The next steps in UK pensions reform

This report highlights the chronic fragmentation in UK pension funds in the context of the government’s Pensions Review. It compares the scale, concentration, and asset allocation of UK pensions with their counterparts in other markets; highlights the wide variation in decisions and outcomes across DC pensions and LGPS funds; flags up some of the challenges ahead; and argues that more consolidation would benefit the wider economy and millions of individuals across the UK.

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The next steps on UK pensions reform

This short paper explores some of the key themes in the first phase of the government’s Pensions Review with a focus on its proposals to reform defined contribution pensions and the Local Government Pension Scheme. The report is written as much for a non-specialist reader as a pensions or asset management specialist.

Here is a short summary of the report:

1. What reforms is the government proposing? The overall thrust of the Pensions Review is to address the fragmentation of the UK pension system and steer it towards a system with a smaller number of larger pension funds. It borrows from the experience of markets like Australia and Canada and is based on the broad principle that bigger pension funds can invest in a wider range of long-term assets (including unlisted equities and infrastructure) at a lower overall cost to deliver better long-term risk-adjusted returns for their members.

   
   

2. How fragmented are pensions in the UK? On some measures, the UK pension system is among the most fragmented in the world. DC pensions are spread across more than 2,500 different pension schemes with a complex patchwork of pension providers (usually large insurance or asset management companies) that derive scale from managing multiple schemes but do not always generate the benefits of running those assets as a single scheme. The fastest growing segment of these pensions is a group of around 30 ‘master trusts’ (multi-employer pension schemes) but with a handful of exceptions, these funds are sub-scale and much smaller than their counterparts in markets like Australia. If LGPS were managed as one fund it would be the sixth largest pension fund in the world, but it is split between 86 different local authorities. Only seven of these funds have assets of more than £10bn.

   
   

3. What does this fragmentation look like in practice? This fragmentation adds complexity to the system, reduces efficiency, raises costs, and limits the investment horizons of many UK pension funds. There is an unusually wide range across DC and LGPS pensions on virtually every metric: across LGPS funds the allocation to private equity and infrastructure assets ranges from 0% to 26% of assets and UK equities range from less than 1% to 30%. The annual running costs of LGPS funds as a proportion of assets ranges from less than 10 basis points to 170bps, and their five-year annualised performance ranges from 3.3% to 8.2%. There is a similarly wide range in outcomes in DC pension funds: the five-year annualised performance of a snapshot of 20 providers is from 5.1% to 12.9%. This suggests that there is significant scope to narrow this divergence and deliver better and more consistent outcomes.

   
   

4. What does investment in private equity and infrastructure look like today? UK pensions have a significantly lower allocation to private assets like unlisted equities and infrastructure than other developed pensions markets like Australia, Canada, and the Netherlands. LGPS funds have an allocation of around 13% to private equity and infrastructure - less than half the allocation by Canadian public sector pensions (34%) and a third lower than Australian public sector funds (18%). The range in allocation (from 0% to 26% of assets) suggests that many funds (particularly smaller funds) do not have the scale, skill, or capacity to invest in these assets. DC funds invest just 2% of their assets in unlisted equities. The biggest providers have committed under the Mansion House Compact to raise this to 5% of the assets in the default funds in which most of their members are invested, but currently only invest 0.4% of these assets in unlisted equities and a further 2.6% in infrastructure.

   
   

5. What does investment in equities and UK equities look like today? Perhaps surprisingly, DC pensions and LGPS funds allocate more to listed equities than equivalent pension funds in other markets (55% and 51% respectively, versus an average of 45% (partly because they have a lower allocation to unlisted equities). This is one of the few areas where most DC and LGPS funds seem to agree, and there is much lower divergence between individual funds and providers. However, both systems allocate a lower proportion of their investment in listed equities to domestic equities than their counterparts in other markets. Across LGPS, UK equities represent 18% of all investment in equities (with a range of 2% to 52%) compared with a weighted average of 23% in other public sector pension systems. DC pensions allocate just 11% of their investment in equities to their domestic market (with a range from 2% to 34%) compared with an average of nearly one third for DC pensions in other markets.

   
   

6. How are UK pension funds performing? The fragmentation of DC pensions and LGPS funds in the UK and the wide divergence in asset allocation would be less of a problem if they were collectively knocking the lights out in terms of performance and if the range in performance between funds was not as wide as it is. A snapshot of DC pension providers shows that their weighted average five-year annualised performance is about 8.3% (not bad) but there is a range of nearly eight percentage points between the top and bottom performing providers (12.9% to 5.1%). The average five-year annualised performance across LGPS was just 5.9% with a range from 8.2% to 3.3%. This suggests that not all pension funds have the scale, skill, or capacity to deliver the best outcomes for their members.

   
   

7. What is the potential growth in investment in private equity and infrastructure? The government hopes that these reforms could increase investment by DC pensions and LGPS funds in unlisted equities and infrastructure by around £80bn. While this figure should be treated with caution, our own estimates based on the experience of other pension systems suggest this is in the right ballpark. If LGPS funds had the same allocation to unlisted equities and infrastructure as public sector pensions in Australia (18%) it would translate into additional investment of around £40bn. If DC pensions closed half the gap in allocation with their counterparts in Australia (to around 7.5% of their assets) it would translate into additional investment of around £47bn. However, most of this increase in allocation would not be invested in UK unlisted equities or infrastructure: we estimate that for every £10bn increase in allocation to unlisted equities and infrastructure assets, £3bn to £4bn would find its way into UK assets, and of that about £1bn would be invested in UK early stage or growth capital.

   
   

8. What is the potential growth in investment in UK equities? Part of the sub-text running through the Pensions Review and the wider debate on UK pensions is that the government would like to see an increase in the allocation by UK pension funds to listed UK equities. The experience of other markets suggests that unless the government offers a tax incentive to invest more in domestic equities (as in Australia) consolidation could actually reduce the allocation to UK equities (Canada and the Netherlands are the only developed markets that have a lower allocation to domestic equities for both public sector pensions and DC pensions than the UK). There has been a lot of debate on the idea of mandating UK pensions to invest more in UK equities: while the government is holding fire on any measures for now, we think the argument for mandation is much stronger for public sector pensions (LGPS) than for other pensions.

   
   

   We estimate that if the government required LGPS funds to allocate 25% of their investment in equities to domestic equities (in line with international norms and recent norms in the UK) it would increase their investment in UK equities by 55% (or around £20bn) and send a wider signal of intent. Of course, the government should simultaneously be doing everything it can in terms of reforms to capital markets and the wider economy to help make the UK a more attractive investment proposition.

   
   

9. What are the main challenges ahead? Pensions reform is hugely sensitive and technical. Any reforms will meet resistance, take a long time, and may not deliver the intended outcomes in practice that look obvious in theory. While most people in the industry agree that fragmentation is a problem, there are many thousands of individuals and firms across DC pensions and LGPS funds who have vested interests to protect. With LGPS, the government faces pushback that it is interfering in local affairs, that only local authorities can fully understand the needs of their members, and that only local management of pensions can protect local interests. With DC pensions, the main pushback is that any limit on the number of size of default funds will be arbitrary, that consolidation will reduce innovation and competition (which can often be translated as ‘will undermine my existing business’), that the cost model for pensions will need to be redesigned; and that there will need to be a wider range of fund vehicles at scale to enable more investment in unlisted assets.

   
   

   Any suggestion of interference in asset allocation will be met with complaints that it cuts across the fiduciary duty of trustees to act in the best interests of their members. Other challenges include the point that while scale is a pre-condition for efficiencies and investing in a wider range of assets such as unlisted equities, it is not sufficient on its own. To maximise scale, you also need skill. This may pose a difficult political challenge when it comes to pay: will the government be prepared to accept the sort of pay levels at public sector pensions in the UK that are common at Canadian public sector funds which are more than five times higher for the the highest paid executives…?

   
   

10. What else could the government be doing to increase investment? While consolidation in DC pensions and across LGPS is an important part of delivering better outcomes for millions of people and encouraging more investment in productive assets, it is not a silver bullet.