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In its response to the Call for Evidence from the Department of Work and Pensions on the usefulness for Defined Benefit (DB) pensions of investment in productive finance, including infrastructure, the EDHEC Infrastructure & Private Assets Research Institute underlines the advantages of this asset class for long-term investors, particularly pension funds, but draws the Department’s attention to the risks of this category of assets, which it considers to be poorly captured by investors.
On the benefit side, through their superior duration, risk-adjusted returns, stability of cash flows and good level of decorrelation with public assets, unlisted infrastructure investments present indisputable advantages, whether in improving the performance of DB pension funds or improving their liability hedging. On the latter point, infrastructure debt can be a good replacement asset in the context of deleveraging Liability-Driven Investing (LDI) strategies.
However, on the risk side, it is not so much the size of the risks as their poor measurement, and therefore their poor management, that is underlined in the EDHEC Infrastructure & Private Assets Research Institute’s response. This poor risk measurement can be summarised in three main points:
- The use of investment benchmarks based on backward-looking appraisal contributions and that have smooth volatility and, de facto, misrepresent the risks of this asset class.
- Asset valuation practices, which are not based on relevant and consistent comparables and discount rates. The case of Thames Water, which was highly overvalued in investors’ accounts compared to its true fair market value, is not an isolated case and is emblematic of this difficulty.
- The difficulty of capturing the climate risk of these assets, which, given the concentration of pension fund investments, can lead to very high extreme losses.
With poor quality data, UK DB plans also face the risk of mistreatment of pension rights. The 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.
In conclusion, the EDHEC Infrastructure & Private Assets Research Institute nonetheless underlines that the right data to measure the financial and non-financial risks of unlisted infrastructure now exists and investors should take the measure of its importance in better managing their infrastructure investments.
In this context, the EDHEC Infrastructure & Private Assets Research Institute recommends that The Pensions Regulator set up best practice rules and require pension funds to show that they have a serious investment and risk management process for this asset class.
Below is a copy of the EDHEC Infrastructure & Private Assets Research Institute’s response to the Department of Work and Pensions’ Call for Evidence can be found here:
