Much is asked or expected of UK pension funds. The general public expect them to produce reliable high-value pensions for retirement, and the Government also expects them to support British industry and entrepreneurship, and more recently, the green energy transition.
There are now two types of pension fund in the UK – the large, legacy funds which support “defined benefit” (DB) pensions offered by UK employers over the past fifty years. For all but government employees (some 5.5 million), these salary-based pensions are almost all now unavailable and therefore the funds are closed to new members. Employers deem them too expensive, hence their closure.
The other type – “defined contribution” (DC) pensions funds are what pretty much everyone in the UK (apart from Government workers) puts their money into for a future pension.
In the DB funds, government has over the years been spooked by the large number of pension fund failures. Many of these funds’ assets proved to be inadequate to pay the pensions promised; and where the sponsoring firm had failed the Pension Protection Fund – an industry-backed government-sponsored insurer – has had to pick up the pieces. The Pension Protection Fund pays lower pensions than promised to the members of failed funds, but at least they are paid something.
As a result of this string of DB fund failures, the Government, via the Pension Regulator, has imposed tighter and tighter restrictions on the freedom of pension trustees to choose investments. This has resulted in what Nigel Wilson, CEO of pensions giant Legal and General, recently called “de-equitisation” – funds moving out of “riskier” equities into “less risky” but lower return Government bonds (gilts). I put “less risky” in quotes because the risk is measured by actuaries relative to the pension funds’ liabilities – which are “bond-like” in their financial characteristics. As it happens, bonds aren’t actually less risky in day-to-day parlance, as some of them have fallen in price by 50 per cent in the 18 months. Equities, by contrast, have not in general fallen at all, but equities do not move in step with bond prices, hence the actuaries’ assessment of relative risk.
So I feel sorry for DB pension fund trustees – they are on the one hand forced by the pensions regulator to invest less and less in equities, and more and more in bonds, and then are criticised for investing in low-return investments.
By contrast, DC pension funds are very different indeed. Until an employee gets near pension age, most DC fund invest heavily in equities, and as a result enjoy higher long-term return than DB funds. Here the trouble is different: DC funds are managed by for-profit professional firms, who compete for investment talent. They have to pass these costs on to their investors, and hence the recent call by Nausicaa Delfas, the new CEO of the UK Pension Regulator, for more efficiency (i.e. lower costs) in this sector. But she also called for more investment in early-stage entrepreneurial firms by pension funds, and here lies another dilemma – such investments are much more risky than conventional listed securities, and to manage them effectively requires a high level of skill and expertise – which is expensive.
Either way, what remains important is that pension funds, either DB or DC, invest in assets which are reliable providers of good returns in relation to their inherent risks, and that they take care to diversify their portfolios to ensure that no specific crisis or failure can seriously derail their returns. The Government should know better than to exhort funds to invest on any other criteria. A “sustainable” or “green” fund one day can become a loss-making one the next, and indeed what constitutes “sustainable” or “green” is itself a moving target.
The Government has thrown a further complication into the pension pot in the past few years. There have been radical changes in the tax treatment of both pension contributions and pension assets. The original idea of pension funds was that they allowed employees and employers to pay into a pension fund without incurring any tax on the income diverted into the fund, and without paying any tax on the dividend, interest and capital gains when realised for the pension. In return, pensioners would pay tax (but not NI) on their pensions as if they were a salary.
In the past decade, not only has the ability of many employees to claim tax relief on their pension contributions been heavily constrained, but the Government has imposed punitive taxes on pension pots that have grown larger than £1m. Now £1m sounds a lot, but today it buys a 65-year-old an index-linked pension of around £44,000 a year – so a good income, but not a fancy lifestyle. Now, even more confusingly, the Government has announced the abandonment of this tax, with Labour saying they will re-introduce it. Savers, pension trustees and their advisors must despair.
Neil Record is chairman of Record PLC