Table of Contents
Summary
Savings in pensions are a key funding source for science and technology firms. This is because the long-term investment horizon of pensions makes them better suited for high-risk, high-reward investments like venture capital (VC). VC is a key form of finance for science and technology firms, which often need to make large investments in hardware, facilities, intellectual property and staffing, well before they can bring a product to market. But the UK’s pension market isn’t investing.
This has been the case in the UK for decades. In 2000, Gordon Brown declared that “Britain as a whole has lagged behind America in business access to VC investment”; yet more than twenty years later, only 10% of the UK VC pool comes from pensions, compared with 72% in the US.
This means that UK firms are losing out on a critical source of capital. It also means that pensioners don’t benefit from the enormous growth achieved when businesses scale successfully.
Unlocking these investments will require the Government to impose new regulatory requirements on pension firms using existing legal powers. This would involve creating new investment structures and enforcing a regulator-defined performance and allocation benchmark for default pension options, preventing UK pension firms from continuing their current practice of benchmarking themselves against an under-perfoming UK market.
This should ensure that the UK's pension system invests as much in VC as comparable countries like Australia, Canada and the US, and should also raise investment performance to the higher level seen in those countries.
Challenge and Opportunity
Science and technology firms are typically cash-intensive and require “growth capital”: deep pools of funding. Public funding cannot meet this requirement due to the sheer volume of funding required. For example, the combined annual budgets for various government initiatives supporting high-risk commercial ventures—including the annual budget of Innovate UK, the multi-year Long-term Investment for Technology and Science, the Life Sciences Investment Programme of the British Business Bank, and the one-off Future Fund: Breakthrough—total around £1.5bn. In contrast, private venture capital (VC) invested in UK SMEs amounted to £16.7bn in 2022 alone.
The UK largely keeps pace with the US on early-stage investments (adjusted for economy size), but lags far behind when it comes to later-stage firms that are scaling up. For firms this means that the UK is, on the whole, just as successful as the US at funding newer, less-developed businesses, but struggles to finance more advanced companies, especially those scaling up activities like hiring or building new facilities.
Figure 1: UK and US average annual overall funding levels by investment stage (2017-2022)
Where is the missing money for late VC and scale ups? In the US, pensions are the most significant source of funding for startups. They are the source of 72% of all VC funding. In the UK, pensions contribute only 10%.
Figure 2: UK and US proportion of commitments made venture capital by funding source, 2017 – 2021
Source: British Business Bank
The ultimate source of this missing money is in the UK’s pension system. An international comparison of pension funds shows that UK Defined Contribution (DC) pensions underinvest in VC. Of the five largest Canadian and US funds, 21% and 13% of their assets were allocated to growth capital (private equity and VC) respectively. Australian pensions allocated 4.6%. However, the very largest UK DC pension schemes allocated just 1.4% to growth capital. Data published in 2023 showed an industry-wide average across the largest pension schemes of just 1% invested in VC, with earlier data showing that roughly two-thirds of all UK DC pension schemes had no investment from their main funds in this category at all.
Figure 3: UK and international pension fund allocation to private equity
Source: Fund annual reports
To support the UK’s successful science and technology sector and the economy overall, pensions must invest more in VC. The rewards for getting this right are enormous: diseases could be cured, computing revolutionised, and the world’s hardest problems solved with technology invented in the UK. This innovation would also drive job creation and economic growth.
Pension systems in Canada, the USA, and Australia have higher returns on average than UK schemes, despite having far higher rates of VC and private equity investment. There is therefore no contradiction between this kind of investment and higher returns. In fact, UK savers would benefit from capturing investment returns of rapidly growing firms, leading to stronger savings accounts and more comfortable retirements. Moreover, it is vital for its economic security that the UK plays its role in the intensifying global technology race; failing to do so would increase reliance on other countries for key strategic capabilities. The Government must act as quickly as possible.
The lack of investment in VC by the UK’s pension sector is not caused by direct regulatory or organisational barriers. This has been repeatedly confirmed by reviews and analyses from the UK’s legal and investment sectors, Government departments and regulators:
Law Commission: “We have not identified any legal or regulatory barriers to investment in [venture capital].”
Investment Association: “Structures exist for [pensions firms] to access [venture capital] effectively.”
Treasury: “The current [lack of investment in venture capital] appears to result from accepted market practice rather than regulation and adds to a short-term investment perspective for these pension fund products.”
Department for Work and Pensions (DWP): “…There have been some long-held beliefs about barriers to development of UK DC pension scheme investing, and a range of long-established investment practices. Together these have acted as barriers to DC schemes investing in [venture capital].”
Instead, a poor culture within the pension industry is causing low investment in VC. This manifests itself in several ways.
The first issue is pension funds’ focus on minimising costs, even at the expense of return on investment. Pension funds pay fees to financial institutions and advisers who handle their savers’ money, with the annual fee for firms’ most popular products capped by law at 0.75% of total assets. Fees for growth capital tend to be higher than other asset classes. As a result, the emphasis on keeping handling fees low rather than maximising returns can hinder these types of investments. A joint consultation by the DWP, FCA, TPR found that “at the largest end of today’s workplace pension market, we know that short term cost dominates decision making.”
Further evidence of cultural problems within the UK pension industry can be found in its lack of ambition and benchmarking. UK pension funds starkly underperform compared to international peers, but they do not measure themselves against them. Over the past five years, the average large pension fund in the US, Canada or Australia has delivered annual growth that is 56% higher than their UK equivalents, with the UK averaging 4.4% growth per year compared to an international average of 6.9%.
Figure 4: UK and international pension fund five year performance, 2018 – 2023
Source: Fund annual reports
Plan of Action
To address these issues, the next Government should use existing powers to change the regulatory framework in which the UK’s pension system operates. This is especially critical for the ‘default’ pension options— the investment strategy applied when savers do not express a specific preference—into which the overwhelming majority of DC pension assets are invested.
The Government should amend the Occupational Pension Schemes (Investment) Regulations 2005 (which cover the functioning and obligations of the UK’s DC pension landscape) so that they:
Benchmark the net performance and asset allocation of default pension options against a regulator-defined international composite of funds. This would include large pension funds in comparable countries, such as Canada, Australia and the US. This will ensure that UK pensions can no longer under-perform international comparisons, and must consider that pension funds in other countries invest far more in assets such as VC.
Require DC pension trustees to consider fees in the context of net returns, rather than fees alone. To prevent pension trustees from only considering the fees that they are charged by investment managers, they should instead consider return on investment net of fees over the expected duration of the investment itselfs. This will bring the UK system in line with that of the Canadian and Australian systems, which for instance require pension trustees to “maximise rate of return, without undue risk of loss”.
These regulations can be changed through statutory instruments issued by the Department for Work and Pensions (DWP). The regulations have themselves been regularly updated by DWP, with the most recent changes taking place in April last year. Subject to consultation and other procedural requirements (as well as necessary legal drafting and advice to ensure there are no unintended consequences), statutory instruments can be issued immediately at no cost to the Treasury other than civil service resources.
FAQs
Why do UK pensions underinvest in growth capital?
This briefing covers DC pensions, which are the kind of pension that most working age people have. DC pensions are where you and your employer contribute to a pension pot, which is invested on your behalf over time. When you reach retirement age, you are entitled to the sum of everything invested, as well as any investment growth. Approximately £18bn was added to DC pension schemes in 2022. This number is expected to rise to £67bn per year over the next decade.
There are two fundamental problems with the UK’s DC pension landscape: cultural barriers reinforced by regulations, and a fractured market. The former is described above. The fractured nature of the market means that many pension schemes are too small to invest in assets like VC, as the pension funds themselves lack the expertise to be able to safely invest. However, there are a number of large DC pension funds in the UK with tens of billions of pounds of investable assets, and despite their scale they still do not invest in venture capital.
DC schemes are different to private Defined Benefit (DB) pensions, which older people in the private sector and public sector employees will tend to have and contain the majority of the UK’s pension wealth. DB schemes typically offer indefinite and guaranteed annual payments to scheme members (who often are or were employees of a specific company connected with the scheme) once they reach retirement age. These are funded through contributions collected from the individual and their employer throughout their working life and invested on their behalf by the scheme.
However, many of these schemes have been closed for some time, meaning that the average age of savers in DB schemes has increased significantly. As a result, these schemes are less suited to high risk, high return investments like venture capital.
What else can the UK do with pensions?
In addition to addressing cultural barriers via targeted regulatory change, the Government could also take action to consolidate the fractured DC pension landscape. The current landscape is fractured as tens of thousands of small businesses set up individual workplace pension schemes and manage themselves, rather than using a large pension firm. This results in a large number of pensions managed by relatively under-professionalised trustees, and who do not have the experience or skills to allocate money to assets such as venture capital or private equity. In 2022, these smaller schemes contained more than £100bn of funds.
Consolidation would allow these savings to benefit from scale and be invested in higher-growth assets like VC. To encourage consolidation, the Government should offer a time-limited tax credit for funds that consolidate. This could apply to any small pension funds that commence consolidation within three years and offer a credit to smaller pension funds per member, with the credit per member decreasing as the pension fund increases in size. This could be relatively cheap, for instance £500 per member for pension funds with fewer than 12 members, and £200 per member after the first 12 for pension funds with fewer than 5000 members, which would cost a maximum of £300m.
Does investing in growth capital risk pensioners’ incomes? Isn’t this just trying to give money to a political priority?
Absolutely not! Pension systems in other countries, such as Canada, Australia and the United States all have far higher investment in growth capital than the UK. Over the past five years, the rate of return on pension investments in these countries have been 56% faster than UK pensions (Figure 4) meaning, if anything, higher growth means pensioners in those countries will be better off than in ours.
This means that, if invested carefully and sensibly, there is no contradiction between putting money into growth capital like private equity or VC and having a secure retirement.
How do our peer countries (e.g. Canada) incentivise investment in growth capital?
The problem for the UK isn’t that we have insufficient incentives for pensions to invest in growth capital. It’s that we have a number of cultural barriers—supported by the existing regulatory framework—that means pension trustees are pointed away from growth capital.
Consider the perspective of the trustee of a DC pension—these are the people that are responsible for deciding which investment firms receive the money of those in the scheme. These trustees are receiving pitches from investment managers to handle their funds. The current system is set up to ensure that these investment managers compete against each other by boasting of their low management fees: not by delivering long-term returns. So the pension trustees are presented with a range of options, and they choose the one with the lowest cost. Because VC is a more expensive kind of financial asset to invest in, providing a low-cost investment plan means excluding these assets from your strategy, even if it would provide more investment growth in the long term.
That’s why we need to change the regulatory framework in which these decisions are made. Investment firms should not over-prioritise having the lowest fees; they should be competing to deliver the highest possible net return for savers. Pensions trustees should not be judged by how effectively they can bring fees down, but rather by how well they can grow savers’ money.
Zachary Spiro is a Policy Fellow at Onward. He is also a Manager at the strategy consulting firm Flint Global. He specialises in R&D policy, emerging technology and economic security, as well as the UK’s relationship with China. Prior to Flint, he worked as a Parliamentary Researcher for Sir Bernard Jenkin MP, in his capacity as Chair of the Public Administration and Constitutional Affairs Committee.