Should we insist pension tax reduction is used to spend money on UK firms? STEVE WEBB replies

I think insisting that the tax relief paid into pensions should be invested in UK companies for UK projects would be reasonable.

Would it cause any fundamental issues if the rules were altered to ensure this happened?

Would pension companies be justified if they complained that this would increase costs/charges?

Steve Webb replies: With nearly two trillion pounds invested in UK workplace pensions, the government is understandably very interested in getting more of this money working to boost the UK economy.

But the level of domestic investment by UK pension schemes has actually been declining rapidly in recent years. 

Looking at modern ‘pot of money’ or defined contribution pensions, the government’s own figures (Pension fund investment and the UK economy) show that a decade ago just over half of the money was invested in the UK compared to less than a quarter now.

Given that defined contribution pensions are where most new pension savings are invested, this is a matter of considerable concern to the government.

There is one very simple explanation for that recent trend.

Workplace pension schemes have largely stopped investing in the UK stock market.

Although pension schemes still own lots of shares (or ‘equities’), overwhelmingly these are now invested in stock markets outside the UK. 

This particularly includes investing in things like technology stocks on the US stock market.

Pension schemes would say that there is a very good reason for this. In the last 15 years, the rate of return on the UK stock market has been well below the return on global stock markets.

For example, in the 2010s, investing in the largest companies on the London stock exchange would have generated an annual return of 5.5 per cent. 

But an index of global stocks would have returned nearly double this (10.5 per cent) and investing just in the US would have generated 14 per cent per year.

That trend has continued into the 2020s, with UK returns so far averaging 4.2 per cent per year compared with 9.9 per cent for global shares and 12.1 per cent for US shares.

As you can see, if someone had invested their pension in UK shares rather than the rest of the world or just the US, their pension pot would now be far smaller.

This is one reason why successive governments have been wary of forcing or even bribing people to invest more in the UK. 

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If a government incentive led you to invest in a way that damaged the long-term value of your pension, you might not be very happy about this.

Even allocating just your tax relief to UK investments rather than putting it in the general pot would have given you a lower pension on average, and this would also come with considerable administrative complexity.

However, the government has certainly not given up on getting an increased proportion of pension savings invested in the UK.

The new government strongly believes that if pension money can be invested into ownership of companies which are not listed on stock markets (sometimes called unlisted equities or private equity) or invested into boosting our infrastructure (eg upgrading the National Grid) then this will help to generate economic growth and provide decent pensions as well.

Rather than force pension schemes to do this directly however, the government has decided to achieve this by driving smaller pension schemes to consolidate into a small number of what it calls ‘mega funds’.

The government argues that once pension schemes start to be in the £25billion-£50billion range they will invest much more in private equity and infrastructure. 

Although it is possible to invest globally in these types of assets, there tends to be much more of a ‘home bias’ in these assets – certainly compared with investing in shares where almost all the money is now invested outside the UK.

Of course, the purpose of pension schemes is to give us a decent income in retirement rather than to help the government with its economic objectives, so a key question is what impact all these changes will have on our final pensions?

On this, the government’s own estimates are pretty disappointing.

The government asked its own experts (the government Actuary’s Department) to model the final pension pot of someone who earned £30,000 per year and paid an 8 per cent pension contribution over 30 years. 

The modelling was done based on current approaches to investing and on a range of alternative assumptions, including investing more in unlisted shares.

The results were rather underwhelming.

The pension pot estimate after thirty years was £259,000 based on current approaches to investing. 

The pot size with a higher allocation to UK shares was also £259,000 and the figure for investing more in ‘private markets’ was £264,000. 

Whilst this last figure is ‘slightly greater’ (as the government put it) they also stress that these figures are highly uncertain.

The best we can say here is that if schemes invest in the way that the government wants them to, then this will probably not make much difference either way to people’s final pensions.

In summary, although successive governments want to see more pension money invested in the UK, any pressure brought in a decade ago to invest in things like UK shares could have seriously damaged people’s pensions. 

So, the government is nervous about anything which looks like telling schemes how to invest, especially if the expert judgment of those who run the schemes is that the best returns may be found outside the UK.

Instead, the government is trying to restructure the pensions market so that more pension schemes will invest in the things which lead to economic growth in the UK. 

It remains to be seen if the changes they are proposing will lead to pension schemes turbo-charging the UK economy or not.