Another UK Pension Disaster in the Making?
The battle for your pension is hotting up. Politicians including Chancellor Jeremy Hunt and his Labour counterpart Rachel Reeves want to funnel more of Britain’s (ie your) pension savings into funding UK companies.
The level of coercion involved varies according to the politician or lobbyist speaking and the audience to whom they are talking. But as both Merryn and Stuart have flagged in separate columns, the government and the City see your savings as their opportunity.
Here are the links to those columns, by the way.
You should read them both, but as the headlines might suggest, neither of my very smart colleagues is overly enthusiastic about this idea. And — spoiler alert! — neither am I.
There’s a lot of fog around this issue, and I’d like to take today’s newsletter to attempt to dispel some of it. Equally, I know that some of my readers will know more about this than I do — you’re a smart bunch too — so please do write in to complain at firstname.lastname@example.org if you think I’m missing something major that needs to be thrown into this discussion.
The Three Types of UK Pension
Let’s take a step back. At a “macro” level, there are basically three different types of pension in the UK (you’ll see why I say “three” rather than “two” in a minute).
The first is a corporate defined benefit pension scheme. This is where you work in the private sector and your employer promises to pay you a proportion of your final salary (related to your length of service), once you retire (linked to inflation, though perhaps not the full amount). You might make contributions, but these don’t drive the final entitlement — providing that is the company’s problem.
The second is a public sector defined benefit pension scheme. You work in the public sector, and the government promises to pay you a proportion of your final salary (or more recently, your lifetime average salary), once you retire, dependent on length of service. Again, it’s index-linked.
You’ll have to make contributions yourself, but again, these don’t have a bearing on the end entitlement. Other than the local government pension schemes, which are fully funded, public sector pension schemes are paid for out of current taxation.
The third is a defined contribution scheme. If you work in the private sector today, this is the one you almost certainly have (so this is what your auto-enrolment scheme is paying into). Under this, assuming you’ve remained opted in (which you almost certainly should), then you pay some of your wages into a pension each month and your employer matches it.
You then hope that the money in that pension grows into a pile big enough to fund the lifestyle you desire when you finally retire. This requires you to take all the investment risk, not to mention the administrative burden, of trying to make sure you achieve that. Oh and if you want index-linking, you’ll have to figure that out for yourself.
Given the choice, which would you rather have? If you’ve any sense, and I know you lot do, you’d prefer one of the DB options. Those put all the risk on the company or the taxpayer, while you get to benefit from the certainty of knowing what you’ll get when you retire.
Unfortunately, over time, the first option has been almost entirely closed to anyone not already benefiting from it. I think there’s one big listed company (Croda International Plc) that still offers a DB scheme which is open to new participants.
What killed the corporate DB scheme? A mixture of things, with Robert Maxwell’s theft (1991), Gordon Brown’s dividend tax raid (1997), and accounting standard FRS 17 (2000) all playing a part. But combined, these things all made providing DB pensions increasingly burdensome for private sector companies. So they stopped offering them.
There Are Good Reasons for DB Schemes to Buy Bonds
Now, you can get annoyed about all this, and yes, I’d like to have a DB pension too. But that’s not what we’re discussing today.
A separate issue which is rearing its head in politics a lot right now, is the idea that the UK has become rather turgid when it comes to investment.
One totemic statistic on this front (and one which — hands up — I’ve thrown around myself) is the fact that DB pension funds have gone from having something like half of their assets in UK equities in the mid-1990s to less than 2% today.
But there’s a good reason for this. Remember that these are corporate DB funds, the overwhelming majority of which are now closed to new members. I’m not an actuary, so please forgive any oversimplifications here, but with no new future employees joining them, these DB funds basically now comprise a lump of increasingly straightforward-to-calculate future liabilities.
What the companies behind these DB funds now want to do is to take as little risk as possible on the investment side, and preferably get these funds to the point where they are sufficiently well-funded to sell to an insurer to run, which would get them off the company books.
In short, it makes sense for this pool of capital to stick with low-risk bonds to match the future liabilities.
(Also, that aforementioned tax raid by Gordon Brown in 1997 — which was a more brutal version of something similar that Norman Lamont had done in 1993 — meant that there was no longer any incentive to favour UK equities over overseas ones, and it also reduced the appeal of equities relative to bonds, so if you’re wondering what changed, that’s an underappreciated culprit right there).
Conflating Two Separate Issues
OK, so we’ve established that private sector DB only wants to buy bonds and then quietly run off those liabilities; and that public sector DB doesn’t actually have any money behind it (with the exception of the local government schemes and also a few other hybrids we won’t delve into right now).
So that leaves us with DC pensions as the main target for all of this newfound enthusiasm for harnessing capital to the UK growth mission.
Can you see how we’ve rather conflated two issues here to come up with a cunning plan that almost certainly only benefits a specific group of politicians and lobbyists?
The UK has a long-running problem with growing companies from small fry to big fish. This is not going to solve that problem.
As for the pensions issue — DC schemes are certainly less appealing than DB schemes. They put all the risk and all the planning issues onto the holder. As my radio colleague Caroline put it, it’s no wonder that Rishi Sunak wants us all to get better at maths, we need it for planning our retirement.
However, auto-enrolment has at least helped to address the provision issue. And moreover, forcing some of that money into funding a specific category of UK company — be they public or private — is not going to help. The history of governments misallocating capital is long and not hard to Google, put it that way.
If the UK is losing its appeal, there are lots of better ways to address that, as Merryn pointed out in this piece: The UK Stock Market Needs Another Nigel Lawson.
Anyway, that’s my tuppence. I’d love to get your views. Send them to the address below, good or bad. I’m particularly interested to hear from anyone who thinks they can add some good historical context to either of these problems (the pensions issue or our long-running inability to turn the UK’s brains into cash).
Also — Merryn and I will be doing an “Ask Us Anything” session on the UK Markets Today blog tomorrow at 1pm. So if you still have a burning question, email it to me now!
Let me be blunt: whenever politicians direct public and private pensions to do anything, it's a disaster in the making.
When it comes to managing money -- all money -- I believe in the "GATP" acronym: Governance, Accountability, Transparency and Performance.
When you are in charge of managing billions of pension dollars, you need to make sure you are placing your contributors, beneficiaries and stakeholders' best interests at the top of the food chain.
Not what governments want but what is in the best long-term interests of your contributors, beneficiaries and stakeholders.
In order to ensure this, Canada's large public pension funds which collectively own a huge chunk of UK private assets (infrastructure, real estate and private equity) operate at arm's length from the government.
They have an independent qualified board of directors overseeing their operations and they manage the bulk of of the assets (80% or more) internally.
To do this properly, they negotiated very competitive compensation packages allowing them to attract and retain top talent to manage assets internally across public and private markets.
In short, Canada's large pension funds know all about the "GATP" acronym and they are held accountable for their long-term performance.
This doesn't mean they're immune from government questions and laws.
I have my own views on investing in China, it's very tricky and fraught with economic and political risks.
And I agree with those who think China faces a decades-long growth plateau as its demographic time bomb starts impacting its long-term growth.
But again, I prefer giving the full investment discretion of these decisions to pension fund managers, not government bureaucrats.
The same with those who think our large pension funds should invest more in Canada.
They already invest quite a bit across public and private assets, why should they invest more?
Because Peter Letko says so?
Give me a break, everyone has a hidden agenda including Letko Brosseau.
It's high time we realize that the Canadian model has been very successful over the last 20 years because it has kept governments out of pensions.
This doesn't mean it's perfect -- far from it -- I have serious questions on compensation run amok at these large pension funds and worry if compensation keeps testing the upper limits, it's only a matter of time before governments do step in and pull the plug on their independent governance model.
Nonetheless, by and large, Canada's large pension funds are world leaders, top performers and the deserve their international recognition and praises they receive.
The UK pension system is decent but complicated.
There too, many working in the private sector are falling through the cracks and risk living in pension poverty.
What happened with the liability-driven pensions triggering a UK bond panic is well known by now.
A lot of UK pensions fell asleep on the wheel, thinking rates would stay low forever, and they got a very rude awakening.
That whole episode should have never happened in the UK where academic and private sector experts can easily work with regulators to avoid such disasters.
But the real disaster will be allowing governments to coerce UK pensions into investing more domestically.
That is the last thing UK pensions should be doing right now, let Canada's large pensions invest in the UK as they diversify away from their home country bias.
When it comes to how to best manage pensions, please remember "GATP", the rest is nonsense.
Below, Chancellor Jeremy Hunt defended his budget on Sky News back in March, saying scrapping the lifetime pensions allowance was a move Labour advocated last year.said it would help tackle issues in the NHS where doctors were retiring early due to pension rules.
And soon after Chancellor Kwarteng announced the UK mini-budget in September 2022, the gilt markets nosedived. While public attention was focused on the currency and mortgage markets, pension fund managers were watching in horror as a little known financial instrument they had relied on for decades threatened to take down huge swathes of defined benefit pensions.
David Chambers, Invesco Professor of Finance at CJBS and co-director of the Centre for Endowment Asset Management (CEAM) explains what is liability driven investment (LDI), and how it works, as well as the risks involved with this type of investment. He is joined by Derek Steeden, Portfolio Manager at Invesco.