How is pension consolidation likely to affect performance and growth?

UK government proposals to merge some smaller public pensions may improve their performance for beneficiaries. But the scale of this effect is likely to be limited, as is the impact on aggregate investment and the country’s rate of economic growth.

On 13 November, the UK government announced proposals to reform significant parts of the UK pension system. One of the largest changes is to local government pension schemes, which collectively manage about £392 billion, a total that is projected to rise to £500 billion by 2030. A further change is also proposed for personal pensions.

The government claims that the changes could ‘unlock’ £80 billion of investment to drive economic growth.

The motivation for the proposals is the UK’s disappointing economic performance since the global financial crisis of 2007-09. Although GDP per capita is an imperfect measure of an economy’s success, it provides a useful guide: in the period up to 2007, economic growth averaged about 2.5% per year; between 2007 and 2023 it averaged only 0.3% per year.

Further, not all of this fall in the growth rate is due to the financial crisis and the effects of the Covid-19 pandemic: the average growth rate for 2009 to 2019 (unaffected by either the financial crisis or the pandemic) was only 1.3% per year, still lower than the long-run average.

The government believes that one of the causes of this poor performance is low investment in the UK economy, and that pension funds could change their behaviour and raise overall investment.

Are the numbers really big?

It is useful to start by asking whether the numbers are plausible. Precisely what it meant by unlocking £80 billion of investment is unclear, but presumably it means an increase of £80 billion over five years.

Since annual investment (gross fixed capital formation) is currently about £480 billion in the UK, that would suggest increasing investment by about 3% a year. It is unclear whether this would have a significant effect on growth.

More importantly, the £80 billion of investment cannot be conjured out of thin air. Total assets of local government and defined contribution (DC) pensions are £1.3 trillion, so £80 billion would be 6% of total assets.

It is not the case that 6% of pension assets are currently lying around idle and just need to be directed to useful investment. At best, pensions could be reallocated from one type of investment to another, but the marginal effect of that would be small unless pension funds made considerable changes in the type of assets that they hold.

How pensions work

The concept of a private pension is very simple: during their working lives, individuals (at that point, employees) make contributions to savings funds (that is, pension funds); during retirement, the individuals (now pensioners) receive an income from that fund.

But there are differences in the terms of the pension. Local government pensions are defined benefit (DB): contributions go into a pot shared by all employees and the income received in retirement is based on a formula linked to an employee’s own individual salary. If the savings fund is insufficient to pay this income, the employer (that is, the local government body) must make up the difference.

Personal pensions are defined contribution (DC): contributions go into individual savings pots belonging to each individual. There is no guaranteed income in retirement and the employer has no obligation to make up any shortfall.

To manage a DB pension fund, it is necessary to invest in a range of assets. Some of the most promising investment opportunities require costly monitoring and evaluation, so there are economies of scale.

Without the ability to monitor effectively, funds may resort to investing in safer low-return investments, but this will result in poorer investment performance overall. A key strand to current government thinking is that this is a significant problem that needs to be solved in the UK local government pension sector.

Note that the total costs of managing and administering local government pension funds in the financial year 2023/24 were just over £2 billion, which is low relative to the total assets being administered. As a result, there is very little scope to cut costs: the objective is to get more efficiency in deciding where to invest.

Consolidating funds

Currently there are 86 local pension funds across England and Wales – some are managing as much as £30 billion and some only £300 million. There is clearly scope for some consolidation, but it is unclear how much this will lead to improvement in performance.

Some of the schemes are already quite large and some of the medium-sized schemes are already achieving economies of scale by pooling their funds. For example, ten different local authorities in the West Country invest via a fund called Brunel Pension Partnership, so merging these schemes might make little difference.

The government does not say what proportion of total pension assets is held by the smallest funds, but it is obviously the case that they hold a relatively small share. A very high proportion of assets is held in the largest funds where the potential gains from efficiency savings is relatively low.

Pension allocation and member type

The second issue is whether local government pension funds are incorrectly investing their funds. Consider Table 1, which shows the types of members for all local government funds in England and Wales.

Table 1: Local government funds in England and Wales, by member type

England and Wales, local government pensions	2023-24
Current employees	2,155,000
Former employees, not yet retired	2,464,000
Pensioners	2,098,000

Source: Ministry of Housing, Communities and Local Government, October 2024; ‘Local government pension scheme funds for England and Wales: 2023 to 2024’.

Only one-third of members are current employees making contributions into the pension fund. Almost as many members are drawing a pension.

In a DB scheme, the terms of a pension cannot be varied once someone has retired and there are restrictions protecting former employees who have not yet retired (and who will not be expected to make further contributions).

Standard financial models conclude that the optimal investment portfolio depends on the composition of members, in particular current employees still making contributions versus pensioners. For relatively mature funds with a high proportion of pensioners, it would be conventional to hold some low-risk assets, such as government bonds.

Government bonds are not the only relatively low-risk assets. Infrastructure is often cited as an alternative asset that can bring secure returns as it is usually an essential good and hence demand is stable.

Perhaps the most obvious essential good is the provision of water, but another large private pension, the Universities Superannuation Scheme, is reported to have written off almost the entire value of its £1 billion holding in Thames Water. The experience of other projects, such as the HS2 railway line, suggests that pension funds that validly wish to hold some low-risk assets should be wary of infrastructure.

Conclusion

There is scope to improve pension fund performance by merging some of the smaller local government pension schemes and holding other assets. But large changes to pension fund assets may be inappropriate and it would be optimistic to expect large improvements.

The primary purpose of pensions is to provide a secure income in retirement. This means that it is unlikely that changes to the pension system will dramatically improve the UK’s rate of economic growth.