Pensions revolution: how to profit from the trends shaping the UK pension system

You might not have noticed, but there’s a quiet revolution taking place.

The UK pension system is one of the largest in the world. With more than £3 trillion ($3.3 trillion) of assets, the UK is second only to Japan ($3.4 trillion) and the US ($32.5 trillion) in terms of size.

The system used to be dominated by massive, multi-billion-pound defined-benefit pensions, such as the BT Pension Scheme, one of the largest company pension schemes in the UK with 270,000 members and £37 billion of assets.

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And while these do still dominate the market (making up around half with both the public and private sectors combined), the new breed of pensions, defined-contribution schemes, are rapidly taking over.

UK pension system: the market shift

Of total assets in UK pensions, around £1.1 trillion, or 38%, are in private-sector defined-benefit schemes and £500 billion (17%) in public-sector funded pension schemes, according to the Pensions Policy Institute.

Many UK public-sector pension schemes, including those for civil servants, teachers and NHS workers, are “unfunded”, which means contributions are used to pay current pensioners (much like a Ponzi scheme), so they’re not counted in the above figure.

Unfunded UK public-sector pension liabilities are somewhere between £1.5 trillion and £2.6 trillion, depending on what you count and how you count it (public-sector net pension obligations reduced by £1.2 trillion, from £2.6 trillion to £1.4 trillion, during the financial year ended 31 March 2023 as a consequence of a sharply rising discount rate. This figure excludes certain local-authority pension liabilities).

Defined-benefit schemes, sometimes called “final-salary” schemes, promise a fixed income for life based on a member’s salary and years of service and used to be the go-to model for pension structures.

They’re still common in the public sector, but of the roughly 5,300 private-sector defined-benefit schemes, only 505 (around 10%) remain open to new members, according to the Pensions and Lifetime Savings Association.

Most schemes are effectively in run-off mode as they’re closed to new members and focus on paying the retirement obligations of existing members. As assets are paid out, and members pass away, the value and number of scheme members has dwindled over the past decade.

Since 2006, the number of members in the remaining private-sector schemes has fallen from 14 million to ten million. The number of defined-benefit schemes has declined from 7,300 in 2012 to 5,190 in 2024.

Defined-benefit schemes are flush with cash

The sharp jump in interest rates over the past three years has had a huge impact on defined-benefit schemes and their funding levels.

Higher interest rates improve pension funding levels by reducing the present value of future liabilities. Funds can also earn a higher return on their investments as they are usually invested in portfolios of government and corporate bonds.

According to the Pension Protection Fund’s (PPF) 2024 edition of The Purple Book, the net surplus in private-sector defined-benefit pension schemes rose to £219 billion last year, representing a funding ratio of 123.1%. As funding levels have jumped, pension-fund trustees have been turning to what’s known as scheme “buyouts” to reduce their exposure.

Defined-benefit pension schemes are great for members, but they can be vast, unwieldy liabilities for the companies that offer them. Funding commitments can consume cash flow and reduce shareholders’ returns and capital spending.

BT’s pension scheme is the perfect example. At £37 billion, it is twice the size of BT itself and at the end of June 2023, its deficit was £3.7 billion, down from £8 billion in June 2020, thanks to £4.4 billion of contributions paid into the fund by the company during the previous three years. That money could have been used to help fund the modernisation of the company’s telecoms infrastructure.

The shift in interest rates and subsequent jump in funding levels has delivered a windfall for companies with well-funded schemes. Some have decided to use this windfall to shift assets off their balance sheets with buyouts.

Buy-ins and buyouts are pension derisking strategies whereby schemes transfer the risks associated with providing retirement benefits to a third party, typically an insurer such as Legal & General, Aviva, M&G, Phoenix Group and Just Group.

A pension buyout involves a complete transfer of the pension scheme’s obligations to an insurer. With a buy-in, an insurer assumes a portion of the scheme’s liabilities.

Whichever route the scheme takes, the end goal is the same: the risks of managing the pension assets are shifted off the balance sheet. The market here is currently around £50-£60 billion a year, creating somewhat of a windfall for the giant insurers that are grabbing this business.

Shifting liabilities also frees up cash for the companies to which the schemes belong.

In one example, last year, Coats fully de-risked its pension scheme (which in 2016 had liabilities eight times higher than the company’s market capitalisation) when it purchased an approximately £1.3 billion bulk annuity policy (buy-in) from the Pension Insurance Corporation. The deal was only possible after the change in interest rates and subsequent improvement in funding levels at the scheme. The scheme had been consuming $30 million a year of the group’s cash flow in deficit repayments. After a one-off payment, the deal could boost the group’s annual free cash flow by as much as a quarter.

As Just Group noted in its 2024 annual report, “pension scheme de-risking is helping to support growth in the UK economy by enabling UK corporates to focus on growing their businesses and by investing the assets in productive finance”.

The most obvious drawback of this strategy is the loss of control of the defined-benefit schemes. Also, as the insurers tend to shift the assets to lower-risk holdings, such as bonds, the well-publicised move away from UK equities by large pension funds is only set to continue. Still, the deals are generating a lot of business for the UK’s largest insurers.

Auto-enrolment gives pensions a boost

The defined-benefit pension market is slowly shrinking as the number of scheme members declines. Meanwhile, the defined-contribution market is expected to expand rapidly over the coming years, turbocharged by the UK’s world-leading auto-enrolment scheme.

Auto-enrolment was introduced in the UK in 2012 and was, at the time, a world first. It was designed to replace defined-benefit schemes and get people to save for the future.

The onus still falls on the employer to set up the pension for the employee, but contributions and, ultimately, retirement benefits are a lot more variable (and cheaper for the company).

Under the current rules, an employer must enrol an employee in a pension scheme if they’re a UK resident, work in the UK, are aged over 22 and earn more than £10,000. The minimum contribution is 8% of an employee’s salary, 3% from employees and 5% from the employer.

Since the introduction of the system, assets in defined-contribution pension schemes have nearly tripled from £200 billion in 2012. Projections suggest the size of the market could hit around £1 trillion by the end of the decade.

There are two segments in the market: the contract-based and trust-based schemes. Presently, these two segments make up roughly equal shares of the market. Under a contract-based scheme, individual contracts are agreed between the scheme member (the company) and the pensions provider, usually an insurance company or an investment platform.

With a trust-based scheme, the company agrees a relationship with a large pension master trust such as Nest or the People’s Pension. These multi-employer schemes are some of the largest and most powerful pension providers. Aside from the defined-benefit and major payers in the defined-contribution market, around £500 billion of funds are held within self-invested personal pensions (Sipps) and £300 billion is in the bulk and buyout annuities market.

This is a general overview of the UK pension sector at this point in time, but there are multiple reviews under way into the sector and constant calls to review the auto-enrolment system. Providers Standard Life and Phoenix have been calling for the auto-enrolment minimum to be raised to 12% of salary a year, and the minimum age and salary requirements to be dropped. The companies have argued this could boost funding by £10 billion. There have also been motions in government to boost auto-enrolment funding requirements.

Then there’s the conversation about the way pension funds are invested.

The legacy defined-benefit schemes have de-risked mainly as they’re no longer investing for the future. The funds are paying out benefits and need to make sure they have enough funds to meet their obligations. As a result, most are invested in bonds and other low-risk, cash-like investments.

Defined-contribution funds, on the other hand, have a far higher equity weighting.

According to the Pensions Policy Institute, in 2023 private-sector defined-benefit schemes had 55% of assets invested in bonds, mainly index-linked gilts, and 20% in cash and cash-like instruments.

In trust-based defined-contribution schemes, equities accounted for 56% of assets, with bonds at 24%. Overall, one-third of UK pension assets are invested in equities.

There are various conversations and consultations going on around how pension funds can be convinced to invest more in productive assets, such as infrastructure and UK equities.

The outcome of these conversations could have a big impact on the UK equity market and investment providers that specialise in alternative and private assets.

How to profit from the changes

There are three main ways for investors to capitalise on the current trends shaping the UK pension industry.

The first is the bulk annuity and pension buyout market. As noted above, the industry is currently dominated by a few major players, such as Legal & General, Aviva, Phoenix Group (via Standard Life), Pension Insurance Corporation (PIC), Rothesay Life, Just Group and Canada Life.

Just Group (LSE: JUST) specialises in smaller schemes and might have the most room for growth. Its largest deal last year was a £1.8 billion full buy-in with the trustees of the G4S pension scheme. Overall, the firm completed £5.4 billion of deals last year across 129 transactions, up 57% year-on-year.

Companies such as Just make money from the buy-in and buyout deals in three ways. Upfront payments to take over the scheme, management fees, and investment returns earned on surplus assets, known as “in-force profit”.

Just reported new business profit of £460 million, up 30% year-on-year, and in-force profit of £236 million, up 24% last year.

Going for growth

While other companies, such as Legal & General, Phoenix and Aviva, have scale, Just has the best growth opportunities as it operates at the smaller end of the market.

Most defined-benefit schemes are at the smaller end of the size spectrum and are just not worth the time and effort for the larger players. Just has developed a program called Beacon to help win business. This software helps calculate insurers’ buyout and buy-in fees and is, according to the company, “now being used by all major employee benefit consultants”.

Just also has a growing annuity sales business, which is benefiting from strong demand for these products, which now offer some of the best guaranteed income in retirement rates the market has seen for over a decade.

Just is reinvesting to grow its business, and this can be seen in the company’s dividend yield. While management hiked the 2024 payout by 20%, the stock’s yield, of around 2% is still the lowest in the sector. Still, dividend cover is the highest in the sector, and the shares are trading at a deep discount to tangible net assets per share of 254p.

If you’re looking for income, M&G (LSE: MNG), Phoenix Group (LSE: PHNX), Chesnara (LSE: CSN) and Legal & General (LSE: LGEN) could be the ones to choose.

With dividend yields of around 9%, they’re income champions, although Phoenix has an edge with its retail and workplace pension arms (under the Standard Life brand). As well as its bulk annuity business, Phoenix is also a top-three player in the market for providing workplace defined-contribution schemes. Assets under administration totalled £66.5 billion at the end of 2024. Gross inflows for the year totalled £9.3 billion. This could become a far more important side of the group over the coming years.

Managing workplace schemes is a higher margin, asset-light business and management has laid out key targets to grow this division into the booming defined-contribution market in the UK. Phoenix also wrote £5.1 billion of bulk annuities last year and has a 12% market share of the individual annuity market, having only re-entered this market in 2023. Of the group, analysts at Panmure Liberum think Phoenix is the best play on the sector due to its “expanding its workplace savings and pensions business and improving the capital intensity of its annuity business, combined with a larger repeatable source of capital generation from its existing book of business”.

The other major players in the market, Aviva (LSE: AV) and Legal & General, are both good options, but they’re far more diversified.

Aviva is much more of a general insurance business and will only become more so after the merger with Direct Line is completed. However, the group’s wealth and savings platform does give it a major foothold in the defined-contribution market, and this is going to be a key area of focus for the company in the coming years.

Legal & General is much the same. It has become one of the UK’s largest asset managers in recent years, providing fund management for the defined-contribution market. With over £1 trillion in assets, it’s the 800lb gorilla in the room, but it’s also vastly complex to understand.

Compared with Just, it’s not going to achieve anything like the sort of growth that could be possible from a smaller player in the market. Still, with a 9% dividend yield, it’s a solid FTSE-100 income play that’s unlikely to disappoint.

A fast-growing fintech

The real opportunity in the market lies in consolidation. There are many small schemes and pots in both the defined-benefit and defined-contribution market. Just is using technology to carve out a market here, and so is one of the UK’s fastest-growing fintechs, PensionBee (LSE: PBEE).

The firm specialises in consolidating small pension funds, using technology to speed up the process. The market for transferable pensions has expanded threefold in the past decade to £1.3 trillion and is now growing 12% annually.

Where PensionBee has the edge is in public awareness. It has spent £64 million on marketing since it was founded and now estimates that it generates £96 of net inflows for every £1 in market spend. It has a 57% brand awareness among consumers – one of the highest levels among all pension brands. It has also invested heavily in the technology to help scale the platform. Last year, the group spent £19.3 million on technology, up 1% year-on-year and a fraction of group assets under management (£5.8 billion).

Analysts at Berenberg believe the company’s “scalable business model, strategic expansion, and robust brand create a compelling growth trajectory”, with assets under management set to double by 2027. The firm delivered its first positive Ebitda figure in 2024 (£2.4 million) and Berenberg estimates that figure will hit £13.6 million by 2027 with a margin of 18.6%.

Another option is XPS Pensions Group (LSE: XPS), the largest pure pensions consultancy in the UK, which works with more than 1,500 pension schemes.

XPS helps pension schemes and trustees navigate many of the challenges outlined above as well as other day-to-day processes associated with running pension schemes. The bulk of its contracts are inflation-linked and long-term, giving a good deal of visibility over future revenue growth.

Towards the tail end of last year, it won a contract to provide administrative services for the John Lewis Partnership Pension Trust, a scheme of nearly 165,000 members. It’s also building an edge helping schemes navigate bulk annuity transfers.

Last year, revenue increased 20% and adjusted Ebitda grew by 30%. Analysts at Panmure Liberum have pencilled in further earnings growth of 20% over the next two years, excluding deals. Earlier this year, it acquired insurance consultancy business Polaris Actuaries and Consultants Limited, which provided the group with “immediate access to long-term, established relationships with master services agreements with the majority of the UK’s leading insurers”.

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