In response to a U.K. government call for evidence as to whether defined benefit pensions should increase their investments in productive finance, including infrastructure, experts at the EDHEC Infrastructure and Private Assets Research Institute warned that such a move is too risky.
The institute’s report, submitted to the U.K.’s Department of Works and Pensions, stated that defined benefit pension plans in the U.K. “should abstain from investing in infrastructure, unless they are able to do so with enough information about risk and the true market value of these investments.”
However, the EDHEC Institute researchers wrote they do not believe there is currently enough accurate information available about infrastructure investments for pension plans to know the true value of the investments.
“The main stumbling block preventing the widespread development of infrastructure investment amongst DB plans in the UK is [that] the type and quality of data available to investors in such assets has been remarkably poor and unreliable,” the EDHEC Institute report stated.
The report also warned that if a pension plan makes an investment using bad data, it faces the risk of breaching its fiduciary duties. Annuity guarantees or lump sum calculations based on incorrect data can lead to an unfair valuation of pension rights and “distort the benefits received by the pensioners,” according to the report, which added that “investors face significant hurdles to invest in infrastructure in a manner that is in line with their prudential and fiduciary responsibilities.”
Despite its caution for pension funds investing in the asset class, the EDHEC report stated that infrastructure can offer “very attractive investment characteristics” for defined benefit plans. Its research found that unlisted infrastructure equity and debt can “play very useful roles in the portfolio of a defined DB plan.” Those classes’ fixed-term and high distribution profile provide bond-like quality, while retaining equity-like features.
EDHEC analysts also wrote that infrastructure investments have “the potential to improve both sides of the balance sheet: by diversifying the portfolio and improving the risk-adjusted returns of a plan’s performance-seeking portfolio, while contributing to its liability hedging objectives.” The institute attributed this quality to the interest rate sensitivity of infrastructure equity and the yield pickup of infrastructure debt, compared with corporate bonds of the same credit quality and duration.
However, according to the report, the tendency in private markets to rely on contributed appraisal data rather than information that accurately represents the risks of the asset class “masks the true characteristics of these investments and precludes any rational decision-making process when it comes to investing in infrastructure.”
The report also pointed out that there have been multiple cases of infrastructure companies going bankrupt or facing significant write-downs.
“Robust data enables an investor to be aware of these risks and, more importantly, manage them in a timely manner,” the report stated. “As long as fair value and risk are not properly measured, U.K. DB plans will continue to either not invest in infrastructure or fail to invest wisely and face the consequences of not managing the risks.”
The report called for the adoption of “serious infrastructure valuation practices” that use the right comparables to estimate the risk premium and “therefore the right discount rates to use in infrastructure valuation.” It also suggested that the U.K.’s workplace pension watchdog, the Pensions Regulator, set up best practice rules and require pension funds to show that they have “a serious investment process for this asset class, which should not remain marginal in institutional investors’ allocations due to its macro and microeconomic benefits.”
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Tags: defined benefit pension, EDHEC Infrastructure and Private Assets Research Institute, Infrastructure, Pension, Pension Funds, pension scheme