By Andrew Smithers
Published by the NIESR in their Autumn 2024 UK Economic Outlook on 6th November 2024.
Introduction
This box picks up on two sessions of discussion involving an invited group of those working in financial services, organised by the NIESR, and a paper I wrote setting out the key issues and explaining their implications. In this box, I list the issues and summarise the specific points that arose in their discussion.
Issue 1. Should savings for retirement be encouraged? If so, is enough being done? If not, how can we do more without government cost?
Issue 2. Should pension funds be encouraged to help the financing of infrastructure, startups or second stage finance?
Issue 3. Has the regulation of pension funds led to relative weakness in UK share prices? If so, has this damaged the UK stock exchange and the United Kingdom as an exporter of financial services? Can this be rectified without government cost?
Issue 4. As equities give higher long-term returns than debt instruments, lengthening the time horizon of pension funds should benefit retirees. Is this desirable, can it be done and, if so, how?
1. Pension Regulation
Many countries have pension problems, but the dramatic change from a successful to a failed pension system seems unique to the United Kingdom and is central to each of the four questions. We cannot return to the days when immature defined benefit plans dominated UK savings. But we can and should halt the negative impact of bad regulation on those that should remain or be created. The mismeasurement of liabilities has been the most damaging aspect of regulation when this has done by reference to the risk-free returns available from index-linked government debt of matching duration to those liabilities. The underlying assumption for this is the Efficient Market Hypothesis (EMH) which has been largely discarded by economists.
Pension liability measurement, using the EMH, has done much damage and is still capable of doing more. It has caused the switch in UK defined benefit plans’ portfolios from equities to debt causing serious problems. It is therefore important that it should stop and be replaced by an alternative method of valuation. As the new method must have sufficient authority to avoid exposing those who use it to legal risks, it requires government backing and the intellectual support provided by detailed analysis.
2. Directing Savings Flows
Growth requires large and well-directed flows of savings and investment. It is generally agreed that governments are entitled to encourage the outcomes they deem desirable and that doing so can include tax incentives. Mandatory direction is, however, both unwise and unacceptable, as it might damage the returns to savers and, if it did, the government would be accountable.
3. Infrastructure, Startups or Second Stage Finance
That financial markets are failing the economy has been a regular concern (The Macmillan Gap) at least since 1931. If tax concessions are to be made, they should first be applied to boosting the tangible fixed capital investment spending of the corporate sector rather than to any sub-sector of it.
4. National Debt and Crowding Out
Public sector investment has now become a major issue and, applying the same principle of not favouring one form of capital spending at the expense of another, it should be encouraged providing it is not at the expense of private sector investment.
Public sector investment can be financed either from increases in domestic or foreign savings, with the rise in savings coming from either lower household consumption, or lower public sector consumption or an increase in the current account deficit. As there seems no likelihood of cuts in government spending, the practical issue is between raising taxes on consumption and increased borrowing. There is growing support for a larger deficit, but it raises the problem of crowding out.
At any time, households have preferred ratios of equity/debt assets so, if increased issues of government debt raise the amount and cost of debt, the amount that companies can borrow at any given level of interest will be smaller. Companies borrow less and invest less when bond yields rise. As the increase in income arising from new investment is likely to be a multiple of the additional interest paid on debt, a rise in the current account deficit (ie, borrowing from abroad) to finance either public or private sector investment is probably desirable unless the impact on interest rates is not large and the problem of crowding out avoided. It follows that the fiscal and balance of payments deficits should not be limited by arbitrary ratios to national income but, to offset the negative impact of crowding out, any relaxing of fiscal restraint should be used to boost private as well as public sector investment. This requires either an increase in the subsidy on new investment or a reduction in the tax on it.
5. The Problem of Equity Returns and Time Horizons or
Subject to one crucial proviso, defined benefit plans compared with defined contribution plans have the virtue of a long time-horizon. Equity returns exhibit negative serial correlation with the result that the risk that investors run of receiving a bad return from them falls much faster than that due simply to the efflux of time. (It is this characteristic which has been neglected by those who have valued pension liabilities with reference to risk-free rates of interest.) The proviso is that the risks for defined benefit plans can be misjudged. These decline with a fund’s duration, and this is determined by the membership. As equity returns are habitually much higher than returns from debt instruments the pension secured for any given level of contributions will usually be much greater the higher the equity ratio. Well constituted defined benefit plans can have higher equity ratios than defined contribution plans for the same risk exposure. It does not follow that in aggregate UK defined contribution plans have a lower exposure to equities than would be appropriate if their owners were members of a well constituted defined benefit plan. The risk exposure of many defined contribution funds may well be much higher than their owners understand. The volatility of asset prices over extended periods causes intergenerational inequity. Those who have benefitted from exceptional high returns over one period are matched by those who suffer over another. The volatility of asset prices over extended periods causes large and undesirable swings in intergenerational welfare, which are greatly reduced by defined benefit plans which have a long time-horizon. The government should therefore encourage pension schemes which have them and this involves preferring industry-wide schemes to those based on single companies and avoiding the regulatory errors that have beset industry-based schemes in the past, for which the problems of The Universities Superannuation Scheme stand out as a sad example.
It should be noted that success in encouraging funds to hold equities reduces their ability to hold bonds. This has the same effect as crowding out and thus amplifies the need for increased subsidies or lower taxation on private sector investment.
6. The Perceived Undervaluation of UK Quoted Companies
UK investors were largely invested in UK shares in 1979 due to exchange control and the market was dominated by defined pension funds. A shift to debt assets was likely as corporate schemes matured but has been greatly accelerated by regulatory mistakes and misvaluations of pension liabilities. This caused the formerly dominant holders of UK shares to be persistent sellers and the assumption that this drove down the relative price of UK shares is too reasonable to be lightly dismissed.
If this view is correct, there is a strong case that the result has been against the UK national interest because:
(i) Undervalued share prices enable foreigners to buy UK shares cheaply. This is particularly damaging today as the United Kingdom is a net importer of capital.
(ii) Undervalued share prices damage the standing of the London Stock Exchange which damages the United Kingdom’s ability to export financial services.
Even if correct it will, nonetheless, be difficult to put right without authoritative analysis which must be based on accurate long-term data on real equity returns and Price-Earnings (PE) multiples. These are unlikely to be currently available given published data probably have major defects, which include large errors in the calculation of corporation tax and withholding taxes on dividend income. Another smaller problem is the absence of PE data on banks before the 1960s. It will also be difficult to make a correct allowance for the impact of capital destruction in wartime and possibly from losses arising from domestic and foreign government confiscations.
Financing such an exercise would be expensive, but not when compared with its potential benefit to the United Kingdom and the London Stock Exchange.
7. Conclusions
1. The regulatory and other errors resulting from the misvaluation of pension liabilities should be ended. A new approach requires government backing and the intellectual support provided by detailed analysis to avoid exposing those who use it to legal risks.
2. Governments are entitled, for example by tax incentives, to encourage savings to flow in directions they deem desirable. Mandatory direction is, however, unwise and would be strongly opposed by the financial services industry.
3. If new financial sources or tax incentives are introduced to offset the perceived failings in financial markets, these should not benefit one industry at the expense of others.
4. If increased public sector investment is financed by additional government borrowing, the negative impact on private sector investment should be offset by using part of the increased borrowing to reduce the taxation of private sector investment.