Report – A mechanical drag on UK equities

This short paper highlights the structural shift in the way UK pension funds invest the money they allocate to equities away from their traditional ‘UK centric’ approach to a ‘global equities’ approach. While this shift is self-evident to people working in the industry it is less well known outside of it. It has had a significant impact on the allocation to UK equities and will continue to act as a drag on the UK market for many years to come.

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The dominant narrative in the debate on the decline in the asset allocation by UK pension funds to UK equities over the past few decades has focused on two factors: the relative unattractiveness of the UK stock market, and the shift en masse by private sector defined benefit pensions away from equities as they have matured, de-risked, or closed.

This paper focuses instead on how and why pension schemes have migrated en masse away from their traditional ‘UK centric’ approach (in which they would typically invest 20% to 30% of their assets in UK equities) to a ‘global equities’ approach (in which their investment in UK equities is roughly in line with the UK’s weight in global indices of about 4%, which translates into about 2% of the fund’s total assets).

This shift is self-evident to people working in asset management and pensions, but it is less well known outside of it. While there are plenty of sensible reasons for UK pensions to reduce the domestic bias in their investment, this paper highlights that it has had a significant impact on the allocation to UK equities and will continue to act as a drag on the UK market for many years to come.

This paper is not complaining about this shift or criticising pension funds for making it. It seeks instead to identify the impact of this shift and highlight poor levels of disclosure around asset allocation to better inform the debate on the future of UK pensions and capital markets. Even sensible decisions have consequences….

We analysed the fund-by-fund asset allocation of all 86 local authority pension funds in the £370bn Local Government Pensions Scheme (LGPS) over the past decade and found:

• The overall allocation to UK equities by LGPS funds has more than halved over the past decade falling from 25% in 2013 to around 10% today.
• The number of funds using a ‘UK centric’ approach more than halved from 75 funds in 2013 to 37 today, and the number using a ‘global equities’ approach rose more than fourfold from 11 to 49 funds.
• The allocation to UK equities by funds which switched to a ‘global equities’ approach in the past decade declined by 85% – and these funds accounted for roughly half of the overall decline in investment in UK equities across the LGPS scheme.
• This shift has been mirrored across the pensions industry, and defined contributions are not going to ride to the rescue of UK equities.
• The level of disclosure by UK pensions of their allocation to UK equities is poor and falling: the proportion of LGPS funds that disclose this has virtually halved from 95% in 2013 to 52%.

The paper argues that this shift has acted as a mechanical drag on UK equities and has helped create a negative feedback loop of lower demand, lower valuations, and lower demand.

We welcome the government’s proposal for pension funds to publicly disclose their asset allocation to UK assets and to UK equities in a simple, clear, and consistent way (something we specifically recommended to the government a few months ago). We also recommend that official data across UK pensions should be consolidated and improved, and that DC pension providers should explore offering an alternative ‘UK weighted’ default fund with a higher allocation to UK equities, perhaps similar to the asset allocation of Australian superfunds.