Proposals to create a more flexible UK pension system should be welcomed
Government intervention in the pensions system seems to be a frequent and favourite pastime in the UK. Indeed, the usual response of the industry to the seemingly perennial tinkering is to groan and ask, politely, to be left alone. However, the current consultation ‘Options for Defined Benefit schemes’ stands out in that it is to be welcomed. The DWP have put some proposals on the table that could both improve outcomes for members and have a positive impact on the UK economy – what’s not to like? We’re supportive and hope the rest of the industry will be too. But, whilst we see the good these changes can bring to the economy, they’re unlikely to support the Chancellor’s Mansion House agenda in any material way. Mr Hunt has said he wants to see UK pension funds doing their bit to support the UK economy, by investing more in so-called UK productive assets. What he’d really like to see is local pension funds investing in UK venture capital to support our entrepreneurial science and technology sector and reverse the trend of excellent British companies having to sell themselves to overseas investors. If adopted, the DB pension reforms on the table are likely to disappoint Mr Hunt, but that shouldn’t stop these proposals progressing.
We need viable alternatives to buyout
Many DB schemes today are rapidly heading on the path to buyout, an option which has long been seen as the ‘gold standard’ for mature DB schemes. However, while this route is well established and is often the right, prudent choice for trustees, we must ultimately challenge the notion that a bulk annuity purchase is the ‘default’ endgame solution for all schemes. The insurance option is expensive and insurers operate with far tighter solvency requirements than pension funds and as a result, are limited in the extent of productive investments they can make in the UK economy. With the huge scale that is estimated (c. £350 billion) to transfer to the insurance market over the next five years or so, there could also be unintended systemic risks (recall how UK LDI activity, whilst sensible on an individual basis, led to a systemic risk that caught us all by surprise in 2022). So, whilst members will have the security of an insurance company standing behind their pension, the benefits to the economy are doubtful and employers end up reaping little reward from the huge contributions they have made into schemes over the last two decades. Looking at all the stakeholders in the round, it would be healthier for DB schemes to have multiple options for their endgame.
Unlocking surpluses
The key to avoiding an inexorable march towards buyout at any cost, is adjusting the way risk and return is shared between members and sponsors. If members and sponsors could share the upside, they would both have an interest in allowing DB schemes to run-on. The mechanism to achieve this, is correctly identified by the DWP as changing the rules on surplus extraction. If sponsors can extract surplus more easily (with appropriate protection for members) they are far more likely to want to run-on their schemes, thereby lengthening the time horizon and opening up schemes to longer term investments. Whilst we doubt many trustees will suddenly start investing in UK venture capital, some of the surplus that is extracted could be reinvested in the sponsors’ businesses, which would ultimately benefit the economy. Anecdotally, as a result of the changes to the surplus taxation announced at the end of last year, we have heard from some clients that their sponsors are changing their perspective to support modest re-risking. In addition, sponsors of DB schemes have generally provided significant funding to DB schemes, and so where appropriate, it would seem reasonable to allow surplus funds to be returned and used by sponsors to invest in their own growth.
Easier extraction of surplus could also drive greater benefits for pensioners and deferred members – through sponsors being willing to keep schemes open and / or surplus sharing arrangements allowing provision of discretionary benefits. However, trustees of DB schemes have fiduciary duties relating to the security of members’ accrued benefits so will need to carefully consider the extent to which release of surplus is consistent with their duties.
Consolidation conundrum
The second aspect of the proposed reforms involves the formation of a public sector consolidator (PSC). The rationale is to improve governance for very small schemes, who have few market options at present due to the fact that they are not attractive to commercial consolidators or insurance companies. Associated with this is the hope that by consolidating many very small pension funds under the auspices of a PSC, the investment strategy can be improved, with an allocation to UK productive assets and associated benefits to members and the British economy.
We can see how a PSC could be useful for small schemes (<£20 million of assets) that are currently not able to access the commercial consolidator or the insurance market route. In a recent Cardano survey of UK CFOs on this topic, 30% of CFOs thought that the PPF can act as a consolidator for small schemes. A government-backed entity would provide improved security and remove the governance and regulatory burden for these schemes and their sponsors. However, the scale of activity for a PSC is unlikely to be that significant in the context of the £1.3 trillion DB pension fund market. By our estimates, around £30 billion (just over 2% of the existing DB market assets) could reasonably be candidates for PSC activity. Even if the PSC made a meaningful allocation to UK productive assets, that’s unlikely to have a material impact on the British economy.
In summary, the two significant proposals being made by the DWP should provide for a richer, more diverse UK pensions sector, with more DB trustees choosing to run-on and invest with a longer-term time horizon. Member outcomes could be improved through enhancing benefits with some surplus assets and the UK economy could benefit from the reinvestment of the surplus assets into sponsors’ businesses. Consolidation of the smaller schemes into a PSC could also enhance member outcomes and benefit the economy through better longer-term investment strategies.
However, neither of these measures is likely to result in a material increase in UK venture capital.
Looking abroad
If the government are serious about getting UK pension funds to invest in local venture capital, we should take a lesson from abroad and look at the Canadian, Nordic and Dutch pension systems for inspiration. The more obvious route, in our view, would be to consider the partial funding of public sector pension funds or the state pension. Funded public or state pension assets would likely adopt similar investment strategies followed by their global peers. Clearly moving from unfunded to funded public sector pensions would be a huge change in policy and require a thoughtful long-term plan. It could seriously move the dial. It should be on the agenda.
