Britain’s ‘capitalism without capital’: the pension funds that shun risk

Immunocore is a success story for the UK’s ambitions in biotechnology. Spun out of Oxford university in 1999, it is pioneering a new generation of medicines to treat cancers, viral infections and autoimmune diseases from the leafy market town of Abingdon-on-Thames.

But for Sir John Bell, the Canadian-British chair of the company and one of the world’s leading immunologists, its story stands out for a less distinguished reason. “Immunocore is, I fear, a classic example of what the UK has been losing,” he says.

In its early days, Immunocore attracted some backing from domestic investors. But three later funding rounds failed to secure any more UK money. When it grew large enough to list on the stock market in 2021, it shunned London in favour of Nasdaq, where its market capitalisation now stands at $2.6bn. 

“We have a massive upfront commitment to the sciences in the UK, then all the commercial benefits go to investors elsewhere,” says Bell, who is also regius professor of medicine at Oxford.

“There wasn’t really any access to long-term scale-up capital in the UK ecosystem,” he recalls. “UK venture capitalists didn’t have pockets deep enough” and domestic pension plans “had no interest” because they are “too conservative to invest in the growth sector”. The result, as he puts it, is that “the most successful British biotech company is now really plugged into the American capital markets”.

Pension schemes and sovereign wealth funds across Canada, Australia and Asia have more leeway from regulators to invest in early-stage companies, listed companies and other asset classes. Partly as a result, British energy, infrastructure, defence and technology assets have fallen into foreign ownership.

“When one of our companies becomes successful, it’s not a UK pensioner who benefits, it’s a teacher in Ontario or someone riding the Singapore metro system,” says Saul Klein, co-founder of LocalGlobe, a London-based early-stage venture capitalist group.

He and Bell are among growing numbers across business, finance and politics who worry about a wider British malaise, where a risk-averse pension system and a moribund market for new equity issues are driving growth and prosperity elsewhere.

“At the moment we’re trying to do capitalism without any capital, an unwillingness to take any risk and a slightly begrudging attitude to people who make money,” says Bell. “We’ve basically put a bomb under the whole concept of this being a capitalist country.”

In the first quarter there were just four London listings, raising only £81mn, according to Dealogic, the sixth-worst quarter for initial public offerings in the UK capital since 1995. Instead, companies are following Immunocore to the US. Arm Holdings, one the UK’s few tech success stories, is set to float in New York, not London. Irish building materials group CRH is planning to shift its listing to the US. And Keith Barr, chief executive of Holiday Inn owner InterContinental Hotels, recently opined that the UK stock market is “not a very attractive place”.

“We have been in the middle of a problem of massive de-equitisation of the UK for the last 20 years,” Julia Hoggett, chief executive of the London Stock Exchange, said at a recent event.

“We can either say we’re not going to talk about it or we can face it.”

An ‘avoidable catastrophe’ 

The roots of this malaise go back over three decades.

In November 1991, the 22-stone naked body of Robert Maxwell was discovered floating in the sea off the Canary Islands. The media mogul had apparently fallen overboard from his yacht.

His mysterious death triggered the swift collapse of his publishing empire as banks called in their loans. It emerged that Maxwell had used assets belonging to the Mirror group pension fund to prop up his companies. The episode contributed to a growing public clamour for tighter rules around pensions, particularly the so-called defined-benefit schemes that make payouts to members in retirement based on their salaries while in work.

The result was a series of changes to tax, regulation and accounting rules that Sir John Kay, one of Britain’s leading economists, characterises as “one of the great avoidable catastrophes of British public policy”. 

“You had a system that worked pretty well, which was replaced by one that constrained investment strategies and effectively killed UK private sector defined-benefit schemes,” he says.

Among the most significant changes was the introduction in 2000 of FRS17, an accounting standard that required companies to calculate the surplus or deficit on their defined-benefit pension schemes each year and disclose any deficit as a financial liability in their accounts just as they would a bank loan or a bond issue.

Company boards, often shocked by both the magnitude and volatility of liabilities, rushed to close defined-benefit schemes, first to new members and then to further accruals. Trustees began shifting assets out of equities — the asset class that historically has delivered the highest inflation-adjusted returns — and into government bonds. The theory of this “liability-driven” investment strategy was that it was lower risk, but for many pension schemes it came unstuck last autumn when bond prices fell sharply following the UK governments “mini-Budget”.

The proportion of all UK pension fund assets invested in equities was 26.4 per cent in 2021, down from 55.7 per cent in 2001, according to the OECD. By contrast, Canadian funds had 40.6 per cent in equities and Australian schemes 47 per cent.

“We have trillions of pounds sitting in pension funds that are not being used to invest in companies, drive growth or do a whole range of things that the economic viability of the country depends on,” says Immuncore’s Bell. “We need to find ways to release this capital.” 

The ‘Maple Revolutionaries’

Canada has shown one way of doing that. Last year, global stocks and bonds lost more than $30tn after inflation, interest rate rises and the war in Ukraine triggered the heaviest losses in asset markets since the 2008 financial crisis.

But the C$247.2bn Ontario Teachers’ Pension Plan, a defined-benefit scheme for 336,000 schoolteachers in the country’s most populous province, gained 4 per cent and maintained fully funded status for a 10th consecutive year.

“We made some bold choices about where we wanted to put our money,” says Jo Taylor, OTPP’s president and chief executive. “Those choices paid off.” The scheme reduced its exposure to fixed income because of concerns about higher inflation, and boosted its holdings in infrastructure, private equity, and other more inflation-sensitive assets.

OTPP’s ability to do this is the result of how the plan was designed when it was formed in 1990. Until then, Ontario teachers’ pensions had been invested solely in government bonds. But a new law that year set up OTPP’s investment board as an independent entity, gave it an exemption from public-sector pay caps so that it could hire people from the private sector, and reduced fees paid to external managers by dictating that most of its portfolio would be run internally.

“There’s a lot of flexibility in terms of how we think about the risks we want to take, the portfolio composition and the ability to move sums between different asset classes,” says Taylor.

The scheme’s ability to combine public market holdings along with direct investments in infrastructure, venture capital and property has helped it deliver average returns of 9.5 per cent a year since it was set up. Its model has been widely adopted across Canada’s public sector — CPP Investments, established in 1999 to oversee and invest the assets of the Canada Pension Plan, has grown from just C$12mn to C$536bn and is now one of the world’s largest investors in private equity.

In the UK, the closest equivalents to Canada’s public pension plans are the Local Government Pension Schemes. These are 86 regional funds that managed a combined £342bn in assets as of March 2021, roughly three-quarters of which are in equities and other risk assets. Unlike their peers in the public sector, they rely on investment growth, rather than using contributions from working members to pay the pensions of retirees. Unlike their private-sector cousins, they are still open to new members.

The UK government began reforming the sector in 2015, asking the 86 schemes across England and Wales to consolidate their assets into a number of pools each with assets of at least £25bn. In the March Budget, the Treasury flagged further reorganisation of local government pension assets.

Mike Weston, chief executive of LGPS Central, which manages the pooled assets of eight Midlands-based funds, says pooling has resulted in cost savings, but it is clear that the government wants to move “further and faster” to enhance returns and widen their investment scope.

“By international standards, we’re all too small,” says Weston. “To get the benefit of scale, pools would ideally be over £100bn and could then operate in the same way that the Canadians and the Australians do, to exercise scale and influence.” 

Strategic asset allocation and investment decision-making still resides with the individual local authority schemes. “Pooling could move significantly further and faster if the government provided stronger guidance and clarity.”

Outside the public sector, defined-benefit pension schemes are now almost extinct and few in the UK are expecting a renaissance. Rising bond yields have sharply reduced the prevalence of scheme deficits and provided an opportunity for sponsors and trustees to negotiate so-called risk transfer deals, where responsibility for payments is shifted to insurers such as Legal & General and Phoenix Group.

This opens the door for these assets to be invested in housing, infrastructure and renewable energy.

But others hold out hope that the £1.4tn in residual defined benefit assets — still worth the equivalent of 64 per cent of the UK’s gross domestic product — could still be harnessed to generate new wealth. “We shouldn’t give up on DB because the average duration is still 15 years,” says Nigel Wilson, chief executive of L&G.

Michael Tory, co-founder of investment banking boutique Ondra Partners, argues that defined-benefit schemes should be decoupled from their corporate sponsors and consolidated into a handful of superfunds.

“The corporate link has severely distorted UK pension funds’ asset allocation — making it accounting rather than investment performance driven — and it has also depressed pension fund returns,” he says. Decoupling “would free them to reorient towards long-term performance, more professional management and scale from consolidation like in other countries, for example, the transition now under way in Holland.” 

Observers point to the strong investment record of the Wellcome Trust, a charitable foundation whose health research is funded by a £37bn investment portfolio, as an example of how funds can thrive without the constraints of a corporate sponsor. It has generated annual returns averaging 11.7 per cent over the past two decades.

Meanwhile, leading UK fund managers, including Richard Buxton at Jupiter and David Cumming at Newton Investment Management, are calling for changes to the accounting framework that requires companies to put pension fund liabilities on the balance sheet.

The future is DC 

Attention is also now switching to defined-contribution schemes, where workers’ contributions are invested and their income in retirement depends on the performance of those investments.

In such a scheme workers, not their employers, shoulder all the risks and uncertainties around investment growth, inflation and longevity. That makes a shift in the UK pension industry’s risk culture crucial, according to Michael Eakins, chief investment officer of savings and insurance group Phoenix Group.

“If you want to invest as cheap as chips in ‘risk-free’ assets you’re not going to be able to afford to retire,” he says. “That’s the elephant in the room that no one is talking about.” 

Robert Swannell, a director of the Investor Forum and a senior adviser at Citi, calls it “among the biggest financial issues facing the UK government today” and says the switch to defined-contribution schemes needs to be accompanied by a financial literacy campaign and a “huge societal education about risk and return”.

“If policymakers don’t get this right, the switch . . . will turn what’s been a tragedy in the demise of DB to a disappointing outcome, at best, in DC,” adds Swannell, a former chair of retailer Marks and Spencer, describing it as “a societal issue that will affect the lives of millions of people in the UK”.

This autumn the government will publish measures to “unlock productive investment” from DC pension funds and other sources, and make the London Stock Exchange a more attractive place to list.

The UK is pushing ahead with plans to exclude performance fees from a cap on workplace pension charges, a move that would allow schemes to invest more in private assets. And last month Schroders launched the UK’s first long-term asset fund, a product designed to facilitate investment by pension funds into less liquid asset classes such as unlisted companies and infrastructure.

L&G’s Wilson said that defined-contribution funds could be similarly mandated to invest 10 to 20 per cent in growth equity and infrastructure. “You do need that soft compulsion,” he says, pointing to the effect that automatically enrolling workers into company retirement schemes has had. Since auto-enrolment was introduced in 2012, the proportion of eligible private-sector employees contributing to a pension has risen from one-third to three-quarters.

William Wright, founder and managing director of think-tank New Financial, says the real opportunity “lies in accelerating the growth of defined
contribution schemes and getting more DC savings and investments into
the pot.” He points to the highly fragmented nature of the UK’s roughly 28,000 defined contribution schemes, which he says could be consolidated to make them more efficient.

Others are calling for individual tax incentives to generate a home bias and encourage UK savers to invest in domestic companies, or to attach a degree of conditionality to pension funds’ tax breaks. They note that personal equity plans, which were the main vehicle for individual investment in the UK prior to the introduction of individual savings accounts in 1999, initially had a minimum threshold for investing in UK equities.

Keith Ambachtsheer, a veteran pensions adviser who worked with OTPP during its overhaul in the 1990s, says that some UK pension plans have the attributes needed to start moving to a governance and mandate model like Canada’s. “It takes a long time to do these transitions; you can’t just turn a switch,” he says.

“But if you don’t start, it never happens.”

Data visualisation by Keith Fray

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