Why did UK pensions stop investing in their home market?
In the 1990s the UK pension funds and UK insurers accounted for just over half of all UK quoted shares but according to ONS data that has now dwindled to just 4.2 per cent. (Luke MacGregor/Bloomberg)
Over the past three years the UK has had two governments. Both, regardless of their differences in fiscal and monetary policy, surprisingly aligned on one mission: to get UK institutions invested in the UK and more specifically, the private markets in the UK.
So how did we get here and why are British pensions so unwilling to invest domestically?
In the 1990s UK pension funds and UK insurers accounted for just over half of all UK quoted shares. But according to ONS data that has now dwindled to just 3.4 per cent.
Steve Hodder, a partner at LCP, said the reason for the fall in the proportion of UK stocks held by pension funds is partly because the £1.4trn UK corporate defined benefit pension scheme sector has been derisking as they get closer to meeting their liabilities.
“We've been on a 20 year journey of [corporate] DB schemes investing less in any type of equity asset. And I think there's a second factor within that, that they have gone from having quite heavily UK-biased equity allocations in the 80s and 90s to generally a global market cap approach,” Hodder said.
Think tank New Financial estimates corporate DB pension funds have a 1.4 per cent weighting to UK stocks.
Hodder said other events such as tax changes by Gordon Brown which removed the tax breaks British schemes received on UK dividends and the general performance of UK stocks were contributing factors. “It became quite an obvious change to ask, ‘why aren't we more global?’” Hodder said.
As a percentage of total assets, the £600bn defined contribution and £430bn local government funds are on average weighted to UK equities at 8 per cent and 9 per cent respectively.
Former pensions minister Baroness Ros Altmann told AOX having a stronghold of long-term investors in the UK allowed the domestic stock market to have a reliable source of growth capital which could also function as a bridge through a downturn.
The most recent ONS data shows the proportion of overseas investors has shot up to a record high 57.7 per cent as at 2022, with Altman saying this poses a risk to the UK stock market. “If these foreign investors suddenly lose confidence in the UK, they have no qualms about dumping the whole lot and moving to another country”.
Altman added, “If you're based in the UK and you have to have a certain proportion of your assets here, you won't just sell the UK holdings…you’re in it for the long term.”
The withdrawal by UK institutional investors has created a downwards spiral whereby British companies have become cheap, according to Altman. New Financial describes this as a doom loop which creates lower valuations, lower demand, and lower performance.
“Small British companies cannot find the kind of growth capital that used to be readily on offer from domestic, long term investors… and has had to look more to debt than equity, which has its own problems. I think it's a vicious cycle that we need to break,” Altman said.
The fiduciary duty issue
One of the larger issues for UK pensions is that trustees who act on behalf of members are required to have the member’s best interest at heart when making decisions such as asset allocation.
Understandably, it is harder for them to justify holding an overweight to a potentially lower performing region even though it may (emphasis on may) come with wider societal benefits.
Tim Giles, trustee director at Independent Governance Group, said that while it was likely members would support action to action to improve UK economic prosperity, trustees must consider whether this outweighs the impact to risk and returns.
Giles added a significant domestic bias to UK equity might impact risk and returns but might not link to UK economic prosperity. “Investment in UK equity is not the same as investment in the UK economy,” he said.
A classic example of this is Anglo American, a mining company which is listed on the FTSE 100 and which has its headquarters in Farringdon in London but which has its operations in countries such as Brazil, South Africa and Australia.
LCP’s Hodder said the “second order, third order benefits” that come with having a home bias are harder to assess and, in a risk averse industry, this causes the ‘more home bias’ argument to fall on deaf ears.
Hodder said: “If you say, let's go against [allocating globally] and let's really pile in and favour the UK on the basis of some vague sense of patriotism and potential for uncertain second order benefits to members… you can see why a somewhat risk averse industry finds it hard to do that.”
Hodder points to a shifting disposition when it comes to fiduciary duty, which is looking to interpret the legislation to take a broader scope and taking non-financial factors into account such as standing of living factors.
Altman questions how members’ standard of living will improve by allocating globally, “what are your members going to experience if the economy itself has been weakened substantially more than it should have been?”
She added, “we're losing future tax revenue when these big companies list elsewhere, because they can't thrive in the UK”.
What allocation is right?
It is understandable that corporate DB schemes are more wary of taking on risk as they have achieved their mission of paying their members’ pensions but the LGPS is still open to new entrants and DC funds are growing with ever-increasing cash inflows.
According to the New Financial, UK equities make up 15 per cent of domestic pension fund’s equity portfolios, 4.2 times the MSCI World index. For other countries such as Australia and Japan, domestic equity weightings are at 52 and 48 per cent respectively, equating to 29 times and eight times the index.
Giles said “ultimately, there remains a domestic equity bias in UK pension scheme investment, but the bias is substantially weaker than it was historically.”
To boost the proportion of UK pension funds allocating to UK stocks, Altman calls for around 25 per cent of all new pension contributions to be invested in UK public markets. The UK’s largest defined contribution scheme, Nest, has a 2 per cent weighting to its own listed market.
Hodder thinks the sweet spot sits at around 20 per cent but where he draws the line is investing most or all of the scheme’s growth portfolio in the UK due to concentration risk.
“A UK focus that takes the UK allocation from five to 20 [per cent], that's not going to destroy diversification of your overall portfolio and that's four times as much investment, which is very powerful,” Hodder said.