From Ros Altmann:economist and pensions,
    investment and retirement policy expert

  • pensionsandsavings.com

    Chancellor should seize the chance to use pension assets to boost growth and build back Britain

    Chancellor should seize the chance to use pension assets to boost growth and build back Britain

    • Pensions offer Chancellor the chance to boost growth directly rather than borrowing billions.   
    • Defined Benefit schemes better suited to such investments than the much smaller pool of Defined Contribution pension funds with liquidity and daily pricing rules.   
    • Over £2trillion in UK pensions could be investing for long-term growth but regulators are driving them to buy gilts and low return bonds.  
    • Heavy regulatory anchors are weighing down DB schemes and could sink them with low or negative returns instead of higher return investments to keep them afloat.   
    • Using more of the £300billion in local authority DB pension funds to rebuild Britain can improve green projects, infrastructure, social housing – and ‘levelling up’.   

    When the Chancellor unveils his plans this week to build back Britain and boost infrastructure and green projects, there is a significant source of domestic funding which he could tap into, but which is in danger of being overlooked. Instead of borrowing billions to add to the enormous public sector debt pile, or relying on Bank of England money-printing to facilitate Government borrowing at lower rates, the Chancellor could harness the power of UK pension assets to boost growth directly.


    Treasury says it wants to use pension assets for a Long-Term Asset fund: It seems that the Treasury is considering encouraging pension assets to invest in infrastructure and other long-term assets, but these plans seem to focus primarily on using Defined Contribution (DC) pension assets, rather than the far larger pool of money in Defined Benefit (DB) schemes.


    DC pensions are much less suited to long-term illiquid investment projects than DB funds: With around £150billion in DC assets, relative to over £2trillion in DB schemes, opportunities to boost growth are greater with DB pensions and they are more suitable for such investments. DC pensions are held in each individual’s own name, with a defined pot of money that they can transfer at short notice to another pension provider and whose investments are generally expected to have daily pricing. The requirement for short notice transfers makes DC funds far less suitable for long-term growth assets that require money to be invested to deliver returns several years hence. By contrast, DB schemes have huge pools of assets that will be needed to pay out pensions over many decades into the future and can afford to tie up more of their capital in illiquid investments.


    Trustees being driven away from higher return assets towards gilts with low or negative returns, adding extra costs onto employers: Ideally, having a diversified investment profile should allow pension funds to benefit from higher expected returns with lower risk over time, rather than focussing on just one or two asset classes, as is prevalent in DC. DB schemes have trustees and advisers to help manage both risks and returns over time. Yet, the current regulatory thinking is driving these schemes away from investing in assets that can deliver better returns, towards more purchases of gilts or other bonds, with low or even negative yields. This makes the cost of providing pensions far higher than it would otherwise be and places an added strain on employers backing the DB pension promises. Especially at the current time, this seems inefficient.


    Latest figures show private DB schemes have most investments in gilts: There has been a dramatic shift in the asset allocation of UK pension funds in the past few years. The impact of Bank of England Quantitative Easing has been a hammer blow for DB schemes, with private sector employers facing ever-rising liabilities and being forced to pile billions of pounds into trying to fix DB deficits and ‘reduce risk’ that their assets will not keep up with these liabilities. At end-2019, private sector DB schemes held over 70% of their direct investments in long-term bonds, of which three quarters were gilts. A few years ago, the schemes held far less than half their assets in such low-yielding assets.


    This sets up a vicious spiral with lower returns and higher costs for employers: However, with gilt yields continually under downward pressure from central bank bond-buying, and lower gilt yields meaning higher liabilities, the drain on corporate resources has been significant. The more gilt yields fall, the more money employers are asked to contribute to DB schemes and then greater pressure trustees face to buy more gilts in a desperate attempt to reduce ‘risk’. More than 70% of employer pension contributions go to DB schemes and over 60% of those contributions in 2019 were paid to reduce deficits. This is like a vicious spiral. Central bank gilt purchases lead to lower gilt yields, which drive higher deficits, which force firms to pay more into their schemes and drive trustees to buy more gilts, thus competing with central banks and adding further downward pressure on yields! Instead of investing in their business, these scheme sponsors are paying huge sums to allow their pension funds to buy bonds that offer little or no returns.


    Regulators weighing down DB schemes with ever-heavier anchors will cause more to sink: Most DB schemes are closed now, but some large funds remain open and have contributions coming in from both workers and employers. These and many of the closed schemes will not need to pay out pensions for many decades to come. However, the Government and regulators have proposed tightening the funding rules that will mean they can invest less and less in productive assets that could both boost the UK economy directly, and deliver much better long-term returns than investing in gilts or other so-called ‘safe’ bonds. This adds enormously to the short-term costs on employers and the confusion between ‘investment risk’ and security of pension payments is in danger of forcing more firms into insolvency.


    Gilts do not match pension liabilities and guarantee underperformance   but higher returns would help them stay afloat: Gilts do not match DB pension liabilities. Index-linked gilts now yield a negative 2% return, so pension trustees will have to continually require employers to pay in extra sums over time, as these assets are guaranteed to underperform the index-linked liabilities. There are no gilts that match longevity or the precise inflation profile of pensions, whereas a more diversified portfolio that allows for higher long-term returns and benefits from different sources of risk premia, has a better chance of delivering the promised pensions at an affordable cost. Encouraging pension funds to invest to boost growth directly, can mean less reduce risk to the employer and the Pension Protection Fund, higher UK growth, lower Government borrowing and better pension prospects for members.


    £300billion in local authority pension funds are underpinned by taxpayers, not the PPF, and could benefit from direct investments for UK growth: Local authority pension schemes are different from those for private sector employers. With nearly £300billion of assets, these schemes are not subject to the same regulatory oversight as private sector schemes and their workers’ pensions are not protected by the Pension Protection Fund. This means that scheme deficits are the responsibility of taxpayers and, if the scheme fails, members’ pensions will be at the mercy of Government decisions. Unlike private schemes which are now 70% invested in fixed income, these schemes hold 60% of their direct investments in equities, unquoted private equity and alternative assets such as hedge funds. They have invested only a tiny fraction of their funds in infrastructure. There could be an opportunity for the Chancellor to significantly increase this. Since 2015, the Government has been trying to ensure local authority pension schemes are managed more efficiently, to drive down costs and improve investment performance. The assets are being pooled into six large funds, instead of being invested by each local pension fund board. But still only a small proportion has been used for infrastructure. In light of the coronavirus economic damage and the Government’s desire to ‘level up’ when rebuilding our economy, using local government pension funds seems an ideal fit.


    I do hope the Chancellor will not miss this opportunity.


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