The UK government wants to shake up pensions – but it can’t guarantee that ‘megafunds’ will want to invest in Britain

The UK chancellor Rachel Reeves talks a lot about achieving better growth. And the latest figure – economic expansion in the last quarter of just 0.1% – suggests plenty of room for improvement.

The evening before that gloomy figure was announced, Reeves revealed her latest plan to get things moving – pension reform. And while there was some mention of potential benefits for actual pensioners, it’s clear that the main incentive for change is to channel more of their pension fund money into UK investment.

This will be done through two main sets of reforms. The first concerns the Local Government Pension Scheme (LGPS) for England and Wales, which has 6.7 million members and assets worth around £392 billion. Its members are mostly current and retired council employees – and mostly women.

The LGPS is essentially a cluster of 86 different schemes, which have already been combining to form eight “asset pools” for the purpose of investing their pension funds and creating cost savings. The chancellor wants to ramp up consolidation through those eight asset pools, and also see a greater proportion of the funds’ assets (currently 5%) being invested in local and regional projects.

The hope is that this will boost the growth of local economies. The LGPS is a “defined benefit” scheme, meaning that it promises members a pension in retirement worked out according to a formula based on their pay while they were working and length of time in the scheme. The way its assets are invested does not affect the amount of pension people get.

The second set of reforms apply to workplace “defined contribution” schemes. These are the sort arranged by (and contributed to) by an employer whereby employees build up a pot of savings to provide an income during retirement.

Usually, employees can choose how they want to invest their pension pot, though schemes must offer at least one default strategy. The vast majority of members go with the default. Four out of five employees choose not to review their investments at all.

Workplace defined contribution schemes are either run by a board of trustees, or by a pension company with whom the employee has a contract. The sector is highly fragmented, with thousands of different schemes, many of them very small. However, over the past 12 years, there has been a move towards consolidation.

Again, the government wants to accelerate this consolidation to encourage the emergence of much larger pension investment funds, similar to those seen in Australia and Canada. Controversially, it is also proposing to make it easier for the assets of contract-based schemes to be transferred to other schemes without the consent of members.

One claimed advantage of larger funds is lower costs. However, the Pensions Policy Institute has found that cost savings tail off once a fund reaches around £500 million. But again, the key driver for the government is to create funds that are large enough to take on additional investment risks – without jeopardising their ability to provide people with financial security in retirement.

Larger funds would free up some pension money to invest in areas such as infrastructure and private equity, with potentially high growth prospects. Such investments tend to be “illiquid” (difficult or impossible to convert into cash at short notice) so are suitable only for long-term investment.

More money, more investment?

The government claims that including such higher-risk investments in the mix can “deliver better returns for savers”. This is likely to be broadly correct, since it is a fundamental investment principle that higher-risk investments need to offer higher returns in order to attract investors. However, evidence suggests that the extra return from investing in illiquid assets could be as low as 1% a year over the long term.

Nevertheless, Reeves is hoping that an additional flow of funding from larger pension schemes (“megafunds”) will boost investment in the UK economy.

But it’s not as simple as that. The idea that simply increasing the amount of savings in an economy will inevitably cause investment to rise was debunked nearly a century ago.

Back in 1936, the influential economist, John Maynard Keynes showed that the most important factor when it comes to investment is what he referred to as businesses’ “animal spirits”. In other words, it all boils down to a feeling of confidence about whether or not investments will lead to a good return. And that will depend on how the other elements of Labour’s growth strategy play out.

Similarly, pension fund managers and savers need to be confident that the UK – and in particular sectors such as private equity and infrastructure – are the best home for some of their pension pot. The general advice for any investor is to diversify savings not just across different assets (equities, bonds, cash, property) and sectors (manufacturing, services, large companies, smaller ones), but also different geographical regions.

So as these new policies for pension schemes unfold, anyone with a pension may want to have a careful look at where the default fund is investing the money they will rely on in the future. They may even consider choosing their own investment strategy instead.

Jonquil Lowe does not work for, consult, own shares in or receive funding from any company or organisation that would benefit from this article, and has disclosed no relevant affiliations beyond their academic appointment.