Infrastructure Investing and UK Pension Funds: Navigating LTAF and Productive Assets
Infrastructure Investing and UK Pension Funds: Navigating LTAF and Productive Assets
November 2023
The Role of Productive Finance in Post-Covid Recovery
“Levelling Up,” “Investment Big Bang,” “Build Back Better.” Those are three examples of catchphrases used by policymakers to encourage private-sector participation in productive, long-term investments in the post-pandemic world. The message behind the words resonates strongly with all who live and work in the United Kingdom, where very real challenges, such as funding for low-carbon infrastructure and investment in transport infrastructure, need addressing. Over the past two years, BNY Mellon has been playing its part in helping to navigate these challenges through its involvement in the productive finance agenda. This involvement began in November 2020 when UK authorities, including the Bank of England, HM Treasury and the Financial Conduct Authority, convened the Productive Finance Working Group which BNY Mellon was invited to join.
Productive Finance Working Group and its Objectives
Its aim: develop practical solutions to the barriers faced by pension funds to investing in long-term, less-liquid assets in order to support the UK’s economic recovery from COVID-19, finance the transition to net zero, and channel investment into socially productive outcomes across all regions of the UK. The output of the working group has included the development of a Long-Term Asset Fund (LTAF) which aimed to create a regulatory framework that better aligns with the investment objectives for financing productive assets. However, structural challenges in the pension industry need to be overcome to unlock their ability to consider longer-term investments.
Challenges Faced by Pension Funds
Pension funds, both Defined Contribution (DC) and Defined Benefit (DB), face a number of challenges that make investing in longer-term, productive assets difficult. These hurdles range from regulatory barriers and tax issues to the availability of investment vehicles and structures.
Regulatory Barriers and Tax Issues
What has become increasingly accepted is that the ability to achieve scale is an important factor when it comes to facilitating the investment of pensions in productive assets. Throughout 2023, BNY Mellon has hosted roundtables with industry experts to address these issues. At one earlier this year in Manchester featuring Manchester Mayor Andy Burnham, a range of industry representatives discussed what the UK can learn from pension funds in Canada and Australia, and the role they have played in increasing productive capital. Consolidation of smaller funds is a common characteristic of both the Australian and Canadian models, resulting in larger pension funds that can benefit from operational and cost efficiencies. On the investments side, scalability improves access to less-liquid opportunities, making it more conducive to infrastructure investments.
Global Insights: Lessons from Canadian and Australian Pension Funds
Canadian Pension Funds: Focus on Consolidation
The consolidation and growth of Canadian pension funds has been facilitated by legislation. The Investment Management Corporation of Ontario, currently the eighth largest Canadian fund, was created by government edict in 2017 to provide investment fund services on behalf of provincial public pension boards. More recently, several university pension plans came together by jointly transferring their assets and liabilities to establish the University Pension Plan. This followed changes to rules on the conversion of single-provider plans into jointly sponsored pension plans – a direct-benefit scheme that has become a dominant feature of the Canadian model owing to its independence and risk-sharing properties. Benefits from economies of scale have become synonymous with characteristics of successful pension funds. While continuing to harness third-party expertise, the Canadian model champions the internal capacity built by its larger funds. Consolidation has made it efficient to develop in-house expertise, thereby reducing the costs of external managers while giving funds greater access to investment opportunities in riskier asset classes. Another consequence is an emphasis on talent: the impact of intra-fund competition in remuneration has contributed to talent retention and improvements in supervision.
Australian Pension Funds: Success with Infrastructure Investment
A central feature of the Australian pension landscape is the superannuation system. Funds pooled their management and infrastructure investment programs into IFM Investors, an investment company collectively owned by the pension funds. This created sufficient scale to develop infrastructure as an asset class, which became a significant holding in many funds. This enabled the funds to develop a centralized expertise for investing in the asset class when no fund at that early stage had the scale to build that skill. In addition, the owners of the collective company ensured a favorable fee environment. As the sector grew, the company began to take on more global clients (at higher commercial fees), which then funded the expansion of its global asset management expertise. The initial Australian funds also developed in-house expertise and began to invest directly in infrastructure, either in partnership or in competition with the initial collective company. Equally important to consider is not only how the funding for productive investment needs to be pooled, but also what role the pooling of the investment products themselves can play in achieving productive finance goals. For example, consideration could be given to how the securitization of products like heat pumps can become an investable asset in this agenda. Pooling of investment products has the additional benefit of bringing in expertise centered on a particular industry or sector, something evident in the Australian experience.
With the Australian system now holding over $3 trillion in assets and the major funds merging into larger entities, infrastructure investment has become more global. Foreign investment in Australia has increased in the past decade, making the competition for assets greater while allowing the government to use this pool of domestic and offshore pension savings to recycle new and existing infrastructure assets back to pension funds in the secondary market. Another key factor in encouraging infrastructure investment is the role public-sector guarantees play in encouraging pension funds to consider productive investments at an earlier stage. Because the Australian market has scale and the existing pool of assets is invested for the long term, the exposure to infrastructure is relatively high – in the range of 5%-10% for most major funds with largely stable or growing asset pools. While competition between funds has increased, and members are able to move funds more easily between superannuation funds, the exposure to illiquid assets has remained elevated due to the overall stability of assets. Australian governments have availed themselves of this pool of assets by selling existing and new infrastructure to funds in the secondary market. As highlighted above, the government then often reinvests the proceeds into further infrastructure, recycling capital from its initial investment into long-term savings pools. Superannuation funds are typically more cautious in undertaking initial development investment in infrastructure; they allow the government to take the development risk instead. Regulators are increasingly focused on ensuring funds have sufficient liquidity to manage cyclical or structural downturns, but this has generally not prevented the fund from holding illiquid assets like infrastructure.
The Importance of Scale in Long-term Asset Investments
While the unique composition and context of domestic pensions will influence how this needs to work in practice, the UK is able to draw lessons from the approaches taken in Canada and Australia. However, it is imperative that any pension reforms aimed at facilitating greater levels of productive capital ensure that the ultimate goal of pension provision continues to be that people can live well in retirement and this means that investment portfolios will continue to need to be appropriately diversified across asset classes and geographies/economies. The challenge is to accelerate this process, deliver returns through productive finance, and contribute to socially productive outcomes while ensuring that all the key stakeholders in the UK pension landscape realize its potential.
Asset Pooling in the UK Pension Landscape
Efforts to achieve scalability through asset pooling have already commenced in the UK. In 2018, local government pension funds began to consolidate more than 80 funds into eight asset pools. Transition speeds have varied, with fund sizes ranging from £16 billion to £60 billion, comprised of the funds’ more liquid assets. Further consolidation is planned in coming years, but the current trajectory is insufficient to replicate the benefits realized in Canada and Australia.
How Scalability Opens Doors for Infrastructure Investment
The UK Chancellor has committed to taking forward a series of reforms aimed at facilitating pension fund investment in productive finance and BNY Mellon will be closely monitoring these developments. If calibrated correctly, these initiatives could play an important role in unlocking capital for investment in productive assets such as infrastructure, though it is essential that any resulting reforms continue to prioritize retirement outcomes for pension scheme members.
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