Unlocking the investment potential of pensions
There is a real opportunity for the government to unlock a significant source of funds to help Britain build back better while helping improve financial security in retirement for millions
This article was produced in association with Lloyds Banking Group
It’s vital to view the UK’s economic recovery in a very strategic way. The unprecedented Government support to individuals and business throughout the pandemic was creative, bold and pragmatic. As Britain builds back, we need to adopt the same approach.
But what does that mean in simple terms? It means unlocking the investment potential of the UK’s pension industry, enabling pension funds to generate stable returns while investing in the real economy, leading to a win-win for the economy and pension savers.
This is called illiquid investment – and it is well suited to long term infrastructure projects (think of projects such as social housing and low carbon transition infrastructure) – the type which drive real macro-economic benefit. It is widely used by Defined Benefit (DB) pension schemes (often called final salary schemes), as well as insurance companies which manage their own portfolios, sovereign wealth funds and family offices.
These organisations are able to invest for the longer term into assets with less liquidity, often seeking the superior returns of private markets, volatility reduction via smoothing or a match of assets against liabilities which run decades into the future with no option to liquidate particular investments at a moment’s notice and move to something else.
Currently, there is more money invested in DB schemes than there is in Defined Contribution (DC) schemes (the type of pension where the size of the pot is defined by how much is paid in), but as Auto Enrolment’s success grows, the ‘flows’ into DC schemes are greater than into DB schemes, so the balance is switching fast. We are becoming a nation of DC, relying on our investments to provide for our life in retirement, instead of the guarantee of an income for life from an employer as DB used to.
Which is why the issues preventing DC schemes from investing into illiquids should be addressed. As we rely more and more on market returns on our savings, better quality investments available in private markets should play a big part in helping improve our retirement outcomes. Remember also that investments in long term projects such as social housing and low carbon transition infrastructure provide a positive impact on the world DC savers will retire into.
“There is a real opportunity for the government to unlock a significant source of funds to help Britain build back better”
It is hard for DC pension schemes to invest in illiquid assets because of liquidity requirements. Liquidity here describes the ability to sell an asset quickly without impacting its price. The UK’s financial regulator, the Financial Conduct Authority (FCA) has a strong focus on it, wanting customers to be able to move their money out of a fund should they choose. This means that if a DC scheme invests in an illiquid asset, it must be able to underwrite the difference if customers want to move their money out but it can’t sell fund units. This is a level of risk that most DC schemes won’t accept, and therefore this keeps their funds from participating in longer term infrastructure investment, start-up funding, direct loans and so on. The Bank of England, HM Treasury and the FCA have recently set up a Productive Finance Working Group looking into this very issue, and we hope that amending the FCA’s requirements on processing transactions for DC pension customers is one area they are considering. Imposing longer notification periods for trading in DC schemes will make illiquid investment significantly more accessible.
Behaviour is another challenge. People value reward in the short term rather than deferred reward in the long term. Markets often reflect this sentiment, leading pension trustees to focus on investment performance in the short term. This will naturally deter investment in longer term illiquid assets, and current regulatory initiatives to have pension schemes compare investment performance over one and three year time horizons will only compound the problem. There is a strong argument for benchmarking over a 10 year horizon.
Similarly, long term illiquid investment can be more expensive for the end consumer because of the higher costs involved in managing more complicated and longer term investments. Given price sensitivity, this naturally dampens scheme demand.
Finally, there is risk. These investments are complicated hence come with a complexity premium, and pension funds need to do proper due diligence to select who they partner with. Perversely though, in terms of investment performance, these investments contribute to diversification and infrequent valuations create a smoothing effect, reducing overall portfolio risk.
There is a real opportunity here for the Government to unlock a significant source of funds to really help Britain build back better while helping improve financial security in retirement for millions. Managed properly, the potential financial benefits are substantial. The ability to focus this investment on sustainable projects is also a clear benefit – yet another way that our pension funds can contribute to building a carbon free future. Whether DB or DC, a pension is by its nature long term. We should take advantage of that and use it to help build a better future worth retiring into.
This article is featured in Prospect’s new “The Road to Recovery” report, published in partnership with Lloyds Banking Group, the Government of Jersey and Jersey Finance. Read the full report PDF here.
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