Moral Hazard haunts the corridors of power

I read this morning some more of a plan to mandate pensions to invest in the less liquid opportunities presented to them in the UK. We know the plan – it involves our savings and it is a hot topic in Westminster and in elevated pension circles

Joseph Mariathasan asks

“Can the country turn a flawed investment ecosystem around?

He claims that decades of complex legislation have fueled many unanticipated consequences, which have seen pension funds invest less in riskier listed equities and illiquid assets.

Last year pension schemes shed around of £550bn of assets pursuing these “less risky” strategies.  This blog is about Government intervention in investment markets and why it runs the risk of creating a moral hazard.

Why Government interventions are themselves “risky”

Only 7 months ago, the Bank of England intervened to bail out pensions that had over-invested in certain  types of  gilt by borrowing on the secondary markets, “fueled” by a Pensions Regulator , zealous to de-risk but lax in testing whether borrowing to buy gilts was a risk-free strategy.

In its reports following the LDI debacle, the Bank of England  points to the way investment funds that invest in the markets that everyone from the City of London’s Mayor to the Chancellor of the Exchequer is calling on pension funds to invest in  – as also using secondary banking to enhance returns, through borrowing.

With perfect timing, Aoifinn Devitt arranged a meeting of the great, good and me to discuss “moral hazard” in investment markets. My friend Con Keating was one of a panel presenting.

In economics, a moral hazard is a situation where an economic actor has an incentive to increase its exposure to risk because it does not bear the full costs of that risk. For example, when a corporation is insured, it may take on higher risk knowing that its insurance will pay the associated costs.

Example one; pension schemes take on risk through LDI knowing that the Pension Regulator is behind them and if things go wrong they can expect the Government to bail them out

Example two; pension schemes take on risk investing in UK private markets knowing the Treasury and DWP are behind them and that the Government will bail them out if the investment goes wrong.

A shot to nothing

There is a much more sophisticated argument being put forward by Con Keating which I will let him rehearse, but put in terms that  I can understand, when Government intervenes in markets to encourage risk-taking, it has an added duty of care to those taking the risks.

The duty of care with regards LDI  is assumed to be to pension schemes and the burden the failure of LDI would place on sponsoring employers. Actually, the BOE appeared more concerned about the integrity of the gilts market which looked at one point to have seen yields spiral out of control. One thing for sure, the BOE’s intervention  was not about protecting member’s pensions

The duty of care relating to private equity funds, is to ensure that members of DC workplace pensions – the planned investors in private markets, do not suffer a second hit in the value of their funds (many are still suffering from the impact of 2022’s market falls).

Trustees and funders may consider such investments “a shot to nothing” as they are only following orders in using their member’s money to boost economic performance.  But this is not the case, they have a fiduciary duty to members who have no guarantee that they will be protected from Woodford-like funds that do not do what they say on the packet.

While Woodford investors may be considered capable of doing their own due diligence , the same cannot be said of those saving into workplace pensions. They rely heavily on their employer to choose their scheme, their trustees to protect their interests and on the system to provide them with proper pensions. Much of this expectation may be misguided – that’s because of understanding of what’s going on – being weak.

In 2015 , 30% of polled members of Nest thought Nest would buy them extra state pension. Therein lies the problem with Government backed pension initiatives, they almost always creates an expectation that leads to moral hazard.

The Government must do more than nudge and coerce.

So far, the Government has done little to improve the security of members investing in private markets, except create a new investment vehicle called the LTAF which enables such investments to sit on the insured investment platforms that many workplace DC schemes sit.

It does of course run two large funded pension schemes that could seed a Government run investment scheme, along the lines that The Mayor of the City of London wants set up. They are Nest – for DC savers and the PPF for members of DB schemes who lose their sponsor.

If the Government is going to create such a fund , then it risks creating another expectation that such a fund will meet the expectations of those who use it (the members of DC workplace pensions for instance). This is like the issuance of Covid loans.  Unless the Government and private sector can do the due diligence on those lent to or invested in, the new fund becomes a non-underwritten version of innovate UK. If it competes for opportunities with private equity managers, it risks driving away the good private equity managers who will seek opportunities overseas.

These are the dilemmas facing the Government and I can see no easy way of solving the problem other than through the simple measures that we will hopefully see emerging from the VFM consultation. We must test performance, we must test the transparency of the costs incurred and we must test the quality of service offered by the funds – liquidity, accurate and timely valuations and so on.

It is right to be skeptical

There are models around the world where DC investors have benefited from investing in private markets. The Australian Super model is one, the US and Canada have harnessed the power of their large pension schemes to access private markets – including in the UK – successfully. We have a former shadow pension minister here to help us understand how the Australians did it. There are Private Equity managers who have helped reshape the LGPS into the investment powerhouse it has become.

But our DC pension system is still far too fractured, poorly advised and poorly governed to venture into illiquid investments without significant help from regulators.

Following the problems of Sept/Oct 2022, we are rightly concerned that regulators are on top of the risks and this makes me nervous to see my money invested in markets for political reasons.

I do not want to be party to moral hazard, where I load up on risks I don’t understand and then come running to my trustees and their  regulators when things go wrong expecting to be bailed out.

I want to see my money invested productively, but not politically.

About henry tapper

Founder of the Pension PlayPen,, partner of Stella, father of Olly . I am the Pension Plowman
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