The UK Government wants pension funds to make a massive direct injection into the UK economy through infrastucture investment. Will its plan take off?

Chancellor of the Exchequer George Osborne used his Autumn Statement on 29 November to outline plans for a Government-backed infrastructure fund that aims to use pension fund capital to boost economic growth.

What remains to be planned is how UK pension funds can be attracted en masse to an asset class that they have thus far been relatively unenthusiastic about. And with sceptics claiming that they face a painstaking task to win pension funds over, Ministers appear to have their work cut out.

Sizing it up

Business Secretary Vince Cable noted in a recent report for think tank Centre Forum that with financing concerns holding back energy projects, "there is a large pool of capital in financial institutions like pension funds looking for long-term investment opportunities with a reliable, utility return. The issue is how to channel this money into large scale infrastructure investments, and quickly."

Government figures are known to be impressed with the ease at which many Australian and North American pension funds back keynote infrastructure projects. The Ontario Teachers Pension Plan's 7.1bn Canadian dollar (£4.4bn) infrastructure portfolio has acquired substantial shares in the lease on the Channel Tunnel rail link and Birmingham Airport.

One obvious reason why UK pension funds have lagged in supporting infrastructure is the fractured structure of the domestic pension market.

Overseas giants like the Ontario Teachers' plan (at £65bn almost twice as large as the biggest UK fund) have extensive resources to invest effectively in big, clunky infrastructure projects, rather than just back the companies behind them.

With this problem of scale in mind, the Government seems to hope that a pooled fund can reduce fees and boost liquidity to an extent that opens infrastructure investing up to the UK's funds.

Alan Brown, Chief Investment Officer at asset managers Schroders told Pension Funds Insider that the Government's ambitions could be fulfilled without looking too far down the size scale. "Small pension funds like to keep things incredibly simple and one can sympathise with that. The larger funds that have their own internal resources might well look at it and be encouraged by their investment consultants – with most pension funds pretty mature and in a de-risking phase there would be a limit to the amount you could attract, that wouldn't rule out an allocation of around £50bn."

Brown says that "infrastructure investing in principal can have some very attractive characteristics, such as an effective hedge against inflation over the long haul." In essence the great hope is that pension funds will look to infrastructure for returns that match their liabilities.

However, Giles Frost, director of infrastructure investing firm Amber Infrastructure Group Limited, which manages a number of listed and unlisted infrastructure funds, told Pension Funds Insider that a pooled fund in itself might not be enough for UK pension funds to follow the example of large Canadian and Australian counterparts on infrastructure.

Frost says that the Government is driven by an assumption that by pooling infrastructure investing in this way the cost of investing "can be brought down. If you are a trustee you would be looking to maximise your returns rather than minimise them."

Frost also points to a possible key difference in the infrastructure investing habits of overseas funds from what the Government hopes to see in the UK. Frost says that "generally speaking the Australian and Canadian funds have been investing in infrastructure as equity owners rather than debt providers."

He adds that pension funds could not automatically be expected "to take up the slack" left by reduced bank financing of infrastructure. Many forms of infrastructure have return prospects directly tied to economic growth, making them potentially risky at the current time.

Making it stick

Others have tried to tempt pension funds with pooled infrastructure fund before, and failed. For instance ING Real Estate closed its European institutional infrastructure fund after just one year in 2009 as it struggled to attract money.

For David Quinlan, a partner at legal firm Taylor Wessing, solving the complex nature of risk associated with infrastructure projects is key.

He told Pension Funds Insider that reliable returns at the 'operational stage' come at the expense of plenty of risk in the construction of major infrastructure projects.

Quinlan, who has advised on a number of institutional infrastructure deals, says there are high up-front costs to these kind of long-term investments and to overcome such a risk a team with the expertise and resourcing to beat that is needed: "To make this plan attractive to pension funds they will need support from the government, for example in offering supporting guarantees to offset the starting risk." 

Frost says that Osborne "might want to push higher-risk infrastructure, like the high speed rail link, and plenty of thought would be needed to get defined benefit funds, most of which are de-risking, to back higher-risk assets. There are a number of things the Government might do to increase the attraction of the asset class to pension funds: for instance they could improve the credit quality by taking a first loss position on some of the transactions to insulate pension fund money or provide a backstop guarantee like a basic level of financial returns."

Another question that cynics might raise is why would pension funds want to support a Government-backed infrastructure project such as a rail network that has suffered from past mismanagement?

Quinlan admits "from a historical perspective there is probably a trust issue and negativity from institutional investors to infrastructure which needs to be overcome. New ideas such as introducing tolls for roads being built could help, but that brings an element of risk and would require plenty of analysis before it is proven to be a sound investment."

Research is lacking in infrastructure in comparison to other asset classes, Quinlan adds. This is another area in which work needs to be done before a lot of pension funds are confident enough to make an investment.

Brown is confident though that the UK needs the kind of infrastructure investing touted in the discussions. He says "by the time you add on roads, bridges, hospitals, schools, prisons, courts, you've got plenty to go with".

Frost adds that "some of the lower risk-type of infrastructure projects are naturally very attractive for pension funds seeking to match liabilities. If you have a 25-year contract from the government to build and operate the school, with all the building operation sub-contracted, you have a long-term cash flow almost as solid as a gilt."

Waiting game

In any case the Government should be patient rather than count on an instant injection of cash to buoy the economy, experts say.

Brown says "pension funds don't in most cases need immediate liquidity so it is conceivable with the right structuring and the right encouragement, you could create a pot around the £50bn mark. That won't happen overnight, and any interested pension funds would go through a couple of quarterly trustee meetings at the very least before they decide, say, to make a 5% infrastructure allocation."

So it seems that proposing an infrastructure investment plan will be the easy bit.

To make it work UK Ministers may have to pay as much attention to investing behaviour as some of their European counterparts are currently being forced to do for very different reasons. If reports about the Government's faith in the potential of private infrastructure investing are to be believed, the future of the British economy could depend on the small print of the plan.

Frost says "the thing I'll be looking for in the announcement won't just be the size of the Government's programme and whether it plans to finance high-speed rail, broadband or whatever. Rather the key point will be how (it) is going to stimulate investment, and how it can be cleverer in structuring to make these investments easier for pension funds."

He continues: "After all, as a pension fund you can buy and sell gilts at will, assets which are perfectly straightforward, dependable and risk-free – albeit low yielding. If you are going to persuade trustees to look at alternative assets then the easier you can make that process of analysis the more ready you will be as an investor to back this."

"In my mind there is a lot of chat about this without anything yet being clear, what is needed is a more engaged conversation between them and infrastructure managers and pension funds."

First published 28.11.2011

dbillingham@wilmington.co.uk