After the torpor of Tory government, Labour has hit the road running. Yesterday Rachel Reeves said she would be pursuing plans to build a UK wealth fund.
Reeves said a taskforce lead by Mark Carney has been delivered a report currently being considered by government. Next steps are expected to be announced soon.
Is it a good idea?
Traditional wealth funds often involve the state reinvesting wealth from oil and gas activities to reduce the risk of being the domestic economy being so reliant on one source of income and wealth, such as Norway.
The proposed Labour fund is materially different. It is looking to pool external funds in a state vehicle. We do not yet know whether the state will also provide its own capital or whether it will provide other incentives to encourage investors to stump up the capital.
At first glance, it is not obvious the UK does need a state vehicle to bolster investment in the UK. After all, there trillions of pounds of institutional investment wealth held by pension schemes and insurers both in the UK and around the world.
Maybe it is as simple as providing the right environment to encourage these investors to allocate to the UK? As the Tory government learnt with its Mansion House reforms getting UK pension schemes to invest in their domestic market is not straightforward.
It’s complicated
A politician can look at the trillions currently held in UK pension schemes and think it is just a matter of persuading them to allocate some of that capital to the UK. But there are multiple reasons why pension schemes and insurance companies would baulk at such an investment.
There are three main types of funded pension schemes in the UK – closed private sector defined benefit schemes, open DB schemes and workplace auto-enrolled defined contribution schemes. Each face a different set of regulatory and market forces shaping their investment strategies. (If you want to understand more about the UK pensions landscape, read this series – start at the bottom.)
The largest pot is closed private sector DB schemes . These have had an interesting couple of years as the rapid reversal in interest rates mean these pension funds are now sitting on surpluses with many looking to transfer their assets to insurance companies.
With around £50bn a year expected to be transferred to the insurance industry, could this be viable source of investment?
Not really. Regulation means the way the annuity portion of insurance business invests in fixed income assets with a tightly defined income stream. The very opposite of risky private equity! The right infrastructure project funded with debt, however, could work – many insurance companies already invest in these.
Closed DB schemes are the most risk adverse – heavily invested in government bonds and not looking to invest either in risky venture capital or illiquid alternatives as they head to buy out.
The government could look at way for these surpluses to instead be used to continue running on these schemes but these schemes do run on, they will want to protect their funding position and will not suddenly want to increase the risk of their portfolios.
Open DB schemes have far fewer constraints. The best example of this type of scheme is the Local Government Pension Scheme. Although it is one scheme, it is made up of 85 partner funds run by local authorities which have now merged in their assets in eight different pools.
These schemes invest in a broad array of assets including infrastructure and private equity. They often have a strong local focus and invest in local housing and green infrastructure. These schemes would be interested in bolstering UK investment but it would have to be have the right risk/return characteristics to match their members’ requirements.
Auto-enrolled workplace DC is where the majority of the UK’s future retirement wealth will be collected. Large schemes are already investing hundreds of millions a month on behalf of their members.
While these schemes have the long-term investment horizons and risk appetites which would match private equity investments, the costs are off-putting. That’s because many of these pension providers compete on cost which limits the amount these schemes are prepared to spend on investment leading to a reliance on passive equities.
Over the long-term, these pension schemes should provide a good source of capital for riskier projects but more needs to change to make this happen. There needs to be a greater emphasis on value for money and greater consolidation to make these vehicles more effective. There is a lot of fragmentation in this industry.
Why have a wealth fund?
The major benefit of a government-run wealth fund is that it would get government officials and investors to meet regularly.
My hope is this would get them to understand each other better. I recently ran an event looking at what policy we needed to make net zero a reality and my overwhelming impression was the huge gulf of understanding between policy makers and the investment industry. This needs to be urgently addressed.
A wealth fund could encourage international and UK investors with the right risk/return outlook to invest more in the assets the country needs to fund its long-term growth. But I’m not sure a wealth fund is required to do this – after all investors are very good at finding investments to meet their particular risk/return requirements.
Is it in the government’s interests?
It’s hard to shake the feeling the government is pursuing ideas like a wealth fund because it feels so severely constrained by the state of the public finances and its own self-imposed fiscal rules.
The bottom line is any investors will be happy to invest when it meets their risk/return profile. That is going to be at a higher cost that sovereign debt – all investors need a risk premia. And the history of both the water companies and PFI show investors can often run rings around the government.
But there is a benefit to the government working with more commercially minded people – the education works both ways. This needs to be done in a way that the government doesn’t live to regret and investors play the most useful role both for UK citizens and beneficiaries of pension schemes.
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