The UK pension system is one of the biggest in the world According to Terry Tanaka, significant changes are underway
Perhaps you haven't noticed, but a silent revolution is happening.
One of the biggest pension systems in the world is the one in the UK. The United Kingdom has assets worth over £3 trillion (£3.3 trillion), which is second only to Japan (£3.4 trillion) and the United States (£32.5 trillion).
The BT Pension Scheme, one of the biggest company pension plans in the UK with 270,000 members and 37 billion in assets, was one of the massive, multi-billion-pound defined-benefit pensions that once controlled the system.
The market is still dominated by these, accounting for about half of the total market across the public and private sectors, but defined-contribution plans, the new type of pension, are quickly gaining ground.
The market shift in the United Kingdom's pension system.
As per the Pensions Policy Institute, approximately 11% of the total assets in UK pensions are in defined-benefit plans run by the private sector, and 17% are in pension plans funded by the public sector.
The above figure does not include contributions to many UK public-sector pension schemes, such as those for teachers, civil servants, and NHS employees, because they are "unfunded," meaning they are used to pay current pensioners (much like a Ponzi scheme).
Depending on how and what you count, unfunded UK public-sector pension liabilities range from 1 trillion to 2 trillion. During the fiscal year that ended on March 31, 2023, public-sector net pension obligations decreased by 1 trillion, from 2 trillion to 1 trillion, due to a sharply increasing discount rate. This figure excludes certain local-authority pension liabilities).
In the past, defined-benefit plansalso known as "final-salary" planswere the standard for pension arrangements. They guarantee a lifelong fixed income based on a member's salary and years of service.
The Pensions and Lifetime Savings Association reports that although defined-benefit plans are still popular in the public sector, only 505 (roughly 10%) of the approximately 5,300 defined-benefit plans in the private sector are still accepting new members.
With their focus on meeting the retirement obligations of current members and their closure to new members, the majority of schemes are essentially in run-off mode. Over the past ten years, the value and number of scheme members have decreased as assets are distributed and members die.
The number of members in the remaining private-sector schemes has decreased from 14 million to 10 million since 2006. In 2024, there were 5,190 defined-benefit plans, down from 7,300 in 2012.
Cash is abundant in defined-benefit plans.
Interest rate increases over the last three years have had a significant effect on defined-benefit plans and their funding levels.
The present value of future liabilities is decreased by higher interest rates, which raises pension funding levels. Due to their typical investment portfolios consisting of corporate and government bonds, funds can also generate a higher return on their capital.
The Purple Book's Pension Protection Funds (PPF) 2024 edition states that the net surplus in defined-benefit pension plans in the private sector increased to 219 billion last year, or a funding ratio of 123.1%. Trustees of pension funds have been using what are known as scheme "buyouts" to lessen their exposure as funding levels have increased.
Although defined-benefit pension plans are fantastic for participants, the companies that offer them may face significant and cumbersome liabilities. Funding obligations may deplete cash flow, lower capital expenditures, and lower shareholder returns.
The ideal illustration is BT's pension plan. With a value of 37 billion, it is twice as large as BT itself. At the end of June 2023, its deficit was 3 billion, compared to 8 billion in June 2020, because the company had contributed £4 billion to the fund over the preceding three years. The funds could have been used to support the company's telecom infrastructure modernization.
Companies with well-funded schemes have benefited greatly from the change in interest rates and the ensuing increase in funding levels. Some have made the decision to use this windfall to buy out assets that are listed on their balance sheets.
Through buy-ins and buyouts, pension derisking strategies, plans shift the risk of paying retirement benefits to a third party, usually an insurer like Legal and General, Aviva, M&G, Phoenix Group, and Just Group.
In a pension buyout, all of the obligations of the pension plan are transferred to an insurer. An insurer takes on some of the scheme's liabilities through a buy-in.
The ultimate objective of the plan remains the same regardless of the path it takes: the risks associated with managing the pension assets are removed from the balance sheet. Currently, the market here generates between £50 billion and £60 billion annually, which provides a kind of windfall for the large insurers vying for this business.
Shifting liabilities also frees up cash for the companies to which the schemes belong.
In one example, last year, Coats fully de-risked its pension scheme (which in 2016 had liabilities eight times higher than the companys market capitalisation) when it purchased an approximately 1.3 billion bulk annuity policy (buy-in) from the Pension Insurance Corporation. The deal was only feasible following the interest rate change and the scheme's subsequent improvement in funding levels. £30 million of the group's cash flow was being used annually for the scheme's deficit repayments. The deal could increase the group's annual free cash flow by up to a quarter after a one-time payment.
In its 2024 annual report, Just Group stated that "by allowing UK corporates to concentrate on expanding their businesses and by investing the assets in productive finance, pension scheme de-risking is helping to support growth in the UK economy."
This strategy's loss of control over defined-benefit schemes is its most evident disadvantage. Furthermore, the widely reported shift by large pension funds away from UK equities is only expected to continue, as insurers have a tendency to move their assets to lower-risk holdings like bonds. For the biggest insurers in the UK, however, the deals are bringing in a lot of business.
Pensions are strengthened by auto-enrollment.
With fewer members, the defined-benefit pension market is gradually contracting. The world's top auto-enrollment program in the UK is expected to propel the defined-contribution market's rapid expansion in the upcoming years.
The UK was the first country in the world to implement auto-enrollment in 2012. It was intended to take the place of defined-benefit plans and encourage saving for the future.
The onus still falls on the employer to set up the pension for the employee, but contributions and, ultimately, retirement benefits are a lot more variable (and cheaper for the company).
Under the current rules, an employer must enrol an employee in a pension scheme if theyre a UK resident, work in the UK, are aged over 22 and earn more than 10,000. The employer must contribute 5% of the employee's salary, while employees must contribute 3%. This is the minimum contribution.
Defined-contribution pension plans' assets have almost tripled since the system's inception, from 200 billion in 2012. According to projections, the market may reach a value of approximately £1 trillion by the end of this decade.
The market is divided into two segments: trust-based schemes and contract-based schemes. Currently, the market is split about evenly between these two segments. Individual agreements are made between the pension providertypically an investment platform or insurance companyand the scheme member (the company) under a contract-based scheme.
The business enters into a partnership with a sizable pension master trust, like Nest or the Peoples Pension, in a trust-based scheme. These multi-employer plans rank among the biggest and most potent pension institutions. Aside from the defined-benefit and major payers in the defined-contribution market, around 500 billion of funds are held within self-invested personal pensions (Sipps) and 300 billion is in the bulk and buyout annuities market.
This is a general overview of the UK pension sector at this point in time, but there are multiple reviews under way into the sector and constant calls to review the auto-enrolment system. In addition to lowering the minimum age and salary requirements, providers Standard Life and Phoenix have been advocating for an increase in the auto-enrollment minimum to 12% of annual salary. According to the businesses, this could increase funding by £10 billion. Motions to increase the funding requirements for auto-enrollment have also been made in the government.
Then there is the discussion of how pension funds are invested.
Since they are no longer making investments for the future, the legacy defined-benefit plans have largely de-risked. The funds must ensure they have sufficient funds to fulfill their responsibilities as they are disbursing benefits. Bonds and other low-risk, cash-like investments are therefore where the majority are invested.
Conversely, defined-contribution funds have a much higher equity weighting.
The Pensions Policy Institute reports that in 2023, bonds, primarily index-linked gilts, accounted for 55% of the assets in private-sector defined-benefit plans, while cash and cash-like instruments made up 20%.
Equities made up 56% of assets in trust-based defined-contribution plans, while bonds made up 24%. In the United Kingdom, equities account for one-third of pension assets.
Concerning how to persuade pension funds to increase their investments in productive assets like infrastructure and UK stocks, numerous discussions and consultations are currently underway.
The results of these discussions could significantly affect investment providers that focus on alternative and private assets as well as the UK equity market.
How to benefit from the modifications.
Investors can profit from the current trends influencing the UK pension sector in three main ways.
The market for bulk annuity and pension buyouts is the first. As previously mentioned, a small number of powerful companies currently control the majority of the market, including Legal & General, Aviva, Phoenix Group (through Standard Life), Pension Insurance Corporation (PIC), Rothesay Life, Just Group, and Canada Life.
Just Group (LSE: JUST) may have the most potential for expansion because it specializes in smaller schemes. Its largest deal last year was a 1.8 billion full buy-in with the trustees of the G4S pension scheme. 129 transactions totaling £50.4 billion were completed by the company last year, a 57 percent increase from the previous year.
There are three ways that businesses like Just profit from buy-in and buyout transactions. Fees for management, investment returns from excess assets (referred to as "in-force profit"), and upfront payments to take over the scheme.
Just announced in-force profit of 236 million, up 24% from the previous year, and new business profit of 460 million, up 30% from the previous year.
Striving for development.
Even though other businesses like Legal & General, Phoenix, and Aviva are larger, Just has the best room for expansion because it serves a smaller market.
Larger players simply do not find defined-benefit schemes worth their time and effort because they are typically at the smaller end of the size spectrum. To help win business, Just created a program called Beacon. This software is "now being used by all major employee benefit consultants," according to the company, and aids in calculating insurer buyout and buy-in fees.
Additionally, Just's annuity sales business is expanding due to the high demand for these products, which currently provide some of the best guaranteed income retirement rates the market has seen in more than ten years.
The company's dividend yield indicates that Just is reinvesting to expand its operations. While management hiked the 2024 payout by 20 percent, the stocks yield, of around 2 percent is still the lowest in the sector. Despite this, the sector's highest dividend cover is still present, and the shares are trading at a steep discount to tangible net assets per share, which is 254p.
M&G (LSE: MNG), Phoenix Group (LSE: PHNX), Chesnara (LSE: CSN), and Legal & General (LSE: LGEN) might be the best options if you're trying to make money.
Phoenix is a leader in income with dividend yields of about 9%, but it has an advantage with its workplace and retail pension divisions (under the Standard Life brand). In addition to its bulk annuity business, Phoenix ranks among the top three providers of workplace defined-contribution plans. By the end of 2024, the total assets under administration were £66.5 billion. The total amount of gross inflows for the year was 9.3 billion. In the upcoming years, this could grow to be a much more significant aspect of the group.
The management of workplace schemes is an asset-light, higher margin business, and they have set important goals to expand this division into the UK's booming defined-contribution market. Additionally, Phoenix wrote £51 billion worth of bulk annuities last year. Having only returned to the individual annuity market in 2023, Phoenix currently holds a 12 percent market share. Phoenix's "expanding its workplace savings and pensions business and improving the capital intensity of its annuity business, combined with a larger repeatable source of capital generation from its existing book of business" makes it the group's best investment in the industry, according to analysts at Panorama Liberum.
The other major players in the market, Aviva (LSE: AV) and Legal & General, are both good options, but theyre far more diversified.
After the completion of the merger with Direct Line, Aviva will only become a more general insurance company. Nevertheless, the company has a significant presence in the defined-contribution market thanks to its wealth and savings platform, and this will be a major area of focus for the business in the years to come.
Legal and General are very similar. It now manages funds for the defined-contribution market and has grown to become one of the biggest asset managers in the UK. With assets worth over £1 trillion, it's the 800-pound gorilla in the room, but it's also very difficult to comprehend.
The company will not be able to grow as much as a smaller player in the market, in contrast to Just. Nevertheless, with a dividend yield of 9%, it's a reliable FTSE-100 income investment that won't let you down.
A fintech that is rapidly expanding.
Consolidation is where the true market opportunity is. Both the defined-contribution and defined-benefit markets have a large number of pots and small schemes. Similar to PensionBee (LSE: PBEE), one of the UK's fastest-growing fintechs, Just is using technology to carve out a market here.
Utilizing technology to expedite the process, the firm specializes in consolidating small pension funds. The market for transferable pensions has grown by 12 percent a year and has tripled in size over the last ten years to reach £13 trillion.
Public awareness is one area in which PensionBee excels. It has invested 64 million dollars in marketing since its founding, and it currently projects that for every dollar spent on marketing, it generates 96 net inflows. One of the highest levels of brand awareness among all pension brands is 57 percent among consumers. In order to help the platform grow, it has also made significant technological investments. Spending 19.3 million on technology last year was up 1% from the previous year and represented a small portion of the group's assets under management (5.8 billion).
With assets under management expected to double by 2027, Berenberg analysts say the company's "scalable business model, strategic expansion, and robust brand create a compelling growth trajectory." The company reported its first positive EBITDA figure in 2024 (2point 4 million), and Berenberg projects that figure will reach 13point 6 million by 2027, with an 18point 6 percent margin.
The largest pure pensions consultancy in the UK, XPS Pensions Group (LSE: XPS), is an additional choice. It works with over 1,500 pension plans.
Many of the aforementioned difficulties, as well as other routine tasks related to managing pension plans, are handled by XPS for trustees and pension plans. The majority of its long-term, inflation-linked contracts provide significant insight into future revenue growth.
The John Lewis Partnership Pension Trust, which has almost 165,000 members, awarded it a contract to handle its administrative needs towards the end of last year. It's also giving schemes a leg up when navigating large annuity transfers.
Revenue rose by 20% and adjusted EBITDA grew by 30% in the previous year. Analysts at Panmure Liberum have pencilled in further earnings growth of 20 percent over the next two years, excluding deals. Polaris Actuaries and Consultants Limited, an insurance consulting firm, was purchased earlier this year, giving the group "immediate access to long-term, established relationships with master services agreements with the majority of the UK's leading insurers."
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