Government plans to create one of the largest pension schemes in the world from a merger of 87 local authority retirement funds could undermine investment in groundbreaking businesses across the north of England, according to former Treasury adviser Lord Jim O’Neill.

Innovative startup businesses, many of them spun out of universities in Manchester, Leeds and Sheffield, could lose out if the Treasury creates a big fund interested only in backing large companies, he said.

O’Neill, who is chair of the £312m Northern Gritstone investment fund, said there was a danger the policy could backfire if the merger fails to preserve the local knowledge and commitment to backing local businesses found in the current system.

“From our experience at Gritstone, it’s a myth that local authority pension fund managers don’t invest in British startup businesses because they do. It is the big pension schemes that are nervous about investing in the kinds of businesses that we support,” he said.

Northern Gritstone backs more than 20 businesses, including the chip maker Pragmatic Semiconductor, which was started by Cambridge University academics and makes “flexible chips” for tracking goods in a factory near Sedgefield in County Durham.

Individual local authority pension schemes provide more than 50% of Gritstone’s funds.

Last month, Rachel Reeves set up a taskforce of industry executives and ministers from the Treasury and Department for Work and Pensions to shake up the industry – cutting costs and improving investment options – to allow retirement scheme managers to boost pension pots by up to £11,000.

One aim of the taskforce is to pave the way for a merger of the 87 individual pension schemes in the Local Government Pension Scheme (LGPS) covering England and Wales. The scheme, which ranks as the seventh largest pension fund in the world, managing £360bn worth of assets, spends £2bn on fees, which could be reduced following a formal merger.

Reeves, who met pension fund managers in Toronto this month to discuss the creation of a “Canadian-style” model in the UK that fosters huge retirement funds investing in UK businesses and infrastructure, said that if local authorities failed to bring about a merger voluntarily, she would legislate next year to abolish them.

O’Neill, a former boss of Goldman Sachs Asset Management who served as a Treasury minister in David Cameron and Theresa May’s governments, was among business ­figures who helped Labour develop its policies before the election.

“If the new fund mimics other large pension schemes, it won’t invest in things like Gritstone. If I was running the merged fund, I wouldn’t. The incentive wouldn’t be there,” he said.

“On the other hand, the fund managers at the Manchester pension scheme felt they had a moral responsibility to support local businesses” , as well as wanting a good long-term return for pension savers,” he said.

Duncan Johnson, the chief executive of Northern Gritstone, said a partial merger of local authority funds into the £64bn Border to Coast scheme, which invests on behalf of a range of local authority funds, had shown how local knowledge could be lost.

“The Border to Coast scheme has no place-based investment policy. It is just about making a return on the investment,” he said.

Johnson also warned the government to support universities after several were found to have large funding shortfalls.

He said university spin-off businesses were crucial to support the UK’s drive to be at the forefront of technology and innovation. Without government support, institutions will fall down the world rankings and lose expert academics behind the next generation of “investable businesses”.

A government spokesperson said planned reforms to UK pensions included a merger of local government schemes so the new entity can “invest in a wider range of UK assets while cutting waste. And we will ­consider legislating to mandate ­pooling if insufficient progress is made by March.”