First published in Political Capital - our weekly public affairs and polling news drop.

On Monday 10th July, Chancellor Jeremy Hunt delivered the annual Mansion House speech. He set out a series of ‘Mansion House reforms’.

Central to these reforms were a series of measures to boost outcomes for savers and increase funding liquidity for high-growth companies through reforms to the UK pension market.

Providing comment in a purely personal capacity, I should start by saying that I’ve been an investor in several private equity investment companies, which have over time produced good returns, and I’m involved with Defined Benefit (DB) pension schemes which have invested in all sorts of illiquid assets for a long time, and again, over time, have received good returns from many of them. 

I’ve also been involved in a small technology venture capital firm some years ago - I have some idea of how risky this sector can be and how much work it is to produce good returns from corporate performance, rather than increasing gearing. I have recently seen some really interesting opportunities in the decarbonisation/net zero world, too.

Why should Defined Contribution (DC) pensions be invested in illiquid assets?

We do have an economy in need of investment, both in terms of companies and infrastructure, and in terms of productivity. We also have a pool of defined contribution schemes which really do need growth to pay future pensions given how little many people are saving, and how small therefore their pension pots might be in the future.

If you are investing for long term growth, you might consider that you need as many chances of getting that as you can sensibly handle. However, there isn’t a magic wand which you can wave to produce extra returns from private markets. 

There’s a debate about this, but in my view, the “illiquidity premium” is what you need for taking the extra risk of investing in illiquid assets, rather than some sort of automatic bonus. However, it’s arguable that companies and managements can do things in private markets – take a long term view, for example, or execute a really difficult restructuring – which are difficult to do in, what can seem myopic, public markets. And public markets shouldn’t be seen as a safe haven, given some of the excesses we see.

5% in unlisted equities for DC default funds by 2030

In his speech, the Chancellor announced that CEOs of many of the UK’s largest DC pension schemes – Aviva, Scottish Widows, L&G, Aegon, Phoenix, and others – have signed the ‘Mansion House Compact’. The Compact commits these DC funds, which represent around two-thirds of the UK’s entire DC workplace market, to the objective of allocating at least 5% of their default funds to unlisted equities by 2030 – and in the process, hope to unlock up to £50 billion of investment into high growth companies by that time.

Should there be a link between the aim to increase investment in unlisted equities, and the expectation that will be invested in the UK? The Chancellor is not now mandating that these private investments should be in the UK, so there’s a bit of aspiration here.

The Pensions Regulator says that total DC assets at 31 December 2021 were £113.5bn. So the estimate of £50bn into high growth companies by 2030 is going some.

I would be really interested, though, in what investment structures internationally have actually encouraged economic success. It is a really important question. Is the rise of Apple down to investment by US DB pension schemes, or 401k plans? Who invests in their tech private equity firms? Sequoia, who invested in Apple in their first fund, say their clients are non-profits (presumably including pensions funds) and universities.

There is perhaps a cultural issue – Dave Svensson at Yale had a lot to do with the investment by foundations in private equity, and in the US there does seem to be a pool of very wealthy donors who are significantly supported by the tax system. 

The Australian funds are interesting and the Chancellor rightly points out the benefits of their scale. Australian Super Fund has about 20% invested in illiquids in their high growth fund (including property) and is opening an office in London. It would have been good to be less UK specific and more evidence based.

However, we do have to be careful about the language around the idea that those large DC firms are investing their funds in illiquids. These are not funds belonging to firms – and are savings pots belonging to individuals – at the end of the day. 

Will it make a difference to returns? For whom?

One of the difficulties for long term savings is that if you are financially vulnerable, it’s difficult to take risk. If you are less vulnerable, you can take more of it. Again, according to TPR, the average DC pension pot size at December 2021 was just over £5000 (excluding hybrid DC schemes). 5% of a default fund probably isn’t going to increase risk significantly but is the increased illiquidity risk and increased cost worth it?

Additionally, the oddities of the Statutory Money Purchase Illustrations which have just come in will need revising. The new rules mean that the less volatile the asset returns, the lower the return projections you are allowed to illustrate. To the extent that illiquid assets are less volatile, then they will reduce the return projections for DC funds.

I do hear a bit of opportunism here: there’s a bandwagon to be jumped on.

Consolidation

The arguments about scale are interesting. In active mandates, there’s lots of evidence to suggest that scale can be detrimental. But scale certainly helps with resource and infrastructure/risk management, which is really important. To have the right level of Trustee skill, pensions management skill and appropriate oversight, you do need a proper set up in order to deal with all sorts of rather basic things as well as the oversight of the investments.

Pensions shouldn’t be anything other than a serious, professional activity. It’s tough when pensions managers and Trustees are trying to do their very best but as part of other roles.

Local Government Pension Scheme and consolidation

I was involved with a very sensible internally managed member of the Local Government Pension Scheme (LGPS) in the old days, which had a significant investment in illiquids. Some of the LGPS pooled arrangements are already developing interesting illiquid investment approaches. Do they need to reorganise again? There is, however, a level below which is very difficult to justify and to fund the resources needed to do an excellent job for members.

Improving returns for DB funds by investing in private equity and turning the PPF into a superfund?

I think the DB arguments are more complicated. More mature, cash negative DB schemes may have some difficulty taking on more illiquidity risk, and my sense is that larger schemes already have quite significant allocations to illiquids, after their long dated gilt holdings fell in value last year (and their funding levels increased).

Also, DB schemes have been significant investors in corporate debt. I’m not at all sure about the DB superfund/PPF suggestion. It seems, as others have said, a moral hazard issue. The PPF does its stuff rather well, but it has a very specific purpose.

Rebundling of commissions

I’m quite unsure about this. I always thought there was a real conflict involving the use of client commission to fund a fund manager’s expenses (to put it crudely). I think the current system has improved the responsibility for and therefore the scrutiny of costs - although I think some smaller and good fund managers found it a competitive barrier, as large firms simply absorbed the research costs themselves.

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