The UK Government wants pension funds to invest in start-up businesses far more than they do. Unsurprisingly, so does the fund industry. But pensions expert John Ralfe says the idea is “98% crackpot”.
In the latest episode of The Investing Show with Robin Powell and Abraham Okusanya, Ralfe says the problem is that most start-up businesses fail, and identifying, in advance, the few that won’t is very hard. As a consequence, he warns, trustees of funds that invest heavily in start-ups will be exposing their members to undue risk.
ABOUT JOHN RALFE
John Ralfe used to be Head of Corporate Finance at Boots, and now works as an independent pensions consultant. He also writes on pensions for the FT and has recently given evidence to the Work and Pensions select committee of MPs on how to improve the pensions system. If you missed the first part of Robin Powell’s interview with John Ralfe, you can watch it here.
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Abraham Okusanya: Hi Robin!
Robin Powell: Hello again, Abraham.
Abraham Okusanya: So last time, we asked the pensions expert John Ralfe about the challenge people face – particularly people on average or below average salaries – to provide for themselves financially in retirement. This time, we are looking at what politicians can do to tackle the pension crisis. Is that right?
Robin Powell: Yes it is, Abraham. It’s going to be very interesting to see what the major parties say about pensions in their manifestos for the next general election, because this is going to be a really important issue in the coming years.
Abraham Okusanya: John explained in the last episode how, in his view, defined benefit – or DB – schemes in the private sector are slowly being consigned to history; and yet they are alive and well in the public sector, aren’t they?
Robin Powell: Indeed they are. There is, though, a definite “but” here. DB schemes are expensive to run and, as we know, there’s huge pressure on public funding at the moment. Politicians are coming under increasing pressure to close the gap between public and private pensions. And John Ralfe says it just has to happen.
John Ralfe: Public sector pensions were last reformed about 10 years ago, and took effect in 2015. The government of the day said, “we’re not going to do anything for the next 25 years,” which is a real hostage to fortune. What’s happened since then is that the defined-benefit pensions that were in place have closed, as I mentioned earlier, and what we’ve now got is an unsustainable gap between public sector defined benefit and private sector defined contribution. Something is going to give. Now, it might not give for another 20 or 30 years – but it is going to give, and it’s much better to introduce measures now which reduce the cost for taxpayers, and that means it’s less likely that it will be some sort of explosion in 20 or 30 years time.
Robin Powell: One of the problems with pension policy is that, no matter how strong the case is for change, there will always be those who want to maintain the status quo. The public sector will understandably want to keep its own DB schemes intact; but John Ralfe says tough decisions need to be made, if we’re to make the pension system fairer.
John Ralfe: The way in which the tax system works in the UK – the tax breaks that you get on pensions are very biased in favour of the 40% taxpayer. You know, you and me, Robin. So if you look at it end to end, and you take into account each of the different components; the 40% taxpayers get a much, much, much bigger tax break than the 20% taxpayers. And you know, as far as I’m concerned, that’s just unfair. If I’m saving £1000 of my after-tax income into a pension scheme, I should get the same tax top up – no more, no less – than somebody on 20%. So I would move to flat rate tax top up at, say, 30%. Neutral for the treasury: it’s fair, it’s also efficient because it encourages the lower-paid to save a bit more – including part-time workers – and it probably should help to close the gender pension gap.
Robin Powell: Another issue that policy makers are currently grappling with is the extent to which pension schemes should support the UK economy. Government ministers and the Tony Blair Institute have both called for pension funds to invest in start-up businesses and infrastructure projects. What does John Ralfe make of that?
John Ralfe: The short answer, Robin – and I’ve been fairly restrained so far – the short answer is it’s completely crackpot. No, I will qualify that! It is 98% crackpot and it’s written by people who may be fantastic fund managers and may have made quite a large amount of money from the fund management industry, but who don’t understand pensions. The idea – and the idea is different depending who you listen to – that you can somehow smash together… a bit like Dominic Cummings on speed, you can smash together private sector DB, private sector DC, maybe public sector, and certainly the Pension Protection Fund assets, and somehow you can make something bigger and better is just completely bonkers. And I hope that, when we have a proper consultation where the treasury has to set this out line by line by line, that we can then see that really it is a completely crackpot idea.
Robin Powell: So John Ralfe is opposed, in principle, to the idea of politicians meddling in pension trustees’ decision making processes and cajoling them in invest in start-up businesses. However, he does see some scope for the local government pension scheme, investing in local firms and projects.
John Ralfe: 70% of the portfolio is probably equities. A very, very, very large proportion of that is in the US, and not very much is in the UK. So, if you look at the Staffordshire pension scheme, for example – Staffordshire happens to be a place that I know reasonably well – the Staffordshire pension scheme has more invested in Silicon Valley than it does in Stoke-on-Trent. And for those who don’t know the geography, Stoke-on-Trent’s the biggest city in Staffordshire. That just can’t be right. So I would certainly want to be doing two things. First of all, merging the local government pension schemes because you then get economies of scale, very significant savings; but then tweaking the asset allocation. So they’re bringing – let’s say – 5%, only 5%, back from the US to the UK and investing that in local infrastructure projects, local housing, green technology, and at the margin that will be a good thing to do. The idea that you can suddenly turn on a tap and there are all these good ideas going begging, I just don’t believe. There’s generally more cash chasing the good ideas. It’s a bit like the BBC’s television programme, Dragon’s Den. They’re all sitting there with piles of money. They might see six or seven people during the course of a programme, and they invest in one. So the idea that there’s all these fantastic ideas, shovel-ready infrastructure projects, or startups, or goodness knows what going begging because they can’t find the money – I just don’t believe.
Robin Powell: One final topic I had to ask John Ralfe about is LDI – or liability driven investing – a type of asset management that Ralfe himself pioneered when he ran the Boots pension scheme. Put simply, LDI is an investment in assets – government bonds, for example – that can generate the cash to pay for financial obligations. The wisdom of LDI was questioned after the gilts crisis that followed the disastrous mini budget in 2022. John Ralfe says, LDI done properly does still make sense.
John Ralfe: So you can have a situation where, if you knew precisely – and with pensions, it’s reasonably precise – on these dates, these are the amounts that are going to be going out to pay pensions on the second Friday of every month, whatever it is. Then you have bonds on the other side paying the same amounts of money that are going out. So, LDI is just jargon for matching your assets and liabilities. Over the last few years, it’s come to mean something else. And what it’s come to mean is, “oh, well actually you spiv around, you take bets.” This is where so-called leveraged LDI comes in. And what we had in the UK last autumn, after the so-called mini budget, was interest rates going up very quickly following a lot of politics involved. Interest rates going up very quickly. What we then realised, and I’m not sure anybody – including me, and certainly not the Bank of England and the pension regulator – realised was that there were a lot of small pension schemes who really didn’t know what they were doing, who were taking bets. They were taking leveraged bets on interest rate movements. When those bets that went against them; under the mechanism, they had to post so-called cash collateral. Where did that cash collateral come from? They had to sell assets. So in anything anybody hears about LDI, be very clear to ask the question: is this just LDI – matching assets and liability is a good thing – or is this leveraged LDI? And without sounding like an old fogey, leverage is not always a bad thing, but leverage is – more often than not – something that will catch you out.
Robin Powell: Abraham – we’ll discuss LDI shortly, but first, how much of a problem is it, do you think, that public sector pensions are so much better generally than private sector pensions? Does it really matter?
Abraham Okusanya: Well, the problem is not that public sector pensions are generous. The problem is that private sector pensions aren’t as generous as they should be.
As you know, part of the, if you like, social contract with public sector workers is that pay is generally lower in the public sector compared to the private sector. Annual return – part of that is that they get much more generous pension schemes. So I think the attention should be on how we can make private sector pensions better, not how we can make public sector pensions less generous.
Robin Powell: What’s your take on whether or not pension funds should invest in start-up businesses to support the UK economy? Shouldn’t trustees focus entirely on what’s in members’ best interests?
Abraham Okusanya: Indeed they should. I am not a big fan of the idea that we should put more government regulations on pension schemes to force them to invest in the UK if they don’t believe that that’s the right thing for them to do. If they can’t come to that conclusion on their own as things stand, the idea that government rules are going to, in effect, force them to do that – I think – is a bad idea. Let’s not forget: pension schemes, UK pension schemes, used to allocate more. They used to allocate more to UK equities than they currently do. Part of the problem isn’t necessarily just about the lack of incentive to invest in the UK. A big part of what’s happening is that the global stock market is now much bigger and the UK stock market is a much smaller proportion of the global stock market. I think it’s currently sitting at about 4%. And so the idea that pension schemes should be forced or incentivised by government to invest more in the UK than they otherwise would, I’m not sure is a very good idea.
Robin Powell: Finally, what about gilts? Much has been said about gilts since they fell in value last autumn. Some say that crisis shows they’re much riskier than we thought. Others, that now is a buying opportunity. What are your thoughts?
Abraham Okusanya: Part of the reason we’re here with pension schemes allocating over half of their entire portfolio into bonds generally, and a large chunk of that into gilts is that, over the years, governments have put more and more regulations on pension schemes, in effect forcing them down this route. And so I used to think that I was alone in this idea: thinking that it’s ludicrous. It’s ridiculous that pension schemes – large pension schemes with a lot of risk governance and framework and very, very long time horizons – would not allocate the largest chunk of their entire portfolio into equities. Instead, they keep it in bonds – whereas individuals who are saving for retirement are being encouraged to allocate more and more of our money into equities. Until I read a book by Paul Johnson, who is the director of the Institute of Fiscal Studies, and he agreed! He agreed that this position that we’re in – where pension funds are allocating a larger proportion of their entire portfolio into bonds and gilts – is absolutely ludicrous. We need to get back to the position where pension funds are investing more inequities and much less in bonds and gilts.
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