UK Pensions, The Current Landscape: A Dramatic Shift Away from Home

In our previous post, we examined the root causes for UK Pensions low domestic equity allocation.  In this second post we examine the current asset allocation state, proposal for mandatory investment, cases both for and against, and the current academic research on this subject.

The Current Landscape: A Dramatic Shift Away from Home

The statistics paint a stark picture. UK pension funds have dramatically reduced their domestic equity exposure, representing one of the most significant shifts in institutional investment behavior of the past three decades. Recent government analysis shows that pension funds with scale to move investment in-house and negotiate lower fees have greater scope to invest in typically more expensive asset classes and private markets, particularly those with high growth impact.⁴

Recent government initiatives, including the Productive Finance Working Group, have seen pension funds agree to invest 5% in UK private assets by 2030, signaling recognition that current allocation levels may be suboptimal.⁵ However, the debate extends beyond private assets to encompass the broader question of UK equity exposure..

The Case for Mandatory UK Equity Allocation

Economic Growth and Capital Market Development

Proponents of mandatory UK equity allocation argue that pension funds have a social responsibility beyond pure return optimization. The "social contract" argument suggests that pension schemes, which benefit from favorable tax treatment and regulatory frameworks, should contribute to domestic economic growth and capital market development.

The City of London's competitiveness as a global financial center partly depends on robust domestic institutional demand. When pension funds allocate minimal amounts to UK equities, it can create a negative feedback loop where reduced liquidity and investor interest make UK markets less attractive to international investors and companies considering listings.

Liability Matching and Currency Risk

From a technical perspective, UK pension schemes have predominantly UK-based liabilities. While global diversification provides risk reduction benefits, there's an argument that some degree of home bias helps match assets to liabilities and reduces currency risk exposure. This is particularly relevant for defined benefit schemes where benefits are paid in sterling.

Long-term Value Creation

Supporters also argue that UK pension funds, as long-term institutional investors, are well-positioned to identify and support undervalued UK companies. The current low allocation may represent an opportunity cost where funds are missing out on superior risk-adjusted returns available in less efficient domestic markets.

The Case Against Mandatory Allocation

The Diversification Imperative

The strongest argument against mandatory UK equity allocation rests on fundamental portfolio theory. The main argument in support of UK pensions reducing their allocation to UK equities is that a globally diversified market-weighted approach delivers better long-term risk adjusted returns. Academic research consistently demonstrates that international diversification reduces portfolio volatility without necessarily sacrificing returns.

The Home Bias Trap

Research on home bias reveals that European pension funds' domestic exposure ranges from 18x (Germany) to an impressive 67x (Spain) the market capitalisation weight, with no evidence of developed market pension funds avoiding home bias entirely. This suggests that natural behavioral tendencies may already create excessive domestic exposure without additional mandates.

Studies examining Dutch pension funds have found that international diversification reduces portfolio risk, while home bias often stems from behavioral factors rather than economic rationale. The academic literature strongly suggests that reducing home bias generally improves risk-adjusted returns.

Fiduciary Duty Concerns

From a governance perspective, mandatory allocation requirements will conflict with trustees' fiduciary duties to act in members' best interests. If global diversification demonstrably produces better risk-adjusted returns, requiring higher UK allocation will expose trustees to legal challenges.

Market Efficiency Arguments

We argue that if UK equities consistently offered superior risk-adjusted returns, rational investors would already be allocating more capital to these opportunities. The current low allocation may reflect efficient market pricing, sending the message that there are simply not enough world-beating UK listed companies, rather than systematic undervaluation.

Academic Research: The Evidence Base

The academic literature on pension fund home bias and international diversification provides mixed but generally cautionary evidence regarding mandatory domestic allocation requirements.

Research by Driessen and Laeven (2007) examining Dutch pension funds found that home bias significantly reduces portfolio efficiency, with internationally diversified portfolios delivering superior risk-adjusted returns.⁶ However, this research also acknowledges that some degree of home bias may be rational given currency matching requirements and regulatory constraints.

Recent academic work examining the UK Universities Superannuation Scheme (USS) using stochastic simulations found that substantial investment in riskier assets (equities) makes the average outcome one where the scheme can comfortably pay accrued benefits, but increases the risk of having far fewer funds than needed to pay existing pension promises.⁷

The broader academic consensus, as reflected in multiple studies published in leading journals, suggests that while home bias is a persistent phenomenon across markets, it typically reduces risk-adjusted returns. Research indicates that only 16% of empirical studies in top finance journals examine non-US markets, suggesting that even academic research suffers from home bias.⁸

Studies on pension fund sustainability and ESG integration have found that pension funds, as major asset owners with long-term investment horizons, need stable and diversified investment strategies.⁹ However, this research also suggests that completely eliminating domestic exposure may ignore legitimate currency matching and liability considerations.

Expert Commentary: The Professional Divide

Supporters of Increased UK Allocation

Industry veterans like Ros Altmann have advocated for significant increases in UK pension fund allocation, suggesting that funds should invest 25% in UK assets or potentially lose tax relief benefits. This view emphasises the social contract between pension schemes and the broader economy.

Investment managers focusing on UK equities have also highlighted potential opportunities, with some arguing that current pessimism about UK markets may be creating attractive entry points for long-term investors.

Critics of Mandatory Requirements

However, many institutional investment professionals, and Andrew Bailey, the Governor of the Bank of England, have pushed back against mandatory allocation requirements. Asset managers and pension consultants frequently emphasize that investment decisions should be driven by risk-adjusted return expectations rather than political or social considerations.

The Pensions and Lifetime Savings Association and other industry bodies have generally favored market-driven approaches to asset allocation, arguing that mandatory requirements could compromise member outcomes.

Implications for Different Stakeholders

For Pension Investors

The impact on pension investors depends critically on whether mandatory UK allocation improves or compromises risk-adjusted returns. If academic research is correct about diversification benefits, members could face reduced outcomes. However, if UK markets are genuinely undervalued or if currency matching benefits are significant, members might benefit.

For Pension Trustees

Trustees face a complex balancing act between fiduciary duties, regulatory requirements, and social responsibilities. Mandatory allocation requirements could provide regulatory "cover" for UK investment decisions but also creates conflicts with their duty to optimise member outcomes.

For the City of London

The City of London would likely benefit from increased pension fund allocation to UK equities. Higher institutional demand could improve market liquidity, support IPO activity, and reinforce London's position as a global financial center. However, these benefits must be weighed against potential efficiency losses.

In our final post, we make a case for a radical reimagining of legislation, regulation, tax, governance to address the root causes of low domestic equity allocation.

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