Given the vast size of the UK’s defined benefit pension funds, it is perhaps no surprise that, since the financial crisis, governments in the UK have looked to funds to contribute to efforts to enable economic recovery, and ‘rebalance’ the economy in geographical and sectoral terms. Assets in UK pension funds are equivalent to more than 120 per cent of UK GDP; within this, local authority funds hold assets worth more than £200 billion.
The May government’s recent ‘patient capital’ review considered whether pension funds were being prohibited by regulation from investing in a manner which supported economic growth as well as fund performance, and the earlier review by John Kay under the coalition government considered whether over-intermediation in the investment chain was having a similar impact.
In terms of local authority funds, the coalition government lifted restrictions on private equity, and the May government is (tentatively) taking forward former Chancellor George Osborne’s agenda to create a small number of mega-funds within the LGPS.
My recent report for the Barrow Cadbury Trust, Localising Pension Fund Investments, considered the specific issue of whether pension fund investment strategies can be localised as part of this broader agenda. Some local authority funds, notably the Greater Manchester Pension Fund, have begun to demonstrate an appetite for, and emerging track record in, local investments.
In general, however, pension funds are invested for the benefit of scheme members, and there are legitimate concerns about the ‘double exposure’ associated with local investment, whereby a local economic downturn might also be reflected in reduced returns on pension investments. However, the concentration of investment hitherto in London-centred capital markets has created similar risk dynamics, whereby a financial crisis led to a deep, national recession, as well as impacting conventional asset values very negatively. Furthermore, the growth of the City of London, partly assisted by pension fund investment practice, arguably contributed to the finance sector over-heating in the first place.
So the risks to members in partially localising investment might have been over-stated. What do we actually know about local investments among pension funds? Unfortunately, frustratingly little. Private sector and especially local authority funds are now allocating a larger portion of their funds to ‘alternative’ asset classes than before the crisis. In general, local authority funds have more scope to invest in alternatives, having not made the same move into gilts witnessed in private sector funds since the crisis. Interestingly, however, the allocation to alternatives for the largest local authority funds has slightly fallen in the last few years.
Within the alternative investments category, local authority pension funds remain far more likely to invest in private equity than assets such as infrastructure (although the two are not necessarily mutually exclusive). A consensus that the private equity industry, with attractively priced opportunities, will provide funds with above-average returns emerges very strongly from funds’ recent annual statements (whereas in the private sector, the move to alternative assets is largely explained by increased hedge fund investments).
An interest in private equity clearly suggests opportunities for the local economy, where investments might take a less conventional form. Yet generally speaking funds’ interest in private equity is part of a diversification strategy, associated with the need to hedge risks as scheme demographics mature. The compatibility with local investments cannot be assumed.
Nor can the apparent synergy between fund scale and localisation. While merged funds might have the capacity to make longer-term, riskier investments, my conversations with stakeholders, summarised in the Barrow Cadbury report, demonstrate that pooled funds are more efficient precisely because they can make larger investments, even if on average the returns are lower. But local investments are small investments, more likely to be attractive to smaller investors. Pooling initiatives risk further detaching investment strategies from local economies.
This issue notwithstanding, the report suggests that the creation of metro-mayors does increase the scope for local authority pension funds to be elected a little more strategically, without compromising the focus on member interests. However, it may be that the localisation agenda should focus rather more on how local authorities can encourage private funds to invest more in their local economy.
Metro-mayors should be looking to mediate between private sector pension funds and potential investees in the local economy, and to create the kind of long-term economic strategies – if central government will let them! – that institutional investors can rely upon in planning their investments.
There is also growing support for the notion that local authorities require greater fiscal powers in order to share investment risks with pension funds, or that national institutions which have such powers, like the British Business Bank, should have a much stronger mandate to support long-term investment in disadvantaged regions.
It is worth noting, finally, that any plan based on the assumption that defined benefit pensions provision will continue indefinitely is, sadly, bound to fail. We are only now beginning to contemplate the implications of the large-scale shift to defined contribution pensions saving in the private sector. Defined contribution investment strategies are generally even more conservative, because of the individualisation of risks. But they also, potentially, put more control into the hands of member over where their savings end up. Will a greater appetite for local investments emerge? If so, there will be lessons to learn for all forms of pensions provision, including LGPS.
Craig Berry is reader in political economy at Manchester Metropolitan University. This blog was originally published on the Room 151 Blogs page. Our thanks to them for allowing us to repost.