Hello everybody and welcome back to another edition of C&F Talks. It's my pleasure today to have with me Michael Aherne and Michael Jacobs, both of whom are Partners at Herbert Smith Freehills. They'll be speaking at our upcoming conference, The Future of UK Capital Markets Regulation, which is being held in London on the 11th of November. Welcome to both of you.

Thank you very much, good to be joining you.

And very much looking forward to the conference.

Very good to have both of you with us. Let's turn to the first question.

The Chancellor, Rachel Reeves, has been very vocal about the subject for your panel, encouraging investment in UK equities by pension funds and insurance companies. A surprising statistic that just 4% of the stock market is now held by pension funds in comparison to 39% in 2000.

I know that prior to that, the figure, the percentage was even higher. Why do UK equities have such a low and ever-decreasing weighting in UK pension fund portfolios? A couple of follow-on, if I may. One of the panellists is from Railpen, who currently holds 33% of their investments in UK equities. What more can be done to encourage other pension funds to follow suit?

It's a very good question, Maurice. To answer the first point, why do they have low and ever-decreasing weighting to equities? The answer to that is most schemes have closed, and I'm presuming here we're focusing primarily on DB schemes, but it might include DC as well. Essentially, since 2000, the majority of schemes have closed.

There's very few schemes that are open. Railpen is one of them, which is why it's got a much greater equity exposure. Because of the way that defined benefit pension schemes are accounted for, and because of those closures, the trustees of the schemes have been encouraged by the regulatory system, and the sponsors of those schemes have been encouraged by the accounting for those liabilities, effectively to manage their risk and look for end-game solutions, ultimately to target the winding up and buyout of the scheme, passing the liabilities on to an insurer.

The reason that we've had that is that the regulator has, as a result of corporate failures, BHS and Carillion being the main ones, leaving large defits in the scheme, which potentially then fall on the PPF, has encouraged schemes and sponsors to fund their schemes to a very prudent level, to take less equity risk, and to effectively target guilt-based funding. That's why you've seen pension schemes move into bonds and guilts. I don't think that movement has been put in place, and I don't think it's going to be halted.

There's some question as to whether you can encourage some schemes to run on, and continue not past their liabilities to insurers, but to manage their surpluses or their surplus assets to effectively target greater returns over and above the entitlements that members have, the benefits they're entitled to, to try and release surplus either to the members through discretionary increases to their benefits, or to the employers through return of surplus. That's quite difficult at the moment, and would require some legislative change. One of the things that actually wasn't within scope of phase one of the Pensions Reform Review, but Rachel Reeves at the International Investment Summit on Monday, and Emma Reynolds at the PLSA conference yesterday, inferred that they might be looking at this in terms of their interim report, is this idea of run on.

But I think, ultimately, the reason why is they're targeting those long liabilities with income streams, and ultimately passing their risk off to the insurers. And the insurers themselves then aren't looking at equity exposures, they're looking to match their liabilities through those long-dated liabilities.

I just add, I agree with everything Michael just said.

I think one of the implications of that is even when a fund is investing in equities, it's doing so on a diversified global basis. And so, the UK's proportion of global GDP is around 4%. And so, surprise, surprise, the correlation between what UK pension funds are investing is around 4%.

So, it's a kind of function of the push to diversification, also that means lower cost as well in terms of tracking using passive investment funds and that kind of thing. So, it's a combination of all these factors that are pushing down UK pension fund participation in the equity markets, which is being plugged by international investors. And that's obviously affecting the shareholder makeup of UK listed companies today, and also marketing on IPO transactions and secondary capital raises as well.

And I think the only thing I'd add to that is in the DC world, which is obviously where the new money is going in with automatic enrolment and growth, you've got boards of trustees that have to set the defaults under those arrangements, and they will have equity exposures. You do have equity exposure, but there they've got to balance up. Most will have some kind of UK equity exposure, but it's about the returns that they're getting on those risks.

And if you go to an all-world index that's providing a higher level of return over the last 10 years compared to a UK index that's producing a lower return, so there's a supply side issue here as well as a demand.

And I think there's, you know, a part of all this is the tax incentive structure and how that drives behaviour, because in other markets, you know, there are more tax advantage positions in terms of investing in domestic equities, which you don't see in this market, or at least you used to, and all those sort of privileges have been slowly withdrawn. And, you know, we have stamp duty.

So we actually, you know, there is a cost of capital in terms of trading in UK securities as well, that adds to the sort of frictional cost of capital for companies and also is a downside for investors. So it's all these things in the mix together collectively mean that UK has gone steadily down over time.

Maurice

So does that mean that the government's plans and the media speculation that we could suddenly have so much more money flowing into UK equities is simply misplaced, you know, accounting and regulation rules, the share of UK stock market of the GDP, global GDP, and the return point you just made. So is this something that really is going to deliver significant investment into UK equities? Is there any way it can be achieved?

I think, if you're just looking at a pensions fix, I don't think that's the answer. The government needs to look at the system as a whole. Indeed, at Herbert Smith Freehold, we ran yesterday, the second instalment of our investing in the UK sort of seminar reshaping the investment system.

And the purpose of that programme is to look at the investment system as a whole, not as a particular area. So I think the government has been doing stuff about looking around the listing rules. And it's said that it's going to look around planning reforms in terms of being able to get infrastructure projects off the ground easier. You need to look at it holistically

So if you're in Australia, for example, where they've got much higher flows of capital from pension schemes going into their home equity markets, there are deep historical reasons for that. One of them being that they do have, there are tax advantages for all Australian taxpayers in paying into Australian equities.

They get effectively income tax rebates on that, but they have a much higher retail kind of culture when it comes to retail investing. Which we used to have.

Which is slowly atrophied away. And I think the other point around what people are looking to invest in is the question of supply, as Michael was saying.

So we need the flow of new high growth companies to come to the market. We need the flow of credible infrastructure projects, the shovel ready things that the pension funds can invest in, because there is a question of is there enough supply. And there absolutely is, but you've got to plug the kind of gap to get these projects ready and off the ground and high growth companies scaled sufficiently so they're attractive to the public markets.

Plus there's the tax reform side of things. Plus there's the sort of listing rule reforms, which are almost concluded. So there's a huge range of holistic things.

But then there's a huge pools of capital in the UK in terms of the local government pension scheme arrangements that are currently coordinated to a degree through pooling. But then that could be taken to another level and that could provide a source of equity capital. There's huge unfunded pension commitments and the government has in terms of NHS and the army and the police that they could start to fund.

And that would provide a new universe of open schemes that would be able to invest in equity. So there is definitely a huge menu of options that the government has to try and do this. But I always come back to the point, we've got the second biggest pool of savings in the world outside of the US. They're just very disaggregated, very unconsolidated. There's lots of costs involved. There's lots of issues in terms of getting that capital into the right place.

And that's the broad emphasis of what the government's trying to do, which we're highly supportive. And this is obviously multiple governments because it was the previous government as well as the current government all trying to push in the same way.

Maurice

So is it that the, do you think the ambit, the scale of the reforms that the chancellor and others and the Capital Markets Industry Taskforce and so on, the initiatives in the private sector, do you think the ambit is sufficient? Do you think they are taking into account all the different elements that they might, or are there some which are being left unexplored?

I think they do. I think they get it. I do. I do think the government gets it.

And I think, you know, when you heard about Rachel Reeves at the International Investment Summit, she was talking about a more holistic approach about wanting companies to not only establish here, but list here. And they are looking at things like playing from. So I do think they get it.

We shouldn't underestimate the scale of the challenge, how complicated it is, even just on the pension side, you've got DB, you've got DC, you've got LGPS, you know, you've now got CDC with the Royal Mail, they're all, and each of those things has different sort of gating issues and complications. So I do think they're, they're approaching it in the right way.

We had, for example, the initiative around the British Growth Partnership, that will act as a vehicle, a co-invest vehicle with the government that could see the influx of money to allow more startup companies.

There's obviously a lot of detail there about who takes the risk there on first losses and things like that. Trustees fundamentally of pension schemes have a duty to invest prudently. Now, that doesn't mean risk averse.

In fact, prudently means you must take some risk, you have to take account of the risk return profile that you're doing. And I just don't think there's an easy fix. The Australian system, for example, in the Canadian system, the US system have taken decades, you know, the Carter reforms in the 70s that came through in the US laid a lot of the foundation for what it does.

It's not an easy fix. And I think one of the things, challenges is in the UK, there has been a tendency to use pensions in particular as a bit of a political football. When, for example, the Chancellor introducing the pension freedom reform, sort of taking your money and buying a Lamborghini rather than buying an annuity, or the protections that were brought in after the Robert Maxwell affair in the early 90s, you know, you're reacting because pensions are inherently quite personal to people and currently quite politically motivated.

If we can step back and have a broader consensus and approach, that might be a good step.

And I think, you know, the level, our level of employers' contributions globally are very low relative to other advanced economies. So we should absolutely be increasing that.

You know, and I think Australia is just going to 12% or something like that. So, you know, it's-

Already, there, yeah.

So it's, you know, that delta is huge. Those are difficult political decisions to make that people, you know, hopefully this government will start to make those difficult decisions.

Maurice

And difficult, I suppose, in the sense that we have a five-year electoral cycle and any government really from the word go has to consider where it's going to be in five years' time, which perhaps puts governments off in a longer-term reform where you're not going to see a degree of payback within that electoral cycle. But do you have the sense that this government's going to do that?

I mean, it certainly has the mandate to, well, it certainly has the base in parliament to do it. They will clearly be considering, they've got a way up. Obviously, they want to be, or signalling they want to be business friendly and encourage innovation and stuff like that.

But on the one hand, they're also introducing a new Bill of Rights, Employment Bill of Rights, that's introducing a lot more obligations on employers. If they do, you know, there's some suggestion they might take away some of the national insurance contribution savings on contributions into pension schemes for employers. And if you're doing that at the same time as ratcheting up the employer level of contribution, which I think everybody that looks at this in the industry and looks at adequacy, and I know adequacy is phase two of the pensions review, everybody looks at it and says, listen, we just, you need more money going into the pots.

And that was always envisaged as part of all talks came round, it was always envisaged that it would gradually go up. And these are difficult political decisions to make.

I do think there's a sort of general consensus that, you know, growth can't be funded by government or government debt, because there is a limit to how much, you know, guilts can be issued, right? And so there's got to be a partnership with the private sector and the infrastructure of private capital providers and pension funds and the whole universe of capital providers to partner with government.

I think that's their main objective is to deliver that partnership. So it achieves real scale and real improvements and drives growth and jobs. It's just some of these things are on a fuse, right? Because the AI revolution, you know, quantum computing, advanced manufacturing, there are windows of opportunity there, which the UK has an incredible legacy of university education, spin outs and history around that we could be leveraging and scaling up businesses to play into those sectors.

It's just, you know, the capital needs to be provided urgently. And if you speak to some market participants, and they say, they say it's pretty existential, we need to have that scale of capital now, we can't wait for pension consolidation to play out in 20, 30 years’ time, because we'll miss the boats. There is a big tension there, I think, in actually, that's going to short term need versus that long term planning.

Now, I think that's entirely right. I mean, we do a lot around AI and new technologies. And the opportunity is here and now. But there is obviously such a strong case for the longer-term reform, as you say, a systemic approach. But I wish we had more time to continue this, because it's a very interesting conversation. But I think our time is up.

So for our viewers, if you want to hear more on this debate on related issues and further discussion of these issues, please do attend the event, which is being held on the 11th of November in London, The Future of the UK Capital Markets Regulation Summit, and further information on our website, www.cityandfinancial.com.

Michael and Michael, thank you so much for joining us today.

Thank you very much.

Thank you.