Current pensions policy and the investment approach of many pension schemes is overly cautious, risks leaving us stuck in a rut of low aspirations and is not giving our young people an even chance to succeed.
By Sir Brian Souter
People who know me understand how important I think pensions are and they may also have heard me talk about the faith my father, a bus driver, showed in me as a very young man by lending his own hard-earned savings to help me start up in business. That was a very early and personal example in my life of the older generation investing in youth and in the future, for which I am forever grateful.
When we had a fresh look into some of the issues affecting pensions, I was really surprised but also disappointed at the level of pessimism shown by the pension industry both about the future prospects for business and its lack of faith in investing in our youth – our next generation of business people and entrepreneurs.
A real concern is that this lack of belief is creating a vicious circle of poor confidence with low aspiration that seems to have convinced nearly everyone that the pensions of the past are just not affordable for the next generation.
A change in investment approach over the last ten years
Without a vibrant economy, there will be additional pressure on private, corporate and government contributions, which will ultimately have a significant impact on pensions being provided to senior citizens. You might expect our pension schemes to be investing heavily in businesses and growth for the future, but they’re not: official figures from the Pension Protection Fund (PPF) clearly show that, over the last decade, pension schemes have by and large switched from investing in businesses (through equities and a wide range of corporate bonds) to investing instead much, much more in UK government gilts and a narrow range of similar bonds.
You might expect our pension schemes to be investing heavily in businesses and growth for the future, but they’re not.
In 2006, the typical UK pension scheme invested more than 60% in equities and less than 30% in gilts and bonds. Rolling forward 10 years and the position is reversed: the typical scheme now holds less than 30% in equities, while more than 50% is in government gilts and bonds, and the balance in other investments such as private property and private hedge funds etc. (£1.5Trn – PPF Purple Book, and FAB Index 31 Jan 2017)
Over that same time, the pure weight of money buying government gilts and bonds has pushed up prices, meaning that the expected return on those assets has plummeted – indeed, many pension schemes now investing in inflation-linked gilts are actually expecting to lose money on them; they are being bought on a prospective negative return!
This is where the vicious circle comes into it: if you invest in assets offering such low prospects of a positive return, you not only need to put more and more money into the pension schemes, but you also get far less back for it than was previously expected. This leads to an ever-increasing cycle of unaffordable funding.
One very clear consequence of this approach is that we now have record levels of “investment capital” in pension schemes. Yet, despite this, there is a constant stream of scare stories about the “pensions black hole” and demands for yet more money to be put into historic pension plans. How can this be?
In considering this, let’s be reminded of the scale of the issue and why it is so fundamental to our economic prospects. The level of pre-funded pension commitments in the UK is colossal: the value of investment assets in the UK’s 6,800 or so defined benefit (DB) pension schemes is around £1,500bn (£1.5Trn – PPF Purple Book, and FAB Index 31 Jan 2017) with around another £217bn of investments in local government pensions.
There is growing acceptance that these fabulously large and important pots of DB investment assets are not being efficiently invested in ways that encourage enterprise and employment.
While not unique, the UK is unusual (and certainly so in European terms) in having such a high level of pre-funded (and private) pension provision. It is clear, therefore, that the proper investment and stewardship of these assets must be of great importance to the UK and that a misallocation of those assets will have an adverse impact on the enterprise economy.
I am not the first to call this out. In February this year, the UK Government published its Green Paper Security and Sustainability in Defined Benefit [DB] Pension Schemes, alongside the Pensions and Lifetime Savings Association’s DB Pension Taskforce review of the future of UK DB pension schemes. The papers cover a range of issues and potential solutions to the “pensions problem”, but amongst other things both consider that improvements could be made to better optimise investment returns.
So, it can be seen that there is growing acceptance that these fabulously large and important pots of DB investment assets are, for some reason, not being efficiently invested in ways that encourage enterprise and employment.
Why do we have a pensions black hole?
Let’s go back to the question I posed above: if we have record levels of investment into pension schemes, and we have amongst the best funded pension arrangements in Europe, why do we have an apparently ever-growing pensions black hole?
The answer may come down to how we measure the cost of those future pensions (“what gets measured gets managed”), which in turn is influencing the more recent investment approach of pension schemes.
Defined benefit pension schemes in the UK have to take account of the requirements of the Pensions Regulator in deciding how to fund their pension liabilities, and it’s argued that the impact of this has over time encouraged many pension schemes to take a much more cautious approach to funding and investment – more money into government gilts and bonds, and far less into business equities. The formal funding plans used by the 6,800 private sector pension schemes, in trying to keep the Regulator happy, show an aggregate deficit of around £400bn to £500bn, but this is based on an assumption of achieving long-term future investment returns of around only 2.4% per annum. (2017 Green Paper (page 25))
If, however, you ask those same schemes how much money they think they will actually need to pay their pensions, using their own estimates of their long-term expected investment returns, they consider that they could have a funding surplus of around £270bn. This is based on their expectations that they are looking to make a long-term return on investments of at least 4.3% on their current assets.8 (First Actuarial Best estimate index (or FAB index))
So, under one method there is a black hole of £400bn to £500bn, while under the other there is a surplus of nearly £300bn. That’s a difference of some £700bn and it is an awful lot of the collective wealth of the nation potentially not being put to best use! The reason for the difference can be put down squarely to the assumptions used about future investment returns and the low-return type of assets that many pension schemes are, increasingly, invested in.
The thing is, this really matters to every one of us. Pension scheme investments should be seen as a huge national asset, capable of being invested in ways that can provide benefit across the generations.
Why are we in this situation?
This is the inevitable consequence of pension regulations devised at the start of this century colliding with the QE response following the 2008 financial crisis.
While the pension regulations do actually allow scheme funding to be based on long-term expected investment returns, the regulatory pressure and pessimism exhibited by many of those advising trustees expect schemes to fund using a gilts-plus basis, and direct them towards investing in gilts in an attempt to “de-risk” schemes. As such, we have one aspect of regulation that is stoking up the demand for particular assets (gilts and other low-yielding bonds), while on the other side a consequence of QE is to even further depress the yields on corporate bonds and gilts.
Taken together, a gilts-based funding approach for pension schemes along with QE has massively pushed up the price of gilts and bonds, depressing the yields to historic and unsustainably low levels. The coming together of these regulations with what was to be only an emergency fiscal initiative has skewed the market, with two major unintended consequences.
First, there is a massive bond bubble; second, we are sucking in important enterprise capital, unnecessarily, into a vortex of increasingly expensive pension schemes. This current trend of de-risking is over-allocating pension assets into government gilts (i.e. future taxation), giving a false sense of certainty for pensioners, and at the same time creating a ticking time bomb, an unsustainable pension and tax burden for future generations.
All bubbles eventually burst and when this one does, the illusion of security from de-risking may be laid bare. While it’s possible to argue that this de-risking may be the right thing to do for a single scheme in isolation, when we consider its impact in the aggregate, across all pension schemes, it is potentially disastrous.
The solution is simple
To me, as a committed investor in businesses and in people, the solutions are simple and indeed self-fulfilling. QE will have to come to an end at some point, and those with a responsibility for pension funding need to take less of a look back and instead look forward, supporting investment in enterprise.
It’s a plain reality of both demographics and economics that it is the future generations who will be paying for the pensions of the current and previous generations (especially those well-off baby boomers). The very least we should be doing is to give them an even chance of success by encouraging enterprise, investing in business, the national infrastructure including social housing, and in jobs.
I’d like to see more of that colossal vault of wealth stored in the £2trn of funded pension scheme assets being put to work across the generations. By reversing the recent trends towards gilts and bonds, in effect we should break the bonds. Then we will best support and sustain the pension benefits by encouraging investment of pension assets in enterprise, growth and jobs.
This article was originally published in the December/January 2018 issue of CA Magazine.