141. Why Aren’t UK Pension Funds Backing Britain?

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1:14Hello and welcome to The Rest is Money with me, Robert Paxton. And me, Steph McGovern. So we have a guest with us today. He's an old friend of Robert's, Michael Torrey. just to give you a bit of his CV. He's the co-founder of a financial advisory firm called Ondra. He's previously worked as head of UK investment banking for Lehman Brothers. My goodness, we covered them a lot at the time in the financial crisis and Morgan Stanley. And Robert, he's a guy you know well, isn't he? And we're really keen to get a sense of what he thinks the problem is in terms of our private companies in the UK, why the stock market here is not doing as well as other countries and why this is all connected to a crisis in pensions and chronic underperformance of shares, of UK shares.

2:01Yeah, that's right. I mean, I've known him as a corporate advisor, but I was very struck a couple of years ago. He did this pretty, I thought, powerful report for the Tony Blair Institute about why the UK stock market had underperformed so strikingly and depressingly against pretty much every other leading stock market in the world, and why British investors were not putting enough money into British companies. And this combination of a poor performing stock market and too little capital gain of British companies is absolutely connected to the lackluster performance of the British economy, particularly the lackluster performance relative to America.

2:50So, you know, I wanted with you to sort of drill down into, you know, how do we basically get money, capital back into British businesses? And, you know, that's why we're talking to Michael. Yeah. So here's our interview with Michael Tory. Michael great to see you this morning um Michael and I've known each other for for decades I'm pretty sure we first spoke when you were at um a bank that no longer even exists called SG Wahlberg but which is a long long time ago I think before we get into why we're talking to you I do have to share with you that one of our important colleagues Tom's gonna be very disappointed when he sees and hears you because you might probably get this a lot but he assumed when I told him that Michael Tory was coming on the programme, that you were a character from the Fast Show and that what we were going to see was a crusty colonel, very drunk in a gentleman's club.

3:47So the fact that you're none of those things is going to very much upset him. The reason we want to talk to you, Michael, is because in the last couple of years, you've been immersing yourself in a problem that should worry all of us, which is that shares listed on the UK stock exchange have been performing way worse than shares of other countries on other countries' stock exchanges. In other words, the value of British companies has been falling very significantly in a relative sense. Give us the figures. Tell us how badly shares on the stock exchange have performed and over what kind of time period.

4:34You have to go back in history. And it's interesting you mentioned in the introduction where we first met many years ago, a firm called SG Warburg. But if you go back to, say, 25 years, around 50 to 60 percent of the UK listed shares that you referred to were owned by British pension funds and insurance companies. And there was a logic to that because these pension funds and insurance companies were matching their long-term liabilities for people's pensions and their insurance obligations, matching them with long-term interests in British shares that would grow over time. And the two things were kind of an equilibrium.

5:07That 60 % from 25 years ago today, the comparable number is 2. 60 % down to 2%. It is staggering. And basically, the pension funds replaced their holdings of British listed shares with gilts. I'm just going to explain this because not everybody who listens will know what gilts are. This is the borrowing of the British government. These are UK government bonds. Yeah. So essentially, the British public, through their savings system, used to own most of British industry, which makes sense, right? Because that's what people knew. And it was a matching of the liabilities and the assets. So if you then imagine that why this mattered, why did it matter?

5:45It went from 60 % to 2%. So the crucial function that these long-term orders provided to the British economy was twofold. Firstly, was the time horizon, because by definition, they were long-term investors. They were with the companies through good times and bad times. They would take risk. They would make long-term investments, but they didn't really focus on what happened this year or next year, they could do it over the long time horizon. And that was crucial. The second thing they would do, and this is even more crucial, when the companies needed capital for growth, for an acquisition, to take some new investment that maybe had some risk, the investors would put up the new capital.

6:23So say a core group, and you see the importance of this. I just walked through the illustration of this, why does this work? Say the top five to 10 shareholders maybe held 25 % of the company. And then if a company had an exciting new project or an acquisition, They would go to see these top five, six shareholders a week before, a day before. And this was back to the days you mentioned at S.G. Warburg. And these shareholders would then effectively commit to provide the equity capital to the company in order to raise the funds they needed for growth or expansion. You remember those days. It was very common.

6:55Many of your listeners will be old enough to remember what a rights issue was. When a company is raising money, they go to the owners and they say, we need a bit more money. and under the old system, they had essentially the right to provide the capital ahead of anybody else. Exactly. And this isn't nostalgia. This system worked and it worked for a reason. So the 25 % that were taken into the company's confidence the day before, a week before, they would study the proposition and they would then effectively commit their own capital to do this and validate it. And that would send a very powerful signal to the other shareholders.

7:31And so typically you'd start with 25 % or 30 % and the take up of these rights issues and the rest of the shareholder base was typically 90 % plus. Because the powerful signal from the core group of long-term shareholders basically said, we studied this, we validated it, this is good for the long term. And then they were natural owners. So if other people didn't take up their shares, they didn't mind taking up some of the other capital because they were natural long-term owners. So now think of it in these terms. That signal is gone. The 60 % to 2%, now when you want to raise capital for a British company, there's nobody that you can actually go to to provide that nucleus of support on which you then create the signal for the other investors.

8:08The signal is gone, and I'll explain the importance of this, which means supply of new capital for growth to British companies has evaporated. It's gone. And think of this as a sealed room. We're all in a sealed room, and there's no new oxygen coming in. Over time, as there's less and less oxygen, we use it up, we get weaker and weaker. And then, of course, what happens is the companies that have no new capital for growth, they become very defensive. And because they're no longer able to invest for growth, their growth rate slows. And if you look at the data, Robert and Steph, it's shocking. The ONS data showed that the British corporate sector 30 years ago, 25 years ago, has grown 10 to 15 percent per annum.

8:45Today, it's five. When companies grow more slowly, guess what? The investors then demand more dividends because if there's no growth and the capital appreciation isn't there, the only way you can get your return is from dividends. And if you look at the FTSE 100, the entire return of the FTSE 100, the largest 100 companies in this country, the entire return over the last 20 years has come not from growing the value of the companies, but from dividends. So investors looking at investing in a British company, if they don't see the growth, then the only way they can get the return is dividends. And if you look at the yield, meaning the return on dividends, and the UK FTSE 100 compared to the equivalent in the US, it's double in this country.

9:23It's double. And it makes sense because if you're an investor, you have to get your return one way or the other. And if it doesn't come from growth, it has to come from dividends. Obviously, when a company is using its cash to give a dividend reward to shareholders, it's not investing in its own growth prospects, as you've been saying. But I just also wanted to ask you one other bit of data before we get into, you know, the sort of why this matters. in something like 1999 or 2000, the UK had, I think, three of the world's 25 most valuable companies. And they were the likes of Vodafone. I'm pretty sure BP and Shell were up there.

10:05So three of the world's 25 biggest companies. And today, the UK doesn't have even one of the world's 25 biggest. And in fact, I'm not even sure at this particular second, we have one of the world's 50 biggest companies. AstraZeneca is normally there or thereabouts. And therefore, we have seen not only the absolute growth of British companies falling, but relative to other economies, the value of our businesses has shrunk massively. Those great companies, their once great companies were built by drawing from the reservoir of the British savings pool. They were able to access capital. I mean, DP, for example, bought two companies in the late 90s, Emoco and Arco.

10:55Vodafone did a big acquisition in Germany. All the companies you mentioned, GSK was Glaxo that bought SmithKline in America. Every one of these companies that we look at in the pantheon of the top 10 to 50 was built when they were able to access the pool of capital I described earlier from the pension funds insurance companies. and we're not building these companies anymore. In fact, as you know, if you look at the data, we used to be buying around the world that created those companies. The last 25 years, British companies have been selling. And I'll just complete the logic because you'll see this analogy with the room, how important it is.

11:28So we're in a room running out of air. The companies are getting weaker. They're not growing anymore. Therefore, they compensate with dividends. And then it becomes a loop because the more dividends you pay, the less you invest. And then you grow even more slowly over time. And the companies then become cheaper because their value is going down. exactly as you described. And then the foreign companies look at this and go, hmm, these are actually pretty good businesses. They just need a little more oxygen. So they arrive with their bottles of oxygen and let a few people out of the room. The companies that leave the UK and are bought, in fact, come back to life because they're actually able to be given the capital that can't be provided in this country.

12:02And take Arm as the best example. Arm left this country when it was acquired by Japanese in 2016. And it was valued at just a little over$30 billion. Today, it trades on the New York Stock Exchange is a value of$175 billion. So that$140 billion uplift was totally accruing to people outside this country and the British public didn't get any of that uplift in value. And that's a good example of what happens to a company that was going to die here and when it goes to another owner that isn't constrained in the way they are in this country, the company could back to life. And that is the essence of what's happened to the valuation of this country.

12:38And people look at us from outside and go, wow, these are great businesses. There's nothing wrong with fundamentally a little more capital and some TLC, some tender loving care can't fix. And that's the tragedy of this because it was all avoidable. Before we get into how we can change all this, I'm really interested in the point you make about how this is related to changes in pensions as well. And the fact that there's not so much appetite for risk because of the fact that we've changed from these kind of defined benefits to defined contribution schemes. Can you just explain a bit about that?

13:08Because that's fascinating. Yeah, yeah, of course. So essentially, the pension fund burden for the corporate sponsors of these funds was made so onerous that the companies closed the funds to new members. And by that, we mean that the people who are already in the pension fund were provided for, but anybody joining the company after a certain date 25 years ago, doesn't have any right to participate in the pension fund, and they had to switch to a different kind of scheme. So these funds then effectively went from infinite time horizon, with no time limit, and looking for long-term growth and a combination of a bit of yield, a bit of growth, a bit of mix.

13:42And then because they had a defined limit to their life, 25, 30 years, whatever it was, and because the companies then had to show the liabilities on the face of their own balance sheets, the risk appetite of the pension funds basically went to zero. And people mistakenly say this is a change in the culture. There's nothing wrong with the culture of this country. This was a rule brought in by the government that basically forced the risk out of the pension funds, effectively, and inflicted the consequences on the rest of the economy. In other words, then, so in terms of what the pension funds were being invested in, it wasn't British companies where it was riskier.

14:19It was into things like gilts, as we've just been talking about. 70 % of what's left of the defined better pension system is invested in gilts. And we saw the impact of that in the gilts crisis in 2022. People think gilts are without risk, but of course, when interest rates went up, it was massively risky. Obviously, we don't want to dwell too much on this because, in a sense, the milk is already spilled and we can't, unfortunately, roll back the clock and end this approach that was taken in the 90s of changing the sort of assets and liabilities of a pension fund from something that was sort of separate from the balance sheet.

15:04of a company to something that was sitting on the company balance sheet. And I think we have to accept that the decision that was taken by regulators and ultimately backed up by government regulation that said, if you've got a big hole in your pension fund, company X, it is your formal responsibility to fill that hole. That was done with the best of intentions, because, you know, we did see whether it was Robert Maxwell as a crook or other companies just playing fast and loose that actually, you know, there were boards that were not taking their pension responsibilities seriously. I mean, unfortunately, as a result of saying to companies, you have to take responsibility to give a decent pension to your people seriously.

16:01We then had these unexpected and rather terrible consequences, as you say, that we've ended up with pension funds that are not taking the risks that we want them to take. But presumably you accept that it's important for companies to essentially honour the promises they've made to their employees when it comes to pensions. Nobody's challenging that, Robert, but there's many ways to skin a cat. So, for example, in this country, we have 5 ,500 relatively small pension funds that obviously are the responsibility of the corporates that sponsor them. But if you look at the ingredients for returns in pension funds, it's very simple.

16:42And look around the world. We are an anomaly. I can absolutely promise you that. There's three things. You need scale, which we don't have. The average pension fund in this country is tiny. Even the biggest pension fund in this country doesn't crack the top 100 globally, which is shocking because we are the fifth, or used to be the fifth, sixth biggest economy in the world. But the individual pension fund is so small because of the fragmentation of the system. It's very hard for them to invest at scale. By definition, they're all small. Secondly, they need an infinite time horizon. The government regulations were so onerous, they forced them to be closed.

17:12And third, you need professional management. At the moment, instead of fund management, you basically have actuaries doing the asset allocation, and they've looked around the world and come up with gilts because there's no risk. So the notion that we have to honour the promise is absolutely right, but that isn't the only way to do it. So if you look at Holland, for example, they have the exact same problem, and they allowed the pension funds to consolidate. And they allowed them to consolidate so they could have scale and time horizon and diversification and not just invest in zero risk and very ostensibly low risk bonds.

17:42You said that the Dutch allowed them to consolidate, or did they compel them to consolidate? There's a bit of a difference there. Yeah, well, they encouraged them, they nudged them to do it, but they didn't force them to do it. They basically, through imposing, for example, a lot of these very small funds in this country are very expensive to run because you need actuaries, all the infrastructure. And then eventually the Dutch actually brought about legislation to fix the problem that we didn't fix in this country. and the tragedy robbers. They did this in 2018, around the time we were looking at it in this country, and they have done exactly what we should have done.

18:16The average pension fund in Holland was tiny and similar to this country in 2018. They've now gone from 2 ,000 funds to about 140 funds, and the average fund has gone from 400 million pounds to about 13, 14 billion euros. So I won't pretend they've solved it completely, but they've absolutely done what we should have done, is allowed consolidation or encouraged it or compelled it. It doesn't really matter. The system we have in this country, it doesn't work. It's broken. And if you think about it, these defined benefit pension funds that everyone's focused on, you're protecting their benefits.

18:49It's 10 million people out of a workforce of, what, 40 million people. And anybody at the age of 45 in this country today is going to live their retirement in poverty because the system that was put in place in the DB system, defined benefit system, is totally inadequate. Is it possible to roll back from that then? Because as you say, you know, we can't just change and go back to what it was, can we? So how do you solve this then? And as a 42-year-old, you've just condemned me to poverty when I retire. Yeah, well, well, I mean, you've seen some of the numbers. There's an institute that's done the analysis of what people need to retire with dignity, including the state pension plus.

19:28And the contributions that are being made today, as you know, the employer's contribution is 3%. and that is woefully short of what's needed. They think in order for this to produce anything like a dignified retirement, you need at least 10%. But look at the math. Look at the consequences of 2 % increase in the national insurance. Before we move on, just on this point, I was talking recently at a pensions event and was discussing the idea of, do you remember when they changed it so when you got your pension, you originally used three quarters of it to buy an annuity? and then you took the rest out as this tax-free lump.

20:05And then they changed the rules because obviously annuities were doing terribly when interest rates were so low. And then there was talk of actually, maybe they shouldn't have to take out an annuity and that all changed. And suddenly they thought we were going to be Lamborghini pensioners where everyone was just going to blow the money. And there was problems about people not really knowing what to do with the money. Do you think there's, I know this is slightly a sidestep, but just in terms of improving pensioners' lives when they reached that point, what was pitched to me was the sense that we should go back to being forced to take out a big annuity.

20:36So this concept of having this kind of guaranteed income and that money, that annuity should be invested in British companies. So all the tax incentives you get for putting money into pensions should help British PLC. Well, that part I absolutely agree with. If you look at the enormous tax privileges that come with pension saving, at the moment, there's no quid pro quo for the British taxpayers. of mostly people with pensions tend to be better off, as you know, yet the British taxpayers are often subsidizing investment in companies in other countries. So I want to address your point because you raise a really powerful point.

21:11There's a wonderful Chinese saying that the best time to plant a tree was 20 years ago, and the second best time is today. So in Canada, and again, there's lots of things wrong with Canada. Hopefully it's going to remain Canada well during this period. but they started the Canadian Pension Plan Investment Board in 1997 with$12 million. And basically every employed person in Canada above the age of 18 has to contribute to it. And today that$12 million plus the contributions from all Canadians is over$400 billion. And most of that has been growth in value of the investments. So I think something in what you said is right, but I do believe that this is a need that has to be met through a degree of pooling.

21:56This isn't something can be left to the individuals. It's too complicated for individuals. And also, you don't get the benefits of scale. This is absolutely vital to our economic future. Lots more to discuss with you, Michael.

22:10So I want to just go back to the growth question. Actually, this government has been consulting on and is promising to come up with a set of proposals that will, particularly when it comes to things like local authority pensions, compel them to merge and become bigger investors, right? So first of all, first question, is the government doing enough to create these super funds that you want? It understands the issue. I mean, both Jeremy Hunt, the last chancellor, and Rachel Reeves spend a lot of time talking about how they want pension funds in the UK to become bigger. Are they doing enough? But secondly, given that we've now had years of our funds not taking the risks we want them to take, I mean, it feels to me naive the idea that they will suddenly decide, you know, they're going to properly back, for example, the latest equivalent of the chipmaker just because they're a bit bigger.

23:11You know, surely other things have to have to happen, too. And I suppose the biggest question of all is, should the government, in a sense, be almost forcing these funds to take more risk, particularly since, as you say, we as taxpayers are subsidizing them? There obviously is no capitalism and no capitalism based growth without capital. And the local authorities is a sideshow. And if you look, it's about 400 billion pounds in total, 450 billion dollars order magnitude. So just to be absolutely clear, the chancellor is not being ambitious enough in trying to create super funds. So what does the chancellor need to do?

23:48Let me just first make a point. In my experience, I've lived here for a very long time. And in my experience in this country, there's a fundamental problem that the separation of power and knowledge and this confusion of power and knowledge. So in my own personal experience, the people with the knowledge to fix this problem in this country typically have no power. And the people with the power to fix it typically do not have the knowledge or the expertise. And I agree with you, there's been some well-intentioned, but this gap between the power and the knowledge has been skillfully exploited by vested interests.

24:22And we've talked a bit about this in the past. And if you look at there are actual beneficiaries of this decline, I mean, saddens me to say, but if you think of the insurance industry in this country makes half its profits roughly from effectively feasting on the decaying remains of this defined benefit pension system and the pension consultants. This is because they do these buyouts of pension funds to guarantee these returns for these funds that are going to be closed down. Exactly. And the irony of all this is the pension fund consultants and the insurance companies that are benefiting from this, they themselves are mostly owned by foreigners.

24:59So, I mean, even the profits we make from the decay don't accrue to people in this country. The pension consultants are, for the most part, subsidiaries of American companies. And even the insurance companies in this country, over half of their shares are owned overseas. So this gap between power and knowledge has been skillfully exploited. There are beneficiaries of this decline. So I think first we have to address that. So now to answer your question, Robert, is I think they definitely aren't doing enough. I think that the vested interest has stood in the way of reforms needed to address this.