British institutional investors represent some of the largest accumulations of wealth in the world. This means that fiduciaries and policy makers have the power to influence many parts of our society and have a duty to use this influence responsibly. This is consistent with a wide view of fiduciary duty, that a beneficiary’s interests are best served by positively impacting the world in which they live, as well as their narrow financial interests. In this post I will discuss what this can mean in practice.
Delivering on their promises
A pension fund or insurance company may provide for the retirement for tens of thousands or hundreds of thousands of individuals. A university endowment may fund the education of hundred of thousands or millions of individuals over its lifetime.
If the institution fails to fulfil its fiduciary duty, the impact can be on more than just the financial wellbeing of its beneficiaries and their families. It can also severely damage the confidence of wider society in the very mission of the institution.
Most agree that people in the UK do not save enough for their retirement. When the scandal-hit Equitable Life insurance company was forced to close in 2000, over a million savers lost large sums of their pensions savings. Perhaps as damaging was the distrust in the pensions industry this created.
Shaping how we all invest
Where institutions go, other investors follow. In the last decade there has been a remarkable increase in ESG investing globally. Very large pension funds, who have recognised the enormous financial consequences of climate change, have been an important driver of this. In response, asset managers have grown their ESG capabilities and brought more ESG focussed products to market, to the benefit of all investors.
However, in the last few years, we have seen the tide beginning to turn. Driven by politics in the US, some large US investment firms are pulling back from their ESG commitments. For now, institutional investors are holding the line, with some even taking money away from asset management firms that have de-prioritised ESG.
Large institutional investors have also been at the forefront of private market investments such as private equity and private debt. This has resulted in new products coming to market that make private markets available to a wider range of investors. Long-Term Asset Funds (LTAFs) are one such recent innovation. These enable members of DC pension funds to invest in private markets, often through the default investment strategy.
Institutional investors can also play a valuable role driving down cost, although the pass-through to other investors isn’t always straightforward. In the UK, DB pension funds have become increasingly well funded. This has reduced how much they need to invest in higher-returning assets and simplifies their investment strategies overall.
Consequently, they are paying less fees to asset managers. This, together with other headwinds such as a shift in demand from active to passive investing, is forcing many investment firms to reassess their business strategies and strive for even more efficient operating models. This can benefit all investors if fund managers pass cost savings on to retail investors as well as institutions.
Moving markets
How institutions go about investing can move both markets and governments. During the 2022 gilts crisis (which I wrote about here), following the government’s mini budget, the leveraged LDI strategies used by UK pension funds helped push up gilt yields to historically high levels in just a few days.
If the Bank of England hadn’t stepped in, the knock-on consequences for financial markets could have been severe. Mortgage rates, which are linked to government bond yields, also spiked, causing pain for many individuals. Eventually, both the Chancellor of the Exchequer and the Prime Minister were forced to resign. Since the gilts crisis, LDI strategies have become much more conservative. However, given their enormous size, institutions still have the power to move and sometimes disrupt markets.
As noted above, there has been a marked increase in private asset investing. This offers new ways for pension funds to grow and, as we shall describe below, can also provide a benefit to society. However, these assets are much scarcer than listed assets, less easy to understand and less liquid. Institutions, asset managers. governments and regulators must ensure that capital is deployed into these assets safely.
Deploying capital
Institutional investors can influence the behaviour of companies through their ESG investment policies. Investors can back companies engaged in activities they support and withhold capital from those behaving poorly. Investing also gives a seat at the table. Institutions and asset managers can engage with a company’s management to improve how the business is run and vote on board resolutions.
Over the last few years, successive UK governments have sought ways to encourage more “productive finance”. This means using the assets of institutional investors to support the growth of the UK economy. This could mean investing in UK listed companies, investing in early-stage companies, or supporting long-term infrastructure projects.
To achieve this, the government may loosen the rules that govern when and how well-funded pension funds can return surpluses to sponsors. The government may also encourage or compel smaller schemes to merge to create the scale required to invest in private markets, and may even require funds to invest a minimum proportion of their assets in the UK.
The challenge for institutions is balancing this with their fiduciary duty to their beneficiaries. UK pension funds invest globally for diversification and to take advantage of a wide range of opportunities. Artificial demand can drive up the cost of scarce private investment opportunities . The interests of pension fund members will need to be carefully safeguarded if rules around returning money to sponsors are loosened. These challenges are not insurmountable; however, the government, regulators, institutions and their advisors will need to thread the needle very carefully to ensure members’ interests are protected.
A short note to readers
In a few weeks I’ll be starting a new role in the City, and this will be my last Big Small Money post. However, I look forward to publishing new content on my new firm’s website and blog portal, so keep an eye on my LinkedIn feed. In the meantime, thank you very much for reading.
Jon
Image: Pexels
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