PENSIONSANDSAVINGS.COM

• UK Pension Funds should support green growth, infrastructure, climate and nature protection. 
• At least 25% of each pension is funded by taxpayers, which could justify requiring allocations to domestic long-term growth projects. 
• UK pension funds have slashed their exposure to equities, especially in the UK, but diversification to higher return assets is overdue.
  

Until late 1990s, pension funds relied on high equity allocations: Actuaries and regulators used to assume that equity investment was the most appropriate asset class for long term pension funds. Capital market theory demonstrated that equities are expected to outperform bonds in the long run, so having a majority of long-term pension assets invested in equities should deliver best returns over time. Just relying on bonds would be giving up these higher expected long-term returns and the UK was a leader in this thinking.

Strong domestic institutional asset base supported City of London and UK growth: Pension funds provided a strong source of domestic institutional support for UK companies and created a thriving financial sector. The UK had more in private pension savings than the rest of Europe put together and UK pension funds had higher equity exposure than US, Continental Europe and Japan.  That started to change after 2000.

As pension liabilities were paid in sterling, pension funds focussed on UK equities: At that time, the standard thinking also suggested, since pension liabilities are sterling denominated, that pension funds should focus more on UK equities in order to reduce currency risk of relying on overseas equities.

Actuarial thinking then turned upside down – instead of equities for long-term pension funds, they started suggesting bonds were best to ‘match’ liabilities: In the past 25 years or so, actuarial thinking turned 180 degrees, to suggest pension funds should have only bonds, in order that they ‘match’ their liabilities better, rather than taking risks in other assets that might perform poorly and lead to big losses that would open up high deficits. This thinking spread across the pension landscape, even though bonds do not actually match pension liabilities in reality – only in theory.

Estimated Pension liabilities kept rising as QE forced bond yields artificially lower: Pension liabilities are measured by the actuarial and accounting standards, by discounting them in line with long-term bond yields, so if bond yields fall, the value of long-term liabilities will be assumed to have risen. So, on paper, this looked an attractive proposition and it was made even more so by the introduction of Quantitative Easing (QE) after the 2008 financial crisis. With central banks artificially forcing bond yields lower, pension liabilities – as estimated by accounting and regulatory reports – kept rising and pension deficits ballooned. So switching into gilts and bonds was seen as a way of reducing the short-term reporting risk of rising deficits and many trustees were persuaded to move assets away from higher expected-return equities (which were not believed to be closely correlated with short-term funding measures and ran the risk of sharp falls). As QE expanded, the risk of not being invested in bonds was perceived as too high, sapping domestic support for equities and encouraging pension funds to search for different types of assets.

Pension liabilities are not properly matched by bonds – funds need extra returns to cover costs and risks: Trustees were told that they must think about matching their asset exposure to the changes in liabilities. This was supposed to protect the scheme from a rising deficit and led to more and more buying of bonds, competing with central banks for the same assets. This drove bond yields down further, reinforcing the rush to increase asset allocation to bonds. But pension liabilities cannot be matched by bonds. They also move in line with longevity, earnings and inflation (consumer price inflation and limited price inflation), as well as having different durations from many bonds. Pension funds also need to cover the costs of running the scheme.  So even if bonds did match liabilities, which they don’t, the schemes still need to earn extra returns above this to cover extra risks and costs.  Or else employers need to keep putting more money into the schemes.

Trustees were told to switch from maximising returns, to minimising risk: As pension liabilities – both for actuarial valuations and company accounts – were measured on the basis of long bond yields, the pension deficits increased as QE expanded post 2008 crash. Instead of holding equities which would be expected to deliver better returns than bonds over time, trustees sought to minimise shorter term risks.

So equity allocations have been slashed – from around 80% or more, to less than 20% now. And as hedging has expanded significantly and funds can hedge currency more cheaply, coupled with the trend towards global equity index funds aiming to capture equity returns, the exposure to UK stocks also plunged from over half to the under 10%.

So the domestic buying of UK equities – once so strong – has been decimated and outlook for DB assets is worrying as more schemes buy annuities:  As the natural domestic buying support that pension funds provided for UK equities has dwindled – and as insurers are increasingly taking over DB schemes assets in exchange for annuities, the Solvency and PRA reserving requirements for annuities also mean these assets increasingly have to be invested in fixed income, not equity. This has already caused a significant fall in equity buying and is unlikely to return.

 

Weighted average asset allocation for UK pension funds (ONS) 

	Equities %	Bonds %
1991	75.0	13.0
2001	71.0	20.0
2006	61.1	28.3
2009	46.4	37.1
2012	38.5	43.2
2015	33.0	47.7
2018	27.0	59.0
2021	19.0	72.0

 

Reckless caution was shown to be damaging last year as bonds collapsed and pension funds lost out: Relying on bonds is, in my view, inappropriate for a long term pension scheme – especially if it is still open and taking in new contributions. This approach is meant to reduce risk but in my view this caution is reckless and the approach locks out higher expected return assets, in favour of assets that are supposedly lower risk, but proved not to be. That myth was shown to be false last year as bond prices were so volatile and markets plunged precipitately, wiping out hundreds of billions of pounds worth of value for UK pension schemes.

 

Government would be right to require schemes to invest minimum amounts in domestic growth assets:  Every year, the UK Government invests around £50billion in UK pension funds. Apart from the lowest earners in Net Pay schemes, every pension fund in the country has at the very least 25% of its assets from HMRC.  Many funds have much higher proportions that originated from taxpayers and, with 25% being paid out tax-free in retirement, there is clearly justification for the Government to require some of that money – perhaps ten per cent of each fund – to support long-term UK growth.

 

I hope the Chancellor will begin radical reforms to require pension funds to support UK growth: The Chancellor should urgently consider how to ensure all UK pension funds invest in a range of long-term assets that can boost green growth, infrastructure, social housing and climate or nature preservation, delivering better outcomes for pensions and the economy.