclear which pension assets are supposed to invest in UK growth. Is it defined benefit or defined contribution schemes?”
The reality is the UK’s funded occupational pension scheme landscape is fragmented. Each of the three main categories – closed defined benefit (DB) pension schemes, open DB (including LGPS schemes), and defined contribution (DC) schemes typically used for automatic enrolment – has a different approach to investment.
Deciding which pension asset base should be investing in UK growth assets is important because it will affect when the government wants this investment to happen.
Saron said: “If you want investment big bang now then you have to go after DB schemes because they are the largest asset base.”
But it is far from certain DB schemes will want to invest. Dabrowski points out that: “The ability of a closed DB fund to invest in growth assets will depend on how close it is buyout.”
A scheme less than 10 years away from transferring its assets to an insurance company is unlikely to want to add additional illiquid assets, such as infrastructure to its portfolio.
“A scheme would only want to add this type of assets if they were to generate returns as well as be able to transfer them to an insurance company,” says Dabrowski.
The number of closed DB pension schemes which want to add more alternatives to their portfolios has recently decreased. Katie Sims, head of alternatives at WTW, says: “Thanks to the disastrous mini budget of last year, many pension schemes find themselves with a much shorter time horizon to buyout than they thought they had. That is not conducive to them increasing allocation to illiquid investments.”
“In addition, many schemes are now over-allocated to alternative investments because the value of both assets and liabilities have fallen and schemes had to sell liquid assets to maintain collateral positions,” adds Sims.
The fundamental challenge is finding the sweet spot which matches pension schemes’ needs with the Government’s requirement for investment into certain types of assets.
Not every closed DB scheme, however, will be thinking about buyout. Dabrowski says: “Some schemes are aiming for self-sufficiency and will exist for up to another four decades, and will therefore be able to take the risk of investing in growth assets.”
Open DB schemes have more than £300 billion of assets, and their investment time horizons are a good match for growth assets.
Dabrowski says: “In recent years much of the interventions have been focused on DC with this part of the DB market neglected despite managing the same size of assets.”
In comparison to DC funds, these open DB funds will have more mature investment strategies and bigger resources as well as more experience in these markets, he adds.
Who is already investing?
In fact, LGPS funds are already investing in UK assets. Dabrowski says: “The governance set-up – with councillors sitting on pension committees as well as regional pool structures – has led to a concentration of investment in local infrastructure projects such as student accommodation.”
James Brundrett, senior investment consultant at Mercer, says: “For example, Cornwall has a local renewable energy investment while Clwyd have joined with Manchester in their regional private equity fund which has made two investments in North Wales.”
Automatic enrolment DC funds also have long time horizons which are a good match for growth assets but have been reluctant to invest in more expensive asset classes.
Dabrowski says: “DC is a nascent market so while it has had rapid growth over the last decade, it lacks the expertise which comes with maturity and scale.” Only now are funds getting to the size which makes it feasible to invest in a broader range of assets.
Saron agrees: “DC assets will grow but it will be over time.” And it is not all DC funds which will be able to invest in these asset classes – it is those with sufficient scale and resources. In other words, only the master trusts. “These are currently still growing their assets,” added Saron.
The government wanting DC schemes to invest in growth assets is putting the cart before the horse. Saron says: “It’s not until a DC scheme is big that it has sufficient resource and the ability to source good deals.”
DC schemes are essentially a cottage industry which is trying to compete with international behemoths for growth assets. “Not every problem can be solved with scale, but it makes it much easier,” adds Saron.
Brundrett said: “Australia is good example of where scale allows DC schemes to become more sophisticated investors.”
Scale is not the only issue holding back DC schemes. Despite increased regulatory scrutiny of value for money, cost remains the key metric used to secure market share, resulting in an over-reliance on passive equities and a reluctance to include more expensive strategies.
Brundrett said: “There needs to be a greater focus on creating higher quality, member-focused outcomes in DC schemes because at the moment there is a race to the bottom driven by fees.”
This is at odds both with using more expensive alternatives assets and a value-for-money assessment of scheme members’ retirement outcomes, he adds. Liquidity has also been an issue. Many DC schemes rely on platforms with daily dealing requirements. This is a mismatch with the illiquid nature of infrastructure, private equity and venture capital.
Nor is it certain where the UK government wants pension schemes to invest. Saron said: “Infrastructure, private equity, venture capital and biotechnology have all been mentioned but they are very different markets.”
Even if pension schemes were to allocate more to growth assets, it is highly unlikely they would allocate assets only to the UK. As Gibson points out: “The UK venture capital market is not large enough for all pension schemes to invest in.” He adds that pension schemes would rather invest any asset globally in order to diversify.
Gibson continues: “For the majority of schemes, putting a significant allocation into UK assets does not make sense from an investment perspective. We welcome initiatives to facilitate investment, but if the government wants to mandate it, the industry is likely to resist strongly.”
Dabrowski concludes: “Pension scheme investment cannot be thought of as a silver bullet. Much of the issues which ail the UK economy today are systemic issues which need to be addressed with careful thought and plans.”