Can UK pension funds boost UK investment?

On 20 July, the Treasury issued a paper by Chancellor Rachel Reeves calling for a “big bang on growth”. It suggested that a small increase in the percentage of UK investment could deliver £8bn of “productive investment” into the UK.

The paper drew attention to the large local authority pension funds totalling £360bn of investment, where the annual fees are £2bn. The government is interested in further consolidation of pension funds and lower overall fees as a result. Its general growth strategy rests on stimulating a lot more UK investment. Most of this additional money will need to come from private sector sources.

The previous government also looked at this possibility and published the Mansion House Compact to get more investment into unquoted shares. It urged more investment by pension funds. Its British Business Bank sought money from pension funds to boost its investment in science and technology through co-investing. The Compact committed a range of pension managers to allocate at least 5% of their default funds to unlisted equities by 2030. This was said to unlock £50bn of investment in high growth companies by then.

The Chancellor also proposed winding up poorly performing Direct Contribution funds. The funds were said to need access to investment vehicles to invest in unlisted high growth companies, as fostered by the British Business Bank approach. The government called for consolidation of defined benefit schemes, and urged a lead be given by the local government schemes.

Capital for investment

As part of its growth strategy the new government is probably keenest on pension funds investing in new ventures that require capital expenditure paid for by money raised. In practice, if the aim is to increase the amount of quoted equity pension funds own in the UK, as some are suggesting, most of the money is spent on buying shares in the market which does not release any new capital for the companies concerned to invest.

If the pension funds subscribe to an Initial Public Offer as a new company lists, then some of that money raised may be to invest. Some of it will usually be payments to existing owners to sell some of their shares. If the pension fund is buying quoted company shares in the market, then it will only be adding to the amount of money the company can invest if they have a rights issue or placing of new shares, which is relatively rare for any given company.

The government paper said there could be £8bn of extra investment. That was taken from a Phoenix company quote saying there could be an extra 1% of £800bn of pension assets invested in “productive assets” by defined contribution schemes by 2030. This is presumably investment into new ventures, however structured.

Fees and investment risk

The aim of reducing fees needs to take into account the extra costs of actively managing share portfolios compared to buying tracker funds and low risk investments. A fund needs to take advice from good analysts who are following companies and working hard to select shares likely to perform well.

If the idea is to increase the amount invested in unquoted companies and into private equity the costs will be considerably higher, as these are even more labour intensive. The companies do not supply so much public information or have such a press following reporting on their progress. The case for doing this would be based on gaining superior returns. Keeping fees down should not be the sole aim and should not be a justification for missing out on areas of good return where management is more expensive.

Consolidating funds into larger ones should be a way of reducing overall fees. Fees are often charged as a percentage of assets under management, with the percentage falling the larger the fund. Some claim if funds are consolidated it also allows more to be invested in higher risk ventures.

The larger funds can still invest significant sums in new projects and companies whilst keeping that investment as a small proportion of total assets. Funds need to be aware that unquoted companies provide less-liquid investments, so the fund needs to keep sufficient liquidity elsewhere to meet bills and cash calls as needed.

When there was a big fall in Liability Driven Investment funds which many held funds needed money to meet their commitments. There are also valuation issues with unquoted companies, making performance analysis more difficult.

Investment in infrastructure

Great British Energy is a government company aiming at boosting investment in renewable energy. It can help harness more private sector investment, as the new Wealth Fund and existing British Business Bank do. It will be looking to pension funds to assist. There have been investments in UK infrastructure by UK pension funds, with carrying degrees of success. Some pension funds are investors in Thames Water which is in need of substantial extra capital. There have been various successful investments in renewable energy.

UK Pension funds are heavily regulated under trust law. The trustees of any fund need to take good advice over the investments and have a duty to the beneficiaries of the Trust to manage risks well and to generate an appropriate return. Government and City pension advisers will be seeking to promote more UK domestic investment in technology, infrastructure and other opportunities within this framework. Different considerations apply to defined benefit schemes where beneficiaries are promised a final salary linked pension, and to defined contribution schemes where people can buy a pension annuity on retirement which will provide whatever pension the assets can stretch to.

There is considerable continuity of policy between the last and the new government over the need to persuade UK pension funds to invest more in the UK. They are using public sector led bodies to pump prime some of the investment projects and urging pension funds to see the possible investment advantages of taking more risk than a heavily bond oriented strategy.

It is using its influence in the public sector to amalgamate local authority schemes to use the big financial fire power of their pensions to both lower overall fees and at the same time to have some more adventurous domestic investments. There is work to be done to relate these proposals to the thousands of schemes and to the boards of trustees who remain responsible for the conduct of their funds and the hiring of the advisers.