The UK’s pensions system is an international outlier, investing too little in illiquid assets. But there's great opportunity here - with DC schemes being able to take on greater risk as they are less constrained by regulation. In this blog, SMF Trustee Melville Rodrigues sets out how the next government should seek to unlock these savings to boost the economy and generate better returns for savers.
The UK’s pensions system is an international outlier. The seven largest pension markets globally allocate on average 23% to illiquid assets – things like property, infrastructure, private equity, and venture capital. In the UK, that number is just 9%.
There is limited scope for defined benefit schemes – where the size of one’s pension depend on factors like seniority, length of service, and final salary – to change this, given regulatory requirements (“liability-driven investment”). But defined contribution (DC) schemes – those where payouts depend on how much one saves and the return it generates – can take on greater risk as they are less constrained by regulation and are younger, so have longer to pay out.
Following the next election, whoever wins, the government should seek to unlock these savings to boost the economy, benefit society, and generate better returns for savers.
The Chancellor Jeremy Hunt has already embarked on a widely welcomed series of reforms: including the Mansion House compact encouraging DC funds to invest at least 5% of their default investments in unlisted equities by 2030, the Edinburgh reforms, and in the Spring Budget 2024 he added disclosure requirements on where DC funds invest and the returns they offer.
The Labour Party’s plan for financial services, Financing Growth, has proposed that The Pensions Regulator (TPR) is given powers to consolidate schemes that offer insufficient value, and to provide explicit guidance around fund and strategy suitability. A paper by the Tony Blair Institute from last May, advocating the creation of large pension funds, similar in scale to those in Canada and Australia, also seems to have influenced the opposition’s thinking.
Such measures will help, tidying up the long tail of small schemes that are unable to make long-term investments. Yet there is a risk of focusing too much on the size of pension schemes. To achieve effective change, policymakers will also need to change the infrastructure and cost-focused culture of the DC market, so as to encourage them to make more active investment decisions in illiquid assets, going beyond the stock market. At the same time, we need supply-side changes to make it easier to invest in such alternative asset classes.
None of which is simple. Illiquid assets involve short-term risk, but long-term returns, and cannot as easily be swapped for traditional liquid assets like equities and bonds. More broadly, the Productive Finance Working Group (PFWG) – a valuable initiative, bringing the Bank of England, Financial Conduct Authority (FCA), and Treasury together with industry, but put on hold – had pointed out the DC schemes must shift their focus from cost to long-term value and improving outcomes for savers.
To get there, we need to develop more Long-Term Asset Funds (LTAF), designed specifically to facilitate DC schemes and retail investors to access alternative asset classes. Current take up is low, in part because existing platforms are geared towards liquid, daily-dealing stocks and bonds, which means LTAFs cannot easily be added to pension portfolios. One way to do this would be to apply the FCA’s ‘Consumer Duty’ to platform providers so that platforms cover liquid and illiquid assets, and require those platforms that only provide daily dealing products to justify why daily liquidity is always necessary and beneficial to members.
What, then, should the next government do? Here are a few suggestions:
- Reduce churn: we have had eight pensions ministers and seven City ministers in the past eight years. The next government should aim to have one of each in place through the whole next parliament. The Pensions Minister must have the courage to address the challenge of under-saving.
- Build on the current pension reforms: rather than re-inventing the wheel, the next government should build on existing policy stability and relative consensus, and continue constructive engagement with industry.
- Manage expectations so that they are sensitive to the pension trustees’ fiduciary obligations relating to financial returns while avoiding regulatory overload (though consider appropriate best practice guidance). We should beware of pensions ‘mission creep’. As well as providing retirements there seems to be a herculean expectation that the funds are now supposed to fix the UK equities market, address climate change, finance rebuilding of UK infrastructure, develop more in-house sophistication to invest in alternatives all at the same time. That is unrealistic.
- Revive the PFWG, and add the Department of Work and Pensions as a sponsor. This could lead to a Pensions and Productive Finance Commission with wider representation (including SMEs), which could consider:
- How to implement the bold ambitions of existing reports, like Labour’s plan for financial services and the Tony Blair Institute’s proposed reforms.
- Creating reciprocal access rights between European and UK managers and investors to encourage foreign investment in the UK
- Addressing industry objections to Labour’s plans to tax carried interest as ordinary income.
We need policies that are joined-up and cross-party, that appropriately involve stakeholders and manage public expectations, and avoid policy overload. We should avoid efforts to seek ‘wedge issues’ or tinkering of the sort that regrettably seems to be afflicting the pension lifetime allowance.
Beyond this, we should seek to improve industry best practice, through nudges like the Spring Budget 2024 disclosure requirements and TPR’s January 2024 guidance for occupational pension scheme trustees considering investing in private markets. My other suggested nudges include:
- Increasing familiarity with alternative investments in the DC community, for example, investing in tailored research on alternatives and educating DC trustees and consultants on the nature of illiquid assets and how to value them.
- Greater scrutiny from pensions on their own operations, including legal fees. As a lawyer involved with pensions and real estate practices, I was surprised that charge out rates for pension lawyers were materially higher than the rates for real estate lawyers.
- Better segmenting offers to different generations: liquidity is more important for older savers, and younger savers tend to have greater desire to ensure their investments promote environmental, social and governance goals.
The new government – working with industry – must focus on developing and delivering effective reform of the DC pension and asset management system. Its aim should be to ensure that DC schemes achieve better returns for their members, and this includes addressing the barriers that inhibit schemes investing in alternatives. British pension holders must no longer miss out.