Mandating the pension system to invest in UK equities?

Luke Bokaba

In recent times, due to the underperformance of UK equities, there have been discussions on how to incentivize UK pension funds to invest in domestic equities at a similar rate to their American counterparts; and whether mandation is the cure.

According to the Financial Times, only 4.4% of UK pension funds are allocated to UK equities; compared to a world average of 10.1%. When comparing domestic equity investments to their American counterparts, the picture looks even grimmer. US funds typically allocate 30-35% of total investments to domestic equities and significantly outperform UK funds’ investments in domestic private equity and alternatives.

However, UK pension funds allocate huge percentages of their funds into bonds, with over double the allocation of their UK counterparts. This indicates that the problem may not solely be the quality of UK assets but equities as a whole, with a persisting fear of overinvesting in more volatile markets.

To further understand UK pension schemes’ fear of equity investments, one must critique the regulations they must abide by:

The Pensions Acts of 1995 and 2004 placed a heavier emphasis on ensuring UK pension funds could manage and meet their liabilities. This motivated UK pension funds to shift to more prudent, less volatile investments.

The Funding Regulations of 2005 require pension schemes to form a Funding Principals’ Statement, this is to motivate funds to further de-risk, at short-term expense but long-term security.

Why would UK pension schemes opt to allocate more assets toward liability-driven investments (LDIs) over the diversification of equities (as their US counterparts conduct) as a method of risk management?

US pension models are dominated by Defined Contribution (DC) schemes, whilst UK schemes are predominantly Defined Benefit (DB).

Defined Benefit schemes are managed by employers and guarantee a set retirement income, calculated based on salary and years of employment, eliminating the risk of retirees outliving their pension.

Defined Contribution schemes are managed by employers and employees, both contributing towards a single account, the final income of retirees in this scheme is dependent on the total contributions and investment performances.

As a consequence of the maturation of DB schemes, UK pension funds prioritized liability-driven investments that closely match their DB-driven liabilities.

The issue of Defined Benefit and liability-driven investments

In late 2022, the UK pension system was brought to its knees after Prime Minister Liz Truss announced unfunded tax cuts worth £45 billion. Her announcement deteriorated Gilts (UK government debt securities), which DB schemes and LDIs rely heavily on – due to the large proportion of UK government bonds that make up DB scheme portfolios.

The near fatality of UK pension schemes highlights that LDIs are not necessarily a safer option than diverse, equity-heavy investments. This is due to their exposure to rapid changes in investor sentiment.

It should be noted that private sector Defined Benefit Schemes are becoming increasingly unpopular, shrinking by 2.5 million members over the past decade.

Conclusion

The primary cause of the lack of investment by UK pension schemes into domestic equities is the dependency on Defined Benefit schemes propelled by liability-driven investments. LDIs are far from perfect and can be argued to be more exposed to macroeconomic cycles and investor confidence than a diverse portfolio of equities.

Mandating pension schemes to increase their investment into UK equities would be a peculiar move, given the predominance of DB schemes. Instead, UK authorities should do more to incentivize a rapid private sector switch to DC schemes.

Making UK capital markets attractive for high-profile listings and incentivizing consumer investment to boost the performance of UK exchanges should be a priority of the new administration. However, the move to raise capital gains tax signifies a step in the wrong direction for UK capital markets.

References:

Department for Work and Pensions (2024). Pension fund investment and the UK economy. [online] GOV.UK. Available at: https://www.gov.uk/government/publications/pension-fundinvestment-and-the-uk-economy

McDougall, M. and Parker, G. (2024). Government could force pension funds to invest more in UK assets. [online] @FinancialTimes. Available at: https://www.ft.com/content/b92011cf-5c81-494aa999-baba0a5a5fb7

Thurley, D., Mirza-Davies, J. and Harker, R. (2024). Pension scheme investments. [online] House of Commons Library. Available at: https://commonslibrary.parliament.uk/research-briefings/cbp10146/

Wells, J. (2024). Pension scheme assets – how they are invested and how and why they change over time | Pensions Policy Institute. [online] Pensions Policy Institute. Available at: https://www.pensionspolicyinstitute.org.uk/research-library/research-reports/2024/pensionscheme-assets-how-they-are-invested-and-how-and-why-they-change-over-time/