In this edition of Investment Blueprint, Aviva Investors' Chris Laxton looks at the various options for schemes seeking to hedge their inflation liability through index-linked assets such as housing and infrastructure
It is a well known fact that many UK pension funds have a funding shortfall and are keen to explore means of reducing that shortfall without increasing their risk exposure.
The valuation of such assets should also have relatively low volatility
This is exceedingly hard for schemes to achieve, especially as index-linked gilts (against which pension fund liabilities are measured) are currently trading at pretty much a 0% real yield.
The ideal assets for a UK pension fund with an under-funding issue are ones which have the following characteristics:
Long-dated (ie more than 25 years) cash flows;
High degree of security;
Indexation, ideally in line with the Retail Prices Index (RPI);
A margin above index-linked gilts of at least 100 basis points;
Sterling-denominated.
Unfortunately there are currently very few investments which offer these characteristics.
This is where inflation-linked real assets come in – investments in the real estate or infrastructure sectors which offer long-term inflation-linked cash flows.
Due to gilt yields being exceedingly low, many pension investors want investments that aim to offer an enhanced return over and above gilts, but without taking material risk.
Which asset suits your scheme?
As a result, inflation-linked real assets are getting attention from pension schemes as they provide the investment characteristics they are looking for.
Social housing – Social housing is the provision of housing accommodation on an affordable basis to the least well off members of society.
The sector is in urgent need of a new source of long-term finance, and because it is long term – highly secure and index-linked cash flows can be structured – pension funds are a natural source of finance.
Contracts for income for more than 35 years can be secured against housing associations or local authority credits, with the underlying added security of ownership of the underlying assets.
Ground rents – Commercial and residential ground rents involve the ownership of the underlying freehold or very long leasehold interest in land.
A typical ground rent investment would be the ownership of the freehold interest in a block of flats, where individual flats are let on 125-150 year leases at a ground rent of between £100 and £500 a year.
The rent would rise every seven to 15 years, either in line with RPI or by a fixed percentage.
Infrastructure – Infrastructure is a massive sector in which there are many highly secure contracts for between 20-30 years.
Unfortunately most contracts include fixed payments, rather than index-linked.
That said, there are investments available with indexation, including within the health and renewable energy sectors (in the latter, some especially attractive margins have been available).
Commercial assets – There are parts of the commercial real estate market where long-term (more than 25 years) lease contracts are available, such as on car parks and office buildings let to local authorities and supermarkets.
These assets are most attractive to pension funds where at the end of the contract the asset reverts to the counterparty, so there is no reversionary value.
Inflation linkage is usually achievable, albeit with a 0% floor – rent can never fall – and a 5% annual cap.
How these assets can help
Pension funds can achieve many of their core objectives through these assets: long-term income; inflation linkage; high income security and a margin of more than 1.5% over index-linked gilts, net of all fees and expenses.
The primary reason that these assets deliver an enhanced return is their relative illiquidity – there is a substantial illiquidity premium.
It could be argued that this, perhaps, is not a very attractive characteristic, however this should not be of undue concern to a pension fund, especially if exposure to inflation-linked real assets is only 10%-15% of all assets.
In view of the underlying long term index-linked cash flows, the valuation of such assets should also have low volatility relative to index-linked gilts in normal market conditions.
The excellent liability matching credentials of these assets, combined with the potential for strong returns relative to assets with a similar risk profile, mean strategies involving these assets are expected to be used increasingly by long-term investors as an alternative to traditional fixed-income assets.
Chris Laxton is real estate investment director at Aviva Investors.
