Opportunities and Constraints

Before these options are laid out, it is necessary to consider both the key outcomes policies need to deliver if they are to genuinely unlock opportunities for patient or productive pension fund investment, and the constraints facing policymakers as they seek to develop and implement ideas in this area.

First, outcomes. Above all, contributions (from employers and employees) into DC schemes must increase. For employees, this is a question of ensuring that pensions saving is more readily available and better incentivised. There must be more opportunities to share risks (with employers and fellow scheme members), and better options for managing longevity risks in particular. Achieving these will lead to better financial outcomes for savers as well as greater scope for patient investment in the domestic economy.

Yet, even if the capacity and appetite for patient investment among pension funds were enhanced, there is a need to increase the capital available by rethinking the design of default funds (as well as their size) and enabling greater control by scheme managers over investment intermediaries (i.e. asset managers). There must also be attention to the destination of patient investment; this is partly a question of the Government setting the tone for long-term investment in the UK economy through industrial strategy, but it also pertains to the specific investment products that pension funds can allocate capital to.

All of this is easier said than done. As indicated above, the inescapable tension in any agenda around reorienting pension fund investments is the legal (and moral) requirement to prioritise returns for members. The theoretical synergy between returns and patience does not override the need to minimise downside risks over pursuing market-beating returns. The closure of DB schemes to new accruals — meaning investment horizons shorten as contributions end — and the replacement of DB provision within individualised DC schemes — meaning low-cost and liquid assets must be prioritised — intensifies this tension.

Of course, prioritising the specific interests of members over the amorphous interests of the domestic economy is usually a good thing, and incentives to save would negatively be affected if savers could not implicitly trust that this deal would be upheld. Yet there are other factors that constrain what the Pensions Review might be able to deliver, and, indeed, how the reform agenda is framed. First, the unwillingness of employers to increase contributions into employee pension pots or take on greater responsibility for managing investment or longevity risks. Second, the Government’s own unwillingness to commit to underwriting these risks, either directly or indirectly through a more generous state pension system (which would increase risk appetite within private pensions saving). The Pensions Review is being conducted in a context in which the Government is relying on employers to invest more in enhancing productivity and creating jobs and is itself committed to strict fiscal rules in a challenging macroeconomic environment. Meaningfully increasing pension-related obligations on employers or the state is off the table.

It is for this reason that the Review’s main proposals are not focused on the role of employers or the state in supporting saving and managing risks, but rather on the role of the private pensions industry. The Government’s room for manoeuvre in this space is also constrained by, thirdly, the investment environment in which pension funds operate, and fourthly, the structural power of financial institutions such as insurance companies and asset managers.^[12] Highly liquid assets are required both as collateral to gain entry into return-seeking pooled funds and to manage cashflow volatility since pension funds have little influence over the conditions in which calls upon collateral are made.  

Many of the firms providing scheme management and investment services are significant employers in the City and important contributors to UK public finances in terms of tax revenue and demand for gilts, and/or they are powerful global firms that the Government believes it has limited control over in practice. This helps to explain the Government’s focus on scaling up pension funds — to enable them to have greater scope for market-shaping rather than market-aping — but also why the actual proposals in this regard are quite limited (with the partial exception of local government funds, where the government itself has stronger levels — I will return to this issue later in this briefing).  

The Pensions Review makes no mention of the National Employment Savings Trust (NEST: the government-owned DC scheme provider aimed at small employers) despite the DWP’s research demonstrating that NEST is leading the way in domestic investment within DC provision. The adjacent consultation did suggest that NEST could be a destination for small DC schemes forced to close, but it seems that the Government is reluctant to build upon NEST’s positive impact on the pensions industry insofar as this would challenge the business models of private sector incumbents.  

The Government additionally seems to assume that its championing of a stronger value-for-money framework for asset allocation decisions — decentring the objective of keeping costs low — will also challenge the low-cost but short-termist index-tracking products that have facilitated concentration of the asset management industry around a handful on international (principally US) providers. It will be acutely aware of the systemic risks posed by the market dominance of firms such as Blackrock but also of those posed by the prospect of a sudden exit of these firms from the UK pensions industry.

Reviving Collectivist Provision

These constraints cannot be wished away. There is, however, more scope to mitigate them than the Review suggests. Rather than focusing on scale (where the evidence base for facilitating patient investment in the domestic economy is mixed) the Government should focus on facilitating collectivist pension schemes.

As noted above, collectivist pension saving effectively means all savers are contributing to one big pot and, crucially, their income after retirement is paid from this pot, financed by ongoing contributions by working-age members as well as investment returns. In DB provision, the terms of how this income is calculated is determined in advance, hence the possibility of scheme insolvency, if these terms cannot be met. In DC provision, however, “collective DC” schemes establish targets but do not guarantee future income levels in advance — these depend on the health of the fund at retirement. Either way, collectivist schemes means that, as long as the scheme remains open to new members and accruals, liquidity needs are minimised and investment time horizons are elongated, thereby enabling a more patient investment strategy.^[13]

Collective DC provision has been permissible in the UK since 2021. But few “pure DC” schemes are likely to level up — levelling down from DB (as we have seen with Royal Mail) is more likely. The Government has so far elected not to put is weight behind collective DC via the Pensions Review (instead, as noted above, seeking to facilitate investment-pooling within individualised DC, by reducing the number of default funds available to members). This is a missed opportunity. The Government should establish a medium-term roadmap for the conversion of all DC schemes (with limited exceptions) to collective DC provision, underpinned by legislation. This plan would be initiated by converting NEST to collective DC.

This does not mean that the Government should soak happily in the tepid bathwater of DB decline. DB remains viable in industries with large, stable employers: the Government should develop sector-by-sector strategies for the maintenance and revival of DB provision and, again, it should consider establishing a multi-employer DB section within NEST. For the latter, a joint venture between NEST and the Pension Protection Fund (PPF) could be explored (note that the TBI’s proposals include merging NEST and the PPF). The aim would be not only to provide employees with greater retirement security, but also to incentivise higher contributions (and therefore greater scale in investment). “Cash balance” DB schemes (which are common in the US) should be explored for this purpose.

The most important collectivist pension scheme is, of course, the state pension. It is worth noting that the balance between state and private provision is not zero-sum. Where the state pension provides greater retirement security for individuals, greater risk-taking within private saving is facilitated, and, therefore, UK pension funds’ poor record of patient investment in the domestic economy is related to the low level of the state pension.^[14] State provision is not going to replace private pensions provision any time soon (nor would this be desirable), but the Government should explore the costs and benefits of increasing state pension payments for people reaching very old age (for example, from the age of 90 onwards). This would remove a great deal of uncertainty around how long into retirement private saving needs to last.

Similarly, the state could provide annuities for DC pension scheme members (or underwrite annuities for self-annuitising collective DC schemes). Public annuity products would be provided on a commercial basis, with rates regularly reviewed. They would be trustworthy and efficient given the scale at which longevity risks could be collectivised, removing some of the uncertainty that breeds conservatism in investment choices. The accumulated capital taken on by the state could also help to finance public investment funds. To maintain an arms-length relationship with the government of the day, NEST could play these roles for private schemes, if and when converted to a collective DC scheme for its own members.

The decline of annuity rates is problematic for encouraging DC pensions saving. But a reliance on insurer-provided annuities is arguably a problem for maximising both returns to members and the benefits to the wider economy, due to the investment culture and regulatory environment which insurance companies operate within. A greater role for the state is part of the answer, and, at the very least, this should focus policymakers’ minds on rolling out collective DC provision, where annuitisation is nominal rather than a transaction with an external provider.

Increasing Contribution Rates

It is incongruous that the Pensions Review has so far neglected to make proposals to increase contributions to pensions saving. This may yet feature in the Review’s second phase but should have been treated as a first-order issue. (The charts below present government data on employer and employee contribution rates, showing in particular the low rates in defined contribution schemes.^[15])

The minimum employer contribution has been three per cent since April 2019. This applies only to qualifying earnings of between £6,240 and £50,270, meaning that the lowest paid receive far less in practice than the stipulated minimum. There is also a £10,000 earnings trigger for automatic enrolment, although employees can opt in to pensions savings if they earn between £6,240 and £10,000. It is beyond time to acknowledge that three per cent is insufficient: the government should establish a timetable for quickly increasing minimum employer contributions and for reducing the lower earnings limit of the qualifying range.

[.fig][.fig-title]Figure 2:Employers Are Not Contributing Enough to Their Employees’ DC Pension Pots[.fig-title][.fig-subtitle]Employer pension contribution rates (% of employees, 2021)[.fig-subtitle][.fig]

[.notes]Source: ONS.[.notes]

[.fig][.fig-title]Figure 3: Employees Are Not Contributing Enough to Their Own DC Pension Pots[.fig-title][.fig-subtitle]Employee pension contribution rates (% of employees, 2021)[.fig-subtitle][.fig]

[.notes]Source: ONS.[.notes]

Tax will be an important lever for going even further in this regard. There may be to scope to develop a path to further reduce employer National Insurance contributions (NICs) for employers paying contributions above the minimum in DC schemes (there is already NICs relief insofar as employers NICs are only paid on remuneration in the form of pay, not pension contributions). This would not be cost-neutral and would be complicated by employers with legacy DB schemes already exceeding minimums to recover or avoid scheme deficits. However, it could be a useful nudge in the right direction.

Higher employer contributions would have a progressive impact; they would help the lowest paid to build up private pensions savings. They would also reduce incentives on employers to hold back wage growth, in turn incentivising productivity-enhancing investment (the Low Pay Commission is the ideal mechanism for ensuring that higher pension contributions are not simply siphoned from general pay while ensuring that they are affordable for employers). They would also lead to a higher volume of capital in pension funds, driving scale irrespective of wider efforts to reduce the number of funds.  

The employee minimum contribution rate of four per cent should rise in tandem with employer contributions, once parity is achieved, albeit with scope for lower minimums for the lowest paid.

We also need a new pensions settlement for the self-employed, who are now more likely to be low paid. There is a risk of employers seeking to engage workers as contractors rather than employees, especially if auto-enrolment regulations are extended to all low-paid employees. Asking employers to make pension contributions for the self-employed workers they use is a non-starter. Without minimum wage protections, this would simply drive down pay and it is preferable for the self-employed to contribute directly to pensions saving insofar as they can qualify for tax relief (they are eligible to join NEST as individuals).

The general imperative here is for employment protection to be strengthened, such that there is a very high bar on classifying a low-paid worker as self-employed. This is not pensions policy in a strict sense but should be within scope for the Pensions Review as self-employment is a systemic drag on increasing pension contributions. Some have suggested the Government could make additional contributions for self-employed people via the tax system.^[16] This is unrealistic, but the Government could explore a path for the self-employed to qualify for lower NICs if they are making substantial contributions to a scheme such as NEST (albeit with upper limits to this mechanism is not exploited by the most affluent self-employed workers).

Transforming Pensions Tax Relief

The most significant tax-related lever available to Government is, of course, pensions tax relief (PTR). It currently costs the Exchequer £47 billion per year to allow pension contributions from pre-income tax income; the cost is £71 billion once NICs are taken into account. The Exchequer gets £22 billion back each year, primarily on pensions in payment, so the net cost of PTR is £49 billion.^[17] Despite this expenditure, there is no evidence that PTR provides for any meaningful savings incentive.^[18] How might this enormous state subsidy be better spent? The Government already presents tax relief as a form of partial match-funding into auto-enrolees’ pension pots (tax relief on employees’ four per cent minimum contribution means, alongside the employers’ three per cent, the overall minimum can be styled as eight per cent).

One of the main criticisms levelled at the PTR system is that it enables unequal outcomes. People receive PTR at their marginal rate (because their pension contributions are made from pre-tax income) on the basis that they pay income tax at the same rate in retirement, when their pensions saving will be converted to income. In practice, many people benefiting from higher-rate PTR will pay basic-rate income tax in retirement. However, while the measures proposed here will help to address this inequality, it should not be a primary consideration for the Pensions Review.

[.fig][.fig-title]Figure 4: The UK spends an enormous amount on pensions tax relief[.fig-title][.fig-subtitle]Annual cost of pensions tax relief, by element (£m, 2022/23)[.fig-subtitle][.fig]

[.notes]Source: HMRC. Note: Hover over bars to see type of cost.[.notes]

The Pensions Review should be focused predominantly on increasing contributions and designing government support in a way that enables pension fund investment strategies to both protect member interests and benefit the wider economy. This would be consistent with increasing subsidies for low- and middle-income savers to provide a substantive saving incentive for those saving the least. Therefore, the Government should consider ending tax relief in its current form and instead making a direct contribution into pensions saving pots varied according to income level.

This could be done in a way that is fiscally neutral, in the narrow sense, by introducing a lower matched contribution for higher earners. However, while this would produce ostensibly progressive outcomes, it could lead to a lower aggregate volume of pensions saving by introducing a perceived saving disincentive for some, with an impact on the cost-effectiveness of private pensions provision. As such, fiscal neutrality should not be prioritised in this regard. (Note that the Government could choose to spend less on direct contributions in comparison with PTR to finance a higher state pension people in very old age, as discussed above.) The Government is already expecting to increase expenditure on PTR over time as more employees are covered by auto-enrolment rules for a greater portion of their career (and especially if action is taken to increase contribution rates) — so the question for the Pensions Review should be how additional expenditure can be utilised most productively. The Finance Innovation Lab has proposed a “starter” contribution into pensions saving for all newborn babies, inaccessible until retirement so that is accumulates a lifetime of compound interest.^[19] This would mean that everyone — including the self-employed — has a ready-made pension saving pot into which further contributions could be made.

Insofar as expenditure on pension contribution subsidies will rise, there are mechanisms available to raise additional revenue while making the system fairer. Introducing new rates of income tax for pensioners — so people receiving higher rates of PTR pay income tax at the same rate in retirement, irrespective of their income — would be hugely complex and probably inadvisable. But there is a far simpler solution: the Government should extend NICs to pensioners’ income (to protect poorer pensioners with some private saving, the trigger level for NICs could be set at a higher level for people above state pension age than for working-age people). Given that pensioners tend to use a greater proportion of their income for consumption, this measure would also have macroeconomic benefits, enabling demand to be managed without harming the living standards of “working people” and create more scope for long-term investment by redirecting resources away from everyday consumption.^[20]

There may even be a case for exempting pension income from this charge, with NI only levied on income from ongoing investment, employment, renting out property, etc., although this would inevitably limit the revenue raised. It is possible also that the revenue raised could be hypothecated to finance a new public investment fund, thereby enhancing the political acceptability of these measures. This would provide for an alternative mechanism by which the pensions system, in broad terms, could support domestic investment (but, again, would be a restriction on the policy’s direct fiscal benefits).

Other tax measures that could be introduced include tapering away income tax personal allowances for the most affluent pensioners (before the current trigger of £100,000), and/or removing the married couple’s allowance — even if the government believes it is justifiable to use tax breaks to incentivise younger people to marry, it surely has little rationale to pay people above state pension age to stay married. There could also be stronger limits on how much tax relief is provided for the lump sums that can be taken from pensions saving pots at retirement.

Supporting the National Economy

Collectivising risks, lengthening investment horizons, increasing contributions, enabling and incentivising more people to save — these are the best ways to encourage pension funds to invest more patiently in the domestic economy.  There are, however, ways to encourage this more directly without resorting to state-dictated investment strategies.

For example, if the reform of PTR proposed here is adopted — abolishing tax relief in favour of a direct government contribution — then the Government should consider providing higher matching contributions to savers who choose to invest more patiently in the domestic economy, through funds with an asset allocation strategy aligned with the Pensions Review’s ambitions. There could even be scope for people to invest part of their pensions saving outside of a formal workplace pension scheme, for instance through national or local citizens’ wealth funds.^[21] The extent of the flexibility available would have to be carefully calibrated to ensure final retirement outcomes are safeguarded, but this is an area where innovation is required to overcome the tensions between the Government’s objectives.

There is scope also to mobilise pension funds’ appetite for gilt investment to support public investment in infrastructure and the energy transition. The Government has sought to insulate itself from fiscal risks arising from the Pensions Review, but the creation of new institutions such as the National Wealth Fund (replacing the UK Infrastructure Bank) and GB Energy offers opportunities for new gilt products, available only to pension funds, which offer better returns to investors insofar as they displace allocations to less productive assets.

The state could also play a stronger role in shaping the asset management industry. There will always be a lack of real agency among some pension funds in how they determine their investment strategies. The Government should consider establishing a publicly-owned asset manager, operating at arms-length from the state and providing a trusted source of investment intermediary services without undermining commercial objectives. This would replicate the NEST model for scheme management (and may allow NEST itself to end its own reliance on the asset management industry).

This body could be limited to providing services related to ESG investment (i.e. in assets deemed to meet rigorous “environmental, social and governance” standards). However, given the widely-reported limitations of the ESG framework,^[22] the Pensions Review could also be seen as an opportunity to revise and strengthen standards for environmentally and socially conscious investment and to bring objectives around the long-term health of the domestic economy into the same framework. This is more pivotal than it sounds: higher standards in this regard would allay concerns that investment in infrastructure and private equity is not the panacea for patient and productive investment it is too often assumed to be. Moreover, the Government must also be prepared to use fiscal policy and public sector capacity to embed “enlightened” investment strategies while at the same time both protecting pension scheme members and allowing them more choice.

A Note on Local Government Pension Funds

This briefing has deliberately steered clear of commenting on local government pension fund investment. That the Local Government Pension Scheme (LGPS) is a core focus of the Pensions Review demonstrates its lack of ambition. The LGPS has been a constant target of recent governments’ efforts to instil more patient investment strategies, essentially because, as a public sector pension scheme, the government has more leverage over LGPS funds than those in the private sector.^[23]

The process of merging dozens of LGPS funds into a smaller number of large funds has been underway for decades. The Government hopes to accelerate this process by the introduction of greater compulsion for smaller funds to join asset pools and requiring more liaison between funds and regional mayors.^[24] The former is worth pursuing, the latter is largely meaningless. There will always be a strong case for converting the LGPS from a funded to an unfunded pension scheme, in line with the rest of the public sector. However, there is also a case for a funded scheme that invests privately from within the public sector.

The reforms discussed throughout this briefing would all be beneficial for LGPS funds. Above all, we need to recognise that the LGPS is part of solution, not part of the problem; the Government should open the LGPS to a wider range of private sector employers as part of reviving DB provision, on a sector-by-sector basis. It is already possible for private employers to have “admitted body” status within the LGPS (typically when they need to offer continued LGPS membership to workers previously employed directly by local government). Introducing more new, younger individual members will support the solvency and size of LGPS funds.

Pension Freedoms

The 2014 pension freedom reforms brought a definitive end to compulsory annuitisation within DC pensions provision in the UK. Allowing people to access their pensions saving before retirement but also continue accumulating returns after retirement rather than financing an annuity has had a noxious impact on the pensions system, preventing the annuities market maturation that the Turner Commission considered essential to the success of auto-enrolment, and leaving the coming wave of DC retirees needing financial advice that is difficult to access.

Alas, the genie cannot go back in the bottle. Yet, pension freedoms are one of the reasons that the rollout of collective DC has been slower than hoped for. The Government must allow individual schemes to insist that members forgo early access — for some if not all of their accumulated capital — in order to benefit from the greater investment efficiency of collectivist provision.

Insofar as pension freedoms will remain part of the UK pensions landscape, the Government should explore allowing forms of early access at even earlier points of an individual’s pensions lifecycle. This would mean allowing scheme members to borrow from their own pot, for strictly limited purposes that benefit society and the economy (regulated by public bodies at scheme level). This could include investment in a newbuild home, to support house-building and home-ownership, and in start-up companies, to support innovation and entrepreneurship.^[25] Crucially, the capital borrowed would be repaid on terms that would justify the use of a tax-incentivised saving vehicle.

Test, learn and lead

The Pensions Review needs to be unlocked from the limitations the Government has placed on it. The prize is too great to let this opportunity slip by. Aspects of the pensions industry need to be challenged to remedy short-termism and conservatism in investment strategies. Employers and individual savers need to make higher contributions. The state will need to shoulder more of the risks involved in pensions saving and enter no-go areas such as PTR reform to make innovation possible and scale achievable.

Not all of the ideas outlined in this essay will fly. But not all the ideas the Pensions Review seems to be flirting with — such as compelling pension funds to invest in ways that might not benefit savers — are desirable either. The Government needs to be ambitious and experimental, testing new approaches even if not all endure. Above all, it needs to be willing to lead — establishing a long-term mission for private pensions saving and setting expectations that providers, employers and citizens all play their part in delivering it.

Asking pension funds to contribute to the domestic economy has never not been a good idea. This is why UK governments have repeatedly returned to it. It is time to get it right.

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