Written By: Venilia Batista Amorim
Venilia Batista Amorim looks at the benefits of SIAs as components of a DB pension scheme and identifies renewable energy and property income investments as sectors of particular interest
The UK pension system has, for some years, been under severe strain as the population ages and fewer workers support more retirees. Furthermore, there are reasons to believe that pension funds may soon be faced with lower returns from the traditional assets in which they invest. There is, therefore, a real worry in the future that the UK will be left with the choice of smaller pensions, later retirement or higher pension contributions. There is a way to at least partially mitigate this challenge: encourage pension schemes to move towards a more diversified investment portfolio, in which secure income assets (SIAs) can be included.
Secured finance has become of increasing interest to institutional investors due to the risk-adjusted yields on offer as a result of the complexity premium, and the ability to achieve greater certainty of cashflows by investing in high quality debt structures.
With many institutional investors continuing to focus on reducing risk relative to liabilities, the demand for index-linked Gilts is increasing. This demand, combined with market conditions, is driving up the price investors have to pay for the reasonably secure, long-term cashflows available from index-linked Gilts.
The de-risking of many defined benefit (DB) pension schemes has been a significant factor in making it harder for other pension funds to de-risk. The Utopian position of being in a well-funded, cashflow-matched position seems increasingly out of reach for many schemes that were not amongst the first to buy index-linked Gilts before prices were driven to current high levels.
According to analysis by Willis Towers Watson, the supply of index-linked Gilts is not expected to meet pension scheme demand until about 2040. This imbalance is likely to maintain a downward pressure on real yields for the next few decades. Therefore, investors are desperately searching for high quality, inflation-linked cashflows with a more attractive yield.
SIAs fit into that category – they are an ideal component of a DB pension scheme’s investment strategy for the following reasons:
- They are expected to generate returns of 2-3% per year in excess of index-linked Gilts;
- They are very secure cashflow streams – more secure than investment grade credit – as they are usually contractual cashflows and have significant collateral backing;
- They generate an attractive distribution yield – approximately 4% per year – which can help meet the payments faced by schemes as they become increasingly cashflow negative;
- The long-term nature of the cashflows provide some natural liability hedging characteristics.
Increasing regulatory capital requirements since the 2008 financial crisis mean that banks are less willing to lend to consumers, corporations and other borrowers. By accepting some illiquidity, and successfully navigating the extra complexity associated with secured finance investments, there is an opportunity for long-term investors to fill the void left by banks. Certainly, regulation will continue to drive the evolution of capital markets and that is creating a structural investment opportunity for non-bank lending strategies.
There are, however, barriers to market entry that will restrict the amount of capital that will flow into SIAs from traditional fixed-income investors. For example, many investors are restricted by benchmarks, style biases, liquidity and resource constraints from considering opportunities outside bond markets. Also, many non-bank investors do not enter the secure finance market because accessing the market requires specialist skills to deal with the extra complexity relative to traditional credit markets.
SIAs are commonly known to generate a predictable income stream of long-dated, fixed or inflation-linked cashflows, which are secured against underlying assets. These assets usually include strategies spanning real estate, infrastructure, renewable energy and real asset debt, and these can provide inflation-linked cashflows coupled with risk-adjusted returns superior to investment-grade credit and index-linked Gilts.
Whilst the underlying assets in a secure income portfolio are not readily traded, there is a healthy secondary market for these assets. A portfolio of high quality SIAs can be traded on the secondary market within a matter of months, sometimes even trading at a premium to the net asset value. However, these assets are unlikely to be appropriate for pension schemes that expect to have a holding period of less than 10 years.
Duncan Hale, portfolio manager of Willis Towers Watson’s Secure Income Fund, said: “The benefits of long-term, inflation-linked returns are clear and, if implemented well, can deliver 4% yields over the long term… [and] can offer investors robust cashflows alongside strong societal benefits.”
One such sector that incorporates both these qualities is renewable energy, which includes wind and solar farms, hydroelectric, geothermal and biomass power-generating facilities, as well as wave and tidal technology. The need for funding to build and operate these facilities has given rise to renewable infrastructure as an asset class.
Renewable energy is an integral part of the UK’s sustainable energy system and the nation’s decarbonisation agenda as the country aims for more than 30% of electricity to be generated by renewables in the long term. State funding often fails to provide enough capital to build and sustain sufficient renewable infrastructure. Private funding is, therefore, needed to make up the shortfall. The capital for new wind farms usually comes from large utility companies, while smaller private developers tend to fund solar power facilities. However, neither type of organisation is a natural long-term owner of the finished product. This is where other investors, such as pension funds, are better suited to hold long-term investments.
“A lot of early discussion around renewables has focused on the environmental benefits. However, since 2009, there has been an increased ability to articulate and demonstrate more clearly their economic and financial benefits too. Consequently, we have seen significant investment in renewable energy production over the past few years. These are attractive assets that provide strong returns, whilst also delivering wider environmental benefits,” Hale added.
Renewable infrastructure investments aim for annual returns of around 7-9%, including dividend yields to approximately 5-6%. These returns are sourced from a mix of government subsidies and sales of power to utilities companies. Given the security of their cashflows, these investments often raise debt to enhance returns to investors. A loan-to-value ratio of 30-40% is common.
Property income investments also seem to be amongst the most popular SIAs. Robert Peto, chair of Standard Life Investments’ Property Income Trust, believes that Brexit and the continued uncertainty surrounding the outcome of those negotiations have impacted the UK economy. As such, combined with subdued consumer spending, the growth in the UK economy was among the slowest of the developed nations last year. Despite this bleak background, the performance of the UK real estate market has been positive, he added.
Peto said that diversification is the key to success. The trust aims to generate an attractive level of income, along with the prospect of both income and capital growth, by investing in a diversified portfolio of UK commercial property assets. It invests in three principal commercial property sectors: office, retail and industrial. Its portfolio total return for the first quarter of this year stood at 1.8%, compared to the benchmark’s 0.4%. It returned 7.7% over the past 12 months, compared to the benchmark’s 5%.
The UK’s Local Government Pension Scheme (LGPS) funds have already started to implement such strategies. The Brunel Pension Partnership, which represents 10 schemes from the LGPS and the Environment Agency, committed £340 million to its secured income portfolio late last year. It was the pool’s first investment in long-lease property, through the M&G Secured Property Income Fund and the Aberdeen Standard Long Lease Property Fund.
Richard Fanshawe, head of private markets at Brunel, said that both investment funds “offer broad immediate diversification, strong long-term performance track records and sector-leading sustainability credentials.”
SIAs look set to remain a primary focus for investors for the months ahead. The latest Schroders’ Global Investor Study conducted at the end of 2018 showed that the average level of income that investors are seeking from their investments has increased from 9% to 10%. “This is an ambitious target,” said Rupert Rucker, Schroders’ head of income solutions. The challenge for the foreseeable future is that traditional sources of income cannot fulfil investors’ needs, he explained.
“In the past, investors could earn decent levels of income with limited risk to their capital by depositing their savings in banks and government bonds. That has changed since the financial crisis, and returns on lower risk assets such as cash and some western government bonds are much lower than they were before 2008,” Rucker noted. This has resulted in a mismatch between investors’ expectations and the reality of the current investment landscape.
The search for income is indeed a question of expectations. Investors may need to dial down their income ambitions in a world of lower interest rates and returns. Earning a sustainable higher income will involve taking on more risk – particularly in terms of volatility. Investors will need to remain invested for a long period of time, as that is the only way that short-term declines and capital values can be restored and income earned.