How to boost investment in UK equities by UK pensions

This report highlights the stark decline in the allocation of DC pensions to UK equities over the past decade and their low level of investment in domestic equities compared with other countries. The potential reforms outlined in this report could increase the allocation to the UK market by DC pensions by between £50bn and £100bn - and still leave them comfortably in line with their international peers and recent historical norms.

New Financial relies on support from the industry to fund its work. Our reports are available to New Financial member firms, government and regulators, and the media. If you would like to enquire about membership or receiving a copy of the report, please click here

New Financial members, governments and regulators, can also access our complete research archive including this report here

How to boost investment in UK equities by UK pensions

The starting point for this report is that a dynamic public equity market matters for millions of individuals in every corner of the country and for the UK economy. Listed UK companies make a large direct economic contribution to local economies through their footprint and operations, employing nearly four million people up and down the country. A more vibrant stock market would enable more UK companies to raise more capital to invest in jobs and growth, provide a funding continuum for high-growth and tech firms to scale up and stay in the UK, help connect millions of individuals saving for their pension with UK companies, and send a strong signal on investment in the UK.

Much of the focus of reforms over the past few years has been on encouraging pensions to invest more in private markets and infrastructure assets than on public equity markets. While this is important, we thought it might be useful to zoom in on potential reforms on the demand side for listed equities. We focused on defined contribution (DC) pensions (which will be the largest pool of pensions assets in the UK by 2030) and explored the potential impact of five different options, how they might work in practice, and what challenges they might face:

• Do nothing: allow the market to adjust to recent geopolitical shifts and changes in the relative performance of different markets, and allow the reforms already underway in UK pensions and capital markets to play out;

  
  

• Contributions: set a minimum UK equities allocation for pension contributions that attract higher or additional rate tax relief (nearly two-thirds of all contributions);

  
  

• Tax-free lump sum: increase the tax-free lump sum that people can take out of their pension from 25% to as much as 35% for pension pots with a higher allocation to UK equities;

  
  

• Mandation: the ‘nuclear option’ of requiring pensions to have a minimum allocation to UK equities of 20% to 25% of their total investment in equities;

  
  

• A UK weighted default fund: require DC default funds to have a ‘UK weighting’ of 20% to 25% of their total investment in equities, with the option for people to opt out (something we first suggested a few years ago).

We analysed each proposal on five factors: the potential impact on levels of investment in UK equities by 2030; how simple it is to understand and to implement from a legislative and regulatory perspective; how practical it would be for the industry and individuals to manage; how much challenge it might face from the industry and other stakeholders; and how difficult it might be from a political perspective.

The report challenges three common arguments in this debate: that it is not the role of government to intervene in the asset allocation of UK pensions; that individuals only care about returns from their pension; and that any additional investment in UK equities would undermine the optimal ‘global diversification’ of UK pensions. While we do not recommend mandation, we think there is a strong social contract argument for a more robust role for government in an industry in which many decisions are already defined by legislation and regulation, and which benefits from such high tax relief. When we asked more than 1,000 people with a pension what they thought, we found that they were more interested in more of their pension being invested in the UK than solely in performance. And we highlight the apparent confusion in the industry that being ‘globally diversified’ means taking a ‘global market weighted’ approach (in which you invest based on the size of a stock market in global indices). It doesn’t. Here is a short summary of the report:

1. Why it matters: this report argues that a more vibrant public equity market matters for people in every corner of the UK. It would help support growth and investment through the big local footprint of listed companies across the country, enable more high-growth companies to scale-up and stay in the UK, better connect millions of individuals saving for their pension with UK companies, and send a strong signal on investing in the UK.

   
   

2. Decision time: this report adds a valuable practical perspective to the debate over the past few years on the decline in how much UK pension funds invest in the UK stock market by analysing five different options for the reform of defined contribution pensions based on their potential impact and ease of implementation.

   
   

3. A vicious circle: the allocation to UK equities by DC funds has fallen from around 40% of their total allocation to equities to just 9% in little more than a decade. They now allocate just 4.9% of their assets to UK equities (about £33bn). On both counts, this is significantly lower than the global average for DC pensions of over 13% of assets in domestic equities, and nearly 30% of total equities invested in domestic equities.

   
   

4. The easy option: the ‘do nothing’ option may sound attractive to many in the industry but under this scenario things would probably get worse before they get better. By 2030, investment in UK equities would fall to just 3.5% of DC pensions assets as more funds shift to a ‘global market weighted’ approach.

   
   

5. The complex options: the proposals to change the tax relief on pension contributions and increase the tax-free lump seem attractive but would have a middling impact on investment in UK equities of between £40bn and £50bn compared with today’s level of investment. These options quickly become very complicated to implement mainly because they would operate at an individual level rather than at a scheme level.

   
   

6. The nuclear option: if the government mandated DC pensions to invest a minimum of 20% of 25% of their allocation to equities in the UK market, investment could more than quadruple compared with today’s levels. However, this option would provoke a fierce backlash and would mean the UK joining China, Hong Kong, and India as the only countries that mandate a minimum investment in domestic equities for their pension funds.

   
   

7. The balanced option: the UK weighted default fund could have a game-changing impact on investment in UK equities with growth of up to £95bn from current levels, and it would be much less challenging to implement than the other options. A potential allocation to UK equities of around 20% of all equities may sound high but is roughly where the industry was as recently as five years ago.

   
   

8. A mismatch in expectations: our survey of more than 1,000 working adults in the UK with a pension highlighted a low level of understanding of their pension and a stark disconnect between their expectations and the industry. On average, people thought 41% of their pension was invested in UK companies or the UK stock market (out by a factor of five to 10 times), and two-thirds of people said pensions should invest more in UK equities even if the returns might be lower than investing in other markets.

   
   

9. The debate on diversification: one of the most striking trends in UK pensions over the past decade has been the shift from a ‘UK centric’ approach to a ‘global market weighted’ approach in the pursuit of better risk adjusted returns. However, being ‘globally diversified’ is the not the same thing as (and does not require taking) a ‘global market weighted’ approach. Pensions could capture the benefit of diversification while retaining a much higher allocation to UK equities by investing on an equal weight basis in a relatively small number of markets.

   
   

10. The next steps: pensions legislation and regulation is fiercely complicated so we have prepared a practical guide to the specific legislative and regulatory steps that the government would need to take in order to implement each of these options. There is a window of opportunity to amend the Pension Schemes Bill as it works its way through Parliament. If the government wants to make a game-changing intervention in this debate (and we think there is a strong case for it to do so) we would recommend pursuing the ‘UK weighted default fund’ option.