Should we insist that pension tax relief be used to invest in UK companies? STEVE WEBB replies

I think it would be reasonable to insist that pension tax relief be invested in British companies for British projects.

Would it cause fundamental problems if the rules were changed to ensure this happened?

Would pension companies be justified in complaining that this would increase costs/burdens?

Steve Webb replies: With almost £2 trillion invested in UK workplace pensions, the government is understandably very interested in putting more of this money to work to stimulate the UK economy.

But the level of domestic investment by UK pension schemes has actually fallen rapidly in recent years.

Looking at the modern ‘pot of money’ or defined contribution pensions, the government’s own figures show (Pension fund investments and the UK economy) shows that just over half of money was invested in Britain ten years ago, compared to less than a quarter today.

Since most new pension savings are invested in defined contribution pensions, this is a matter of great concern for the government.

There is one very simple explanation for that recent trend.

Workplace pension schemes have largely stopped investing in the UK stock market.

Although pension funds still own many shares (or ‘shares’), the vast majority of these are now invested in stock markets outside Britain.

This specifically includes investing in things like technology stocks in the US stock market.

Pension schemes would say there is a very good reason for this. Over the past fifteen years, returns on the UK stock market have been well below returns on global stock markets.

For example, in the 2010s, investing in the largest companies on the London Stock Exchange would have delivered an annual return of 5.5 percent.

But an index of global equities would have returned almost double this (10.5 percent), and investing alone in the US would have returned 14 percent per year.

This trend has continued into the 2020s, with UK returns to date averaging 4.2 per cent per year, compared to 9.9 per cent for global equities and 12.1 per cent for US equities.

As you can see, if someone had invested their pension in UK shares rather than the rest of the world or just the US, their pension pot would now be much smaller.

This is one reason why successive governments have been wary of coercing or even bribing people to invest more in Britain.

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If a government incentive makes you invest in a way that damages the value of your pension in the long term, you may not be happy about it.

Even if you only allocated your tax relief to UK investments rather than putting them into the general pot, you would have received a lower pension on average, and this would also introduce significant administrative complexity.

However, the government has certainly not given up on investing a greater share of pension savings in Britain.

The new government strongly believes that pension money can be invested in companies that are not listed on the stock market (also called unlisted shares or private equity) or invested in boosting our infrastructure (for example upgrading the National Grid), this will help ensure economic growth and also provide decent pensions.

However, rather than forcing pension schemes to do this directly, the government has decided to achieve this by consolidating smaller pension schemes into a small number of what it calls ‘mega funds’.

The government says that once pension schemes reach between £25 billion and £50 billion, they will invest much more in private equity and infrastructure.

While it is possible to invest in these types of assets globally, there is usually much more of a ‘home bias’ in these assets – especially compared to investing in shares where almost all money is now invested outside the UK.

The purpose of pension schemes is, of course, to give us a decent income in retirement, rather than to help the government with its economic objectives. An important question is therefore what impact all these changes will have on our ultimate pensions.

On this point, the government’s own estimates are quite disappointing.

The government asked its own experts (the government’s Department of Actuaries) to model the final pension pot of someone earning £30,000 a year and paying an 8 percent pension contribution over thirty years.

The modeling was carried out based on current investment approaches and based on a range of alternative assumptions, including increased investment in unlisted shares.

The results were quite disappointing.

The estimated pension pot after thirty years was £259,000, based on the current approach to investing.

The pot size with a higher allocation to UK shares was also £259,000 and the amount for investing more in ‘private markets’ was £264,000.

Although the latter figure is ‘slightly higher’ (as the government puts it), they also emphasize that these figures are very uncertain.

The best we can say here is that if schemes invest in the way the government wants, this is unlikely to make much difference to people’s eventual pensions anyway.

In summary, while successive governments are keen to see more pension money in Britain, any push to invest in things like UK shares a decade ago could seriously damage people’s pensions.

So the government is nervous about anything that looks like telling funds how to invest, especially when the expert judgment of those running the projects is that the best returns can be found outside Britain.

Instead, the government is trying to restructure the pension market so that more pension schemes will invest in things that drive economic growth in Britain.

It remains to be seen whether the changes they propose will result in pension schemes boosting the UK economy or not.