Opportunities in real assets
Why should institutional investors consider exposure to infrastructure and social housing? Julian Taylor of Aviva Investors explains the opportunities available through investment in real assets.
There is a clear political will behind encouraging pension schemes to invest in UK social housing and infrastructure projects. As banks continue to scale back funding support, there is a possibility for pension funds to help meet the need for financing and invest in these areas. Whilst institutional investors have their own priorities and objectives to consider besides political encouragement, we believe these types of assets do tick many of the right boxes for pension schemes and are likely to play an increasing role in investment solutions for UK pension funds in view of their attractive returns and relatively good liability matching characteristics.
With bond yields remaining low, the challenge for schemes of meeting future liabilities is significant. The returns pension funds are receiving when buying good quality fixed coupon and index-linked UK government bonds are at historically low levels, making liability matching difficult for schemes. Low real interest rates mean schemes' funding ratios are expanding, not reducing. This in turn places pressure on plan sponsors to increase their contributions, which they are reluctant to do in the current economic environment.
The evolution of fixed income markets and the increasing availability of inflation-hedging income streams from other assets provide an enhanced range of options which, if intelligently harnessed, could help a schemes' funding position.
We believe appropriately structured social housing and infrastructure investments, which we refer to as return enhancing and liability matching (REaLM) assets, are an ideal partial investment solution for investors with long-term horizons.
The secure, long-dated and inflation-linked income streams offered by REaLM assets have the potential to provide a good hedge against inflation and interest rate risks, and are expected to provide an enhanced return over index-linked gilts. The long-dated nature of the income streams from REaLM assets can help to offset any duration mismatch between pension fund assets and liabilities. As such, they can help improve schemes' funding ratios.
Taking a look at social housing, we find that the underlying dynamics of the sector are compelling, with demand increasing. In a report last year, Barclays estimated an unsatisfied demand of two million households in the UK alone. A large quantity of new social housing will need to be built over the next five years at a time when the sector's primary sources of capital - government grant aid and bank lending - are being curtailed. UK pension funds and annuity businesses are especially well placed to help fill this funding gap and some asset managers acting for pension funds and insurers already have established track records in this field.
Social housing in the UK is considered a highly secure and robustly regulated sector and we believe it is well-suited to providing long-term inflation-linked cash flows, which can be used by schemes to match liabilities.
Another area offering interesting opportunities is infrastructure investing. As with the social housing sector there is an urgent need for investment, but the traditional funding sources have largely dried up. As a result, the sector provides an attractive investment opportunity for long term investors, such as pension funds, to fill some of this funding gap.
Indeed, in the latest Autumn Statement, the chancellor George Osborne called for pension funds to do just this in order to help the UK government reach its funding target for projects, and this is a push that is being seen not just in the UK, but across the EU.
Real assets, such as social housing and infrastructure, can provide long-dated income streams combined with low risk in what is a challenging income environment. As long term investors, we believe pension schemes are especially well positioned to exploit the opportunity this presents.
Julian Taylor is head of return enhancing and liability matching assets at Aviva Investors.