Pension funds could play an important role in achieving a more balanced economy, but new investments should prioritise benefits for members above all else
Regional economic imbalances – that is inequalities in the outcomes between different regions and localities in the UK – have long been a cause for concern for politicians and policy-makers. In response, pension funds, with their vast amounts of investable capital, have become increasingly prominent in debates about how to achieve geographically balanced economic growth. Yet, there have been few policy initiatives aimed at supporting this agenda.
In autumn 2017 I worked with Dr Craig Berry on a research project which explored how pension investments could be localised to support local economies. In this blog post I will give an overview of the key issues raised by this research and will discuss both the challenges and opportunities for localising pension fund investments. While the research project evaluated the potential of both private and public pension fund investment, I will focus upon the latter, namely Local Authority Pension Funds (LAPF), due to this type of fund being at the centre of debates surrounding the rebalancing agenda.
Perhaps the greatest obstacle to localising pension fund investments is the chronic funding gap which plagues many local authority pension funds. For example, latest figures demonstrate that the Local Government Pension Scheme (LGPS) currently has a deficit of around £35 billion with a funding ratio of 85 per cent. While the scheme remains cash-flow positive benefits being paid out now outweigh contributions with a small number of funds consuming their assets in order to meet their member benefit liabilities. This misalignment between costs and income has meant that predictable short-term returns have come to play an increasingly important role in determining the investment decisions of fund managers. Bonds and equities – which are readily convertible to cash – continue to be the default option with funds favouring this type of low risk, short-term assets.
While pensions funds have increased their exposure to ‘alternative assets’ – described as being an asset which falls outside of the conventional asset classes of equities or bonds – following the 2008 financial crisis, allocations towards this type of asset remain small with less than 10 per cent of all LAPF investment being held in this class. What is more, of those pension experts who attended the seminar series held across the three city regions, there was a consensus that localised investments, particularly infrastructure projects, fell within the ‘alternative asset’ class. As such, it was felt that due to the associated risk of commercialisation, construction, the instability of government support for projects along with the often long-term nature of returns on this kind of investment, pension fund investment in alternatives would remain small.
A second related factor which may disrupt the localisation of pension fund investment is the scale and cost of managing funds. Currently the LGPS is organised as 91 individual funds. However, it is argued that smaller funds are inefficient and expensive to run with greater administration and investment costs to members. The LAPF pooling agenda, initiated by the Cameron government in 2015, was intended to overcome these shortcomings by obliging LGPS authorities to combine their assets into larger investment pools. In addition to delivering administrative savings it would also be an opportunity to re-organise the capacity of vast pension fund resources to make large-scale infrastructure investment thus helping the UK economy to grow. Yet, the pooling initiative, while potentially delivering costs savings, may not necessarily favour localised investments. For example, local investment projects tend to be run by small or individual investors who are more in tune with regional economic conditions. However, large scale pension funds will always favour large scale investments and thus marginalising or overlooking more localised, smaller investment projects. In this instance the pooling of the LGPS may lead to less rather than more local investments.
Furthermore, the current lack of a facilitator which can bring institutional investors and local investment opportunities together means that small localised investments will need to be more actively managed thus increasing costs and make such investments less attractive to large scale funds. Likewise, pooling among LAPF while increasing scale and reducing costs, would mean that the investments decisions are removed further still from the local economies in which capital is being created through local people saving for pension. However, one potential solution coming out of the seminar series was that local authorities and metro mayors could potentially play an important role in bringing pension funds and investors together, although this too would not be without its own problems.
It was also recognised at the various seminars that much of the capital generated through saving for a pension is invested outside of the local community that savers live and work in. However, while it was felt that it would be desirable to retain a degree of this capital within the local economy through investments projects, concerns were also raised that such a move could leave savers open to a ‘double exposure’ were the region to experience an economic downturn. In such a scenario savers could be hit twice: first by dwindling business, lost revenue and unemployment and second by reducing the value of local pension investments. Yet, it was suggested that these effects could be potentially mitigated by different regions entering into reciprocal agreements with other localities which could reduce risk and lessen exposures.
Local authority pension funds face a number of challenges. Budget cuts, a fall in the value of sterling, record low interest rates and an ageing population have all meant that pension funds have seen the value of liabilities rise leading to a misalignment between costs and income. At the same time, there persists deep divisions between the outcomes and opportunities faced by different regions in the UK. Orienting pension fund investment towards more localised projects has been suggested as a means to both add diversity to funds’ portfolios while at the same time retaining investable capital in the regions in which members live, work and save. Yet, it is vital that such initiatives be approached with caution due to the potential downside risks and that stakeholder’s interest are not jeopardised in the pursuit of achieving a balanced economy. It is essential that pension funds’ investments and allocations are managed efficiently and effectively and to the benefit of members which should be prioritised above all else.
READ MORE: Craig Berry’s report ‘Localising Pension Fund Investments: Engaging with stakeholders, overcoming the barriers’ can be downloaded here