Duncan Lamont is head of strategic research at Schroders.
The UK pension fund system has emerged as a popular and convenient bogeyman for a range of woes afflicting Britain’s financial fortunes.
Companies choosing to list their shares in New York instead of London; our inability to convert world-leading life science expertise into commercial, domestic success; a shortage of long term capital to back UK infrastructure projects . . . It’s all the fault of UK pension plans apparently.
This is unfair and is unhelpful. The responsibility of “defined benefit” is to ensure there is sufficient money to pay people’s pensions. If something makes sense from an investment perspective they should and, in my experience, will consider it. But they aren’t a piggy banks to be raided for whatever happens to be the political priority of the day.
It’s true that the average DB allocation to UK equities has fallen from over 50 per cent in the 1990s to less than 2 per cent in 2022.
But many of the reasons are grounded in sensible investment basics, like diversification and risk management. It’s misguided to think that it could be reversed by a wave of a regulatory wand.
It’s also a narrow view of the UK pensions landscape. DB is only one part, and a diminishing one at that. “Defined contribution” pension funds are in a very different place and offer a far more optimistic outlook. This is where attention should be paid to the regulatory environment. Not to force them to “buy British” but to identify where there are barriers to that money being invested productively and profitably, and remove them.
“You can’t handle the truth!”
In the mid-1990s, the average UK DB pension fund had 75 per cent of its money in equities and just over 70 per cent of that in the UK — at a time when the UK was around 10 per cent of the global stock market. This resulted in having over half their portfolio in UK stocks.
The first big shift came after DB advisers and trustees realised that this wasn’t very diversified. This is especially the case given the UK equities have always been top-heavy. Just a handful of companies made up a large part of the entire stock market. (This remains the case today. The biggest five companies make up 36 per cent of the total market and the biggest ten account for 53 per cent.)
Between 1996 and 2012, UK DB funds reduced the UK from 71 per cent of equities to 33 per cent. Last year it fell to a record low of 13 per cent, but most of the move out of the UK happened during that initial period.
Despite this, returns on the UK stock market at the time almost matched the US (5.6 per cent a year vs 6 per cent a year).
The price-to-earnings multiple also went sideways versus the US for most of this period. In fact, the UK traded on a slightly higher valuation relative to the US at the end than it did at the start. It didn’t start falling behind on a more persistent basis until 2016.
If there was ever a time when you’d think pension fund selling should have presented a problem, that post-1996 period was it. But the market did absolutely fine compared to the US.
It’s also worth noting that geographic diversification has been a global trend. Everyone has been looking to limit their home bias, including American investors. Overseas investors now own more than 50 per cent of the UK stock market.
So, while some lament our domestic savings going overseas, the UK has benefited from additional inward investment as overseas investors have done the same. None of this was regulation-driven, and most people would surely agree that diversification is a good thing. It certainly was for UK pensioners — UK equities returned 6 per cent a year for the past decade, the US 12 per cent.
Past performance is not a guide to the future, and the UK is certainly very cheaply valued compared with global peers today, but this highlights why a more diversified strategy is simple investment common sense.
I love big bonds and I cannot lie
We can’t talk about DB pensions without talking about bonds. And it is absolutely the case that they have been buying bonds in a big way. The average allocation rose from about 20 per cent in 1996 to 50 per cent by 2012. Last year it rose to 63 per cent. But as with the international shift, the bulk of this transition took place at a time when UK equities were doing fine.
A DB pension is ultimately a series of fixed and inflation-linked promised payments to scheme members. The “least risky” asset to back these payments, is therefore a combination of fixed and inflation-linked government bonds; anything else involves risk.
Government critics should also remember that, by buying these bonds, DB pension schemes have been lending the UK huge sums of money to be spent on the government’s wider political priorities. Those arguing for DB to abandon bonds in favour of equities should be careful what they wish for. Last Autumn gave a taste of what could happen.
Moreover, it’s naive to think that pension funds could or should ignore bond yields entirely when thinking about the value of their liabilities. Only 10 per cent of private sector DB schemes in the UK are open to new members anyway. Enthusiasm from company management to run them is gone.
For many, the end game is to secure members’ benefits with an insurance company, in what’s called a “buyout”. This is only achievable once a scheme’s funding has moved from deficit to fully funded (or where a cheque is written to cover any shortfall). Insurance companies use bond yields to value the liabilities and work out the price to be paid. If you’re targeting a buyout, you can’t dodge them forever.
Tweaks will do naught
What if valuation methodologies were changed, would it lead to more equities being bought? It’s very unlikely, to be honest.
Most schemes are closed to new members and have just become a liability on a balance sheet to be managed. If an investment decision doesn’t pay off, the sponsor (usually an employer) has to pony up extra cash to pay people’s pensions. For some companies, the pension fund can be quite large relative to the underlying business. If they can’t find the cash or the business goes insolvent for any other reason, the pension fund ends up in the Pension Protection Fund, the industry lifeboat. Once there, members’ benefits are cut.
Investment risk isn’t to be taken lightly — precisely why The Pensions Regulator says the strength of the employer should be taken into account when setting investment strategy. Even if companies were encouraged to invest more in equities, most probably wouldn’t want to.
Last year’s rise in bond yields has changed pension scheme funding levels dramatically. There are different ways to value pension liabilities but it doesn’t matter which you use, they all say the same thing: funding levels (assets divided by liabilities) have soared. Assets fell but liabilities fell by more.
According to PwC, UK DB assets are now worth £160bn more than the value of their liabilities when those liabilities are valued on the stringent, buyout basis. That doesn’t mean every scheme is overflowing, but many are. And those that are not are a lot closer than they expected to be right now.
The vast majority now have less need to take risk with their investments. So why on earth would they want to jeopardise that by taking a punt on equity markets? There simply isn’t any need.
So, no, even if the funding rules were twiddled with, anyone who is arguing that UK DB will ever be big buyers of UK equities again is living in the past. That ship sailed long ago.
The DB king is dead, long live the DC king
As of March of last year, there were an estimated 960,000 active members of private sector DB schemes. In comparison, thanks to auto-enrolment, there are 18mn active members of DC schemes.
Private sector DC contributions are already more than double the amount going into private sector DB each year. According to data from Broadridge, £49bn was contributed to DC in 2020, a figure that is rising every year. £25bn went into private sector DB in the most recently available 12 month period (to June 2022), a figure that keeps falling every year.
Collectively, £670bn is forecast to be contributed to DC plans in the decade to 2030. That will lift DC assets to £1.3tn. from around £545bn today. Private sector DB assets today are around £1.5tn. This DC projection does not include an estimated £300bn relating to individuals who are expected to retire during this period, so the true figure which ends up in DC-related retirement savings strategies of some sort will be even higher.
So if you want to talk about the future of pension funds, DC is where it’s at. And guess what? They allocate lots to equities!
Industry assets are dominated by master trusts, vehicles in which individuals spread across many employers can save for retirement. NEST is probably the most well known. According to the Pensions Policy Institute’s DC Asset Allocation Survey, master trust default strategies allocate 70 per cent to equities, for members 20 years away from retirement. And 96 per cent of members end up in the default strategy. So most contributions end up in stocks.
DC pension savers are therefore set to invest billions of pounds in UK equities in the coming years. Any headwind from DB selling could be about to turn into a tailwind from DC buying.
Unlocking private capital
Many DC savers have several decades until retirement but most DC savings vehicles have historically only been in funds which can be bought or sold on a daily basis. This has constrained them to assets such as public equities or bonds.
As a result, DC savers have faced barriers to accessing the potential of private assets — such as infrastructure, private equity, or real estate — and private companies and projects have been starved of access to the long-term capital that is growing rapidly in DC pensions. The 2020 Pension charges survey found that two thirds of DC schemes had no direct exposure to assets like these.
This has long been acknowledged as a shortcoming. To counter it, the UK Chancellor in 2020 launched something called Long Term Asset Funds, or LTAFs. These vehicles make it easier for a broader range of investors to gain exposure to private assets by offering periodic liquidity rather than daily. (Full disclosure, Schroders recently received approval from the Financial Conduct Authority to launch the first LTAF.)
But this alone isn’t enough. There are close to 27,000 DC schemes in the UK, 25,700 of which are micro schemes of fewer than 12 members. Master trusts are bigger but the 36 we have in the UK also makes this a fragmented market by international standards. Smaller schemes and master trusts lack the resources, expertise, and scale to invest in private assets in an efficient way. As a result, most do not. We’ve argued, (most recently via the Capital Markets Industry Taskforce) that consolidation is imperative. Without it, DC savers will lose out.
But remember, every pound that goes into private assets is a pound that hasn’t gone into UK equities or the government’s coffers. You can’t whack all the moles at once.
So yes, we need to make sure that pensions are regulated appropriately. But always with the appropriate goal in mind: for DB this is maximising the potential for contractually promised benefits to be met, and for DC is it to maximise the potential for individuals’ retirement needs to be met.