Once the champions of domestic investment, UK pension funds’ allocation to British companies is at an all-time low. Defined contribution (DC) funds’ allocation to London-listed equities plummeted from 40% in 2012 to 8% eleven years later.
Meanwhile defined benefit (DB) funds investment in the UK’s stock market has dropped from 32% in 2006 to just under 2% by 2023.
Even the local authority pension scheme’s (LGPS) commitment to UK equities has more than halved during the past decade falling from 25% in 2013 to around 10% today.
Therefore total UK pension allocations to domestic assets are far lower than the equity share held on home turf in Canada (22%), New Zealand (42%) and Australia (45%).
Figures from think tank New Financial show the story is repeated in private investment where UK pension funds have a 6% allocation to domestic private equity and infrastructure assets; far lower than their peers in Canada (34%), Finland (17%) and Australia (14%).
William Wright, founder and managing director at New Financial, says this allocation to domestic equities is among the lowest of any developed pension system around the world with only Canada, the Netherlands and Norway having a lower allocation.
“It is less than half the weighted-average allocation to domestic equities across our sample, excluding the US,” Wright adds. “The overall allocation to equities by UK pension funds of 30% is lower than every market except Canada, Denmark and the Netherlands.”
Destroying the doom loop
This, Wright says, has created a “doom loop” of lower demand, lower valuations and a less dynamic UK market.
No wonder then the UK government is desperate to break the vicious circle and bring some assets back home.
Last August, chancellor Rachel Reeves said UK schemes should “learn lessons from the Canadian model and re up the UK economy, which would deliver better returns for savers and unlock billions of pounds of investment”.
The government is now in the midst of a far reaching pension review which could see sweeping reforms designed to “unlock billions of pounds of new investment for the UK economy and boost returns for savers”.
Although what this rhetoric will actually mean for pension funds is the key point of discussion, and why the outcome of the review and its subsequent consultation are being anticipated so eagerly.
In the meantime, pension trustees and those responsible for the investment of the nation’s retirement funds can continue to allocate to strategies that favour global diversification, which reflect the international nature of equity markets.
Chris Arcari, head of capital markets at Hymans Roberson, says: “Many institutional investors have shifted equity allocations towards positions which are more representative of the UK’s increasingly smaller weight of global market capitalisation.”
Lok Ma, trustee director at independent pension trustee firm Law Debenture, says it makes sense to have a geographical spread to offset the risk of regional volatility.
But he notes, with geographical diversification comes geopolitical risk. “Diversification across geography is obviously a sensible thing but you have to think about the geopolitical considerations,” Ma says. “While diversification is a great thing, if it all goes horribly wrong there is a real chance you won’t get your money back.”
While UK schemes were relatively well insulated from the impact of Russia’s invasion of Ukraine in 2022, several multi-billion-pound schemes including the National Employment Savings Trust (Nest), Universities Superannuation Scheme and Transport for London were all forced to withdraw assets from the region as a result of the conflict.
Arcari says the challenge for those at the pension investment coalface lies in the almost complete inability to foresee such calamitous events. “It is difficult to pre-empt or trade political instability and macro-economic volatility,” he adds. “The only free lunch in this regard is to have a diversified portfolio with assets which might provide o sets in certain circumstances.”
Arcari says that given current bond yield levels, these assets are “well placed to provide ballast in a garden-variety downturn or shock”. For example, one where growth and inflation, or at least expectations of them, fall sharply.
“However, diminishing returns from globalisation, disruption to supply chains from climate change and geopolitical tensions, and political opposition to immigration as a cure to more persistently tight labour markets, mean we are potentially entering a more fragile supply-side environment than in the post-global financial crisis period,” he adds.
Trade wars
There are also impacts from the trade tariffs imposed by US president Donald Trump and the subsequent expected retaliation from affected countries.
In February, President Trump signed an executive order imposing an additional 25% tariff on steel and aluminium imports into the US, due to come in during March.
While there is still room for negotiation, Ewa Manthey, commodities strategist at ING, says many countries are ramping up their defences, making further trade escalation inevitable. “President Trump has laid the foundations for further trade escalations. This will not be the last tariff move. Retaliation is on, and it’s going to get nasty,” Manthey says.
The question for investors is whether a “nasty” trade war means they retreat from those markets they believe will be wounded in battle.
Tom Stevenson, investment director at Fidelity International, says: “The consensus, outside the Trump administration, is that tariffs are bad news. The view is that the threat is serious, and it will cause a big economic growth hit, for the US and its trading partners, as well as an inflation surge in America.”
However, it is also possible that deepening hostilities between major economic forces result in a form of de-globalisation that makes it even more important for pension funds to have exposure to different geographies.
For Ma, we might be moving into a more segregated world as a result of trade barriers. “I have seen an argument that says, actually that makes a stronger case for diversification, because the markets are less correlated with each other which means your gains in one place could offset losses in another place to a greater extent than before,” he says.
Global credit markets
While UK pension funds have shown appetite for overseas equities, their taste for foreign fixed income has been more muted.
As DB schemes mature, they have chosen to de-risk with many choosing to shift to fixed income, specifically UK government bonds which are closely aligned with their liability profiles.
However, research from JPMorgan Asset Management warns investors against an over-reliance on UK bonds, specifically gilts reminding investors of the fallout from the September 2022 crisis.
“It is prudent to consider global diversification of the core fixed income portfolio, across government and corporate bonds. “The sterling market, while important, is dwarfed by the immense size of the global credit market – there are about 750 bonds in the UK credit market versus about 7,800 in the global credit market ex-UK, and the market capitalisation of UK credit is a mere 5% of the global credit market,” the research read.
Hedging the risk
Irrespective of whether you opt for overseas bonds or stocks or a mixture of both, investing abroad brings the risk that foreign currencies fall against the pound.
Obviously, this reduces the value of your international assets and either means that future returns need to be higher, or contributions must rise to make up for the shortfall.
How trustees approach currency hedging is scheme specific, but Arcari at Hymans says it has an important impact on fixed-income allocations.
“The volatility reducing effect of hedging fixed income exposures is far more significant for fixed income exposures than it is for equity and other growth asset exposures. The higher the volatility of the underlying asset, the smaller the gain in terms of volatility reduction from hedging the currency that is achieved. For this reason, we would suggest hedging all fixed income exposures as standard,” Arcari continues. “Currency hedging, of course, incurs a cost, so it is understandable that schemes might be more cost effectively able to invest in sterling-denominated fixed income assets.”
Ajeet Manjrekar, global co-head of client solutions at Schroders, agrees that fixed-income assets should typically be fully hedged back to sterling, while for “on-risk assets held to generate growth, schemes may choose to hedge a proportion of the over- seas currency risk”.
There are tactical reasons why a pension fund may choose to leave a proportion of their exposure unhedged.
Allocations to safe haven currencies – those from countries with stable governments, central banks and financial systems where investors take shelter in challenging economic conditions – often strengthen in challenging market conditions.
Ma says: “I’ve seen more and more schemes deliberately retain some exposure to currencies like a US dollar; it’s a downside risk management strategy. If there is global uncertainty, the dollar tends to strengthen which can o set some of your losses elsewhere.”
Going private
While the propensity from UK pension funds has been to journey overseas to help manage risk and deliver return, there is a growing trend to consider homegrown alternative investment options.
The government is desperate to use UK pension funds – particularly the £3trn held in workplace schemes – to bolster its growth and net-zero ambitions by channelling assets into domestic unlisted equity and infrastructure projects.
Several of the UK’s largest DC schemes have committed to allocating at least 5% of their default funds to unlisted equities by 2030 as part of the Mansion House Compact, but this will take time and raises questions about whether the government is interfering decision-makers’ fiduciary duties to members.
When asked whether UK schemes should favour domestic allocations to unlisted assets, Manjrekar says: “It depends on each scheme’s specific investment needs, trustee beliefs and risk appetite. Where UK assets provide attractive risk/return opportunities whether in public or private markets that align to the specific scheme’s needs, then this statement is fair.”
Meanwhile, Arcari says: “For schemes with a desire to deliver local impact and invest in UK productive finance then there is potentially a greater role for sterling-based assets in private markets. The UK can also be attractive from a private markets’ perspective given the strong regulatory framework and protections that apply to provide some certainty over income or return streams, albeit some assets can come with a higher price tag.”
When you are sitting on one of the largest pension markets in the world, it is undoubtedly frustrating for government and business that so many trillions of pounds in assets are heading out of the UK and overseas.
Yet pension funds exist solely to provide financial security for their members in retirement and that means investing where they will get the best risk-adjusted returns.
UK policy can – and likely will – adapt to make the UK more attractive to its pension funds, but ultimately it will always make sense for schemes to hold at least some of their portfolios abroad.
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