by Yvonne Braun
When we launched the “Pay Your Pension Some Attention” campaign last autumn, little did we know just how much attention for pensions it would generate beyond our target audience of British savers. So we warmly welcome the focus from Government and many other organisations on how to make pension money work as hard as possible to spur economic growth for the benefit of society.
The ABI and its members share the purpose of driving change to help build and support a thriving society. But ideas for change need to be informed by clarity about the key features of the UK’s private pension system, and most importantly, by the appreciation that pension money is savers’ money, intended to secure their standard of living in retirement. The litmus test for any policy proposals therefore has to be that they deliver better outcomes for savers.
Defined benefit and defined contribution pensions – different worlds
The UK’s pension system divides into defined benefit and defined contribution pensions, two starkly different systems in terms of demography, generosity of employer contributions, and the long-term future of these schemes. These factors are crucial when considering the most appropriate investment.
Open defined benefit (DB) pensions are becoming a rarity in the private sector, with only 9% of schemes still open to new entrants, and fewer than 800,000 people still making contributions out of the total of 9.8 million scheme members1. The vast majority of people with DB entitlements (outside of the public sector and local Government) are approaching retirement or already retired. In contrast, defined contribution (DC) pensions are broadly speaking the domain of the young in the private sector.
Similar to other gaps between the generations (free education versus student loans, affordable housing versus out-of-reach deposits), there is a chasm between employer contributions for DB (22.2% on average in private sector schemes in 2019) and DC schemes (3.5% on average in 20192). This is the key factor that is driving poorer outcomes for DC pension savers compared to DB savers, rather than asset allocation as is sometimes suggested.
In terms of investment, for as long as DB pension liabilities sit on an employer’s balance sheet, the ideal investment strategy for closed (and therefore the majority of) DB schemes is to hold low-risk assets delivering steady cashflows to meet regular pension payments – like bonds. For younger DC savers, it’s a completely different story – they are decades away from retirement and can afford to invest in assets with higher rewards and corresponding risks. DC savers do not have a guaranteed retirement income in the way that DB savers do (unless they purchase an annuity at retirement), and so will be more reliant on the performance of their investments. As DC savers near the payout phase, they are more likely to be moved to less risky assets, but this varies widely, especially since the pension freedoms changes in 2015.
What needs to happen to channel more DB money to productive assets?
Consolidation is a tried and tested way for DB schemes to reduce cost and access more diverse investment opportunities. There are over £1.6 trillion pounds in private sector DB schemes, but out of over 5,000 schemes, less than 300 look after more than £1bn in assets. Since 72% of DB schemes have assets under £100m, there is significant scope for efficiency, although it is by no means a panacea and needs to ensure that savers' future income is secure.
The insurance sector plays a major role in consolidating and securing DB pension schemes. Employers can transfer the responsibility for their pension scheme by moving its assets and liabilities to an insurer for an exit payment, a so-called buy-out transaction. Insurers have already consolidated £300bn of DB assets and look after the retirements of around 1.6million DB members.
While capital rules (both Solvency 2 and Solvency UK) make investments in equities fairly unattractive, buy-out insurers invest pension money directly into the fabric of UK society, from urban regeneration to social housing, renewable energy, electric vehicle charging infrastructure, and later living communities. For example, buy-out insurers are investing in the Thames Tideway Tunnel to prevent future sewage spills, Hornsea 1&2, the world’s biggest offshore windfarms, and Wirral Waters One, the UK’s largest urban regeneration project. The new Solvency UK rules, if implemented appropriately, will enable insurers to invest even more in UK productive assets.
This risk transfer market is growing strongly as more and more schemes take advantage of the opportunity to de-risk. In 2022, the pension risk transfer market reached a transaction volume of £44.7bn in one of its strongest years so far, and the market is projected to grow by £50bn each year for the next decade.
Consolidation through insurers is a suitable goal for all private DB schemes as it ensures the protection of policyholders, which is paramount. Where schemes are not likely to reach buy-out, a wider role could be considered for the UK’s pension lifeboat, the Pension Protection Fund (PPF). Enabling solvent employers with small underfunded schemes to transfer the investment of their assets to the PPF would provide access to scale (the PPF has £39bn assets under management), and its proven investment and risk management capabilities. Any such change would need to put savers first and avoid moral hazard, and therefore should maintain the link with the employer and ensure that full benefits are paid.
This approach would avoid the pitfalls of the “Superfunds” proposal from the Department for Work and Pensions (DWP) 2018 consultation: the PPF is a not-for-profit institution which already has scale. In contrast, “Superfunds” were set up by highly sophisticated financial services players who would have needed to create scale from scratch. As a result, they were not focused on taking on small underfunded schemes (where the real problems lie).
Further consolidation is also appropriate for the 86 Local Government Pension Funds (LGPS) which together administer £350bn in assets for the retirements of local authority workers. The LGPS is the only UK pension institution comparable to the large schemes overseas. The part-consolidation achieved so far has not been bold enough – in fact, LGPS overheads have increased and compare unfavourably to the Canada Pension Plan which is of a similar size (£330bn) but has much lower overheads.
The ABI therefore supports the proposals in Budget 2023 to speed up the pace and scale of LGPS pooling – if a single pool was created, it would at one stroke rival large funds overseas, with similar benefits for reduced costs and more diverse and growth-seeking investments. This also makes sense because these are open schemes with new local authority employees constantly joining the workforce and a correspondingly long time and investment horizon.
What changes are needed for DC?
Workplace DC pensions are projected to grow from £500bn to £1trn in 20303 and schemes are already consolidating at a rate of 8 to 10% annually4. DC pensions are invested in UK and international equities alongside other asset classes. The UK is not an outlier when it comes to investing elsewhere – in countries from Australia to Canada and the Netherlands, there has also been a decrease in pension schemes’ domestic equity exposure5.
Savers in this market are a lot younger than in private sector DB schemes, so investing in growth assets is more appropriate. However, a key feature of this market is a pervasive “cost is king” culture in all parts of the supply chain. This includes trustees, employers, employee benefit consultants (EBCs) - which advise trustees and employers on pension scheme selection - as well as providers competing for business. This drives a race to the bottom on price at the expense of a more holistic focus on investment returns and service levels as equally important measures of value. It is one of the key barriers stopping pension providers from investing in a wider class of assets.
The effectiveness of measures already taken, such as exempting performance fees for investments in illiquid assets from the charge cap for automatic enrolment schemes, will be blunted as long as this “cost is king” culture persists.
There is a concerted effort from Government and regulators to force a more holistic assessment of value for money beyond cost. Small schemes (below £100m) are already required to consider whether they are providing value for money and, if not, to consider consolidation. And DWP, Financial Conduct Authority (FCA) and The Pensions Regulator (TPR) are consulting on standards for measuring value for money which include investment performance, quality of service, and cost. We welcome these standards and the upcoming requirements for trustees to disclose the full asset allocation of their default funds, as they should bring about more holistic thinking by employers, trustees, EBCs and providers.
It is important these standards have an opportunity to work their way through the system. But if they are not found to drive a culture change around cost as well as greater consolidation, greater powers should be given to the Pensions Regulator to enforce consolidation where schemes, especially smaller ones, do not provide value for money. It should also be considered whether EBCs should fall into the orbit of financial services regulation for the advice they provide to employers. The Competition and markets Authority (CMA) and FCA had already recommended new regulatory permissions for investment consultants.
Whilst we are supportive of the aims and ambition, we would also urge some caution around the scale and pace at which pension schemes will be able to increase their investments in productive private assets. Operational challenges around private assets remain, from liquidity management to ensuring member fairness where investments need to be locked in for several years until returns are expected. Private assets also require extensive due diligence including assessing ESG credentials, which can be more difficult. Investments can take about one to two years to materialise and for some of these productive assets, such as infrastructure or venture capital, there is a very limited supply of UK opportunities.
In this context, the ABI welcomes the creation of new Long-Term Asset Funds (LTAFs) to facilitate pension investments in illiquid assets. We were closely involved in the Productive Finance Working Group and our members are among the first to offer LTAFs. We also support the Government’s consultation on the Long-Term Investments For Technology and Science (LIFTS) initiative, which would see £250m of co-funding from Government to support DC investment into the science and technology sectors and develop the link between the venture capital ecosystem and pension investment.
Conversely, we do not believe that Government should require pension money to be channelled into particular sectors as different administrations will inevitably have different political priorities for sectors needing support.
Collective defined contribution pensions
Collective defined contribution pension schemes are often seen as a panacea, enabling greater risk-sharing between different generations while limiting employer liabilities, as well as more investment in growth assets.
Risk sharing can be powerful – it is the principle behind annuities – but it is crucial that a new regime for CDC pensions is co-created by all departments and regulators with an interest: the DWP, HM Treasury (HMT), TPR, the FCA and Prudential Regulation Authority (PRA). If this does not happen, it will simply create regulatory arbitrage and consumer confusion.
The mammoth in the room
Finally, the UK’s DC workplace pension system, although growing rapidly, is only in its infancy. Contributions stand at 8%, but are only applicable to a band of earnings which means that the real contribution rate for many will be lower. Compare this to the Australian superannuation rate (paid by the employer) of 10.5% (11% from July 2023), rising to 12% in 2025, and it is clear we need a long-term plan to increase savings rates if we want to aspire to similar levels of DC maturity.
We have previously laid out suggestions to gradually raise employer and employee contributions over the next 10 years to 2032. Government should engage with this and chart a path towards raising rates. For a start, Government should press ahead with its plan to increase auto enrolment (AE) contributions by removing the lower earnings limit and by starting automatic enrolment at age 18 instead of 22. Only by increasing the flow of new assets into DC pensions can we hope to provide more capital for UK plc, and better retirement incomes, in the future.