Pension fund investments of the future
Writing exclusively for the ICAEW Financial Services Faculty, former Coalition government pensions czar and pensions expert Ros Altmann considers the future of pension fund investments.
As we rebuild our economy following the Covid growth shock, I believe pension assets could play a significant role in stimulating new industries and in funding much-needed long-term investment in infrastructure, housing and new technologies, while also helping address climate change and biodiversity loss.
Cop26 President Alok Sharma, the UN and Mark Carney among others, have all recently called on pension funds to help in the fight against global warming. Pension funds can play a central role in helping reach net zero. Their long-term liabilities and investment profile renders them particularly vulnerable to climate change damage and can also be influential in aligning other investors towards net zero.
I believe scheme members will increasingly want their pension money to fit with their own values, to protect the planet and boost growth, which means scheme assets should increasingly be used in the battle to rebuild Britain, improve governance, enhance social responsibility and mitigate climate change risks. Such projects can also help protect traditional investments in global industries from being devalued in the transition to a low carbon world.
Government legislation
The recent 2021 Pension Schemes Act set out a Government objective to encourage pension funds to make and disclose plans assessing and addressing climate risks. This is welcome, but action to allocate money is needed now, not just plans for future investments. The Government’s aims seem to focus more on Defined Contribution pension assets, rather than the traditional Defined Benefit schemes. That seems to me to be a wasted opportunity which this article will explore.
The UK has one of the largest private pension industries in the world. The vast majority of the invested assets are in Defined Benefit (DB) pension funds, which are worth well over £2 trillion. Newer Defined Contribution (DC) scheme assets are worth less than a tenth of this sum. DB schemes are underwritten by employers and promise a specified amount of pension. These funds need to invest in long-term assets to deliver returns sufficient to meet the increasing costs of pensions over time.
Other countries
Pension funds in other countries, including the US, Canada and Australia have benefitted in past years from long-term investment in early-stage businesses, which are typically higher risk and less liquid but can offer higher returns for success.
These overseas pension funds also invest in global infrastructure projects that deliver solid, inflation-linked, returns over many years. However, UK Defined Benefit pension funds have been much slower to embrace the advantages of such asset class diversification and have often focussed more on conventional assets, such as quoted equities, fixed income and property.
UK pension trustees, who are responsible for DB scheme investment decisions, typically have only small exposure to infrastructure, housing, private equity and other alternative assets – and have tended to focus more on bonds rather than early stage or less liquid projects.
In my view, this has meant UK pension schemes, their employers and members, missed out on opportunities to boost returns and to benefit the wider economy. Instead, the benefits of long-term investment in UK infrastructure or private equity have flowed more to other countries, while UK employers have had to add billions of pounds of corporate resource to make up the shortfalls in their pension schemes.
Fiscal policy and DB schemes
In recent years, Quantitative Easing (QE) policies have driven long rates to record lows – and inflated long-term liabilities, scheme deficits have risen sharply due to falling interest rates and inadequate investment returns.
The largest schemes diversified into alternative assets, but only a small percentage of the funds. They have also used hedge funds and derivatives, to try to address volatility and risk, but they invest predominantly in publicly traded major markets.
This is regrettable, because the UK’s DB schemes should have been ideally placed to invest in growth-producing, higher risk and higher expected return projects, and they are managed by trustees with professional advisers who have access to a wide-ranging global pool of asset managers.
DB trustees have moved from around 70% equities/30% bonds allocation 20 years ago, and some have recognised the merits of expanding into new asset classes, in order to reap the benefits of diversification and alternative sources of risk premium, but the past few years have seen increased bond investing, aiming to lower risk, but also lowering returns. This has not necessarily been an optimal long-term strategy.
Their significant scheme asset size and long-term liability payouts can facilitate diversifying into less liquid asset classes with long-term return horizons, giving pension trustees added investment freedom to help the post-pandemic recovery with investment in domestic infrastructure and growth-boosting industries.
Building back better?
So will pension assets be used to build back better in coming years, or will this opportunity be missed?
I fear the Government has set its ambitions for using pension assets relatively low. By focussing more on DC schemes than DB schemes, and only considering rather small allocations, the opportunity will not be fully grasped.
DB pension capital has significant power, which is exercised by scheme trustees. However, ultimately the Pensions Regulator and scheme advisers influence the portfolio asset mix and risk. Ultra-cautious advisers and Regulators have been steering DB trustees towards fixed income investing, away from supposedly higher risk but higher expected return asset classes which, over the long-term, could deliver better risk-adjusted returns and also boost growth.
In recent years, most UK DB schemes have closed because the costs and risks proved unsustainably high for private sector employers. This has been part of a negative spiral, with trustees trying to minimise risk but at the expense of higher returns. This strategy increased pension costs and was further compounded by ongoing declines in long yields, as QE expanded. If this approach is maintained, the opportunity of using remaining DB assets will not be properly grasped.
Focus on Defined Contribution
A further concern is the desire to focus on DC pensions, rather than DB. Certainly, pensions of the future are likely to be DC, as DB scheme closures mean the millions of workers newly brought into pensions by auto-enrolment will be in DC schemes.
These do not guarantee any particular pension outcome and have no employer to stand behind them. All the investment risk is borne by members themselves, who are far less well-equipped than DB trustees to assess risk and construct well-diversified portfolios.
DC pension plans are generally smaller than DB and their investments are even less diversified. Investment power is usually in the hands of DC trustees or Independent Governance Committees, who govern the investments for so-called ‘default funds’ in workplace pensions, which most workers will be contributing to. These are designed to offer an investment solution for those workers (the vast majority) who do not feel confident or competent to select their own portfolios.
DC pension funds were typically run by insurance companies and started as ‘personal pensions’. They have far fewer economies of scale than DB schemes, which means higher fee levels than DB trustees could negotiate with their asset managers and other service providers.
Government concerns about high charges resulted in auto-enrolment pensions policy imposing a cap on default fund charges of a maximum 0.75% annual management charge as a percent of assets. Fees for typical DB schemes (even with much more diversified investments) are usually well under half this level – and are paid by employers, rather than members.
Constraints on funds
There are important differences between DB and DC schemes. Particular constraints on DC funds, including requirements for daily pricing, rapid transferability, and sending each individual member regular statements. This adds to administration costs and also poses particular difficulties for providers, with large numbers of uneconomic small pots with tiny amounts invested.
Even larger DC schemes often have higher cost bases than DB and the 0.75% cap may also hamper diversification, as using major markets and index funds reduces fund management costs. Thus, DC plans are almost wholly invested in just bonds and equities, with little or no exposure to alternative assets and they are currently less able to diversify as much as their long-term nature might suggest.
Ministers are considering increasing the DC fee cap to allow non traded asset classes to be included but that may not be the right answer.
Investment diversification is not just hampered by the fee cap. The requirements for DC pensions to be priced daily and allow members to transfer their pension from one provider to another relatively quickly also make illiquid investments problematic.
DB fund recognition
So, although Ministers have recently made clear their desire for pension assets to be more widely invested in less liquid and higher potential growth, or environmentally friendly investments, the focus on DC assets hinders those aims.
I believe it would be preferable to recognise the advantages of DB schemes, in terms of their size, their trustees’ longer-term time horizons, less need for liquidity and lack of daily pricing requirements.
The conflicting messages about using alternative assets, private markets, infrastructure, social housing and environmentally friendly projects to meet long-term pension obligations are unhelpful. On the one hand, DC schemes are being encouraged to broaden their exposure to these investments, to reduce the negative impact of investments on the sustainability of the planet, to increase governance standards and boost long-term growth prospects.
But at the same time, DB schemes are being steered away from such opportunities, even though they could significantly benefit. The solution, in my view, should encompass use of both DB and DC assets in the post-pandemic rebuilding plans, in order to use our country’s massive pension assets more productively – and to help the green growth agenda.
Investment risk and the regulators
Especially in a post-QE world, I do not believe DB investors and Regulators can be confident they know what investment risk means, with the risk-free asset having been distorted by central bank bond purchases.
It is possible, therefore, that managing pension risk and return could be better achieved by diversifying portfolios into different asset classes, rather than assuming that adding more fixed income is necessarily an effective risk-reduction strategy.
The Pensions Regulator has been discouraging DB schemes from using the private markets, which can deliver better forecast returns, for fear of trustees artificially making schemes look more affordable and lowering sponsor contributions over time.
The Regulator considers high allocations to private markets as a threat to the scheme’s capacity to meet its obligations and fears the Pension Protection Fund (PPF) might inherit unmarketable assets if the sponsor becomes insolvent. However, without assets that can outperform liabilities, many schemes will struggle to overcome deficits and the costs to the sponsoring employer may prove too high, which itself could pose greater risks for the PPF.
Local Authority opportunities
A particular opportunity may lie with local authority schemes, which are ultimately underpinned by taxpayers, and not covered by the PPF.
Using the £200billion local authority pension assets more extensively for growth-boosting and environmentally friendly investment projects, rather than the current relatively unambitious aim of just 10-15% of assets being invested this way, would seem sensible.
An added safeguard for pension investors could be offered by the Government too, in the form of guaranteed minimum returns equivalent to today’s gilt yields. Taxpayer money would not be needed for the investments, but trustees are offered today’s low yields as an underpin if project returns do not exceed low gilt yields. However, the likelihood is that most projects will deliver greater benefits to the scheme and wider society.
What the government should do
In summary, the Government needs to ensure that financing requirements and projects are joined up with pension funds.
In the past, overseas funds and insurers were often offered attractive Government investment opportunities in infrastructure, housing or other projects and no doubt they will continue to seek good UK investment opportunities.
But I believe it is vital that our domestic pension schemes – whether DB or DC, large or small – can also participate in these opportunities to boost the economy, protect the planet and deliver better pensions too.
About the author
Ros is a leading authority on later life issues, including pensions, social care and retirement policy. Numerous major awards have recognised her work to demystify finance and make pensions work better for people. She was the UK Pensions Minister from 2015 – 16 and is a member of the House of Lords where she sits as Baroness Altmann of Tottenham.