Working paper: capital markets in the UK – a new sense of urgency

June 2023 • Topic: Rebooting UK capital markets • by William Wright

This short paper is a summary of the key themes in our current work on the urgent need for more structural reform of pensions, capital markets, and long-term investment in the UK. It includes some key points from a recent dinner hosted by New Financial with C-suite representatives from across the industry, as well as conversations with senior politicians, policymakers, and market participants over the past few months. We will be publishing a more substantial report outlining the case for reform and how to deliver it in September.

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The paradox of UK capital markets

The starting point for discussion is the paradox of UK capital markets: on the one hand, there is an abundance of long-term capital sloshing around the UK in the form of pensions and insurance assets (at nearly £5 trillion, the UK has the second largest pools of long-term capital in the world after the US). But on the other, there is a drought of UK capital being invested in long-term productive assets in the UK such as equities, infrastructure, and growth companies.

The structural decline in long-term domestic investment in UK capital markets and companies over the past few decades has significant implications for the UK’s long-term growth, productivity, and prosperity. In an increasingly challenging geopolitical environment, the UK is now disproportionately reliant on overseas capital for investment in its critical infrastructure, in sensitive technologies, and scale-up capital for early-stage businesses.

The UK has a good start-up ecosystem, world class research and ideas in its universities, a concentration of finance and risk management expertise in the City, and a deep pool of capital. To misquote the late Eric Morecambe, we are playing all the right notes – but not necessarily in the right order.

A structural shift

Our recent paper on Unlocking the capital in capital markets highlighted the dramatic shift in the risk appetite and asset allocation of UK pension funds and insurance companies over the past few decades.  

In theory, investors with long-term time horizons and long-term liabilities like pension funds should be ideally placed to invest in long-term productive assets such as listed and unlisted equity to both generate returns for their members and to support the UK economy. In practice, we found that:

• Over the past 25 years, UK pension funds have reduced their allocation to equities from 73% to 27% – and they have slashed their allocation to UK equities from 53% to just 6%.
• Over the same period, they have quadrupled their allocation to bonds to 56%. UK pensions now have the highest allocation to bonds and lowest allocation to equities of any comparable pension system in the world.
• Since 2000, the share of the UK stock market owned by UK pensions and insurance companies has fallen from 39% to just 4%. And just 1% of the £4.6 trillion in pensions and insurance assets is invested in unlisted UK companies.

Why should we care?

To most people, how UK pensions and insurance companies invest their money is a remarkably dull and remote debate. And besides, why should we worry about UK pensions when overseas investors seem perfectly happy to invest here? But there are many tangible reasons why everyone should care about it and why addressing it demands a new sense of urgency:

• A more resilient economy: the starting point for long-term growth and prosperity is long-term investment. In light of the pandemic, the invasion of Ukraine, and the energy crisis, the UK needs to build a more dynamic and resilient economy, and this will require a huge amount of investment, a change in mindset, and a change in risk appetite. ‘Why does nothing work in the UK?’ is a common and powerful question. Investment is a big part of the answer.
• Financing the transition: the transition to net zero over the next 25 years requires a huge amount of investment over and above what governments and bank lending can provide.
• The Wimbledon effect: there is nothing wrong with non-UK investment and no-one is suggesting that the UK should pull up the drawbridge to international capital. But it should be an active choice, not the only available option. For a country with so much capital at its disposal, the UK should not be so heavily dependent on the kindness of strangers for whom investing in the UK may turn out to be a purely transactional affair if things turn sour.
• Relocation, relocation, relocation: the recent decision by Arm Holdings to list in New York rather than London, and news that UK-listed firms CRH and Flutter are reconsidering their UK listing, has highlighted the problem. But in many cases this relocation happens much earlier in a company’s life cycle: many high-growth firms rely on US venture capital to fund their growth, which often means the company (along with its future growth, jobs, investment, and returns) shifts to the US as well.
• A matter of national security: in an increasingly challenging geopolitical environment, outsourcing investment in critical infrastructure to SWFs from sometimes questionable regimes raises direct concerns for national security. And, under a broader definition of national security, the longer-term prosperity of the UK and its citizens is also under threat from low investment, low returns, and low growth.
• A tangible cost: the structure, regulation, and mindset of the pensions industry means that millions of people are missing out on the benefits of investing in a wider range of assets and paying over the odds for the inefficiencies embedded in the system.
• A vicious circle: the withdrawal of such a huge pool of natural demand for investing in UK companies over the past few decades has undermined valuations and risks creating a self-fulfilling doom loop for UK companies. This has flattened returns in the UK, exposed more UK companies to foreign takeovers, reduced the risk appetite and investment time horizons of UK plc, and reduced growth, investment, and job creation. Rinse and repeat.
• A social contract: banking and finance relies more than most industries on an unwritten social license. The more remote individuals and communities across the UK feel from their pensions and from ‘the City’, the more stretched that license will be become (with potentially negative political consequences). The inter-generational contract in the UK is already under pressure and could become untenable without significant reform of inadequate pensions.
• Squeezed in the middle: the Inflation Reduction Act in the US and the EU’s likely response will unlock a huge amount of investment on both sides of the Atlantic. Without a bold investment-led strategy of its own, the UK could end up being squeezed in the middle between two much larger trading and economic blocs.
• A holistic approach: while many of the reforms already underway are welcome, a piecemeal approach will hardly dent the challenges outline above. A bolder approach that joins up the dots and approaches the problem from the whole chain of banking, finance, and capital markets rather than a series of individual sectors might have a chance.

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