The chancellor, the shadow chancellor and even the Lord Mayor of the City of London have called for more pension fund investment in UK companies and infrastructure. Bernard Casey writes that these calls may reveal a misunderstanding of pension funds’ fiduciary duty to pension savers and governments’ role to provide public services. He says that buying more equities or putting more money into infrastructure means putting less money into something else.
There have been repeated exhortations that UK pension funds invest more in the UK and help promote “UK Plc”. Chancellor Jeremy Hunt’s Mansion House speech of 10 July was yet the latest case in point, with talk of £50 billion in investment. A month ago, the shadow chancellor quoted the same amount of money. The Lord Mayor of the City of London has put forward plans whereby pension funds should put £50 billion into a “future growth fund”, while two months ago the Tony Blair Institute made proposals for the creation of “superfunds” that would be able to engage in growth-promoting investments.
Most of these exhortations call for a greater holding of UK equities. Some have involved suggestions that investments contribute to the improvement of UK infrastructure. Some, but not all, have also suggested that pension funds not only hold more UK assets, but for longer. This would produce its own benefits – both for beneficiaries and for the UK economy.
Exactly the size of pension fund holdings in UK equities is not always clear. Most figures suggest that about two per cent are held by such institutions – covering private sector defined benefit (DB) funds, public sector defined contribution (DC) funds and funded local government (DB) plans. All commentators suggest that the proportion used to be considerably higher, and this is the cause of “malaise”. The value of direct holdings of UK equities by UK funds is about £41 billion – only a bit over one per cent of total UK stock market value.
It is necessary to consider what holding more UK equities and investing in infrastructure mean and what shifting the portfolio implies. After all, buying more equities or putting more money into infrastructure means putting less money into something else.
1. Owning more equities
Equities are traded on markets in which most purchases are from equity sellers. All things being equal, buying more equities does not mean channelling new money to UK companies. This would happen only if more equity were being issued, but most major companies do not issue new equity. Indeed, to do so is described as “dilution” and existing share owners do not like it. It usually happens only in extremis, when companies in difficulties try to raise more cash. Healthy companies borrow – by issuing bonds.
New issuances are referred to as initial public offerings (IPOs). Sometimes private companies “go public”. Occasionally, these might be large companies, and the amount of stock made available is considerable. But most are small companies, and many are issuing on alternative markets, not the Footsie (FTSE). These companies are not, in general, the sort of companies that pension funds want to invest in, even if some invest via special funds (agglomeration of such companies) or via venture capital funds. Moreover, the UK is hosting increasingly fewer IPOs, as plenty of commentators are keen to point out. At best, an increase in purchases of acceptable securities might push up marginally the valuation of the companies concerned, Possibly, they might feel more confident and, in turn, invest more in the UK. And lenders might be more willing to provide them with the finance to do so. But there are a lot of “ifs”.
Owning equities is risky. Hence there is an “equity risk premium” – the additional return over and above that of holding safe government bonds. Yes, in the long run, equities increase in value, but they do not always do so. Markets and individual companies can fall. Given that defined benefit pensions are a contractual obligation, it might be wise to ensure that holdings are what they are “expected” to be in the long term. Yet “put options” – which guarantee that a determined price can be obtained in the future – are expensive. Moreover, they are sold for rather short periods – often of a few months or less – and are not available for the long periods that lie behind pension commitments. The costs of such options would be prohibitive.
A decade or more ago, the Kay Report criticised institutional shareholders – such as pension funds – for not being “persistent” investors. They ought not to keep trading their holdings merely to benefit from short-term gains, since they could afford to be “in the game for the long term” (after all, they had long-term obligations). Long-termism is a different story. Simply becoming greater owners of UK equity will not, of itself, lead to more long termism. But the proponents of growth- and super-funds think they will.
2. Owning more infrastructure
Long-termism often goes together with “infrastructure”, which seems to involve long-term assets. Since the time at least of the Conservative-Liberal Democrat coalition government in the 2010s, there have been politicians and others advocating that, if the government is constrained in its borrowing, institutions such as pension funds could and should step in and bear some of the costs. The examples of Canada and Australia are often pointed to. In both counties, it is said, there seems to be much more of this than in the UK.
What is largely ignored is that almost all this infrastructure investment is in “brown” not “green” infrastructure. Pension funds are shy of taking on the construction risks of new (=green) projects. There is enough history of massive cost overruns and delays. Rather, they want existing (=brown) infrastructure that can generate steady streams of cash, often linked to consumer prices. And pension funds buy and sell such assets, often from one another. University Superannuation Scheme (USS), the largest private defined-benefit fund in the UK, is a substantial owner of Thames Water, which it purchased from Macquarie, an Australian asset manager. OMERS, which provides pensions for municipal workers in the Canadian province of Ontario, is another major shareholder in Thames Water. Thames Water is the company that has had to make a major cash call, wanting £1.5 billion from its shareholders but so far getting only £750mn. USS also owned a share in the express railway linking Sydney Airport to downtown. Cbus, the Australian fund for the construction industry, owns part of Manchester airport, just as USS owns part of Heathrow, and another Australian fund owns part of South East Water, which it purchased from a Canadian pension fund.
The big defined-benefit Canadian funds who were investing in infrastructure had an additional advantage. They are backed, implicitly at the very least, by provincial governments. Thus, even if their “green” investments do go wrong, their beneficiaries – pensioners – are certain they will still receive their retirement benefits.
3. Rebalancing portfolios
Buying more equities and investing in more infrastructure would mean reducing holdings in bonds, mainly in UK government bonds. Some say these make up close to 60-70 per cent of holdings – and are the root of the problem, but in fact the share appears to be closer to 20 per cent – most of which was issued in the UK.
Setting off these bonds would have its own impact upon their prices. The bond market would face more sellers than buyers, pushing down their prices. The UK government would only be able to issue the volume of bonds it might wish to if it sold them cheaper. As we all learn at an early stage in economics, the price of a bond is inversely related to interest rates. The government would have to pay more on the borrowing it makes to help cover the costs of its activities. These activities include infrastructure, which governments, because they can borrow cheaper than any other institution, ought to be the first to finance. None of this is an issue that the exhorters seem to address.
At the same time, one of the legacies of the Truss government’s economic experiment was a massive increase in interest rates as lenders foresaw a steepening fiscal deficit. Temporarily, this led to a severe destabilisation of pension funds – as manifested in the so-called liability-driven investment (LDI) crisis. In this crisis, they had to sell off bonds to meet margin calls on contracts they had made on the assumption that rates would remain low and, by doing so, fuelled a negative spiral. While the new chancellor, with a bit of help from the Bank of England, reversed some of the worst of the immediate consequences of the “mini budget”, UK interest rates have risen sharply in the last year. Mortgage holders have been the first to suffer that pain. The rebalancing agenda would merely intensify their agony. Again, none of the exhorters has mentioned this.
In short, the Hunt/Reeves/Lyons/TBI (the Reeves and TBI plans) are poorly thought out and thought through. If pension funds do not want to invest in the UK, they should scarcely be forced to do so. Nor would it be wise for them to pull out of the UK bond market. At the Mansion House, this was recognised. After all, the fiduciary duty of pension funds is to their beneficiaries – and these are pension savers, not UK Plc. Pension funds should get on with their job. Government should get on with its job. The latter includes the provision of public services and, if the government is credible, it will be able to raise money to help it do so. Pension funds will invest in UK industry if UK industry deserves it. And it will buy the debt that government wants to issue, and which it needs to meet its obligations, as long as the government is able to price it appropriately.
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