Productive finance: soundbites or substance?

Whilst the government’s ambition to see defined benefit (“DB”) pension schemes invest more in UK productive assets to promote economic growth is a laudable one, they will have to go a lot further if they expect any material change to happen.

To borrow the PPF’s views^[1] on investment, ‘productive finance’ assets are:

• Equity – both public and private, and
• Real assets – including property, infrastructure, timber, and farmland.
• They are investments which help support businesses.

Although investment in the debt of property, infrastructure, and businesses can be included, in the cleanest and typical definition of productive finance, as adopted by the PPF, these wouldn’t be included. That means investing in productive finance assets means investing for growth – taking risk for the prospect of higher returns.

DB Pension Context

In contrast UK DB pension schemes have, in the main, been on a long and continuing de-risking trend over the past two decades, with less than 10% of schemes open to new members and the majority closed to future accrual: whereas in 2006 some 61% of their assets were invested in equities, by 2023 this had dropped to just 18%. Trying to funnel a small and ever decreasing slice into UK productive finance assets is already an uphill task, therefore.

This is compounded by the regulatory and trust requirement for trustees to diversify their asset holdings which means UK investments generally only represent a small part of a scheme’s overall holdings, the majority invested overseas. For example, almost 90% of schemes’ aggregate allocation to quoted equities is invested overseas, leaving just under 10% in the UK. Channelling a greater proportion of DB schemes investments into productive finance assets will only have a relatively muted increase in UK investment, therefore.

A further difficulty for trustees is that many of the productive finance assets the government is seeking investment in are complex and risky investments requiring significant due diligence. For all but the largest schemes, this presents a significant obstacle to such investment. One only need look at the recent failed investments of various local councils that have now gone bankrupt, which has included investment in solar farms, housing, and commercial property, to see how wrong, and how quickly, this type of investment can go where ill-considered. Understandably, trustees of most schemes will generally be reticent to expose their schemes to these risks particularly if the returns aren’t required either.

Moreover, the largest schemes hold most of DB pension scheme assets, with almost 75% of the £1.4 trillion of total assets concentrated in just 319 (some 6%) of all schemes (and 90% of all assets in the largest 20% of schemes)^[2]. Changing the investment behaviours of most schemes will therefore have limited impact: only the largest schemes matter to the level of investment in UK productive finance.

The Largest DB Schemes

The largest schemes, however, typically already have a material level of exposure to the sort of productive finance assets the government wants to see increased investment in. For example, the Universities Superannuation Scheme, the largest private sector scheme with over £75 billion of assets^[3], has just under three-fifths invested for growth, all of which is in productive finance type assets. Unless they increased their allocation to growth, or reduced their global diversification, they would find it difficult to invest further in such assets.

Larger schemes have limited scope to increase their allocations further, therefore, given the need to maintain appropriate diversification of their portfolios, and that many are also into the de-risking part of their journeys too, not looking to further increase their growth assets. This is highlighted by the figures^[4] in the 23 February 2024 consultation, Options for Defined Benefit Schemes, which showed the following breakdown of schemes’ assets by funding level on a buy-out basis:

As shown, two-thirds of schemes are already funded sufficiently to buy-out with an insurer, with most of the remaining schemes within touching distance of achieving this goal, too, at which point growth assets and the risks associated with them are no longer required.

Recent Government Initiatives

Whilst the government has set out proposals to enable and encourage schemes to continue running on, with a view to sponsors and members sharing in further surplus generation, in and of itself this is again unlikely to result in a material increase in productive finance investment, unless debt-type investments are included. The reason for this is that most schemes are likely to want to adopt run-on investment strategies that are like how insurers invest, which would typically mean predominantly investing in credit-based assets. Whilst pension schemes do not suffer the same restrictions as insurers, in terms of the Solvency 2 requirements around matching assets, nonetheless, it is to be expected that equity and property-type investments would be relatively minimal.

Indeed, the government’s ambitions^[5] on productive finance are to channel investment towards funding plant and equipment, research and development, infrastructure, and private equity. In this respect their definition of productive finance is much narrower than the PPF’s and whilst that increases the scope to expand such investment relative to the levels today, it also concentrates it into more niche asset classes. This is likely to give rise to diversification problems, in terms of trustees meeting their fiduciary duties to suitably diversify investments, notwithstanding the need to find suitable assets to invest in, too.

An Alternative Emphasis?

Rather than trying, in all likelihood unsuccessfully given the above, to cajole private sector DB pension schemes to invest more in productive finance, the government would be better placed considering the large, funded, public-sector schemes it controls and what might be possible there. These schemes remain open to members and new benefit accrual and are therefore much better placed to invest accordingly - for the long term – something the government itself has recognised^[6]. They also have significant assets.

For example:

• The Local Government Pension Scheme (“LGPS”) has £400 billion alone^[7].
• The Railways Pension Scheme has £30+ billion^[8].
• The Mineworkers Pension Scheme is £10+ billion^[9].

Collectively, there are some £500 billion or more of assets across funded public-sector schemes that the government could much more easily, repurpose to meet its productive finance aims. Whilst these schemes typically invest a significant proportion of their investments in productive finance assets – for example, the LGPS invests broadly three-quarters^[10] of its assets across equities, property, and private equity – these are not exclusively invested in the UK, or in the type of productive finance investment the UK government would ideally like to see.

The government is currently taking steps to encourage the LGPS funds to increase their allocation to such assets, with an ambition to see them double^[11] their investment in private equity to 10%, “…to support the high-growth, innovative technology companies that often struggle to obtain the scale-up capital they need to reach their potential.”. Whilst this is a relatively low amount of nominal investment – an additional £20 billion into private equity – if channelled towards venture capital, this is significant, the government having identified a gap of £5 billion per annum to fill. Not all the government’s aims on productive finance necessarily require significant increases in nominal investment, therefore. Of course, as the target is only an ambition – and not limited to investment in UK private equity – any increase is likely to be heavily diluted from primarily being investment overseas.

Nonetheless, if the government really wants to see a step change in investment in UK productive finance, these public-sector schemes provide a much more obvious and arguably easier route to achieving their goals. By its very nature, the LGPS operates in the local government arena and has significant investment experience available to it.

There is also the Pension Protection Fund (“PPF”) which, with some £33 billion of assets giving rise to £12 billion of reserves, making it the 5th largest defined benefit pension scheme in the UK. The PPF ultimately operates to deliver the legislative requirements set out in Part 2 of the Pensions Act 2004 for them. The government could amend the legislation to alter the requirements for how the PPF’s monies are invested to focus on UK productive finance assets, even making it a cornerstone for such investment.

The government assuming responsibility for DB pension scheme liabilities and with that, taking the scheme’s assets onto the government’s balance sheet, is not a new concept. As part of the privatisation of Royal Mail in 2012, some £28 billion of assets were transferred from the Royal Mail Pension Plan to the government, as part of their taking responsibility for most of its liabilities.

Ultimately, it’s within the volition of the government, if they really want to create a UK powerhouse, to require the LGPS and other funded public-sector schemes to invest all their monies into a newly created sovereign wealth fund, enabling a step change in the level of desired investment.

Whether the government wants to take such a step, and the level of investment in the UK they are looking to achieve, remain open questions.

[1] https://www.ppf.co.uk/blog-posts/Productive-finance-and-how-we-think-about-it-at-the-PPF

[2] https://ppf.co.uk/-/media/PPF-Website/Public/Purple-Book-Data-2023/PPF-The-Purple-Book-2023.pdf

[3] https://www.uss.co.uk/news-and-views/latest-news/2023/07/07252023_uss-publishes-2023-report-and-accounts

[4] https://www.gov.uk/government/consultations/options-for-defined-benefit-schemes/options-for-defined-benefit-schemes#chapter-2-model-for-a-public-sector-consolidator

[5] See footnote 3 of https://www.gov.uk/government/consultations/options-for-defined-benefit-schemes/options-for-defined-benefit-schemes#ministerial-foreword

[6] “The LGPS is largely well funded and has a very long-term time horizon, unlike most private sector defined benefit funds, which are typically closed and much more mature.” https://www.gov.uk/government/consultations/local-government-pension-scheme-england-and-wales-next-steps-on-investments/local-government-pension-scheme-england-and-wales-next-steps-on-investments

[7] https://www.lapfinvestments.com/lgps-in-surplus-as-assets-hit-record-400-billion/

[8] https://member.railwayspensions.co.uk/knowledge-hub/investments

[9] https://www.mps-pension.org.uk/media/1asfwbbq/2022-stewardship-report.pdf

[10] https://lgpsboard.org/index.php/2022-investment

[11] https://www.gov.uk/government/consultations/local-government-pension-scheme-england-and-wales-next-steps-on-investments/local-government-pension-scheme-england-and-wales-next-steps-on-investments