Making pension funds patient: will we ever get it right? Part 2
By Craig Berry
The first part of this post reflected on the barriers to UK pension funds taking on riskier and long-term investments. In this second part, I consider whether recent proposals to consolidate thousands of funds into a smaller number of large-scale funds are likely, finally, to make the difference.
Scale blazers
In a recent Financial Times piece, Martin Wolf argued that we can induce greater patience by consolidating 5000+ legacy defined benefit pension funds into a small number of very large schemes. Government, rather than employers, would guarantee pension payments (a role it essentially already has anyway, through the Pension Protection Fund (PPF) which absorbs pension schemes that become insolvent). Crucially, however, Wolf’s plan involves defined contribution as well as defined benefit provision, with the initial merger of legacy defined benefit funds serving to capitalise new ‘collective defined contribution’ (CDC) schemes.
Wolf’s emphasis on scale follows a recent report by former UK Prime Minister Tony Blair and former UK opposition leader William Hague (for the Tony Blair Institute for Global Change). In A New National Purpose, Blair and Hague recommend depriving both defined benefit and defined contribution of privileged tax treatment where funds are valued below £25 billion — which would force scheme mergers.
Essentially, scale is the lesson that Blair and Hague have learned from the tendency of large Canadian and Australian pension funds to invest in the UK, generally far more than domestic pension funds.
Blair and Hague also suggest that the PPF merges with the National Employment Savings Trust (NEST; the government-owned defined contribution provider for small employers) to create a single investment fund. However, it is not clear why simply bringing PPF and NEST capital under the same set of investment managers is a recipe for overcoming the inherent barriers to patient investment in either defined benefit or defined contribution provision.
As noted above, Wolf’s proposals go a little further, by allowing existing defined contribution schemes to ‘opt in’ to the new superfunds which would be created by defined benefit mergers. Savers would of course continue as defined contribution members, but there would be scope to convert these schemes to CDC by drawing upon legacy defined benefit assets. Generally speaking, CDC allows for more patient investments than pure or individualised defined contribution, because retired members receive pension payments from within their scheme rather than needing to convert their pot into an annuity via an external provider.
CDC provision still lacks a guarantor, so some of the patient attributes that are evident (in theory) in open defined benefit provision would remain absent. But it might be the next best thing. Unlike legacy or closed defined benefit provision, the new defined benefit/CDC hybrid funds would at least have ongoing cash contributions from current defined contribution savers.
State capitalism
Unfortunately, these proposals suffer from three key flaws. First, they do not account for the role of ‘pension freedoms’ (that is, the 2014 early access reforms noted above) in further inhibiting patient investment in defined contribution provision. Any reform would have to incorporate a reversal of this change, or at least an effective workaround.
Second, they are based on very little critical analysis of what Canadian and Australian pension funds are actually doing in the UK. It is not really about patient investment at all: they provide debt-based financing for infrastructure projects, essentially as part of a low-risk, fixed-income strategy. They are not doing what UK pension funds should be doing, but instead doing what the banking sector, or the British state through direct public investment, should be doing.
Third, the nature of the finance sector within which UK pension funds (large and small) operate, as documented by Bonizzi et al, is largely overlooked. Funds will still need liquidity, and therefore they will still confront the constraints inherent in a market-based and collateralised financial system. It is worth mentioning that the UK does still have many open defined benefit schemes with large investment funds — for local government employees. These schemes also benefit from a double guarantor: their sponsoring employers cannot become insolvent, and any fund in serious trouble would be absorbed by the state anyway. Yet even these funds very rarely engage in patient investment in the UK economy.
See for example the recent announcement by the mayoral combined authority in South Yorkshire. Just as national government implores pension funds to invest more in the UK as a whole, local authorities often implore funds associated with their own workforces to invest more locally. But the small print suggests that the South Yorkshire Pensions Authority decision to invest £500 million in a new Place Based Impact Investment Portfolio is less significant than first appears. Firstly, the £500 million figure relates to allocations made over a vague 5–10 year period: barely more than the fund already commits to local investment. Moreover, while some segments of the new portfolio will be dedicated to South Yorkshire exclusively, ‘[o]ther elements of the portfolio covering specialist housing and traditional private equity and private debt investment will be selected for both their return and impact characteristics and the Pensions Authority will look to work with fund managers to direct some of their investment into South Yorkshire’.
Local government pension funds are large-scale, open to contributions, influenced by local politicians highly incentivised to invest for a general economic benefit, and as safe as houses. If we cannot convince them to invest more patiently, with a domestic focus, then it indicates how steep the uphill struggle is for this agenda more generally.
Blair and Hague do in fact seem to be aware of the inadequacy of their primary focus on scale. As such, they also recommend that UK pension funds are required to allocate 25% of their funds to UK assets (‘infrastructure, equities or growth companies’). Current UK Chancellor Jeremy Hunt appears to be keen on this approach too.
This would represent a seismic shift in pension fund investment governance. Diluting the principle that member interests, not the national interest, should be at the heart of all investment decisions would be another step towards state capitalism in the UK (similar moves have been seen recently in Hungary and some South American countries), brought about by ostensibly pro-market politicians with few credible answers to the failure of neoliberalism.
The alternatives
Are there any policy options that would lead to genuine change? Possible reforms include:
1. A stronger role for trade unions in fund governance, on the basis that worker representatives are best placed to uphold a broader view of member interests within investment decisions. But this is not a panacea: the UK has low levels of unionisation, and trade union involvement in governance is often associated with deepening financialisation and pro-cyclical investment practice.
2. Instead of expecting pension funds to invest in the national interest (in return for tax relief), we could instead place the power in the hands of individual members. Scheme members could qualify for a higher rate of pensions tax relief if they opt to participate in a riskier, patient investment strategy.
3. We could turn the question of pension fund investment practice on its head, as I explored a recent IIPP working paper with Nick O’Donovan. Rather than expecting pension funds to invest patiently, we could instead allow individual members to access their savings early in order to finance investment in innovation and entrepreneurship.
4. The most radical approach would be for the state itself to establish a defined benefit pension fund for all savers — essentially reintroducing an additional state pension, albeit on a funded basis. Liquidity concerns would be eliminated because the government would have no requirement to engage in market operations to finance pension payments. The private pensions industry would be decimated too.
5. A slightly less radical approach would be to curtail the period of life covered by private pensions. The government could introduce a much higher state pension for people reaching, say, 85. If private pensions no longer need to last a lifetime, it could lead to a more nuanced account of members’ financial interests.
Perhaps the most significant thing we could do, before expecting pension funds to fix the economy, is, well, fix the economy. Establishing a credible path for long-term economic development, backed up by public investment and muscular industrial policy, would encourage pension funds to come along for the ride and invest more patiently in the areas that government itself is showing faith in.
This argument has its merits, but it again begs the question of why we would even need pension funds’ supplementary investments in these circumstances. If the public sector is leading, banks can support the private sector to follow. Let pensions be pensions. The more likely scenario, of course, is that pension funds, in their current form, would expect the public sector to de-risk investment opportunities before they were prepared to commit significant funds. In short, the illusion of patience might be achieved, while impatience remains the default.
Conclusion
What recent governments have asked pension funds to do is disavow regular financial market practice, whilst entirely reliant on investment returns (defined benefit), or obliged to maximise the pot value of individual scheme members (defined contribution). As I argue in Pensions Imperilled, this is essentially impossible without employers or the state playing an anchoring role within the accumulation process — but the necessity and legitimacy of this function has been almost entirely eroded.
Supporting economic development can remain an important, secondary objective for pension fund investment practice, supported by policy and regulation where possible. But we should acknowledge that, looking across the UK pensions system as a whole, we are a very long way from achieving the first, that is, securing decent retirement incomes for all.
Prioritising this objective probably means doing some of the things that have been discussed in this post anyway. We should start by building out from NEST, providing CDC benefits to today’s pensions savers (and if absorbing legacy defined benefit funds helps, then it would be worth exploring). Over the longer term, it means strengthening state guarantees, to more thoroughly de-financialise UK pensions provision.
