Report: UK capital markets – a new sense of urgency
September 2023 • Rebooting UK capital markets • by William Wright
This report highlights the emergence of two separate but related structural problems in UK pensions and capital markets that are undermining the long-term prosperity of the UK. Addressing inadequate pensions for millions of people in the next few decades and rebuilding a virtuous circle of investment and growth in capital markets will require a renewed and concerted focus in government, regulators and the industry.
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A parallel crisis in UK pensions and capital markets
Over the past few decades, layers of well-intended regulatory reform have created a framework and culture in UK pensions and investment that seems actively designed to eliminate risk and discourage long-term investment. Pension funds have had their risk appetite kicked out of them, and companies have been incentivised to reduce volatility in their pension schemes, shut them down, and offload them. This has sucked hundreds of billions of pounds of natural demand out of the UK market, leaving the UK reliant on overseas investment in some critical sectors. And millions of individuals saving for their pension have been left facing a future pension penalty.
This report, published in partnership with abrdn and Citi, argues that most of the debate around UK pensions and capital markets has been looking at this problem from the wrong end of the telescope. Instead of asking ‘how can we get more money from UK pensions into more productive investment?’ we have reframed the essay question to instead ask ‘how do we enable the pensions industry to do a better day job of providing a secure and comfortable retirement for millions of people in every corner of the UK?’.
The more closely we have analysed this problem, the more it has become clear that there is not one crisis but two related crises. First, while the UK pension system looks robust at first glance, there is a storm brewing for millions of people in the coming decades in terms of an inadequate income in retirement. Despite the success of auto-enrolment, nearly a third of the UK workforce are not saving for a pension at all; the majority of people are not saving enough; and structural and cultural challenges embedded in the UK pension system (such as fragmentation and the focus on cost rather than value) add up to smaller pensions in future.
And second, the structural decline in UK capital markets and long-term investment by UK investors has now reached the point of crisis. Despite having highly developed capital markets and deep pools of long-term assets, the UK stock market has stagnated over the past decade; UK growth companies are increasingly reliant on overseas investors; and the UK has among the lowest rates of investment, productivity, and economic growth of its peers.
What to do about it
There is a unique window of opportunity to address this problem. In the short term, the UK should rapidly increase pension contributions; push ahead with consolidation and the Mansion House reforms; urgently review how to shift the regulatory and cultural mindset in pensions and approach to risk; and launch a new pensions commission to design a pension system fit for the next 50 years. In the longer term, it should embrace more radical ideas such as the consolidation of DC pensions from over 3,000 schemes to just a few dozen; or start to shift the huge unfunded public sector pension schemes such as the civil service and NHS to a funded model.
The potential prize is huge: hundreds of billions of pounds in investment in productive assets could be unlocked with relatively minor reforms; millions of individuals could look forward to a more comfortable retirement; and the UK could have a giant state pension fund with more than £2 trillion in assets at its disposal within 25 years. The best time to have tackled this would have been a few decades ago. The second best time is now.
Summary of ‘UK capital markets – a new sense of urgency’
1) A parallel crisis: this report analyses what we see as a parallel crisis in the UK. First, a crisis in future pensions provision driven by structural problems in the UK pensions industry; and second, a separate but related crisis in UK capital markets, particularly the collapse in long-term domestic investment in productive assets. This combined crisis is of critical importance to the long-term growth and prosperity of the UK.
2) The crisis in UK pensions: the structure and regulation of the UK pension system in terms of patchy participation rates, low contributions, fragmentation, a focus on ‘costs at all cost’, narrow asset allocation, and mediocre returns has undermined the risk profile of pensions and is storing up trouble for millions of individuals over the next few decades who will face an inadequate income in retirement.
3) The crisis in UK capital markets: the structural decline in UK capital markets over the past few decades has reached a crisis point. The number of listed companies has virtually halved over 25 years, new issue volumes have collapsed, valuations have stagnated, and the UK’s share of global markets has fallen. The appetite among UK investors for long-term investment in UK productive assets has shrunk, and the UK is increasingly reliant on overseas investors to provide growth capital and investment in critical infrastructure.
4) Reframing the essay question: in light of this parallel crisis and the often-challenging debate over the past year we have reframed the essay question from ‘how do we get pensions to invest more money in UK growth companies and infrastructure?’ to ‘how do we ensure that the pensions industry can do a better day job of providing a secure and comfortable retirement for millions of people in every corner of the UK?’.
5) A social contract: the asset allocation of UK pension funds should not be mandated. However, given the generous £48bn in net tax reliefs paid by UK taxpayers on pension contributions in 2021 (more than the entire defence budget), it is not unreasonable that there should be some form of quid pro quo in return.
6) Economic sovereignty: in a globally-connected economy you can argue that it should not matter where companies get investment from or where they choose to list. However, raising capital from non-UK investors or on overseas markets should be an active choice – not the only available option. The risk is that the jobs, investment, growth, and returns companies generate migrates overseas.
7) A good start: the UK government has made a good start on pensions reform with the Mansion House reforms outlined last month and the programme of Edinburgh Reforms for capital markets last year. There is a need to go a lot further on pensions reform and to learn from other highly-developed pensions systems such as Australia, Canada, Sweden and the Netherlands as to what does and doesn’t work.
8) Reforming pensions: in the short term the UK should remove obstacles to wider participation and agree a glidepath to higher pension contributions. Given the long-term nature and critical importance of pensions there is a strong case for a pensions commission with cross-party support. While corporate DB pensions are the largest part of the market and may offer some scope for reform, efforts should focus more on DC pensions (with more radical consolidation into a series of ‘super trusts’) and on public sector pensions.
9) Reforming capital markets: the UK has all the right building blocks in place to develop bigger and better capital markets. The government and the industry should work together across sectors to further the Edinburgh Reforms and develop a more strategic plan that joins up the dots and builds on these strengths.
10) Reforming the wider economy: ultimately, the best way to boost long-term investment in the UK is to make the UK a more attractive investment proposition. Beyond pensions and capital markets reform, the UK) will need to develop a clearer and more consistent industrial strategy focused on delivering better infrastructure (in the broadest sense) and on a handful of key sectors and priorities.
Thank you to the many firms and individuals who have fed into this project with their ideas and expertise over the past year. Thank you to the team at New Financial for their hard work and patience, to Toby Nangle for his exhaustive and diligent research, and to our members for supporting our work in making the case for bigger and better capital markets. And thank you to abrdn and Citi for their generous support for this important project. The recommendations in this paper are mine and New Financial’s alone and should not be taken as representing the views of our partners on this project.