Comparing the asset allocation of global pension systems

This report highlights that UK pension funds have a significantly lower absolute and relative allocation to domestic equities and unlisted equities than most of their counterparts in developed pension systems around the world. It shows that UK pensions could increase their allocation to the UK market by 50% to 100% and still be comfortably in line with their international peers and historical norms.

In the debate on how much or how little UK pension funds invest in the UK stock market, the missing link has been a reliable comparison of how the UK compares with other developed pension systems.

We thought it might be useful to explore how the allocation by UK pensions to domestic and international equities compares with 12 other developed pension systems around the world. While comparing the asset allocation of ‘pensions’ in aggregate is a useful start, the wide range in the structure of each market means that no two systems are the same. This makes any headline comparison of asset allocation almost meaningless as the outcome is more a function of structural differences than of investment behaviour.

So we also conducted a unique ‘apples to apples’ comparison of the main ‘buckets’ of pensions in the UK with the most relevant ‘buckets’ of pensions in other systems: comparing UK public sector defined benefit (DB) pensions with, for example, public sector pensions in Canada; defined contribution (DC) pensions with the likes of Australian supers; and private sector DB schemes in the UK with their counterparts in the US and other markets.

The report - in partnership with the Capital Markets Industry Taskforce - shows that while the UK is not alone in dealing with a low and falling allocation to its local stock market by local pension funds, UK pensions in aggregate and the different ‘buckets’ of UK pensions are towards the bottom of the pack in both absolute and relative terms.

Each part of the UK pension system has a lower allocation to domestic equities as a percentage of their total assets, as a proportion of their total allocation to equities, and relative to the size of the local stock market, than the global weighted average (excluding the US) of the pension systems we analysed.

The report is directly relevant to the current political debate, with the new Labour government launching a pensions review and thinking about how to encourage more investment by UK pensions in the UK.

The report identifies different groups of countries based on the asset allocation of their pension funds, presents some of the arguments for and against pension funds having a greater home bias, and outlines some policy recommendations.

It does not specifically recommend that UK pension funds should increase their allocation to domestic equities or set a target. But we ran a series of different ‘what if…?’ scenarios which show that UK pensions could significantly increase their allocation to domestic equities and still be comfortably in line with their historical norms and with pension funds in other markets.

Here is a short summary of the report:

1. An international comparison: this report adds a valuable international perspective to the debate over the past few years on the decline in how much UK pension funds invest in the UK stock market. It shows that on virtually every metric, UK pensions are towards the bottom of the pack in terms of their allocation to domestic equities compared with a dozen other developed pension systems on both an absolute and relative level.

   
   

2. A vicious circle: the proportion of their assets that UK pension funds allocate to UK equities has fallen to 4.4%, compared with our estimate last year of 6.1% and down from over half of their assets 25 years ago. This disguises big differences between the main ‘buckets’ of pensions in the UK: corporate defined benefit schemes allocate just 1.4% to UK equities, public sector defined benefit schemes 9%, and defined contribution pensions around 8%.

   
   

3. Bringing up the rear: this allocation to domestic equities is among the lowest of any developed pension system around the world with only Canada, the Netherlands, and Norway having a lower allocation. It is less than half the weighted average allocation to domestic equities across our sample excluding the US. The overall allocation to equities by UK pension funds of 30% is lower than every market except Canada, Denmark, and the Netherlands.

   
   

4. A global approach: the main drivers of this decline have been the de-risking of private sector DB schemes and the shift across UK pensions from a ‘UK centric’ approach to a global market-weighted approach to equities with investment allocated broadly in line with a market’s weighting in global indices. As UK pensions have switched out of UK equities, they have helped feed a doom loop of lower demand, lower valuations, and a less dynamic market.

   
   

5. Apples to apples: the differences in the structure between different pension systems means that an aggregate level comparison is not very useful. We compared the asset allocation of the main ‘buckets’ of UK pensions (public DB, private DB, and DC) with the most relevant buckets in other systems. In every case, UK pensions have a lower allocation to domestic equities as a percentage of their assets, as a proportion of their total allocation to equities, and relative to the size of the local stock market than the weighted average of other pension systems.

   
   

6. Different perspectives: there are five clear groups of pension systems based on their asset allocation. At one end, privileged markets like the US with a huge pension system and huge stock market. At the other end, ‘financial purists’ like Canada and the Netherlands. And in between, ‘patriotic social democracy’ markets like Denmark, Finland, and Sweden; markets where pensions seem like an extension of government policy (Japan, Korea, and Hong); and Australia, where the high allocation to domestic equities is a response to fiscal incentives.

   
   

7. What if…? This report does not specifically recommend that UK pension funds increase their allocation to UK equities or set a target as to what that allocation might be. We ran four different scenarios which shows that UK pensions could increase their investment in domestic equities by 50% to 100% and still be comfortably inside historical norms and the norms of other pension systems.

   
   

8. A heated debate: the main argument in support of UK pensions reducing their allocation to UK equities is that a globally diversified market-weighted approach delivers better long-term risk adjusted returns. The main argument for a slightly higher home bias is the strong social contract argument that there might be a form of quid pro quo attached the generous tax relief on pensions of nearly £50bn a year. This report analyses both sides of the debate.

   
   

9. Private equity and infrastructure: UK pension funds have a significantly lower allocation to private equity and infrastructure assets (around 6% combined) than many of their peers (Canadian public sector pensions 34%, Finnish pensions 17%, and Australian supers 14%). The hallmark of pension systems with a high allocation to these assets is concentration and the scale of individual funds: the UK has the least concentrated and most fragmented pension system of any market in our sample.

   
   

10. Policy recommendations: we outline a range of potential policy solutions for the new Labour government as part of its pensions review to help increase the scale and efficiency of the UK pension system; stimulate the debate on domestic investment and encourage more investment in UK assets; help make investing more attractive outside the pension system; and improving disclosure by UK pension funds.