Laura Myers is head of DC pensions and a partner at LCP. Steve Webb is a partner at LCP and former pensions minister.
The Chancellor has a problem. On the one hand, we are told that generating economic growth is the over-riding ‘mission’ of the government. On the other, the government is severely constrained when it comes to either taxing more or borrowing more to generate funds for public investment.
It is therefore not surprising that the Chancellor would be keen to tap into the over £2.5trn invested in workplace pensions and, like her predecessors, is trying to find ways to get more of that money invested in line with the government's priorities.
Unfortunately, there is a risk that the route the government has chosen to achieve this goal – consolidating the DC market into a small number of ‘mega funds' – will take a long time, cause massive cost and disruption and may still fail to deliver its stated objectives.
We think that there is a better way.
The government's consultation on the Mansion House announcements closes on Thursday (16 January) and the supporting documents are explicit about the government's agenda. Rather than mandating schemes as to how they should invest, it plans to use greater scheme size as an indirect way of achieving its objective to get more investment in UK productive finance.
According to the background documents which accompanied the Mansion House speech, the government believes that larger schemes are more likely to allocate to illiquid assets and private markets. Unlike equity investments, which are overwhelmingly global, illiquids and private markets have a much greater home bias. It therefore follows that if government can drive consolidation into a smaller number of ‘mega funds' this should lead – without explicit mandation – to greater domestic investment and enhanced economic growth.
There are however several flaws with this strategy.
First, despite occasional rhetorical nods in the direction of good outcomes for savers, this policy agenda is really not about improving member outcomes.
The government's own analysis, undertaken by the Government Actuary's Department and published as part of the Mansion House announcements, suggests that even over thirty years this revised investment approach would at best lead to ‘slightly' improved pension pots at retirement. The member is very much an innocent bystander in all of this.
The second issue – and one which should concern the government – is that all of this is likely to take considerable time.
The government is talking about not implementing these changes until 2030 at the earliest. However, many we have spoken to across the industry suggest that a more realistic timetable would run several years beyond this. Potentially higher economic growth in the mid-2030s would no doubt be welcome, but seems unlikely to win the government the next general election or even the one after that.
Worse still, a radical restructuring of the DC master trust pension market is far from being a free lunch and is a real-time experiment directly affecting the future retirements of millions of people.
It is far from straightforward to combine these pension schemes, and the cost of doing so will almost certainly be borne ultimately by members – the schemes we are talking about are mainly commercial entities after all. And the end state of this market could be a small number of massive schemes who may have a very low appetite to stand out from the crowd or to innovate.
With an estimated DC workplace market of £1trn by 2030 and further growth thereafter, we could easily be talking not about the £25bn-£50bn schemes mentioned in the consultation but about schemes and providers with well over £100bn in assets. We know very little about the point at which diseconomies of scale set in, and it is far from clear that members will ultimately benefit from such a market structure.
There is also no guarantee that these huge mega funds will invest in line with the government's priorities. Without mandation (which rightly has little support across the industry) any greater allocation to illiquids and private markets will not automatically favour the UK, whereas some smaller schemes who are already investing in a way the government would approve of could be driven out by the push to scale.
Meanwhile, the downside risk is that all of this legislative, regulatory and policy focus on driving scale diverts attention from other measures which could deliver a greater level of productive finance on a much swifter timetable.
Our view is that instead of using scale as a proxy for UK productive finance, the government should instead be explicit about the types of investments that it wants to see. This would include defining whether it is all UK investment for example or only certain ‘productive' assets.
Once this has been done, we propose a new ‘comply or explain' regime for DC scheme investments, one which goes beyond existing disclosure requirements.
The idea is that the government would define what it means by productive finance, set out where it believes investment is needed and then expect the pensions industry to play its part.
Trustees and providers would retain their freedom to invest in the best interests of members but would have to explain to the regulator if they had concluded that this was not compatible with a specified minimum allocation to, for example, UK infrastructure.
One attraction of this approach is that it would likely encourage an increased supply of investible domestic assets much more quickly. The substantial inflows into DC in the coming years will need a productive home, greatly supporting the Chancellor's objectives and doing it in a way which has a significantly lower level of disruption across the industry. This can also generate funding for domestic projects much sooner than a new regime which would not even come into force until post 2030.
The ‘comply or explain' approach also has the merit that it should be possible to focus on where funds under management as a whole are invested, regardless of whether they are in the trust world or the contract world or in one default or many.
In short, our advice to ministers is to be explicit about what they want to achieve and to regulate for that rather than using the proxy of scale and hoping that this will indirectly and eventually lead to the same outcome.
Laura Myers is head of DC pensions and a partner at LCP. Steve Webb is a partner at LCP and former pensions minister.
