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John Ralfe is an independent pension consultant.
Is the answer to the UK’s chronic under-investment problem really down the back of the pension sofa?
Chancellor Jeremy Hunt certainly thinks so, and his Mansion House speech in July set-out how defined contribution pensions should invest 5 per cent of their assets in private equity, venture capital and start-ups.
Pension pundits have also weighed in, suggesting umpteen ways for company defined benefit pensions to put more of their £1.7trn assets into equities.
Sadly, pretty much all these ideas are half-baked — they misunderstand either how DB pensions work, how financial markets work, or how trustee decision-making works. Some manage to misunderstand all three.
Still, something is happening. The government says “there may be potential for the assets held by DB schemes to work harder for members, employers and the economy” and a formal consultation has just closed, asking for views on two big ideas:
— getting DB schemes to “invest for surplus”, by switching from boring bonds and gilts to equities and other “productive assets”, with companies being able to withdraw cash, under strict conditions.
— setting-up a new “public sector consolidator” to hoover up DB schemes, and invest in equities/“productive assets” with economies of scale and expertise.
Let’s look past the Government’s apparent belief that only quoted and unquoted equities are “productive assets” — even though companies use cash from corporate bonds to invest in their businesses, and gilts pay for all sorts of public goods — and focus on the bigger picture.
Any attempt to persuade or cajole DB schemes back into equities just won’t work. We can’t rerun “the cult of the equity” like an 80s sitcom, because the nature of DB pension promises has fundamentally changed in the last few decades.
DB pensions, with no guaranteed annual inflation increases, used to be effectively “with profits” — members shared the risk and return of asset performance. Good performance meant a pension increase, poor performance meant no increase.
Companies were relaxed about holding equities, as they were only on the hook for deficit contributions if assets fell below the modest value of the guaranteed pension. “Discretionary” increases acted as a safety valve.
Guaranteed capped annual inflation increases, coupled with much lower low real interest rates of the last 25 years, fundamentally changed DB pensions from “with-profits” to annuities. Today, members share none of the risk of the risk and return of asset performance.
If equities were the matching asset back in the day, fixed and inflation-linked bonds are now the matching asset.
Matching pension assets and liabilities — holding bonds, not equities — is standard corporate finance stuff, going back 40 years to the great US economist Fischer Black. This was taken up actuaries who applied these principles to the UK, in “Exley, Mehta and Smith”, in 1997.
Today, pension trustees — and I am the chair of a small scheme — have no incentive to hold more equities. Our job is to protect pension promises.
Persuading trustees to hold more equities would require companies to start sharing outperformance again, giving members, say, a quarter of any annual equity outperformance. But giving away some equity upside, keeping all the downside — as companies are on-the-hook to make up deficits — makes no sense.
If any company really does want to “invest for surplus” it should leave pensions out of it altogether, and simply borrow directly on its own balance sheet and buy equities. No company would ever choose to do this, so why should do so it indirectly through the pension fund?
“Investing for surplus” is just another form of disguised leverage, which never ends well.
If the government wants to encourage investment in specific industries it should continue providing targeted tax breaks not swing a pension sledgehammer.
So what about the other suggestions — allowing companies to withdraw cash from their pension schemes?
Currently, there is no mechanism allowing companies to do this until pensions have been bought-out. This is to protect members, and prevent pensions being treated as a (tax-free) piggy-bank: we should be very suspicious of any change.
And, anyway, what’s in it for members? They are bound to lose out as the date of any insurance company buyout is pushed back.
Persuading trustees to agree would require both a bank guarantee for the cash withdrawn triggered on insolvency, and the company to offer compensation through increasing pensions. Companies might as well borrow straight from the bank.
The Government’s other big idea — of a “public sector consolidator” — is also full of holes. Here’s the big one: the only guarantor of the “public sector consolidator” would the government. There is no one else. This would be a huge policy change. Why should taxpayers start guaranteeing hundreds of billions of pounds of private sector DB pensions?
If the government really wants a compliant pool of capital to invest in “productive finance”, rather than guaranteeing private sector pensions, why not transfer all assets and liabilities to a new public sector pension scheme — like Royal Mail at privatisation in 2012 — so the government could then invest exactly as it wants?
Simpler still, why not just issue gilts and then invest directly?
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