Why the ‘gateway’ for DB superfunds is not a technical issue but a growth one

The issue of the Pensions Regulator’s (TPR) superfund “gateway” is typically seen as a technical matter, primarily concerning member security. That is a mistake. The width of the gateway lies at the heart of the government’s growth and investment strategy.

How big a part of the pensions landscape does the government want pension superfunds to be? Should insurance buyout be the dominant and primary endgame for private DB pension schemes, or do we want a balance between insurance buyouts and superfunds?

Answering this requires an understanding of how both buyout and superfund strategies could contribute to the government’s growth and investment agenda.

The potential of superfunds

Superfunds should be viewed merely as trust-based pension schemes that operate on a self-sufficiency (or run-on) basis, with a known and tangible financial sponsor rather than a corporate sponsor of inherently uncertain future strength. Investment, not derisking, lies at the heart of their business models.

They should be undertaking appropriate investment risk, backed by at-risk capital right throughout the lifetime of their members, because this optimises member security and outcomes – assuming excess returns are shared – reduces the cost of providing pensions, and potentially improves the prosperity of the country in which the members will retire.

Investment in real assets, infrastructure, building businesses, and buying property should be core to what superfunds do.

Patient capital can be deployed into assets that improve the country over the long-term, and into sustainable and regenerative projects in areas of the country left behind by larger funds.

The role of insurance

Insurance buyouts predominantly result in investment in gilts and bonds. A small amount can be invested in real assets, but usually the bond element of the financial structures of such assets.

These fixed income instruments do not provide the growth capital that scaling businesses need to invest, but they do finance UK government debt – in turn producing historically low returns, driving up the costs for sponsoring employers.

Relaxing Solvency UK rules would help, but there’s little sign at the moment that the Prudential Regulatory Authority has the appetite to do this.

More significantly, insurance buyouts drive derisking of DB pension scheme investment strategies, typically 20 years earlier than schemes operating on a self-sufficiency basis. This means they are far less helpful in providing investment capital to the real economy than superfunds or other pension schemes operating on a self-sufficiency basis.

The problem with the superfund gateway

The gateway as currently constructed would result in superfunds being a niche part of the market. In the last five years, only one superfund has been set up – Clara – and since it operates on a ‘bridge-to-buyout’ basis, it’s not delivering the benefits to the economy that self-sufficiency superfunds are capable of.

Construction of the gateway is draconian and arbitrary, as it prohibits superfund entry not only to schemes well enough funded to buy out, but may also be extended to those deemed to be likely to be able to buy out in the future, which can only ever be a matter of opinion.

It constrains the freedom of trustees to act in what they judge to be the best interests of their members. In a choice between a buyout and a superfund plus benefit enhancement, they must opt for the former.

The emerging gateway legislation might also prevent large ‘run-on’ schemes from converting to superfunds, forcing them into buyout.

We currently have £1.2trn in DB pension schemes. If superfunds become a niche vehicle, or bridge-to-buyout superfunds predominate, we might anticipate a market share of 5% to 10%, with £60bn to £120bn ultimately being made available for investment into the real economy.

If the gateway is widened, however, superfunds should be capable of attracting 25% to 50% of the market, making £300bn to £600bn available to the real economy, subject to profit extraction and prudential regulation also being appropriately addressed.

It also opens up to members the opportunity to be better protected from the uncertainty of sponsor support and to take advantage of the fruits of more productive investment, while protected from any downside by a securely ringfenced and accessible capital buffer.

Understanding systemic risks

If the entire £1.2trn within the DB sector, or the vast bulk of it, is channelled into insurance companies, which are all competing for matching assets as defined under Solvency UK, this will result in an excess of demand for particular assets over supply. This, in turn, creates potential systemic risks, adding fuel to the power of bond vigilantes.

Retaining both parts of the DB pension sector by spreading it between trust-based schemes and contract-based insurance policies will diversify risk and help to build on the existing strengths of the UK trust-based pensions sector. Properly regulated, superfunds should be able to innovate and develop new solutions such as profit sharing, collective defined contribution, and decumulation solutions for their members.

How do we prevent opposition from insurance companies? Easy! We permit them to set up superfunds operating outside their Solvency UK ring fences. If the commercial attraction to insurers of both solutions is equivalent, this would reduce if not eliminate the existing bias they currently have towards buyouts.

Such companies are natural providers of superfunds. They already have the administration, pricing and investment skills required, and doing so would help not just to re-energise the UK life insurance sector but could accelerate consolidation of the DB pension sector. There is a precedent for operating outside Solvency UK already in the ring-fencing of UK banks.

The swing factor for the real economy is between a quarter and half a trillion pounds available to invest in the real economy, and, if constituted properly, we can potentially incentivise half of this to go into the UK.

An important consideration for the government is what this would mean for the demand for future UK gilt issues. While demand would not go away, the government needs to ask itself whether it is serious about rebooting the UK economy’s growth and investment, or if its real agenda is having a captive buyer for UK gilts.

Ashok Gupta is the chair and founding director of New Capital Consensus