Report – Unlocking the capital in capital markets
March 2023 • Rebooting UK capital markets • by William Wright
This report highlights the dramatic shift over the past 25 years in the risk appetite and asset allocation of nearly £3 trillion in UK pension funds. The sharp drop in their allocation to the UK stock market since 1997 -from 53% to just 6% -is one of the fundamental structural challenges facing capital markets in the UK and it will require a renewed and concerted focus to change course.
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Upstream vs downstream
Over the past few years, a huge amount of work has been done by the UK government, regulators, and the industry to reboot the framework for banking, finance, and capital markets to ensure that it is both competitive on the global stage and better able to support the UK economy. Much of this work – such as the listings review, the secondary capital raising review, and the Edinburgh Reforms package -and much of the debate around it has focused on what we call ‘downstream’ issues, such as changes to regulations to remove obvious barriers to more effective capital markets.
While this work is hugely valuable, the underlying challenges facing UK capital markets and the UK economy are much further ‘upstream’ than the detail of the listings regime. These embedded structural issues have been decades in the making -and none more so than the dramatic shift in risk appetite and investment by UK pensions over the past 25 years away from equities (and away from the UK stock market in particular) into bonds.
In our view, this structural shift -effectively sucking huge amounts of natural demand out of the UK market -has been one of the main causes of the challenges faced by UK capital markets today. While it is important to address the ‘downstream’ issues, they are not the root cause of the problem so addressing them will not solve it.
This short paper outlines the scale of this shift; compares the UK with other developed pension systems around the world; drills down into the asset allocation of different types of pension to uncover some positive news; identifies some of the main drivers behind it; and outlines some potential solutions. 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 like 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.
To be fair, pension funds and insurers have not so much lost their risk appetite as had it kicked it out of them over the past few decades by the cumulative impact of well-intended reforms to accounting standards, regulation, and tax. At every turn, they have responded rationally to the incentives and disincentives in front of them. It is also important to stress that there is no silver bullet to reverse course, and that much of the pensions money that has been sucked out of the UK equity market is not coming back.
While the headline numbers look bleak, we think there is a huge opportunity ahead to build on the strong foundations for pensions and insurance in the UK (the second largest pool of long-term capital in the world) and restructure the system to incentivise, enable, and empower pensions to invest more in productive assets. Given the importance of driving investment in every corner of the UK, it is vital for government and the industry to work together to develop a long-term sustainable plan -ideally with cross-party support -that may well need to include more radical reforms than have so far been proposed.
In this paper we have tried to reconcile different definitions and taxonomies across a wide range of complementary but sometimes conflicting data sources, building on our first attempt a few years ago to map out the problem. Our estimates may well be a few percentage points out here and there, but the direction of travel is clear. We have made some quite big assumptions, and no doubt some quite big mistakes, which are entirely my own. The data in this report was prepared for the UK’s Capital Markets Industry Taskforce, but the report and analysis should not be taken as representing its views.