Encouraging pension funds to deviate from standard asset classes is nothing new, but is the latest push to encourage more investment into productive finance likely to be embraced by the pensions industry, at a time when it has everything to lose, and not that much to gain?
The Mansion House reforms and subsequent call for evidence by the Department for Work and Pensions (DWP) Options for defined benefit (DB) schemes have sought input on how DB pension schemes, and the Pension Protection Fund, could support increased investment in UK companies.
One of the main themes to emerge, and what appears high on the Government's wish list, is the need to expand the role of pension schemes more investment in productive finance.
During the past three years there has been a general consensus: that pension funds should be 'doing more' to help the local UK economy.
Productive finance: long-term opportunities?
The Productive Finance Working Group was set up to look at ways of encouraging investing in more long-term, less liquid assets.
The working group, run by the Bank of England, HM Treasury and the Financial Conduct Authority, published its ‘A roadmap for increasing productive finance investment’ report in September 2021.
The report included recommendations to create an environment in which defined contribution (DC) schemes and other investors could benefit from appropriate long-term opportunities. These recommendations included taking on a new approach to liquidity management and widening access to less liquid assets.
Some of these recommendations manifested themselves in the Mansion House reforms as well as need to regulate for the use Long-Term Asset Funds (LTAFs) and encourage investment in private equity.
Productive finance - defined?
Joe Dabrowski, deputy director of policy at the PLSA, explained that productive finance was a catch-all term for more risk-taking in areas of the UK economy the Government believed has potential for higher growth.
He said: "There is not an absolute certainty as to what productive finance is. The intent is to not be overly prescriptive. But there are particular things that the government is interested in.”
Productive finance certainly includes bioscience and tech companies, as well as infrastructure projects.
Dabrowski said: “As we have seen with some of these companies, they begin to get scale, and then they go and list overseas, or get bought up by some big American competitor.
“These companies don't stay in the UK so the Government wants to get more money flowing into some of them at different stages of the capital cycle.”
Since the financial crisis, said Dabrowski, governments have been looking at how to get more institutional capital into parts of the economy, and to keep UK companies in the UK.
“Because of shortages of wider growth in accessible cash many governments do, from time to time, come back to the question of what more can pension funds do to support the economy.”
“We're in one of those times again,” Dabrowski said.
Weighing up the risks
Productive finance may not be suitable for every scheme. As Dabrowski pointed out: “The sector isn't one big sort of homogenous blob."
“A closed DB scheme working towards running either a low risk strategy or looking at buy-out with an insurer will have a different appetite for additional risk or additional UK private equity or startup investment than a pure open scheme which is looking for running for the next 40 years."
“If you're a defined contribution scheme, with lots of young members, actually, you can carry some more risk, and equally it's the same for some of the local government pension funds who are all open or very well funded, and have long-term horizons."
"Are the right opportunities there to meet the needs of pension funds? Are there enough of them? Are they available at the right price? Do they do the thing that they need to do?
"And how do they fit against other opportunities, because they're not just sitting there in isolation."
Higher risks and greater costs
Jamie Jenkins, director of policy and communications at Royal London, said: “Productive finance is generally considered to be a deviation from standard asset classes such as listed equities or bonds, and instead focuses on unlisted, illiquid investments."
The Government has recognised that pension assets are better suited to this type of investment, due to their longer time horizon, he added.
“The belief is that they could provide a good source of capital to sectors that need it, while providing scope for better returns to pension savers in return. However, this needs to be balanced against the probability of higher risks and possibly greater costs of investment.”
Tim Orton, chief investment officer at Aegon, said investors will naturally seek to diversify their portfolios and generate higher returns, but he added that investing in private assets requires rigorous due diligence.
He said: “The demand for private market investments is expected to continue to grow in the coming years, as investors seek to diversify their portfolios and generate higher returns. “As with any component of a DC default strategy, they should be reviewed regularly to ensure they remain fit for purpose and can evolve.
"As an asset owner, we see this as our fundamental role in the value chain."
“Any decision to invest should be carefully considered and evaluated. Investing in private assets within DC investments requires rigorous due diligence, and understanding of liquidity issues, which can be more complex than traditional asset classes due to the nature of the investment.
"Working with trustees and establishing a strong governance process from the outset is essential to ensure that there is a measurable and sustainable improvement in member outcomes.”
Efforts to promote productive finance have been met with caution by some in the pensions industry.
Nigel Peaple, director of policy and advocacy for the PLSA said there was an appetite to invest in the UK.
He added: “Pension funds play an essential role in supporting the UK economy. The UK has one of the most sophisticated and mature pensions systems in the world – it is a great British success story, which provides security to tens of millions of savers."
“How pension funds can play a bigger role in providing capital to support growth in the UK economy is an important question, and in our discussions with schemes there is a clear appetite to invest in the UK."
"Pension funds are open to increasing investment in UK growth provided it is in the interests of the savers whose money we manage.”
Regulating productive finance
Steven Taylor, chair at the Association of Consulting Actuaries, said encouraging schemes to invest more in productive assets would be a significant change in direction for the pensions industry, and that better regulatory guidance was needed.
He said: “If schemes increase their investments in productive assets, this is likely to increase risk. The recent direction of travel for defined benefit DB funding in the UK has been to reduce risk, led by the regulatory environment, and – under new legislation expected to come into force in 2024 – to plan to reduce risk further by requiring all schemes to set a journey plan to low dependency as the scheme matures.”
He added: "Encouraging schemes to invest more in productive assets would be a significant change in direction that would need to be reflected in the statutory objectives and the approach of the Pensions Regulator and in regulatory guidance, – and a reconsideration of the new regime about to come in to force."
“Our view is that the proposed regulatory requirements for low dependency are too restrictive, and the legislation should be sufficiently flexible to allow employer covenant to be taken into account beyond significant maturity.”
More incentives needed
Dabrowski said even if the right regulation is in place there may be some reluctance to invest in some types of productive finance, particularly infrastructure schemes.
“Those things have changed quite a lot, flip flopped over for the last five to 10 years. Look at HS2 as an example, and some of the nuclear opportunities that have been stopped and started."
More encouragement in the way of tax incentives may be needed as well as a look at the charging structure of all productive finance asset classes.
But whatever changes or innovations are made they will, have to be done within the confines of fiduciary duty.
"Not for any other purpose," said Dabrowski. "That's the duty of the scheme, to its savers."
