By: Dr Craig Berry (Manchester Metropolitan University), Dr Bruno Bonizzi (University of Hertfordshire) and Dr Jennifer Churchill (University of the West of England)

The issue of pension funds’ apparent disappearance from equity investments has received attention in recent weeks, most notably from Martin Wolf, chief economics commentator at the Financial Times. Wolf dates this trend to 2006, but the ‘de-equitisation’ trend actually goes back to 2001, and has been a focus of our research: pensions have moved away from company shares into bonds and alternative assets.

Wolf points to regulation, lack of appetite among individual corporations for the risk and cost of properly funding schemes, and the small size of the schemes as being the likely culprits for these developments. A way around these problems, argues Wolf, would be to move away from corporate sponsors through consolidation, in line with a suggestion by former Morgan Stanley and JP Morgan banker, Michael Tory (now of boutique investment house, Ondra).

The debate has largely overlooked the fact that ‘superfunds’ are already permissible in the world of defined benefit pensions provision (see The Pensions Regulator’s interim regime for consolidated superfunds). Nevertheless, the suggestion has some merit. But it is useful to consider more carefully the determinants of changing pension fund behaviour – which we see as a paradigmatic shift in pension fund investment practice – to understand why.

Pension fund asset allocations clearly show the rise of liability-driven investment (LDI) – in essence, the attempt to get cash inflows to reliably match obligated cash outflows in a timely fashion (the survival constraint). Such a move was also the consequence of mark-to-market accounting and a tougher regulatory framework about funding levels. The difficulty and cost of meeting this constraint has been increasing in recent years, due to the sharper segmentation between safe assets, with ever-falling yields that guarantee access to liquidity in a downturn, and other assets that do not, which is reflected in pension investments.

LDI is a short-term solution to a long-term problem. As the cost of liability-matching increases (due to falling yields), the need for performance from the growth arm of the portfolio becomes more urgent (hence the move from equity to alternative assets). Equities are caught in the middle of portfolio diversification, neither offering the security of assets such as gilts, nor the income arising from riskier asset classes.

There are of course two major trends which tend to be overlooked in discussions of pensions funds’ contribution to investments in ‘the real economy’. First, collectivist defined benefit pensions provision is fast being overtaken by individualised defined contribution schemes, as a direct objective of public policy. Given that investment risks are shouldered only by individual savers, defined contribution provision actually intensifies the need for conservative investment strategies.

Second, it is a mistake to assume that equity investment is synonymous with investment in real, productive economic activity. Equity markets have been transformed by the shift to passive investment and index-tracking: the image of pension funds as responsible corporate stewards of the companies they own shares in is antiquated.

None of this is to suggest that consolidation within defined benefit provision would not be a more efficient way to manage risks and administer funds (and it would mirror the consolidating market structure of defined contribution). The question is whether it should release employers from obligations to guarantee retirement outcomes for their workforce. The erosion of this guarantee, and its eradication in defined contribution provision, is another major factor – but too often overlooked – in turning pension funds towards short-termist investment practice.

The ultimate guarantor is the state. Whereas the Regulator’s superfunds regime involves a degree of employer involvement in providing capital buffers for consolidated funds, the Wolf and Tory proposals actually absolve employers altogether, and envisage some form of state ‘backstop’ to allow for greater adventurousness in investments.

Again, the proposal is not without merit. But it begs the question of why the state would want to do this, when it could provide its own vehicle for fund consolidation more efficiently (and arguably already does, given the expansion of the Pension Protection Fund for nominally insolvent funds). It may be that private superfunds underpinned by the state would be required to tighten rather than loosen asset allocation regulation, to minimise risks to public finances, whereas a state-managed consolidation fund could essentially be a bulk purchaser of bonds which enable public investment in productive economic activity. This would allow for the provision of good, reliable pensions, at the same time as supporting the real economy.

This debate has a long way to run. The Prime Minister, Boris Johnson, and Chancellor, Rishi Sunak, recently added their voices to it in the form of an open letter, ‘challenging’ pension funds to investment more ‘long-term UK assets’, albeit with no indication of the regulatory changes that might be necessary to bring about this outcome. Pensions provision clearly has a role to play in supporting the economy as well as enabling decent retirement incomes. But the question of the role we want the state to play in this regard must be addressed as a matter of priority.