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Increasing pensions investment into private asset classes is critical to supporting competitive and high-growth sectors.
Pension investment performance is rightly under the spotlight after the new government announced its pension review.
“Investment” was very much the buzzword of this announcement (mentioned 35 times). “Growth” wasn’t far behind, with 25 mentions.
Meanwhile, “adequacy” was mentioned four times. In a similar vein, the recent Pension Schemes Bill omitted proposals to raise the default contribution rate (currently 8%) for those who are auto-enrolled.
Arguably, however, increasing default rates sooner rather than later is crucial to the UK’s chances of achieving this greater investment and growth.
The UK has faced low levels of growth since the financial crisis of 2008, lagging behind other developed economies in the OECD and the G7.
Increasing business investment is an important step to improving this growth. If UK business investment had matched the average of France, Germany and the US since 2008, the UK’s GDP would be nearly 4% higher today, according to the Resolution Foundation’s report, Ending Stagnation. This would boost wages by around £1,250 a year.
Higher levels of household savings – boosted by increased default pension contribution rates, when the time is right – could play an important role in this greater UK investment.
Venture capital investment
Many of the UK’s high-growth-potential sectors – such as fintech, energy generation, artificial intelligence and life sciences – require a lot of expenditure on research and development early on. This usually requires venture capital (VC) investment.
Pension funds are a key source of VC funding, as well as related asset classes, such as private equity and private debt.
As a result, the UK government has rightly focused on how to unlock more investment from pension funds into productive finance, particularly unlisted equities such as VC. This has included the Mansion House Compact, the Value for Money framework, and reforms to the charge cap on default funds.
Most recently, Treasury has launched a review of pensions investment, which is expected to report by March 2025. This review will focus on increasing productive investment by Defined Contribution (DC) pensions and the Local Government Pension Scheme, by driving consolidation. It does not currently include listed equities or Solvency UK, but the Labour government has indicated support for reform in both areas.
And to help with decarbonising the energy grid by 2030, the government aims to crowd in private capital, via co-investment, facilitated by:
- A new National Wealth Fund (created by merging UKIB and BBB) with £7.3 billion of capital to invest in priority sectors.
- A government owned energy company, GB Energy with £8.3 billion to invest in green energy generation and infrastructure.
These are important steps. But the amount of UK pension savings available for investment is also an important factor in these investment opportunities.
Increasing pension default contributions is therefore an important lever to pull, which could benefit not just individual savers’ financial security in retirement, but also the UK economy.
Of course, contribution rates should only be increased when the economic conditions are right for both individuals and employers. This means any such increases running in parallel with growth in the UK economy.
That said, delaying an increase in contributions for too long could itself be costly to the UK economy – as outlined below.
Impact of delay
Increasing default contribution rates from 8% to 12% will result in total additional annual pension contributions of £10 billion1. For context, there is an estimated £600 billion of current DC pension assets.
So every five-year delay to increasing auto-enrolment contributions could cost around £2.5 billion in investment in unlisted equities. Assuming a 5% asset allocation to unlisted equities in line with the Mansion House Compact.
The same delay could also cost £11.5 billion of investment in UK equities, assuming allocation to UK listed equities of around 23%.
Financing net zero
Such a delay could also have implications for the UK’s climate targets.
Around £2.7 trillion of long-term investment will be needed to meet these targets, according to the Climate Change Committee’s (CCC) Sixth Carbon Budget.
This would include investment in the infrastructure needed for a low-carbon economy, such as decarbonising the building stock and transport, and building the generation and network required for a net zero power system.
Private finance will need to make a significant contribution to this investment. Much of this investment could come from DC pension saving, through asset allocations to Real Estate Investment Trusts (REITs) and infrastructure.
Master Trusts currently invest 3% in infrastructure, on average2. And REIT allocations are around 2%, on average, across all schemes.
Therefore, every five-year delay to increasing auto-enrolment contributions could cost around £2.5 billion in investment in infrastructure and REIT.
Higher saving households
More household pension saving in unlisted equities and other private assets could also provide better investment returns for UK savers.
Private equity, VC, and real estate assets have obtained significant returns in recent years, according to analysis by the British Business Bank (BBB). Private debt offers smaller but still significant returns, with a lower risk profile than VC and private equity.
Let’s take an average 22-year-old saver. A 5% allocation to venture capital and growth equity could deliver them with a 7%–12% increase in retirement savings over their lifetime, according to analysis from the BBB.
As a result, increasing contribution levels and allocating these savings into private assets could be a win-win for savers and the economy.
Home bias
The UK participates in a global market for investment. Additional UK pension saving from higher contributions will seek returns in overseas investments as well as domestic ones – similar to the global private market positions of Australia’s ‘super funds’, or Canada’s Maple 8.
In turn, UK firms and infrastructure will also attract money from overseas investors, an area in which the country is relatively strong.
However, most countries that succeed in boosting investment finance this to a large extent through higher household savings.
First, this is because there is always some ‘home bias’ in where savings are invested.
Second, funding higher investment purely through overseas routes is likely to increase the UK’s already large current account deficit, which risks macroeconomic instability.
The new government’s pensions review is a good start to improving the UK’s pensions system. However, to achieve its “big bang” of reforms to unlock growth, the government may well wish to increase default contributions to 12% over a phased period.
This would support higher household savings, greater investment, and boost growth.
Next steps
To read more on this subject, please see:
A framework for increasing pension auto-enrolment contributions
Auto-enrolment: what’s the cost of not increasing contribution rates to 12%?
Auto-enrolment: how and when should default contribution rates rise to 12%?