The problem with UK government pressure on pension funds to diversify

UK politicians are urging the country’s pension funds to invest less in UK government bonds (Gilts) and more in riskier and complex assets, including young UK companies and infrastructure. Railpen’s head of investment strategy and research, John Greaves, explains the various problems with the plan.

The asset mix of closed defined benefit (DB) pension funds in the UK has been moving more into low risk assets like Gilts in recent decades as these schemes have matured.

The sudden rise in government bond yields over the past 12 months has accelerated this trend. It’s led politicians and some industry spokespeople to look at the £1.2 trillion of assets in schemes like these (around 5,000 DB schemes) and argue it shouldn’t all be invested in Gilts and corporate bonds.

That’s a perfectly reasonable argument, but the language being used by some implies that trustees are at fault and pension fund managers are risk averse, says John Greaves, head of investment strategy at Railpen, the £37 billion fund.

This misunderstands the role of defined benefit funds, mandated essentially via a contract between employer and member to deliver a particular level of benefits in retirement.

UK pension funds support this outcome; delivering on this pension promise is a great result and it’s the responsibility of the trustee to deliver on this without taking unnecessary risk. The Pensions Regulator has quite understandably been emphasising the importance of reducing investment risk over time for these closed DB schemes to reduce reliance on the sponsor.

“We must consider the current funding positions and scheme objectives before encouraging pension funds to invest in alternative assets such as infrastructure and private equity, which tend to be higher risk. Many closed DB pension funds are well funded and do not need to take this added risk to deliver the returns required,” he continues.

Additionally, for those schemes that wish to change their investment mindsets and take on more risk, Greaves notes that the wider regulatory and legal frameworks play a significant role in shaping the decisions of trustees, too. The idea that trustees are risk averse because many pension schemes own a material amount of Gilts is not true, because Gilts have a vital role to play in a portfolio to deliver on the pension promise mentioned before.

“I believe the issue lies elsewhere, particularly in regards to the low member engagement and contribution levels in the UK,” he says.

The relatively recent democratisation of pension saving, in the form of auto-enrolment, and the low levels of both employer and employee minimum contributions have created a wealth gap compared to other pension systems.

Auto-enrolment is moving in the right direction, but the UK is still a long way behind other countries. For example, in Australia, employer contributions are moving to 12 per cent minimum. In the UK, employer contribution minimums are only 3 per cent, and members contribute 5 per cent.

“We are not yet contributing enough into our pensions,” he says.

The UK has an unfunded state pension system and many larger public sector schemes are also unfunded. There is also a proliferation of private sector schemes and individually invested plans with an emphasis on member choice and flexibility, rather than scale and investing for the long-term. There is not a big pot of institutionally managed money, sitting in the accumulation and growth phase of investing, available to deploy.

risk management Benefits

Railpen manages around £37 billion of both open and closed DB pension funds, and also DC. Most of the fund’s assets back the liabilities of open pension schemes. Even in open DB schemes, government bond assets have an important role to play, providing diversification (although this varies when inflation is high) and today a reasonable return by recent history, even after inflation.

Bonds can provide shelter for open DB schemes in times of volatility – like a growth shock – or a shift in market and economic regime – like a potential return to the low yield world of only 18 months ago. If the return drivers in a growth portfolio stall, government bonds can help manage that risk.

“For Railpen’s open schemes, bonds are an important risk management tool, even if we don’t invest as much in them as the closed DB funds we manage. Of course it’s possible to find secure assets that have many of the same characteristics as government bonds over the long-term, like infrastructure and other real assets, where we invest a significant amount of the schemes money – around 12 per cent, mostly in the UK, with ambitions to move higher,” he says.

Ultimately, a trustee board, with support from advisors, is best placed to decide the right asset mix to deliver on a pension fund’s goals, concludes Greaves.

“We work closely with our trustee to continuously review our asset allocation and risk profile to deliver the best outcome for the 350,000 members that entrust us with this responsibility.”