Will the promising romance between pension funds and infrastructure projects work out?
Construction companies want long-term investment for infrastructure projects. Pension funds want long-term investments. The two appear to be ideal partners. But securing a tie-up between them has proved to be a hard slog.
A year ago, during his Autumn Statement, the chancellor of the exchequer George Osborne pledged to generate £20bn worth of infrastructure investment from the nation’s pension funds. The figure grabbed a lot of headlines. But as Osborne prepares to deliver his 2012 Autumn Statement next week, just 4% of that investment - £800m - has been achieved - and that only in the form of
soft commitments to the industry’s Pensions Infrastructure Platform (PIP) initiative (see box).
“You have a bride and groom that seem destined for one another, but somebody needs to set up the first date,” says Toby Buscombe, a principal in the alternative investments boutique at pensions consultancy Mercer.
Given the obvious attraction, what’s holding pension funds back from tying the knot with its prospective infrastructure bride?
UK pension funds hold an average of 1% of their £2.4 trillion assets in infrastructure. To put this figure into context, it is less than a quarter of the proportion accounted for by hedge funds, and much less than their international peers.
UK pension fund investment has traditionally been dominated by equities. However shares have generated poor returns over the past decade. This year, for the first time since records were collected, UK pension funds hold fewer equities than bonds, according to the recently published industry bible, the Purple Book. Another factor pushing final salary schemes to slim down their equities portfolios is the need to seek the kind of safe and steady returns that will ensure their ageing members’ benefits get paid.
But while shares may have lost their sheen, the yields on bonds are rock bottom - so low, in fact, that some bondholders are paying interest to the governments that issue them, rather than the other way round.
The Society of Pension Consultants (SPC) warned in a recent report that it would not be possible to create enough index-linked government bonds, otherwise known as gilts, to meet UK pension funds’ appetite for such investments over the next decade. “Pension funds are crying out for an alternative to gilts,” says SPC president Roger Mattingly.
Infrastructure’s appeal for investors is that it provides the kind of stable, long-term returns offered by gilts. These returns are a good match for final salary schemes, with their liabilities stretching down the decades.
In addition UK pension funds interest in infrastructure has been quickened by increased activity from their Australian and Canadian counterparts, including the eyebrow-raising £2.1bn acquisition in 2010 of the High Speed One rail link by the Canadian teachers and local government workers’ schemes. However, from the perspective of construction companies, it’s often the wrong kind of infrastructure that appeals to pension funds. The funds like brownfield assets - those that are already built and generating predictable returns.
Alan Rubenstein is chief executive of the Pension Protection Fund (PPF), the rescue fund for failed final salary schemes, which is one of the PIP’s two main backers. “Brownfield infrastructure is the kind of thing [investors] want,” he says, “but competition for those assets is huge.” In addition, pensions funds haven’t tended to take part because the investment vehicles aren’t set up in the right way.
The lack of supply of these brownfield assets is prompting pension funds’ interest in the delivery of new projects. As Joanne Segars, chief executive of the National Association of Pension Funds, told Building last week, some of her members are prepared to invest in greenfield projects. However it remains a fringe activity for UK pension schemes, which generally lack the skills and experience to weigh up the greater risks of getting involved in the infrastructure construction phase.
Mike Taylor, chief executive of the public sector division at London Pension Funds Authority (LPFA), says: “As yet funds don’t exist that the Local Government Pension Scheme or indeed any pension funds would want to go for.”
Nevertheless, Mattingly, who is also a partner at pensions consultancy JLT, sees huge opportunities in greenfield infrastructure. “If you can get involved at the greenfield stage and then stay throughout the lifetime of the project, you have your Holy Grail of a predictable income stream of pretty long duration that will be hugely attractive in terms of matching off liabilities and cash flows.”
But while many of his pension fund clients are intrigued by the prospect of investing in national infrastructure, their primary focus is on their fiduciary duty to safeguard members’ assets.
“There’s no way they can do it from a fiduciary point of view if the risk is too great - they would be hauled over the coals if things went belly up,” he says. “It’s getting to that Holy Grail without undue risk which is the challenge.”
During the summer, the government unveiled a series of guarantees - worth up to £40bn - designed to give the private sector a greater incentive to invest in infrastructure projects. However, the guarantees on offer so far haven’t exactly whetted pension funds’ appetites.
“We want more detail,” says PPF’s Rubenstein. “We would like to see more detail on situations where we have a contractor who wants to build the thing, a pension fund that wants to finance the thing and we need somebody to take away the greenfield risk.”
The LPFA’s Taylor is equally sniffy. “They don’t appear to be targeted at pension funds,” he says of the initiative. “They appear to be targeted at the provider of the infrastructure, the developers. I’ve not seen any guarantee that would influence us one iota.”
What his organisation wants, he says, is a tangible incentive from the government, such as a bond equivalent return during the construction phase of projects. “That would be interesting, but I’m sure that’s not on the Treasury’s agenda,” he says. “Nothing much is happening.”
Alexander Jan, associate director at Arup, suggests another mechanism for offering pension funds the security they want: “The government could provide an enhanced guarantee so that if there was a cost over-run during that phase of the project, the first call could be on them. Having that would lower the cost of the debt, which would help projects to proceed.”
He cites a deal announced last week in the Netherlands to finance the widening of the N33 trunk road, which will be delivered by Bam. Under the deal, the giant Dutch pension fund APG is providing upfront finance and will receive payments from tolls on the existing road.
Recent weeks have also seen a move by communities secretary Eric Pickles to relax the rules surrounding local government pension fund investment in infrastructure. Under the proposed change, council funds could invest up to 30% in the kind of partnership vehicles normally used for infrastructure projects. The LPFA’s Taylor says that the move is a welcome one, but is unlikely to be a game changer.
Ultimately, Rubenstein explains, pension funds will only invest when the arrangements suit them. “We are not doing this because the government wants us to or because we want to do something that is socially beneficial,” he says. “Clearly there are projects like social infrastructure where you can at the same time benefit the environment and society, but the driver is to deliver for pension funds low-risk and inflation-linked returns that they want.”
So until the government can find a way of making it worthwhile for them to invest, pension funds are unlikely to seal the knot with the construction industry.
The £800m worth of soft commitments announced by the Pensions Infrastructure Platform pales next to George Osborne’s pledge to generate £20bn worth of infrastructure investment from UK pension funds.
However, the commitment still represents good progress, argue pension experts, given pension schemes’ historic reluctance to get their hands dirty with infrastructure projects.
The platform, which is a joint project between the National Association of Pension Funds and the Pension Protection Fund (PPF) - a rescue fund for failed final salary pension schemes - is due to be up and running in the first half of next year. It is specifically designed to be a fund that pensions can invest directly in, and it is not yet clear whether it will put money in to new-build schemes. Seven funds, including BT’s, have so far signed up as founding investors in the platform with another in the pipeline.
It is seen as necessary because one of the issues currently holding back pension funds from investing in infrastructure is the kind of financial vehicles that they generally have to use to access the asset class.
Only the biggest funds, like the big Canadian schemes, have the capacity to invest directly in infrastructure projects. Infrastructure investment is therefore mainly accessed indirectly via private equity-style partnership vehicles.
PPF chief executive Alan Rubenstein says this is out of kilter with the more patient approach pension schemes need to take.
“People don’t hold assets for the long term - it’s the buy it, hold it, flip it mentality. Pension funds want funds that take an approach consistent with what they want which is long-term, inflation-linked cash flows.”
The PIP is designed to remedy these problems, charging its members lower management fees and investing for the long term.
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