A new threat to our pensions – Kate Deer explains why we should be up in arms about Jeremy Hunt’s Mansion House speech.
Just a few months ago, the French government announced dramatic reforms to the French retirement system and French people were up in arms: cars were burning, shops were looted and the country was brought to a grinding halt.
But when on 10 July Chancellor Jeremy Hunt announced some big changes to the UK’s pension industry, you could hear the tumbleweed rolling down the escalators at Bank tube station. What little coverage there was broadly supported the proposals; the Telegraph, for example, simply endorsed the claim that this would ‘boost pensions by £1,000 a year’.
What is being proposed? Unlike Macron, Hunt did not target the state pension age, but is rather proposing a different investment style for defined contribution (DC) pension funds and local government pension schemes, which would lead to more investment in private equity, which he describes as ‘high growth industries’.
What is a DC pension?
These are the pension funds in which most workers are now enrolled, which have grown greatly since the introduction of automatic enrolment between 2012 and 2018. They involve a regular pension contribution that is automatically taken out of your salary, topped up by your employer and put into a savings account which is automatically invested until you retire.
Local government pensions, like most other public sector schemes, are defined benefit (DB) pensions which guarantee a certain income in retirement. The key difference is that with a DC fund your pension income is not guaranteed, but depends on the investment returns of the fund you are invested with.
While DC funds are not as generous as DB pensions, they do allow workers to save for retirement and receive employer contributions to bulk up their savings. Also, DC funds generally invest in a broad combination of assets, so it is almost impossible to lose all your money.
But there are also some big downsides to DC funds. If markets crash, members are left with less money in their pockets. This happened for example to members who were due to retire on a DC pension last year when the bond market crashed.
Secondly, while you should in theory be free to pick different investment strategies for your pension savings, in practice most people are enrolled with a default fund, and have no idea how their pension money is being invested.
Moreover, because DC pension contributions are in most cases way too little to guarantee a decent income in retirement, DC pension funds are generally invested in riskier assets like stocks to produce higher returns to offset the fact that the pots are too small. Most DC funds for younger members who are still far away from retiring are heavily invested in equities (stocks and shares). This has worked out well so far while stock markets have been rising. But it could become a problem if stock markets crash.
What is the Mansion House Compact?
Jeremy Hunt has now announced that he wants pension funds to invest in different assets through the Mansion House Compact. This is a deal with the five largest DC Master Trusts which commits them to invest at least 5% of their default funds in private equity.
This deal has been backed by Aviva, Scottish Widows, L&GA, Aegon, Phoenix Nest, Smart Pension M&G and Mercer – the biggest private pension providers.
Why is the government proposing this?
If Jeremy Hunt is to be believed, this is great news for ordinary DC savers. He claims that the average saver will be £1,000 a year better off when they retire due to private equity offering higher returns.
Hunt claims that if the entire DC market follows suit, this would ‘unlock’ £50 billion of investment, which in turn should be great news for the British economy. So it should be win-win, shouldn’t it? Well, not quite. First of all, the government does have an agenda with this.
In recent times its strategy for the economy has been solely focussed on attracting private capital for vital investments, because its borrowing costs have increased sharply. Yields on UK government debt are now higher than under Liz Truss. The UK now has the highest borrowing costs among the G7, and yields are also at their highest level since 1998.
All this means that it is becoming a lot harder for the government to take out new debt to invest in the economy. So why not take the money from your pension instead?
It’s also worth adding that this is by no means additional money, as Hunt claims. These are your savings; you would have saved them anyway. This is simply a choice to invest them in private equity, rather than in government bonds or equities.
What is the problem with private equity?
Hunt argues that this should be good news for DC savers. In return for taking on higher risks, they will also get higher returns. But it is not at all clear what sort of assets pension funds would be investing in. Some private equity funds could fund windfarms or other renewable energy projects, which is something that Nest has done for example. But they could also play a role in running vital infrastructure into the ground.
One obvious example is water companies in England and Wales, which since their privatisations in the 1980s and 1990s have often been bought up by private equity firms. This has often led to these firms taking out a lot more debt to pay higher returns to investors, rather than using their profits to keep the businesses running sustainably.
Most recently, this led to the collapse of Thames Water, which has seen a massive increase in debt since it was taken over by a private equity firm, and has also been fined by regulators over its sewage leaks.
Thames Water and other utilities firms are owned by pension funds through a private equity manager. For example, the USS Universities Pension Fund held a 20% stake in the water firm. This turned out to be extremely risky. When Thames Water struggled to refinance its debt, USS and other major investors were forced to fork out more money to keep the firm running. This added to what was already bad news for USS members.
But most of their retirement saving is nevertheless secured because they receive a DB pension. It would be much worse for DC members because they would be liable for the losses.
These risks are only likely to increase. A lot of private equity run firms are highly geared, which means they took out a lot of debt when interest rates were low. But firms that are trying to refinance now with rates rising will face much higher interest rates, which increases the chance of them going bust.
In short, rather than the government investing in the British economy, the chancellor is proposing to spend your pension money on these very risky investments, just when interest rates are rising. Any losses will be borne by you. And there is of course no guarantee that the funds would be invested here or dedicated to causes like the energy transition.
It’s important to add that this should not be a reason not to save into a DC pension. For most workers in the UK, saving into a pension is their best bet of securing some additional income in retirement, and it forces your employer to top up your savings too.
For now, this is just a 5% allocation. But the fact that the government feels entitled to use your savings to compensate for its lack of investment sets a dangerous precedent. In any case, you might want to keep a closer eye on the type of assets your pension money is invested in. No doubt, many of us would accept lower investment returns and even higher risk, if they knew their savings are being used to fund social housing or renewable energy projects. But right now, there is no guarantee that this will be the case.
More importantly, we should hammer home the point that vital public services such as water supply and transport should be renationalised and not be run by private equity firms. But don’t look to the Labour Party for change – Rachel Reeves has already ruled out renationalisations and said she would make the 5% contribution to private markets for DC funds mandatory.