It has been clear for many years that our domestic pension and long-term institutional assets have not been investing as much as they should and could in more diversified sources of return to support the British economy. While Canadian, American and Australian pension or endowment funds have benefited from many of the attractive infrastructure and private equity UK investment projects, well over £2trillion of Defined Benefit (DB) and around £200billion in Defined Contribution (DC) domestic schemes have not broadened their investment horizons in the same way. They have not benefited much from such diversification and alternative investment risk premia.
Pension schemes have been increasing allocation to guaranteed low return projects in efforts to reduce risk: In recent years, regulators and advisers have steered UK Defined Benefit (DB) schemes away from taking risks, and indeed have sanctioned less diversification of risk, with encouragement of additional allocations to guaranteed low return assets such as gilts or other supposedly ‘safe’ bonds.
‘Investment Big Bang’ could be kick-started with local authority pension funds: Nearly £300billion local authority pension schemes could be a powerful way to kick-start the Investment Big Bang, but of course trustees need confidence that they have the skills to select the appropriate projects. Encouraging or directing local authority pension schemes to invest far more in UK growth funds and infrastructure projects can help overcome their deficits and boost green growth directly as well as local infrastructure or housing. These funds have significant deficits and are fully underwritten by taxpayers (council pension schemes do not belong to the PPF, so members are only protected by taxpayers).
Pension funds need to outperform their liabilities, not just match them – green gilts do not mean upside: It is indeed sensible to encourage pension funds and other investors to back British growth, infrastructure and fast-growing small businesses as well as areas such as social housing or build to rent. These have the potential to deliver a less risky, more diversified stream of returns, including inflation-linked returns, and a better chance of outperforming liabilities. Indeed, just matching liabilities is not enough when a scheme is already in deficit and, given the need to meet costs over time too, some outperformance of gilts is still required. However, trustees need to feel more confident that they will not be penalised for backing British businesses and growth. Just offering ‘green gilts’ does not deliver the upside returns that many pension investors need for long-term success.
Government could guarantee minimum returns for long-term investors on any Long-term Asset Fund: The Government has not provided sufficient opportunities or freedom for domestic institutions, pension funds and insurance firms to invest significant amounts of their money into growth–boosting projects. The Long-Term Asset Fund is an interesting proposal here. It could be particularly powerful if Government would consider offering these institutional investors a minimum yield over, say, 10 or 20 years, to match today’s 10- or 20-year gilt yields, then these higher growth assets could replace current allocations to gilts. The pension fund would have a guaranteed yield of perhaps 0.5 per cent and 1 per cent, which would be paid if the investments did not deliver as much as this very low hurdle rate. The Long-term Asset Fund would pool a number of growth projects together, perhaps across varying types of asset, that would be designed to boost UK growth and ‘build back better’. Of course, this adds some risk to the Government’s balance sheet, but if the projects are successful – and the majority should be – then domestic investors could both drive growth and meet their liabilities better.
QE inflated pension liabilities and increased scheme deficits, driving further ‘risk reduction’: As long-term gilt yields fell sharply following QE policies since 2009, pension liabilities ballooned. QE inflated liabilities by more than their backing assets, leading to much higher deficits. This caused greater focus on avoiding investing in higher expected return assets (which are considered higher risk) even though they had the potential to outperform liabilities over time. Instead, ‘liability matching’ became more prevalent. As future expected returns fell, due to sale of higher expected return assets, employers have had to plough huge sums into their schemes to fix deficits. This money could be better used to boost growth in my view and now is a good time.
Diversification into alternative asset classes could provide superior risk management: I have been calling for a different approach to pension scheme risk control, which emphasises diversification, rather than liability matching. Given the uncertainty created by QE for traditional capital asset risk models, perhaps pension risk management can be achieved at least as well with alternative sources of risk premia, using a diversified portfolio across more asset classes, rather than trying to increase holdings of guaranteed low yielding bonds to protect downside risks. Reducing downside risk may also mean removing upside potential.
DC pension schemes have more hurdles to overcome and need greater attention: The use of DB assets and insurance funds may be more readily achieved than using DC schemes. Existing barriers for DC pension schemes to invest in small growth firms, early-stage research, infrastructure and other alternative assets are much greater. Whereas DB scheme trustees and insurers have regulatory or reserving issues to overcome, they do have more control over their investment time horizons. DC scheme barriers are not just related to fees that their default funds can charge. Indeed, for large DB funds, a 0.75% overall fee would not preclude most alternative higher expected return investments. However, DC schemes are expected to price their funds daily and be able to sell their investments at short notice to meet redemptions, which adds further significant barriers. This needs to be addressed urgently. For example, a portion of DC investments could be allocated to a series of national ‘pension’ infrastructure or growth funds (Long-term Asset Funds), which offer long-term returns and do not have to ensure daily pricing or liquidity. These would need to be able to be transferred from one investor’s DC fund to another fund in specie. No pricing or selling would be available or expected, the investor’s share of the fund would just be moved to another DC scheme.
To conclude, an ‘Investment Big Bang’, harnessing domestic institutional and pension assets, is a great idea, but there are some hurdles to navigate before it can be successfully rolled out. As we seek to recover from Covid and build back better, the opportunities are there for the taking.
