UK government wants to make pension pots bigger with riskier investments – but it faces big challenges

The pension market in the UK has expanded to become the largest in Europe, worth over £2.5 trillion in 2021. Successive British governments have encouraged this growth, especially through the auto-enrolment scheme which made workplace pension contributions compulsory.

But they haven’t yet managed to channel those funds in ways that really boost the economy and make people better off. Now the UK chancellor Jeremy Hunt is attempting to tackle this with reforms aimed at making fund managers invest more boldly, expanding tomorrow’s pensions pots at the same time as providing an economic jolt today.

These plans would mark a major change for pension funds which traditionally keep most of their money in assets viewed as safe and long-term sources of income and capital growth. This steers them towards shares (equities) and bonds (traded debt) issued by large established companies, and government bonds, considered the safest form of debt.

Even when running a “defined contribution” scheme whose payouts depend on investment performance, fund managers are cautious about other asset types like private equity and property. For while these can yield higher profit, they may also crash in value. Hunt now wants to push them to raise their returns by making more investments considered higher risk – especially in small firms developing new technologies.

According to government calculations, the rewards could be great: an extra £50 billion of investment into innovative firms by 2030, giving a 12% (£1,000 a year) boost to the pension of an 18-year-old who enrols in one today.

The planned shift is even more radical for “defined benefit” pensions, the kind which are linked to salaries earned before retirement. These hold the majority of their investments in government bonds and high quality corporate debt, having moved away from equities in the past 15 years to ensure that capital stays safe and income stable.

The chancellor again believes a small step away from this cautious approach will bring large gains. According to Treasury predictions, doubling public sector pension funds’ holdings of private equity to 10% of their portfolio would unlock another £25 billion of investment by 2030.

The gamble has already begun

But despite their reputation for caution, pension funds have already been forced into bolder strategies thanks to recent low interest rates and other policies pursued by central banks since the global financial crisis of 2008. Those conditions meant low bond yields and low returns on investments, making it hard to keep pace with payouts for an ageing population living longer in retirement.

Some pension funds responded by borrowing, using their bond holdings as collateral, and investing the extra funds in a wider range of assets to raise their overall returns. The strategy worked well while banks were keeping interest rates low and pushing bond prices up through programmes of quantitative easing.

But when bond prices fell unexpectedly, it left funds confronting sudden losses, and scrambling for cash. That happened in March 2020 when COVID caused a global sell-off of sovereign bonds and shares.

And it happened again in September 2022 when the UK’s borrowing plans (under the premiership of Liz Truss) triggered a market response which wiped £170 billion off the value of defined benefit pension funds, forcing the Bank of England to step in as an emergency buyer of government bonds.

The same bank has now welcomed the government’s plans to boost pension fund investment in businesses. But it has also made that aim harder to achieve by raising interest rates by almost 5% since the end of 2021.

Higher interest rates reduce the number of business projects attractive to investors, by making it more profitable to keep money safely parked in bank deposits or government bonds. Those rate rises have also significantly reduced household wealth, curbing consumer spending and further reducing the incentive for business investment.

Channelling of funds into British companies has been further hampered by a narrowing range of opportunities in the UK. The number of firms listed in London has fallen more than 40% since 2008, with many opting for the US or the EU instead. Initial public offerings – when a private company lists its shares on a stock exchange – in the UK dried up again last year after a brief 2021 revival.

So the government’s plans also include simplified rules for new company listings, aimed at giving London the chance to emulate New York, where the concentration of technology stocks on the Nasdaq has made it especially buoyant as the US economy recovers.

This will involve removing more than 100 sections of EU law to streamline financial regulation. For a government that needs more private sector investment while its own finances are massively stretched, that looks like a small risk with potentially big returns.

But its appeal may be dampened by memories of how previous “light touch” regulation led to the crisis conditions of 2008 – and the main cause of poor investment performance ever since.