Can DB run-on deliver on UK productive finance?

Spring is my favourite season, as it is the season furthest away from winter. Fortunately for me, according to the meteorological calendar, spring already started on 1 March as it does every year. In contrast, astronomical spring is defined by the “vernal equinox”, starting when the sun crosses the equator from south to north, and this year will begin on 20 March and end on 21 June. But there are other definitions of spring too, and we’ll just have to wait and see which one the government meant when it promised the much-awaited response to the Options for Defined Benefit Schemes consultation “in spring”.

Timing aside, the government has big plans for how it will encourage greater investment in so-called “productive growth assets” which typically relate to higher risk illiquid equity investments, typified by venture capital, private equity, property and infrastructure. So, if the government manages to deliver a package of incentives such that many DB schemes do decide to run on, how much new investment in UK productive assets might we see? I’m going to aim to put some numbers on what “great” could look like.

At a recent webinar on the topic, we polled the audience of trustees and employers on their schemes’ plans. 40% said that buyout remained the right path for them. However, 17% said they had already decided to run on and the other 43% were either undecided or were reviewing their plans. So let’s just imagine that the government policy is so well targeted that all 60% who haven’t yet decided on buyout decide to run on. And let’s also, for the sake of our thought experiment, say that they proportionately represent 60% of the current £1.6trn of UK defined pension scheme assets including private sector schemes and the Local Government Pension Scheme (LGPS). So we’ve got 60% of £1.6trn which makes a nice round £1trn to work with. How much of this might make its way into UK productive finance?

Will schemes be dialling up risk?

The first question is how much risk are schemes going to take? Answer - not a great deal. Why? Well, remember the story about the master with three servants, where the two who invested it well were celebrated but the third who buried it and made no money was castigated. What you don’t often hear about is the fourth servant, who started with enough money to pay all their liabilities but took too much risk and ended up going into the PPF. Everyone was so embarrassed that that servant didn’t even make it into the story.

OK, so I’m pretty sure the PPF didn’t exist back then, but my point is, when a scheme is fully funded on a low dependency basis, few trustees are going to risk failure. And rightly so - their role is to provide the promised benefits. Going back to a company cap in hand after you had a healthy surplus is not a good look. The bottom line is if you get to fully funded early, like many pension schemes have, you still need to protect the ability to pay all the members' benefits in full.  

Balanced or Barbell?

Investing with member security in mind can be done in two broad ways. Either invest in a balanced strategy, which seeks to invest in moderate risk assets across the portfolio, or invest in a barbell strategy - comprised of two parts - a low risk matching strategy (to meet liabilities) plus a “moonshot” portfolio (for the surplus).

It is likely that little, if any, assets from a balanced approach would find their way into private equity portfolios, being too extreme relative to the overall portfolio return target.

The barbell approach on the other hand would have scope to invest with much more conviction. Government figures in January suggested a surplus of £160bn on a low risk basis. Again assuming 60% of this surplus remains in the pension space once the 40% that seek buyout have bought out, that leaves £100bn of surplus. But this isn’t all ‘moonshot compatible’. After all, we need something to top up our liability matching portfolio if it suffers a modest protracted downturn, for instance if credit defaults pick up. If all the surplus is invested in illiquid assets, there’s no flexibility. Something like a 5% buffer might be considered reasonable, which translates to £45bn. So from our £100bn, that leaves up to £55bn to invest in higher growth illiquid assets across the DB industry assuming everyone opts for the barbell approach.

UK bias within private market investments

Even in a world of global opportunities, the UK pension market has tended to have more of a bias to UK assets within its private market allocations. The government estimates that around 45% of UK pension fund investment in private equity is UK based. Assuming the £55bn is invested with this bias, we end up with £25bn investment in UK productive assets. This is a meaningful sum, but let’s not forget I have deliberately put some heroic assumptions to work to get a feel for the upper limit. Introducing even a modest degree of realism into each layer of my numbers and this quickly diminishes to below £10bn of new money looking for UK productive assets to invest in.

Some have called on the £400bn LGPS market to do the heavy lifting. In a poll of 90 UK fund managers at our annual webinar in February, almost half believed that LGPS was going to account for the greatest share of the investment into UK productive finance. However, as I see it, the philosophy around not taking too much risk in relation to past service for private sector DB schemes also applies to the LGPS. Just because the LGPS are open and the sponsors are funded by taxpayers doesn’t mean they are invincible.

Has run-on over promised?

I’m doubtful that investment portfolios of DB schemes are going to deliver a meaningful boost to UK venture capital investment or even broader higher risk private markets in general. But focusing on that would be completely missing the point. Run-on could still be brilliant for the UK economy. A well-constructed set of policies could lead to billions of trapped surplus assets being repatriated and directly invested back into the UK via payments to sponsoring employers and members. What’s needed is incentivisation for UK companies to reinvest the proceeds tax efficiently in their own expansion, or subsidise more generous Defined Contribution saving. DC pensions can then in turn propagate the UK productive finance agenda in keeping with the Mansion House Compact. In a previous paper, we have set out the arguments for why running on in this way could generate steady cashflow amounting to £100bn of surplus over 10 years. Regulatory distortions currently mean surplus assets in a scheme are worth less to both the members and sponsor than if those same assets were outside of the scheme. Removing these hindrances would empower trustees and sponsors to make decisions that maximise value all round. A transformational change in policy has the potential to tap a substantial pool of capital and inject it right into the heart of the economy.