How real assets fit into your inflation battle

Rising inflation amid a low-growth environment, where for some ‘safety’ has become prohibitively expensive, is causing schemes to reassess what risks they can and should take.

For the full The Specialist report on property and infrastructure, go here to find the PDF.

Added to that, the backdrop of rickety and limited infrastructure to service the UK population, while banks’ purse strings remain tight, presents yet another layer of complexity – but at the same time is creating opportunity for scheme investors.

Property and infrastructure projects are hungry for the funding that institutional investors such as pension funds can provide, while at the same time schemes are desperate to anchor their portfolios to inflation-linked investments that these real assets can generate.

Although a relatively simple concept to understand on the surface, inflation becomes far more complex when looking at its effect on defined benefit pension schemes, especially within the confines of the current macroeconomy.

What is less obvious is whether inflation is indeed the most urgent threat schemes currently face – and if it is, to what degree they seek to defend themselves.

Despite all the doomsaying, inflation is not always bad news for pensions. At the most basic level, when inflation increases so too does the cost of schemes’ pensioner payouts.

However, many schemes have a cap on their inflation liabilities, meaning that if the rate tops this level, in some cases liabilities could fall as the value of other assets rise (see box, right).

But not all schemes will be in a position to view inflation with such benevolence.

And those turning to the history books for guidance on what was done in previous times of high inflation will be disappointed to find a starkly different environment for UK pension schemes, which bears little relation to the challenges many face today.

When inflation last presented a serious challenge to pension schemes, back in the late 1980s and early 1990s, the rate approached a whopping 10 per cent a year, compared with the 3-5 per cent seen more recently.

However, in contrast with today’s low-yielding environment, interest rates and property price rises were also very high. And these conditions enabled many DB schemes to use equities to hedge inflation.

Broader economic conditions were not the only thing leaning in schemes’ favour. “Most had no legal obligation to increase pensions in line with inflation, other than salary linkage, and actuaries didn’t generally base their inflation assumptions on the index-linked gilt market,” explains Phil Page, client director at fiduciary manager Cardano.

Longer time horizons and the fact most DB schemes were still open to new members also helped curtail the effects of inflation and any short-term underperformance of equities.

So what’s changed? The current landscape is really quite different. For most schemes, both pensioner payments and actuarial assumptions are tethered to an index, and the closure of most final salary schemes means there’s no new money coming in.

At the end of March CPI stood at 2.8 per cent, with RPI 50 basis points higher, both above the Bank of England’s 2 per cent target.

While the rate has steadied over the past six months, supply-side pressures mean the bank’s prices measure is likely to top 3 per cent by the summer.

As a result of the uncertainty, the number of inflation hedges taken out surpassed those of interest rate hedging in 2012, helped in part by attractive pricing, according to Page.

He notes that interest rate risk is usually the largest risk for pension schemes for two reasons: “All of the fund’s liabilities are exposed to changes in interest rates, whereas only some of the liabilities are typically linked to inflation… and interest rates tend to be more volatile than market-implied inflation rates.”

However, he adds that since the decision was made to change the RPI calculation method, announced in January, the price of hedging inflation has shot up.

It is this environment, coupled with the hunt for yield in a low-growth world, that is bringing real assets such as property and infrastructure sharply into focus for UK pension schemes.

Through real assets, schemes are essentially looking for a proxy for bonds, often with equity-like opportunity for growth.

Where illiquidity may previously have been an unwanted risk, for example, schemes are opening up to the potential added return offered by illiquidity premia.

But care must be taken not to blindly plough into these asset classes and take cover regardless of cost.

So how close an inflation match can be achieved through property and infrastructure?

Gimme shelter

Rents from property provide income streams to investors and are often upwards-only. But many lease agreements are only reviewed every five years, meaning there’s a long run before they are exposed to open market rental dynamics.

“They will therefore be slow to adjust to inflation shocks and at best provide only a partial hedge,” says Chris Taylor, chief executive of Hermes Real Estate. “There are, however, some real estate asset types including supermarkets, hotels, healthcare and leisure offering investors long leases of 25 years or more, with rents linked directly to RPI, and so these provide an explicit inflation linkage.”

But if schemes want a piece of the long-lease property action they had better move quickly, as strong demand is already pushing up prices. Taylor also adds that at the end of the lease there is no guarantee of capital value – unlike that of a bond at maturity.

Property returns have exceeded inflation over the past 60 years, with income rather than capital growth acting as the main driver. Total returns from direct UK commercial property, for example, averaged 10.7 per cent a year between 1970 and 2012, according to the IPD annual index, compared with 12.4 per cent for equities and 10.1 per cent for medium-term bonds.

What’s more, property returns displayed lower volatility than bonds and equities, says Rob Martin, director of research at Legal & General Property, a point that “underlines the diversification benefits of an investment in property”.

He adds: “Yields available from UK property are relatively high compared to their own history and other asset classes. There is also an increasing awareness of longer-term inflation risk, and property is seen as one way of hedging that risk for investors with inflation-linked liabilities.”

However, these benefits come with potential burdens for schemes, including lower liquidity, tenant counterparty risk, relatively large lot sizes, and higher due diligence and management costs.

Martin says the “heterogenous nature of the assets” is also something investors have to navigate. But even this appears to be broadening with subsectors such as social housing and student accommodation coming to the fore, which Phil Ellis, client director at Aviva Investors, says offer the added security of “government-linked rent reviews” and “university covenants”.

While property is not a new area for most schemes, many are looking to increase their allocation to the asset class:

• The British Waterways Pension Fund already had a 10 per cent allocation to property, but last year added to that a further 5 per cent allocation via a property income fund;

• The Plumbing & Mechanical Services (UK) Industry Pension Scheme has a 10 per cent allocation within its return-seeking portfolio, but also has a 5 per cent allocation to cash, part of which has been earmarked for property, according to its pensions manager Robert Burgon. Its 6 per cent allocation to infrastructure sits within its matching portfolio;

• The Environment Agency Pension Fund, however, in its investment strategy for 2012-14 outlined plans to raise its maximum investment to property from 5 to 6 per cent and introduce a 4 per cent allocation to infrastructure – both of which will sit within its growth portfolio.

So it is clear that, depending on how individual investments are structured, property and infrastructure can play a variety of roles in different portfolios.

Pensions Infrastructure Platform

The bank lending squeeze is increasingly opening up opportunities for schemes to take part in infrastructure. The Pensions Infrastructure Platform, initiated by the National Association of Pension Funds and the Pension Protection Fund, has been waving the flag for the asset class and aims to help bring about the theoretical ‘win-win’ for UK pension schemes and the UK economy.

However, so far it has received a total commitment of £1bn of its £2bn target, and has not yet decided how the money will be managed and invested – and whether it will include the greenfield construction risk that has proved a deal-breaker for many pension schemes looking at infrastructure investing.

According to Mercer’s Asset Allocation Survey 2012, 3.6 per cent of UK schemes have an allocation to the asset class, and of those the average stake is 5.5 per cent of total portfolio (see graph above).

But regardless of the progress Pip makes over the coming months, it is important for schemes to be clear on exactly what infrastructure offers – and whether they could be accessing the same benefits more easily via property.

Steven White, a consultant at Buck Consultants, comments that infrastructure carries “less economic sensitivity” than property, although he adds that long-lease property goes some way to mitigate this.

John MacDonald, head of alternatives at Hymans Robertson, agrees and says this is one of the asset class’s most important characteristics for schemes aside from long-term cash flows.

“The value of infrastructure investments is typically not directly affected by economic and geopolitical events, and investors benefit from long-term sustainable yield,” he says. “The revenue expected from infrastructure assets is generally predictable over time and tends to be linked to inflation, which can be attractive to investors, such as pension schemes, whose liabilities are sensitive to inflation.”

But MacDonald warns that schemes should not view infrastructure as a matching asset, rather it should be considered a growth asset with potential matching characteristics.

Indeed, data on the correlation between infrastructure and inflation are difficult to get hold of. The lack of a reliable and transparent benchmark led to the Universities Superannuation Scheme setting up its own direct infrastructure team to invest in the underlying assets.

But there are myriad other ways for schemes to access the asset class, says Hans Holmen, senior infrastructure consultant at Aon Hewitt, and schemes need to be better informed on the types of assets and where the underlying cash flows are coming from.

“Whether that be the government, the users, how much inflation linkage there is in these assets, what the underlying stability of cash flows is like and how all these things fit together,” he says.

Part of the difficulty, says Ian Berry, manager of Aviva Investors’ infrastructure fund, is that the multitude of subsectors means nobody wants to publish anything for fear they’ll be perceived to be doing worse than someone else.

“If they’ve taken low risk they can just say ‘We’ve taken low risk’ – but nobody cares, they just like the higher numbers,” he says. He admits his fund does not publish its data, though it is considering releasing some information in the future.

Another key differentiator is the actual asset concerned, says Giles Frost, director at Amber Infrastructure Group, which has £5bn assets under management. With infrastructure, investors own a defined long-term cash flow rather than the underlying bricks and mortar asset, which he argues removes the uncertainty of a property’s value when a lease expires.

“Revenues on many projects are inflation-linked and operating costs typically grow in line with RPI. So as inflation grows, it is likely that investment returns can also be maintained in real terms,” he adds.

However, MacDonald contests whether the asset class’s predictability is really that clear cut and says schemes should be wary of the disconnect between their objectives and that of fund managers.

“There is something of a mismatch currently between the expectations of pension scheme investors in infrastructure – long-term, predictable, inflation-linked yield – and the reality,” he notes.

“Most infrastructure funds are structured in the same way as closed-ended private equity funds, with a relatively short fund life of 12 years or so and a focus on capital appreciation and exit rather than yield.” However, he adds that open-ended funds are starting to emerge, which are more aligned with investors’ objectives.

Fees vary significantly from manager to manager, and depend on the investee projects and investors’ objectives. Aon Hewitt’s Holmen says you can pay anything from around 50bp for a brownfield project or PFI fund, up to 2 per cent for private equity-like structures, with a carry fee of up to 20 per cent.

Aviva Investors’ Berry says 50bp is “incredibly cheap” and presents some managers with the dilemma of whether it’s worth doing at all.

The road ahead

There is a potential asymmetry in the way property and infrastructure are valued within a pension scheme compared with how liabilities are calculated, according to the Society of Pension Consultants.

In its white paper Vision 20:20, published last June, it warned of a “funding volatility that hits the employer sponsor’s balance sheet” and has recommended such accounting anomalies be removed to help incentivise pension schemes to invest in property and infrastructure.

The routes into property and infrastructure are many and varied, and despite some hurdles will only continue to grow as new products are packaged up to meet the needs of UK pension schemes and the wider economy – particularly in the case of infrastructure.

The real bonus for schemes in terms of both property and infrastructure ultimately comes in the form of potential growth on top of a quasi-hedge against rising inflation. But whichever mix schemes choose, experience suggests it is crucial to be fully cognisant of the risk and reward characteristics of each allocation.

No two deals are exactly the same and their relationship to any one scheme’s liability profile will have its limitations.

Maxine Kelly is a freelance journalist