Dear Laura Trott,

We are writing in relation to the collection of announcements that were made as part of the Chancellor’s Mansion House speech on 10 July 2023. Please take on board these comments as part of your calls for evidence on options for DB pensions and trustee skills and duties. We are particularly interested in those announcements that relate to the UK pensions industry. We are supportive of the movement to review the structure of the UK pensions industry and consider whether there are ways this could be improved. We are also supportive of discussions around productive finance but believe it is integral for any definition of productive finance to incorporate sustainability. When reviewing the UK pensions industry, we think there is a particular importance for focus to be made on the following areas:

1. How the pensions industry can increase the impact of its investment on the social and environmental sustainability of the UK and global economy
2. How intergenerational inequality can be addressed within the pension industry.

In this letter we set out why these two themes are so important to the UK economy and pension scheme members, and how the ongoing calls for evidence and considerations that the UK government are looking into can support progress in this area.

Sustainable investing in pensions

There is significant evidence¹ that the success of our global economy is dependent on meeting the broad range of UN sustainable development goals. In particular, there are expected to be devastating societal and financial impacts if we do not meet the global net zero goals we have in place. To meet these goals, including the UK’s own net zero goal, a significant amount of investment will be needed.

We believe that private DB pensions should be able to provide a source of investment for this. Private pension funds are often large, long-term investors who will be affected by the systemic risks to the economy that sustainability-related factors like climate change and social inequality pose. It is therefore within the best interest of private DB pension fund members to invest in a way that aligns with positive sustainable outcomes.

However, in the UK, we do not currently see private pensions providing sufficient levels of investment in areas that drive forward sustainability goals. Many of the sustainable impact investments we would like to see private pensions contributing to fall under the equity and private markets asset classes; for example, technology to facilitate the transition to a net zero economy, renewable energy and infrastructure, and other social impact funds.

Private UK DB pension schemes (which consist of over £1trn of assets) do not currently hold a significant level of their investments in these asset classes, which represents a huge missed opportunity.

This is due to the trend towards de-risking that we have seen across the UK DB private pensions industry. Funding levels of DB schemes have significantly improved over the past decade, and under the current rules Trustees who manage these schemes are expected to reduce target investment returns as schemes mature. Trustees also have little incentive to generate any additional returns once pension schemes become fully funded. This means that they often invest inefficiently, holding very low risk assets that do not contribute to improved sustainable outcomes.

Many of these pension schemes have plans to be passed on to an insurer. To get themselves ready to be passed to an insurer, they need to ensure that they are invested in asset classes that the insurer can accept: these are generally very low risk assets like gilts and corporate bonds, which again, do not contribute to sustainable investment. This means that, even if the insurers they end up transacting with invest in sustainable impact funds themselves, there is a period of time before this transaction takes place where the assets are not being invested in this way. This period of time is likely to cover the next few years, and so is a very important period - we need to see our greenhouse gas emissions halved by 2030, so it is concerning if the money and investment is not being put to use to help do this. Once a pension scheme’s assets are with an insurer, there are also limitations to the sustainable impact investments that the insurer can make due to Solvency II regulations.

We believe this lack of sustainable impact investing from UK DB pensions is one that could pose a serious systemic risk to the UK economy, and so should be addressed.

Fiduciary duty

In addition to the structural issues within the DB pensions industry set out above, another issue that may be limiting the actions that trustees take on sustainability hinges around the current interpretation of fiduciary duty. At its most basic level we believe “fiduciary duty” is a well understood concept. The core principle that trustees must act in the best interests of members is deeply embedded in trustee thinking.

However, there are naturally varying levels of understanding of some of the more legal/technical debates concerning the nature of “best interests” and the timeframe over which this is considered, which means that some trustees may be more cautious about taking certain factors into account. We understand that the Department is reviewing this area as part of its stewardship review this autumn. We believe the concept and legal interpretation of fiduciary duty in relation to stewardship and in particular climate change, should be urgently reviewed.

In terms of timeframes, we believe the phrase “financially material considerations over the appropriate time horizon of the investments”² can create barriers to trustees taking non-traditional factors into account beyond the (often) short time period to a buyout transfer to an insurer (for DB) or over the working lifetime of members (for DC). In practice, super long-term factors (e.g. 50 year long-term future UK economic growth, and climate change risk) will also financially impact the members of pension schemes (and their families). In our view, this is an area of fiduciary duty that merits clarification.

We also believe there should be clarification within the definition of fiduciary duty that trustees may have regard to the real-world impact of their investment decisions, not just the impact that external ESG factors have on their scheme’s investments. This is relevant not only because those real-world impacts will take place over their members’ lifetimes, but because they will have an impact on the stability of financial systems – and thereby the security of pensions – long before the worst impacts of e.g. climate change (if left unchecked) may be felt.

Our view is that pension trustee fiduciary duties should be reframed to enable pension schemes to contribute to broader climate and societal goals in order to act in their beneficiaries’ ultimate best interests.

Intergenerational inequality in pensions

We have serious concerns about the societal risks we could face due to inequality. Intergenerational inequality is a particular concern in the UK, and this will be exacerbated over the coming decades due to inequality in pension provision.

There is a key difference in demographics of members of private UK DB pension schemes and UK DC pension schemes. UK DC members are generally a younger part of the working population, whereas UK DB members tend to be older, and often already retired. There is a clear risk here that the pensions system currently upholds systemic intergenerational inequality which could pose a number of knock-on risks to society and the economy.

While members of UK DB schemes are promised a steady stream of income in their retirement, UK DC members have to rely on the pot they and their employers contribute to over their working lifetime building up to a sufficient level to provide them with the money they need for the rest of their life once they retire.

The PLSA³ has conducted research and found that based on current levels of contributions to DC pensions, the majority of DC members are not projected to have enough money for an adequate standard of living in retirement. Indeed, contributions based on auto-enrolment minimums are not expected to provide a sufficient income to DC members in retirement.

Safe retirement outcomes are needed for all generations, and so more DC contributions need to be made to these schemes, in addition to other actions such as ones around financial education. We believe that recycling surpluses from DB schemes that are now “over funded” into DC funds should form an important part of the social contract between generations, to ensure that intergenerational inequality is addressed. 

A potential solution

We believe that there are solutions that can be implemented by the government and the wider industry to address these issues. In particular we are supportive of LCP’s proposal for Protection Supporting Prosperity, which they have set out in more detail here.

This idea proposes that a new opt-in part of the PPF is introduced for well-funded private DB pension schemes, whereby these schemes will pay an additional levy in order to receive 100% protection for their DB member benefits in the event that the pension scheme sponsor becomes insolvent. These schemes would also be allowed to extract surpluses generated by the pension scheme above a certain level to be extracted (eg to be used to increase DC savings).

This full protection combined with the ability for surplus to be extracted would provide trustees with the incentive structure needed to invest in a way that generates higher returns while still ensuring they are meeting their duty to protect their DB member benefits. These schemes could then invest in a way that delivers long-term sustainable impact, generating additional returns and contributing to positive societal and environmental outcomes. We would recommend that any surpluses generated are used to improve DC contributions to address our concerns around intergenerational inequality.

We believe that this solution would meet our objectives of providing investment in long-term sustainable impact opportunities, address intergenerational inequality, all while protecting current DB members’ benefits. 

Other actions to support sustainability and equality in pensions

We think sustainability and equality can also be addressed in other areas of the Mansion House announcements.

We would encourage the considerations around trustee capabilities and duties to align with long-term sustainable outcomes, as per the Principle for Responsible Investment’s response to this call for evidence⁴.

We are supportive of more DC money being invested in unlisted equities, and of more LGPS investment pools being encouraged to invest in UK productive finance, but would encourage such investments to be focussed in sustainable areas, such as green technology that is required to facilitate the transition to a net zero economy.

We are also supportive of the British Business Bank doing more work to provide investors with the investment vehicles needed to contribute to sustainable, productive finance.

Conclusion

We are supportive of the idea of incentivising pension schemes to invest in productive finance, but believe that such investing must support sustainable impact. We think that sustainability risks like climate change could pose major risks to the stability of the UK economy, and so need to be addressed on a large scale. We have serious concerns about the looming intergenerational inequality in the UK, and the contribution of unequal pension provision towards this, and support ideas to use DB surpluses to pay additional DC contributions, in order to address this.

Whilst these are considerable and difficult challenges, we believe that through collaboration across government, regulators and the pensions industry, solutions can be found that will greatly improve the prospects for retirement savings, the UK economy and the sustainability of our planet.

Co-signed by Charlotte O’Leary, CEO, Pensions for Purpose

Steve Hodder, Partner, LCP

Laasya Shekaran, Consultant, LCP

¹UNDP: Business and the SDGs, PRI: SDGs driving macroeconomic growth

²The Occupational Pension Schemes (Investment) Regulations 2005, 2(3)(b)(vi)

³PLSA: 5 steps to better pensions

⁴PRI: Response - DWP/HMT Call for Evidence