OECD research: A focus on long-term opportunities
The OECD’s recent survey of large pension funds shows that despite increased interest in alternative investments, there has been less traction in areas like direct infrastructure. Investors are concerned about regulation and there is a lack of bankable opportunities. Raffaele Della Croce and Joel Paula discuss international initiatives to stimulate interest in long-term opportunities
Public and private pension funds, and public pension reserve funds, occupy an increasingly important role in the financial system. Not only do they provide income to beneficiaries and help to sustain standards of living for millions of people, they also act as important sources of investment capital and long-term financing. Given the increase in asset levels since the global financial crisis (GFC) of 2008, the accumulation of savings in these institutions has never been larger. In order to advance the recovery to the next level, the challenge now is to put savings and financial liquidity to productive use in order to support sustainable growth.
But with financial markets strongly affected by policymakers’ actions, investment paralysis – the problem of having few attractive opportunities in an environment where asset values already seem high – is a challenge. Quantitative easing in the United States, high fiscal debts in Europe and Japan, and shifting economic signals in emerging markets make it increasingly challenging for institutional investors to design policy allocations using traditional methods.
Furthermore, the post-GFC environment is changing the way that financial institutions like banks act as market makers and providers of credit. The recent OECD Survey of Large Pension Funds and Public Pension Reserve Funds reveals some emerging practices and trends that funds are using to overcome these barriers.
The search for uncorrelated lower volatility returns, the expansion of alternatives, the optimisation of fixed income portfolios through diversification and yield enhancement, and revision of asset allocation techniques have been some key themes in institutional investment portfolios in the recent economic environment. Most institutional investment portfolios invest in emerging markets and funds continue to refine exposure.
In particular, with return expectations low for stocks and bonds, institutions are increasingly diversifying investments away from traditional investments and a salient trend over the past few years has been an increase in alternative investments. Allocation to investments such as hedge funds, private equity, real estate, and infrastructure is by no means new.
Yet evidence from the recent OECD survey indicates increased allocations and interest in alternatives recently. This was especially true among the largest pension funds: the top ten funds in the survey, representing $1.5trn (€1.3trn) in assets in 2013, increased alternative investment allocations from 17.6% of the total portfolio in 2010 to 19.5% in 2013, on average. This included increases in all major alternative investment categories.
Public pension reserve funds – a key investor segment of the survey, also increased alternative investments over the past four years from 10.5% to 14.7% on average. This figure in particular is a noteworthy shift in the investment position of reserve funds, which back pay-as-you-go retirement systems and are different from funded pension schemes. Low bond yields and muted equity returns were again some of the major driving factors cited.
Looking more closely at alternative investment categories, infrastructure is less mature and there are fewer funds that have exposure, although this is changing. Of the 71 funds that responded to the survey, 28 reported direct infrastructure exposure, defined as direct infrastructure funds, equity co-investment, or direct equity investment.
Five pension funds and one reserve fund indicated that they planned to increase target allocations to infrastructure in the next 1-2 years. Seven pension funds and three reserve funds reported that they planned to open new target allocations to infrastructure. Some funds also reported infrastructure debt exposure through project loans or bonds. Indeed, infrastructure is an asset category with many different risk return profiles. By investing in direct equity, mezzanine debt, project loans or bonds, there is a spectrum of risk/return profiles that can meet various investor objectives.
Yet compared to other alternative investment categories, direct infrastructure comprised the smallest segment, occupying just 1.9% of the total portfolio of the top ten largest pension funds on average. Looking at the entire survey population, representing $7.8trn in assets, on average just 1.0% was allocated to infrastructure considered as direct.
There is an opportunity for policymakers to seize on investment trends in alternatives and in particular infrastructure. Yet the right mix of market regulation and policy is necessary – both for the pension funds themselves and infrastructure markets. Barriers and disincentives that limit infrastructure investment need to be addressed. As seen in the survey, there seems to be great potential capacity to expand institutional investment in infrastructure, taking into account the target allocations of the funds that already have established allocations and those that are considering opening new allocations.
OECD work on institutional investors and long-term investment in the context of the G20
In their November 2014 Brisbane Summit communiqué, G20 leaders prioritised work to “facilitate long-term financing from institutional investors”. Contributions by the G20/OECD Task Force on Institutional Investors and Long-term Financing included:
• A report on the first set of effective approaches to support implementation of the g20/oecd high-level principles on long-term investment financing by institutional investors, compiling a set of concrete actions member states are taking to implement the high-level principles.
• The G20/OECD checklist on long-term investment financing strategies and institutional investors.
• An OECD report on private financing and government support to promote long-term investments in infrastructure.
Further deliverables for the OECD related to this agenda will include:
• OECD research on the taxonomy of instruments and incentives for stimulating the finance of infrastructure, first presented to the G20/OECD task force in early September 2014.
• The results of the G20/OECD checklist on long-term investment financing strategies.
• A report on the remaining effective approaches to support implementation of the G20/OECD high-level principles on long-term investment financing by institutional investors.
Other prospective OECD work in this area includes a report on the risk-return characteristics of infrastructure as an asset class and the continuation of the annual survey of large pension funds’ investments under a G20 mandate, as well as the launch of the large insurer survey.
The G20 Australian Presidency and the OECD also co-organised the G20/OECD high-level roundtable on institutional investors and long-term investment in Singapore on 4 June 2014. A similar event will be organised in 2015 in co-operation with the G20 Turkish Presidency.
For example, Norway’s Government Pension Fund Global, considered to be the world’s largest sovereign wealth fund with $849.6bn in assets at the end of 2013, announced in 2014 that it would research and consider adding infrastructure investments to its portfolio. Currently, the fund is not allowed to invest in unlisted infrastructure, per Norwegian statute. A panel of experts is to review the possible addition of infrastructure, with a recommendation pending in 2016.
Japan’s Government Pension Investment Fund recently announced a major change to its asset allocation which will include alternative investments such as infrastructure. Both of these funds are extremely large and reflect major changes in policy.
At the recent OECD roundtable on long-term investment policy, institutional investors in attendance cited two main obstacles to infrastructure investment. First was the lack of a transparent and stable policy framework and regulatory risk was a top concern. Second was a lack of bankable investment opportunities.
“The right mix of market regulation and policy is necessary – both for the pension funds themselves and infrastructure markets. Barriers and disincentives that limit infrastructure investment need to be addressed”
Other important issues raised included clear and predictable accounting standards, long-term metrics for performance valuations and compensations, standardisation in project documentation, and transferability of loans and portability of guarantees. The expansion of financial instruments available for long-term investment (eg, bonds, equity, basic securitisation of loans), and the need for a clear risk allocation matrix to assign to the potential risk owner (government, investor or both) were also raised.
Ultimately, the primary concern for investors is investment performance in the context of specific objectives, such as paying pensions and annuities. Infrastructure can become an alternative asset class for private investors provided investors can access bankable projects and an acceptable risk/return profile is offered.
Governments are responding to the need to invest for future growth. The G20’s Brisbane action plan launched just before Christmas recognises that improving the domestic investment climate is “essential to attract new private sector finance for investment”, highlighting the urgent need to address impediments to investment, such as restrictions on foreign direct investment and market access barriers. At the same meeting, G20 Leaders launched the new Global Infrastructure Hub, which will focus on project preparation and data collection and which will be based in Sydney (see panel).
In Europe, the Juncker plan also addresses the infrastructure investment deficit. The stated objective of the plan is to leverage private sector capital, encouraging investment in infrastructure and SMEs. While much will depend on the specific choices regarding the project pipeline and the associated assistance programme, the specific focus raises some doubts as to whether sufficient investors will be willing to contribute the substantial funds that are expected without additional assurances. With the continuation of such policy work, governments can bridge the investment gap, laying a more solid footing for a robust economic recovery.
To this end, the programme of work of the OECD Long-term Investment Project is focused on building bridges between policymakers and long-term investors. For instance, OECD research includes a comprehensive taxonomy for infrastructure financing that covers the wide variety of both financing options and risk mitigation methods. The ongoing G20/OECD workflow will advance the policy dialogue on institutional investment matters. Planned events in the coming year will provide opportunities for institutional investors to gather and to advance the agenda.
Raffaele Della Croce, lead manager, and Joel Paula, policy analyst, both contribute to the OECD Long-term Investment Project.
• For the complete survey, follow this link
• For more information on the Long-term Investment Project, see: www.oecd.org/finance/lti