The UK is on the brink of a rare opportunity to transform its pension system, potentially reshaping the future of UK pension savers. Juanita Gonzalez-Uribe and Robyn Klingler-Vidra write that the key to driving innovation-led growth lies in one critical factor: improving venture capital literacy among pension fund managers.
Pension reform is one of the few areas where the new Labor government and the previous Conservative government are united. Both support increased pension investment in UK private equity, particularly venture capital (VC), a move that could unlock the country’s innovation-led growth.
Their reasoning makes sense. Other government tools to boost VC, researched by Robyn Klinger-Vidra and which include direct investment and tax incentives, are already in place, with the British Business Bank as a major shareholder and numerous VC-related tax schemes available. The mechanism for financing start-ups and growth capital that the UK lacks, compared to other leading innovation ecosystems, are pension fund investments in venture capital. UK pension funds invest much less in VC compared to Australia, Canada and the US.
As a result, the UK continues to face a growing problem where start-ups struggle to secure funding as they scale and often look to Silicon Valley for funding. At the behest of American investors, these structures could then move their growing company and its talent to the United States. Without the support of UK pension funds, there is a risk that the UK will continue to fall behind in funding start-ups and development. This would leave foreign investors, not UK savers, benefiting from funding the nation’s innovation. And the ecosystem stands to lose future unicorns moving abroad.
Strong pension fund allocations to VCs
The proposed change in pension allocation towards risk capital is supported by academic research. Private equity investments can offer diversification and higher risk-adjusted returns, benefiting UK pensioners. At the same time, this change could significantly strengthen the UK’s entrepreneurial funding and align the economy with wider innovation goals.
Juanita Gonzalez-Uribe’s study highlights this effect with a natural experiment in the United States. In the 2000s, state pension funds in that country gradually increased their allocation to risk capital following the adoption of “prudential man rules” across states. Like the ERISA Act of 1979, these rules clarified pension investment guidelines, classified VC as a prudent asset class, and allowed Treasuries to invest in it.
The results of these adoptions were striking: adopting states saw local pension funds increase their annual local mortgage liability obligations by an average of $175 million (roughly a 50 percent increase), compared to out-of-state funds. This influx of capital spurred greater investment in local entrepreneurs, helped fuel entrepreneurial growth, and aligned the economy with broader innovation goals.
Applied to the UK, this suggests that the right pension reform could unlock much-needed resources for local innovation growth. Currently, 16 times more global pension money flows into UK private assets than from UK pension funds themselves.
Why don’t they invest (more) in VC?
UK rules do not explicitly prohibit pension funds from investing in hedge funds. Underinvestment is largely caused by the way pension funds manage their capital.
First, allocation decisions are often made based on fee levels. VC funds tend to charge a “2 and 20” fee model; 2 percent for management fee and 20 percent performance fee. Other investment managers often charge less, perhaps because they have larger funds to manage or because they are less active investors.
Second, hedge funds tend to be small. Pension funds would have to make many small allocations, which requires both the expertise to select VC managers and the manpower to manage bandoneon-style — like the multiple instruments popular in Latin America — multi-factor portfolios. To invest in VC at scale, UK pension funds would need to invest in VC literacy to acquire VC executive underwriting skills and have strategies to better pool investments (such as through fund-of-funds structures).
Government efforts
Recent attempts to boost pension funds’ investment in private equity have sought to mandate allocations. In July 2023, then-Chancellor Jeremy Hunt launched the “Mansion House Compact,” in which the UK’s nine defined contribution pension fund managers committed to investing at least 5 percent of their default funds in unlisted stocks by 2030. This is already into venture capital allocation, with Aviva Investors announcing a venture capital and strategy fund in September 2024.
Chancellor Rachel Reeves has also made pension reform a key part of her economic policy. The chancellor advocates consolidation, mirroring the Canadian model, so that the UK deploys capital through major investment managers. This could partially address the problem of pension fund capacity hindering their VC allocation; A pension fund group manager may be better equipped to recruit and retain talent capable of ensuring the quality of risk managers.
The problem with forced assignments
Some government rhetoric suggests that VC allocations could be enforced if pension funds do not voluntarily accept them. Although the government’s frustration is understandable, forcing pension funds into a rigid structure is unlikely to yield good results. The government’s role may be better served by clarifying investment rules, as the US experience with the Prudent Man rules shows. The current uncertainty about consolidation methods, for example, may be halting activity. In a recent interview Mike Weston, chief executive of Local Government Pension Schemes Central, said “consolidation could move significantly further and faster if the government provided stronger guidance and clarity”.
Investors move towards the private market for returns, not for mandates. If pension funds have the right capacity and governance, they will invest where returns are strongest. John Graham, CEO of the Canada Pension Plan (CPP) Investment Board, one of the world’s largest pension funds, recently emphasized his opposition to “any restrictions on portfolio construction” or being forced into specific asset classes. In an interview, he noted that CPP’s success has come from “control, scale and a return-oriented mandate that gives us the freedom to invest wherever we see the best potential for return.”
VC training for pension funds
While strong-arming large pension funds into five per cent allocations (and consolidating dozens of small pension funds into a large manager) addresses some of the root causes of UK pensions’ anemic VC investment, it does not solve the pensions problem. lack of VC literacy by managers.
To open up pension funds to the UK venture capital market, the capacity of pension fund managers with exposures needs to be significantly enhanced. This market is notoriously complex, with returns that are highly skewed and persistent. It’s not just about investing in VC: it’s about investing in the right funds and participating as a high-quality limited company. Unlike mutual funds, there is strong evidence of ‘alpha’, but top-performing funds are often oversubscribed, which can make access a challenge. Also, the ability of pension fund managers to invest in new and growing securities companies that own small, vertical-specific funds would be key. Emerging VC managers can deliver strong risk-adjusted returns, according to Preqin data.
Whether UK pension funds can secure access to premium funds on competitive terms depends on their ability to build internal capacity or attract seasoned investors – both costly endeavours. Many people link the UK’s wider productivity problems to a lack of managerial talent, yet the conversation about pension VC management skills has been lacking. Advancing early stage technology and investment literacy is essential to developing pension fund managers who can effectively navigate the risks and complexities of the VC industry.
The US experience with public pension funds offers a cautionary lesson. A study by Yael Hochberg and Josh Rauh found that U.S. pension funds’ in-state private equity investments outperformed both their out-of-state private equity investments and outside investors by two to four percentage points. “Local” doesn’t always mean better. In the broader academic literature, evidence suggests that geographic limitations are a pitfall to avoid.
The next steps are key
Pension reform in the UK is accelerating. Last month, the Government’s call for a pension investment review concluded, and the Pensions and Private Equity Expert Committee released its interim report. Britain has a once-in-a-generation opportunity to overhaul its pension system. Exciting times lie ahead for UK pension savers – and potentially for UK innovation too.
If this wave sees UK pension funds achieve strong risk-adjusted returns in their exposure allocations, it will set in motion a virtuous cycle of more money flowing in. This is what has been happening since the late 1970s in the US, with pension funds and university endowments reaping significant returns on VC investments.
But requiring pension fund managers to identify good VC managers and act as high-quality shareholders when they are not yet ready to do so will likely lead to poor returns. Low risk-adjusted returns or investments in poorly managed funds would poison the well, not revive it.
Now is the time to invest in training around VC literacy, not forcing investments on pension fund managers who may or may not be ready. Training is needed to understand the unique characteristics of venture capital, including how to conduct due diligence (well), how high quality venture capitalists work with their portfolio companies, how returns are calculated (such as total value of capital contributed and public. market equivalent), possible backstop requirements on liquidity so that funds subject to contributions can invest and more. In this way, pension fund managers will be better able to assess the potential of VC managers, especially among new and small managers who can deliver returns and focus on cutting-edge innovations.
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This blog post represents the views of the author, not the position of the LSE Business Review or the London School of Economics and Political Science.
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