The Great UK Pension Allocation Debate: Should Mandatory Investment in UK Equities Be the Path Forward?

Recursive - a Fractyl Consulting Analysis Part 1 of 3. 

The UK pension landscape stands at a crossroads. With UK DB funds allocating just 4.4% of their assets to UK equities, down from over half of their portfolios in previous decades, policymakers are encouraging increased UK investment through voluntary frameworks, though some commentators have begun to explore whether more prescriptive approaches could emerge.

This debate has intensified following the government's recent Pensions Investment Review and the Mansion House Accord, which unlocked up to £50 billion in UK investment commitments.¹,²

The Root Causes: A Systemic Breakdown of UK Pension Investment

Understanding the current state requires examining the drivers behind the dramatic shift away from UK equities. The root causes represent a systemic breakdown spanning regulatory, structural, behavioural, and market factors that have created a self-reinforcing cycle of domestic disinvestment.

Root Cause 1: The Fiduciary Duty Straightjacket

The primary structural cause lies in the narrow, legalistic interpretation of fiduciary duty that has evolved since the 1990s. UK pension trustees operate under trust-based governance regulated by The Pensions Regulator (TPR), with approximately 1,100 pension schemes with 12 or more members operating under fiduciary principles.³

The legal framework, established primarily through case law rather than statute, has created a "fiduciary duty straightjacket" - where trustees may interpret their legal obligations so narrowly that they cannot consider the broader economic context that determines long-term pension sustainability. This interpretation ignores the fundamental insight that pension fund returns are intrinsically linked to the health of the domestic economy that provides their members' employment and economic security.

The seminal case of Cowan v Scargill [1985] established that trustees must act in members' best interests, but subsequent interpretations have created a false dichotomy between financial returns and economic stewardship. This has produced a perverse outcome where actions that might enhance long-term economic growth (and thus long-term pension sustainability) are considered legally risky.

Recent government guidance has clarified that trustees may consider wider economic sustainability if it aligns with financial interests of beneficiaries, but lacks the certainty of statute or case law.

Root Cause 2: The Investment Consultant Oligopoly

A second, more pervasive root cause is the concentration of investment decision-making power among a handful of investment consultants. Our analysis reveals that just five firms control approximately 70% of UK pension fund advisory relationships, creating an oligopoly, with the risk of associated market failure.

This concentration has led to "herding behaviour" - where pension funds adopt homogenised asset allocation strategies to avoid relative underperformance, regardless of whether these strategies optimise absolute returns for their specific membership. The consultant model incentivises risk avoidance over return optimisation, as consultants face asymmetric career risks: they are punished for unconventional strategies that underperform but not rewarded for unconventional strategies that outperform: ‘tepid bath of mediocrity’ everyone?

Research on institutional investor behaviour demonstrates that this herding effect is particularly pronounced in asset allocation decisions, where the career risk of being different and wrong far exceeds the career benefit of being different and right.

Root Cause 3: The Scale and Capability Deficit Crisis

The UK pension system's extreme fragmentation has created a fundamental scale problem. Government analysis identifies that there are potential disadvantages and challenges for pension providers in reaching large scale, including investment difficulties and the ability to find attractive assets to invest in that are large enough.

Unlike successful pension systems in Canada, Australia, and the Netherlands, the UK has failed to achieve the scale necessary for sophisticated investment management. This capability deficit has several dimensions:

• Due Diligence Capacity: Small schemes cannot afford the specialist expertise required to evaluate complex domestic investments, particularly in private markets and smaller companies

• Negotiating Power: Fragmented schemes lack the bargaining power to access the best investment opportunities or negotiate favourable terms

• Risk Management: Individual schemes cannot effectively diversify across multiple domestic investment strategies

• Information Asymmetries: Small schemes rely on generic investment advice rather than developing proprietary insights

This scale deficit has pushed funds toward passive global index strategies that naturally underweight domestic markets, creating a self-reinforcing cycle of domestic disinvestment.

Root Cause 4: The Regulatory Risk Asymmetry

The regulatory framework itself creates systematic asymmetric incentives that penalize domestic investment. Research by the PRI found that there are policy, structural and market barriers to sustainability in key pension systems, including the UK, which impact the ability of pension funds to incorporate ESG factors.

While diversification away from UK assets is automatically viewed as prudent risk management, any concentration in domestic assets faces heightened regulatory scrutiny. This regulatory asymmetry has several manifestations:

• Reporting Requirements: Schemes with higher domestic allocation face more extensive reporting and justification requirements

• Prudential Regulation: Regulatory stress tests implicitly assume that domestic concentration represents higher risk

• Professional Liability: Trustees and advisers face greater professional liability exposure for domestic investment decisions

• Benchmarking Bias: Regulatory benchmarks and performance measures favour globally diversified strategies

Root Cause 5: The Market Structure Dysfunction

Despite the UK's economic advantages, overseas pensions invest 16 times more in British venture capital and private equity than domestic public and private pensions do. This extraordinary statistic reveals a fundamental market structure dysfunction where the UK pension system has become disconnected from the domestic economy it should naturally support.

This dysfunction has several dimensions:

• Deal Flow Capture: International investors have better access to UK investment opportunities than domestic pension funds

• Information Networks: Foreign investors have developed superior information networks for identifying UK investments

• Execution Capability: International pension funds have invested in the capabilities needed to execute domestic UK investments

• Risk Tolerance: Foreign investors demonstrate higher risk tolerance for UK investments than domestic funds

Root Cause 6: The Behavioural Finance Failure

The shift away from UK equities also reflects systematic behavioural biases that have not been adequately addressed by governance frameworks. These include:

• Availability Heuristic: Trustees overweight easily recalled examples of domestic investment failures

• Loss Aversion: The psychological pain of domestic investment losses exceeds the pleasure of gains

• Confirmation Bias: Trustees seek information that confirms their existing beliefs about domestic investment risks

• Social Proof: Trustees follow the decisions of peer organizations rather than conducting independent analysis

These behavioural factors interact with the structural causes to create a powerful psychological barrier to domestic investment that persists even when objective analysis suggests higher domestic allocation might be beneficial.

In our next blog post, we examine the current asset allocation state, proposal for mandatory investment, cases both for and against and academic research.

References:

1. HM Treasury, "Pensions Investment Review: Final Report," May 30, 2025

2. HM Treasury, "Pension schemes back British growth," May 13, 2025

3. HM Treasury, "Pension fund investment and the UK economy," November 27, 2024

4. Ibid.

5. HM Treasury, "Mansion House Accord," May 13, 2025

6. Driessen, J., & Laeven, L. (2007). "International portfolio diversification benefits: Cross-country evidence from a local perspective." Journal of Banking & Finance, 31(6), 1693-1712

7. Miles, D., & Cerny, A. (2024). "Optimal risk for pension funds: the sustainability of the UK Universities pension scheme." CEPR Discussion Paper No. 19254

8. Karolyi, G. A. (2016). "Home bias, an academic puzzle." Review of Finance, 20(6), 2049-2078

9. Various authors (2023). "Integration of ESG Issues in Investments Practices of Pension Funds." ResearchGate

10. Tony Blair Institute for Global Change (2023). "Investing in the Future: Boosting Savings and Prosperity for the UK"

11. Principles for Responsible Investment (2025). "Progress and priorities: reviewing sustainability in key pension systems"

12. French, K. R., & Poterba, J. M. (1991). "Investor diversification and international equity markets." American Economic Review, 81(2), 222-226

13. Huberman, G. (2001). "Familiarity breeds investment." Review of Financial Studies, 14(3), 659-680