UK pensions should support UK growth, including green growth, infrastructure, climate and nature protection.
At least 25 per cent of each pension is funded by taxpayers, which could justify requiring allocations to domestic long-term growth projects. This wouldn’t only help stimulate growth in UK , but could ensure better diversification within these schemes — helping deliver better returns for savers, pensions and the economy.
Until the late 1990s, pension funds relied on high equity allocations, with actuaries and regulators assuming equity investments were the most appropriate asset class for long term pension funds as they were expected to outperform bonds in the long run.
Pension funds provided a strong source of domestic institutional support for UK companies and created a thriving financial sector at this time. 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.
However this started to change after 2000. As pension liabilities were paid in sterling, pension funds had focused on UK equities, in order to reduce currency risk of relying on overseas equities. But actuarial thinking started to change, with the suggestion that bonds may be a better ‘match’ to pension liabilities.
In the past 25 years or so, actuarial thinking has turned 180 degrees, to suggest pension funds should have only bonds, to match liabilities, rather than investing in other assets that might perform poorly and lead to big losses that potentially lead to high deficits. This thinking spread across the pension landscape, even though bonds do not actually match pension liabilities in reality – only in theory.
This trend was exacerbated by quantitative easing, which forced bond yields artificially lower. With central banks artificially depressing bond yields, 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 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.
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. These liabilities also move in line with earnings, longevity and inflation. Pension funds also need to cover the costs of running the scheme. So even if bonds did match liabilities, which they don’t, 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.
During this period trustees were told to switch from maximising returns, to minimising risk. As a result equity allocations have been slashed – from around 80 per cent or more, to less than 20 per cent now.
At the same time, the equity allocation tend to be more focused on global equity index funds, which can be hedged more cheaper, which has reduced the exposure to UK stocks to under 10 per cent.
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. This ‘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.
Bonds are meant to reduce risk, but in my view this caution locks out higher expected return assets, in favour of assets that are supposedly lower risk, but have proved not to be. This was clearly demonstrated last year, with bond prices volatile and markets plunging precipitately — wiping out hundreds of billions of pounds worth of value for UK pension schemes and weakening domestic asset support.
Every year, the UK Government invests around £50billion in UK pension funds and, in my view, there is justification for the Government to require some of that money – perhaps 10 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. Ensuring all UK pension funds invest in a range of long-term assets can boost green growth, infrastructure, social housing and nature preservation.
