Over recent years the money paid in by employers and employees, and the investment returns on the assets in which the pension scheme monies have been invested, have generally not been enough to keep pace with the pension scheme liabilities. Real assets such as property and infrastructure can help trustees to meet their required rate of return.
With pension scheme deficits continuing, the investment challenge for the trustees of pension schemes has traditionally been to strike a balance between investing in assets that match long term liabilities, such as UK government bonds (nominal and index-linked gilts), and assets such as equities that achieve growth, in order to reduce pension scheme deficits.
“Trustees of UK defined benefit pension schemes have a difficult job. Their primary task is to ensure that members’ benefits are paid out as and when they fall due – with payments stretching out over many decades. The problem is that the money paid in by employers and employees, and the investment returns on the assets in which the pension scheme monies have been invested, have generally not been enough over recent years to keep pace with the pension scheme liabilities (i.e. the promise to pay pensions in the future). On the asset side of the equation, returns on equities have been volatile, while the valuation of liabilities has been negatively impacted by the current low interest rate environment.”
Looking at alternatives
But now trustees are broadening their search, and have been seeking out other (alternative) asset classes that:
- Target similar returns to equities, but are less correlated with equities (given the frequent ‘bumpy rides’ produced by the latter)
- Provide a stream of income similar to bonds, but producing higher returns, and, ideally with income payments that increase in line with the Retail Price Index or the Consumer Price Index (since pension liabilities generally increase with inflation).
As a result, and especially since the economic and financial crisis in 2008, pension schemes have been investing in both financial and physical alternative asset classes, liquid and illiquid assets, and in new strategies that are not really separate asset classes at all, such as hedge funds.
The range of so-called alternative assets can be segmented into various categories, and a particular focus of pension scheme trustees of late has been real assets. While a definition of this category could be those asset classes that provide specific protection against rising prices (such as index-linked gilts), we prefer to view real assets as those that are ‘physical or tangible’, whether invested in directly, or indirectly via a fund, and including property (real estate), infrastructure, timber and farmland. The remainder of this article will focus on the first two of these asset types.
There are various ways for UK pension schemes to invest in property and infrastructure. Firstly, direct investment in a ‘physical or tangible’ asset; such as the purchase of an office block, or a direct interest in a wind farm. Secondly, there are various indirect investment avenues including open-ended funds, and closed-ended funds such as REITs. The direct route is a relatively illiquid way of getting exposure to real assets, while indirect exposure via REITs provides a much more liquid exposure - but there is a place for both in pension scheme portfolios.
Direct investment in real assets is distinct from traditional asset classes such as public quoted equities and government bonds. Office blocks are not actively traded on exchanges, are illiquid, and so are typically held for long time periods (and thus fitting in with the time horizon of the liabilities of pension schemes).
What’s the appeal?
One of the appeals of a direct investment is the fact that the asset is ‘physical and tangible’, which can provide a greater sense of security for trustees.
Another appeal of property and infrastructure in general is that their typical investment performance bridges the gap between equities and bonds. The stable bond-like payment structure often provided by, for example infrastructure, provides the consistent (and often inflation-uplifted) cash flows that are needed to meet expected future pension payments. But these assets can also offer the potential for equity-like upside, and so can help close the pension scheme funding gap.
For pension schemes investing in UK property, the investment market has been traditionally dominated by three main commercial property sectors, offices, retail, and industrial. However alternative property investments, such as hotels and other leisure, and student housing, as well as residential property have become increasingly popular in recent years. Larger pension schemes are also looking at property overseas. From an income (and matching liabilities) perspective, pension scheme trustees have increasingly been investing in long lease properties, either directly or through funds, with leases that are 20 to 25 years in length and let with very safe covenants.
Infrastructure assets, with their long term, inflation-linked cash flow profiles, are increasingly being considered as an alternative to traditional matching assets such as inflation-linked gilts. Pension scheme trustees are attracted to the predictable, stable, risk-adjusted returns from these long term assets; they protect against inflation and help to diversify their portfolios.
Infrastructure is a broad asset class and the assets often have very different risk and return profiles. Trustees need to consider whether the infrastructure asset class is suitable for their pension scheme, and if so, which type of infrastructure assets to invest in, and how to access the asset class; directly or via a fund vehicle.
The decision as to whether to invest directly, or through an appropriate fund, will usually be taken by trustees on the grounds of the size of a pension scheme’s assets. It is generally only larger schemes that can invest directly, given the high cost of a typical investment, and the requirement for the assets of pension schemes to be diversified.
There are a wide range of real assets’ pooled funds available to trustees, including unit linked life insurance funds, Limited Partnerships, offshore (e.g. Jersey) unit trusts, Real Estate Investment Trusts (REITs) and property authorised investment funds (PAIFs). In the future, the UK tax transparent Authorised Contractual Schemes (ACSs) may also become more popular, following the changes to the treatment of Stamp Duty Land Tax which come into effective in the summer of 2016.
The choice of fund structure will depend on such issues as the underlying investment strategy (‘core’ versus ‘specialist’), requirement for liquidity (e.g. daily traded funds vs a Limited Partnership), the annual management charge, and the jurisdiction in which the fund operates, particularly in light of growing concerns about the use of off-shore tax structures.
Real assets such as property and infrastructure can help trustees meet their required rate of return, and by generally having a low correlation to equities and fixed income, they act as diversifiers, hence improving the expected risk adjusted return of pension scheme portfolios.
This material is for general information only and is not intended to provide specific advice.