Pensions are probably something you associate with red-faced middle-aged people stomping around on TV, or with your parents’ seemingly absurd fixation with saving enough for their retirement. But behind all this, there’s a trillion pound industry that’s arguably the most influential long-term investor in the business world.
Pension funds pool the assets of a large number of different people, often all working for the same employer or employers. The resulting sums of money, which can be pretty big, are then usually managed by the company or a third party, such as an asset manager, on behalf of the individual investors. The money is often invested in shares, but may also be used to buy bonds, property, commodities, or other assets and financial products. This capital is therefore a vital part of the UK’s economic system as it provides the funds that businesses, governments and individuals need to function, and there’s some interesting career paths for graduates here who want to get into finance, particularly those interested in investment.
The big five pensions issues
Pensions is a hugely complex topic – not even professionals who’ve been in the business for 20 years know everything. But you have to start somewhere, and we reckon that knowing a bit about the following will give you a pretty good head start.
When the UK state pension age of 65 was first established in 1889, guess what the average UK life expectancy was? It was 65. That’s right, you’d probably be dead before you could collect your pension. But retirement periods have drastically lengthened over the past century, and it’s both private employers and the taxpayer that have to finance the elderly population. So, with people living longer than ever, it’s becoming increasingly hard to do so – and experts say this state of affairs is unsustainable.
The DB to DC switch
This big switch has taken place largely over the past decade, predominantly in the case of private sector pensions, very many of which have made the change. The shift has been spurred by the realisation that there’s not enough money in both private and public sector pension funds to continue making the kind of retirement payments that, until now, senior citizens have enjoyed. Why? A number of factors are to blame, including poor investment returns, falling birth rates meaning a smaller working population, and improved healthcare resulting in increased longevity (see above).
The switch means that today’s younger generations will receive worse pension provisions than their grandparents, and perhaps parents, who will get unsustainably generous packages. It also means the retirement income of those in our generation usually won’t rest on a safe promise made by our employers, but on the markets.
Public sector pensions
Notoriously generous public sector pensions – historically always DB – have been a source of fierce debate in the industry of late. Ex-politician Lord Hutton published a report calling for the reform of the system. His main suggestions were that retirement ages should be increased, and that workers should receive half their average lifetime wage every year from retirement, as opposed to the current more generous final salary arrangement, where employees receive half their final salary. Unsurprisingly, public sector workers such as teachers and NHS staff are up in arms because they don’t want to lose out on what they see as their due, but most experts insist the changes are economically necessary.
The UK is different to many other developed economies (such as Australia and Denmark) in that it isn’t compulsory here to pay into a pension when you start work. However, things are about to get a lot more complicated. In a bid to increase national retirement savings, the government has decided to require every company in the UK to enrol its employees into a pension scheme into which it will have to contribute a minimum of 3 per cent of their salary.
Changing investment patterns
The way long-term investors like pension funds invest their money changes as the markets do, as pension fund managers keep a watchful eye on them. Pension funds now often invest on a global basis, with emerging markets stocks (particularly in the BRIC nations – Brazil, Russia, India and China) experiencing a surge in popularity in recent years.
More recently though, DB pension funds are looking to de-risk their investments to make sure members’ payouts are secure. They’re also shifting towards ESG investments (those meeting certain environmental, social and governance standards) as part of this de-risking process.
The government’s new national pensions vehicle, the National Employment Savings Trust (NEST), will adopt a low risk investment technique, investing heavily in fixed income.
The major players
The big pension schemes
The pension schemes of large businesses make up around 90 per cent of all institutional investment in the UK. Because these employers have paid money into pension funds of thousands of employees for periods of up to around 50 years which have then grown through investment, they’ve got enormous amounts of money to invest, making them highly influential in the market. For example, if pension funds start to sell their shares in a company (like when NewsCorp’s governance practices were questioned), the impact will be considerable. The companies with the biggest pension schemes in the UK often control several billion in assets each.
The pension providers
It makes both economic and practical sense for even the largest companies with the most resources to use a specialist provider to look after their pension scheme rather than running it themselves. Providers come up with tailor-made schemes for companies, and work with them to comply with regulations and update it over time, in return for a fee. For example, providers are currently active in educating their clients about auto-enrolment. Providers usually look after medium to large schemes, because they are more likely to be able to afford to run a pension scheme, although there are small companies that use pension providers too. Not all pension schemes are employer-based – providers also run private schemes that individuals can join.
The asset managers
Asset managers manage the money people pay into their pension schemes, and work closely with the schemes’ trustees to come up with an investment plan that will produce the best returns for the scheme members. Asset managers invest the money in a variety of different ways, managing some of it actively by placing it in handpicked individual investment vehicles such as equities, bonds or property, and some of it passively by investing in index funds, that is, funds that reflect the performance of the FTSE 100. Asset managers strategically move money around various different investments in order to generate maximum returns over a long period of time. This diversifies and de-risks the investment, reducing the chance of their funds doing badly.
The consultants and administrators
The consultants advise pension schemes on numerous aspects of the way they are run, such as investment strategies, record keeping and other administrative aspects, management, and structuring. They are brought in to improve the design of pension schemes, and ultimately to improve their efficiency. The large consultancies also offer administration services to schemes, helping them with organisation. Consultants are beginning to work with pension providers to come up with “wrap” savings solutions for institutional clients, such as schemes that offer an ISA as well as a pension, which give employees more flexible savings options.