All economics is either a series of footnotes to Adam Smith – or wrong. True, given that I’m a senior fellow at the Adam Smith Institute, you could assume that I’m just biased, but there is more than a modicum of truth to that statement. Unfortunately, our new Chancellor has just unveiled some proposed changes to pensions that come more than a little unstuck when asked to pass the Adam Smith test.
Rachel Reeves has announced that the Government will transform our pensions system. Or rather, so far, that the Government is committed to having a meeting about doing things to our pensions system that will make us all gaze in wonder. The two main thrusts are to increase returns by reducing costs (‘further consolidation and broader investment strategies to potentially deliver higher returns for pensions’) and also to see about the use of those pension funds for investment in the UK:
‘An investment shift in defined contribution schemes could deliver £8 billion of new productive investment into the UK economy.’
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‘Action will be taken to unleash the full investment might of the £360bn Local Government Pension Scheme to make it an engine for UK growth.’
The problem is that there’s a significant tension here. In fact, the two ideas are working entirely at loggerheads with each other, for reasons explained, rather famously, by Adam Smith.
The first part, about consolidation, simply involves mashing together the investing of a number of small funds. This would then reduce those funds’ costs. On the face of it, this seems sensible enough, even unobjectionable. Only a cynic – or, as I prefer to describe myself, a ‘realist’ – would point out that having fewer investment managers in charge of fewer investment management plans means the end result will be a system easier for politicians to control. I suspect that the ultimate aim here is to get those pensions being spent upon what politicians would like the money spent upon. Rather than reducing investing costs, it’s about being able to direct that investment. But, well, that’s me.
The second part is where we meet Adam Smith. The one mention of ‘invisible hand’ in Wealth of Nations is about how foreign trade has a higher return than domestic, and yet many will – just because they will – fail to maximise their returns and instead continue to invest at home:
He generally, indeed, neither intends to promote the public interest, nor knows how much he is promoting it. By preferring the support of domestic to that of foreign industry, he intends only his own security; and by directing that industry in such a manner as its produce may be of the greatest value, he intends only his own gain, and he is in this, as in many other cases, led by an invisible hand to promote an end which was no part of his intention.
This seems to be describing exactly what Reeves is trying to do. Get more of those domestic savings invested domestically and so trigger that invisible hand. But that’s the wrong, diametrically wrong, lesson to be taking from Smith. If the Government wants to maximise pension pots, then people should be investing in foreign equities, not domestic.
In fact, it’s a standard assumption in investment circles that there’s far, far, too much ‘home bias’ going on. If anything, people should be encouraged to invest much more in foreign markets: not get co-opted into backing domestic opportunities.
The significant nature of home bias can be illustrated using the example of UK pension funds. In 2021 these funds held nearly 36% of their equity portfolio in domestic stocks, which then represented about 4% of the free-float market capitalization of the MSCI World index.
A rule of thumb is that the home allocation should be the same as the portion of the global market that is that home market. So, UK pension funds are already wildly over-UK allocated. Hugely so.
Sure, it’s true, if folk invest their pensions posts at home then that benefits the domestic economy. But it comes at the cost of lower returns on those domestic investments. To maximise investment returns – or, to put it another way, to minimise the necessary pension contributions for a certain level of retirement income – vastly more of those pensions savings should be invested abroad. Out in that big wide world out there.
This is exactly not what Labour’s new plans are about. Instead, the declared aim is to have more British pension funds invested in the British stock market. Which is wholly and entirely the wrong action if you want to increase returns.
Reeves’ mistake comes from not understanding what Smith was saying. The invisible hand quote gets disconnected from the initial observation about foreign profits being higher. Which is the same point being made by today’s investment managers about home bias. This ‘invisible hand’ isn’t something we should be trying to insist upon, it’s something we should be educating savers out of.
To maximise pensions, more should be invested overseas, much more. This is, obviously, in tension with the Government’s declared aim of having more to invest in Britain. Reeves is trying to present these changes as win-win, but pensioners will pay the price. Good sense says pension funds should be investing more globally, not narrowing their horizons.
But then we should all have known that, right? As Maggie Thatcher said, the problem is that socialists always run out of other peoples’ money. Now that they’ve already spent everything they can tax out of us they’re coming for the right to spend – sorry, allocate – our pensions savings. Aren’t we the lucky ones?
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