Who will invest in real assets – and what new requirements should managers observe?
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Real assets have long been known for their ability to generate inflation-adjusted cashflows and provide a stable store of value for both DB and DC schemes. However, post-pandemic working habits and the UK government’s green agenda have redefined the appeal of different types of real assets. Real estate managers are at significant risk of missing their carbon reduction targets. What factors define the future flows into real assets?
Will the new DB funding code increase demand for real assets?
The new DB funding code is expected to come into force in October 2023. Apart from strengthening the connection between funding levels, covenant risk and investment strategy, low dependency will become the default long-term funding goal that all DB schemes must achieve. This means that pension funds will have to transition their portfolios into low-risk cashflow matching assets by the time they achieve significant maturity, which is 12 years of liability duration.
In explaining their approach to Fast Track scheme governance under the new funding regime, the Pension Regulator assume an asset allocation at significant maturity comprised of 85% bonds and cash. However, between pension schemes planning to run off with low dependency on the sponsor and insurance companies sourcing assets to back pension liabilities in risk transfer transactions, there will be significant competition for these low-risk liquid assets.
Real assets have long featured in pension fund asset allocation for their cashflow-generating properties, but different sectors have different appeal – especially now after the COVID-19 pandemic altered working habits. Based on various research projects conducted by mallowstreet, just 42% of UK schemes thought long lease property to be appropriate for a cashflow-driven investment (CDI) strategy in 2020. However, 84% said they would consider diversified real assets – including infrastructure – in 2019.
Can real assets play a role in the developing DC retirement product market?
Despite the introduction of retirement pathways, many DC schemes remain accumulation-only and plan to signpost to master trusts or annuity providers depending on the retirement choices of their members. However, DC membership is still relatively young, and the market for retirement products is nascent.
As this market takes shape, it appears real assets have a role to play in it – and the multi-year research we have conducted in partnership with Milliman supports this view. In 2020, 45% of DC schemes thought it appropriate to include property in the asset allocation at retirement, and 30% considered an allocation to property later on in retirement.
But can real assets be accessed in a liquid way?
SOFI, mallowstreet's proprietary AI software built to help asset managers refine their ability to engage with investors, shows that schemes often ask about liquidity when considering investing in real assets.
Liquidity is particularly important to DC schemes because members can become deferred at any point in time when changing careers – and may choose to transfer their DC pot into another arrangement under their new employer. Additionally, the Trustee Report 2021 commissioned by Janus Henderson revealed that DC schemes prefer to access illiquid assets via multi-asset or blended funds, and we expect 2022 data to support this. All this suggests that, despite the recent decision to exclude performance fees from the DC charge cap to improve access to illiquid assets, the problem with accessibility is far from resolved.
Interestingly, liquidity is far from a DC-only problem. The Pension Risk Transfer Report 2022 commissioned by Rothesay shows that schemes aiming for buy-out are reducing their allocations to illiquid assets, in order to transfer liabilities to insurers. Bulk annuity providers have limited appetite for such assets, meaning they are unable to accept them ‘in specie’ during a transaction.
What about the ESG credentials of real assets investments?
The ESG impact on property values and cashflows used to be poorly understood in 2019 – so how has it evolved over the past several years? It is clear that infrastructure assets have a huge role to play in supporting the green transition and net zero agenda, given that they include important positive contributors like renewable energy, EV infrastructure, carbon capture and even social infrastructure.
However, real estate seems harder to decarbonise for the time being, with a majority of managers focusing on improving energy efficiency of refurbished and new buildings. Given the growing risk of real estate managers missing their carbon reduction targets, it is vital for them to align ESG practices with the requirements of institutional investors and keep their investment solutions relevant.
How will real assets portfolios evolve, and what requirements should managers heed?
With so much change in the real assets investment landscape, managers have not only pension regulation to stay on top of, but also the accelerating green agenda and financial markets reform in the UK. To understand how pension funds and insurers in the UK are re-thinking their portfolios, we are planning a research project on real assets – so contact us if you’d like to become a research partner.