BPMT finds the perfect inflation match
BPMT is the Netherlands’ third largest pension fund for the metal industry. In common with other Dutch defined benefit pension funds, the biggest risk it faces is inflation, since its liabilities are index-linked to prices. This impact of inflation on a pension fund can be huge and can be costly.
So the question the fund’s asset manager Mn Services found it worthwhile to investigate was: “What instruments could be made available to BPMT in order to provide it with a direct hedge against price inflation?”.
Mn Services researched the conventional hedges against inflation such as commodities and real estate.
The solution lay not in real estate as such but in the rent produced. In commercial leases, the rents are subject to annual increases directly linked to the consumer price index (CPI).
Mn Services realised that if it could extract separately the inflation from the real estate it would be able to create a perfect hedge for inflation risk affecting BPMT’s liabilities.
Working with Inflation Exchange Fund NV and Bouwfonds, Mn Services created a SPV, which enables the owner of commercial real estate to receive a source of funding, along with the traditional equity and mortgage funding, from the discounted cash flow value of the future inflation cash flows. Within this structure the obligations towards all parties involved can be met. The rental income can be used to pay the mortgage bank, the property manager and the inflation buyer.
The SPV supplies the bank with loan guarantees. Each year a certain proportion of the loan principal amount is amortised from the net rental income until a certain minimum floor is met. The amortisation creates additional security a kind of collateral for the benefit of the inflation buyerpayments. It means that as soon as the loan has been amortised there will be more surpluses available for meeting the inflation obligations. At lower debt levels the conflict of interest between the mortgage lender and the inflation buyer are minimised.
In this way, the amortisation acts as a kind of kind of buffer. If real estate rents fall, the loan-to-value is sufficiently low for the SPV to attract additional funding in order to continue to meet its obligations against the inflation buyer. and the owner of the real estate runs a greater risk of not receiving inflation. The total structure has been stress-tested for several factors, in particular, high inflation rates and high vacancy rates.
The aim is to make sound financial arrangements so that the inflation buyer will be always be first-ranked, after the mortgage lender, placed on the first position to get money out of the SPV.
However, the provider of the loan also has priority within the legal framework. The commercial real estate rents are used to meet the obligations of the both loan and the inflation contract. If rents fall, there is conflict between two almost equal priorities – meeting interest obligations and inflation operations. That is why it is important to minimise the loan component as quickly and as early as possible.
Incorporating inflation contracts also has other advantages. It can enables pension funds to invest in higher risk asset classes at the same total level of risk. The liabilities on one side of the balance sheet and the asset mix on the other side have a different profile. If at least a part of the asset mix has the profile of an index-linked contract – so that it matches the liabilities – the fund will be exposed to less risk.
The optimal allocation of inflation contracts is quite substantial – up to 10% of total assets. So if the fund does not change its overall risk attitude, it is free to take new positions. As a result, the fund can have a higher exposure to equities, private equity, and hedge funds.
The optimal allocation of inflation contracts is quite substantial – up to 10% of total assets. So if the fund does not change its overall risk attitude, it is free to take new positions. As a result, So athe fund can have a higher exposure to equities, private equity, and hedge funds.
Mn Services’ solution was unique to the needs of BPMT. However, the structure is can also be applied applicable to assets other than real estate, and could provide solutions to other clients such as pension funds. Mn Services is still looking at the possibilities of investing in inflation, which it regards as the current ‘best buy’ for DB pension plans.