Governments throughout the eurozone are making huge strides in tapping into pension fund assets as a potential source of financing domestic economic growth.
While some are using the carrot approach, others are wielding the stick to access pension assets.
“Europe has been relying a lot on banks to finance (small and midsize businesses) and infrastructure, much more so than the U.S., which relies more on capital markets,” said Raffaele Della Croce, economist in the private pensions unit at the Paris-based Organization for Economic Co-Operation and Development. Given banks' constraints on lending, the need for alternative sources for financing economic activities is more drastic, he added. The issue prompted the OECD's project “Institutional Investors and Long-Term Investments.”
The European Union — along with the governments of Ireland, the U.K., Denmark and the Netherlands, among others — is implementing initiatives to tap into countries' large pools of pension assets to help spur economic growth.
The moves have been prompted by two factors: constraints in borrowing that governments face and a volatile market environment that limit institutions' appetite for equities, said David Blake, director of the Pensions Institute at Cass Business School in London. “Since governments are currently unable to make the sort of capital investments that would normally help to get their economy out of recession, they're encouraging those with the money — especially the pension funds — to do so instead,” Mr. Blake said.
One of the most conspicuous examples of how governments are using political muscle to influence pension investing is that of Ireland's National Pensions Reserve Fund, which was established in April 2001 to supplement the country's pension costs starting in 2025.
As of Sept. 30, the Dublin-based NPRF shrank to about half of what it was at its 2007 height of about €22 billion ($29 billion). A large proportion of the fund was used to recapitalize Irish banks in 2009, and about e6 billion remains in the discretionary portfolio — which had an allocation of 49% in equity, 18% in fixed income and 33% in alternatives as of Sept. 30, according to data from the NPRF. The directed portfolio totaled about e8 billion and is invested in the Bank of Ireland and Allied Irish Banks.
“The vast bulk of the fund has been used to recapitalize banks, and a lot of that probably will not be recovered,” said Jerry Moriarty, CEO of the Irish Association of Pension Funds, Dublin.
Of the remainder of the discretionary portfolio, additional assets likely will be channeled into “productive investment into sectors of strategic importance to the Irish economy including infrastructure, water, venture capital and provision of long-term capital to the (small and medium enterprises) sector,” according to an e-mailed response from an NRPF spokesman who asked not to be identified. “A key principle is that the NPRF investment, which is to be solely on a commercial basis, will seek co-investment from third-party investors. In this way, the fund's assets can be used as a catalyst to attract additional third-party capital for investment in the Irish economy.”
According to the e-mail: “Ireland-focused investments will be structured with the twin objectives of generating a commercial risk-adjusted return for the fund, while benefiting the Irish economy.”
Such initiatives “can be seen as a win-win situation, matching the government's need for cash and pension funds' need for long-term investments,” Mr. Moriarty said. “But they can be fraught with dangers.”
An obvious potential setback is a lack of diversification, he added.
Even where direct shifts of more institutional assets into the domestic economy have been largely avoided, governments throughout the eurozone are implementing indirect measures to attract more investments from pension funds, insurance companies and endowments.
In November, the European Investment Bank signed an agreement with the European Commission to initiate the Europe 2020 Project Bond Initiative. The program provides credit enhancements to companies that are raising senior debt for infrastructure projects to gain institutional investments, according to information provided by the EIB.
As much as €2 trillion will be needed to meet 2020 objectives for infrastructure investments, although the pilot phase of the Project Bond Initiative probably will raise about e4 billion in senior debt from institutional investors. The EIB will provide about €230 million in a subordinated debt tranche, which acts as a cushion for the senior debt tranche and an incentive for investors.
“This is not a big figure and won't have much impact in the infrastructure investments needs for next year,” Mr. Della Croce said. “This is a pilot program, and what they're aiming for is to first find the right (investment) model for long-term investors” to access infrastructure.
In Denmark, the government has been working with several organizations including the 789 billion Danish kroner ($140 billion) ATP, Hilleroed, to establish Dansk Vaekstkapital, which invests in domestic SMEs. In the Netherlands, the government is leading efforts to allow public-private partnerships for which up to 70% of the cost of infrastructure projects can be financed by inflation-linked debt suitable for pension funds.
Reluctant to participate
Despite offering what are potentially attractive terms in the low-interest-rate environment, pension funds still are largely reluctant to participate, fund executives and consultants said.
“It is not yet compelling for pension funds, but it's promising,” said Phil Page, client manager at Cardano Risk Management BV, London. While certain risk/return characteristics of various initiatives are suitable for pension funds, there are significant barriers. In infrastructure, for example, one problem is the conflicting needs of governments' desire to invest in the development stages of infrastructure projects and pension funds' preference to invest in the operation phase.
In the development phase, “it could take potentially five years or more before (the project) reaches the cash-flow generative stage,” Mr. Page said.
Other issues link to the inflation-matching characteristics of infrastructure, sources said. Infrastructure debt, which can comprise up to 90% of a project's financing, is usually not linked to inflation. Infrastructure equity, on the other hand, can be unstable. “While infrastructure is often viewed as inflation-linked assets,” Mr. Page said, “it isn't clear whether (infrastructure) bond or equity holders can benefit from (infrastructure's) overall link to inflation.”
However, there's possibly a misunderstanding among institutions of the risk associated with the construction phase of infrastructure projects, said Frederic Blanc-Brude, research director at EDHEC Risk Institute based in Singapore. Mr. Blanc-Brude, who's a specialist in infrastructure finance, said the risk is “not as bad as investors think.”
“Public projects have a terrible record” during the construction phase, said Mr. Blanc-Brude, who is leading the Natixis/EDHEC Risk Institute research program on infrastructure debt investment. “But if you look at private projects, the risk of cost overruns has mostly been adequately managed.”
Furthermore, “adding a bit of construction risk can help build more efficient infrastructure debt portfolios,” Mr. Blanc-Brude said.
5 pension funds commit
In the U.K., a government-backed program to draw pension assets to domestic infrastructure projects that initially aimed to raise up to £20 billion ($32 billion) has garnered an initial £1 billion.
In addition to the Pension Protection Fund, which is Britain's equivalent to the Pension Benefit Guaranty Corp., five major pension funds have committed to the program, called the Pensions Investment Platform. They are the £36 billion BT Pension Scheme; the £18 billion Railways Pension Scheme, the £11.2 billion Strathclyde Pension Fund, the £9.4 billion BAE Systems Pension Scheme and the £8.9 billion West Midlands Pension Fund.
“The main benefit (for pension funds investing in these programs) would be the ability to diversify beyond ordinary fixed-income investments, especially now that yields have sunk so low,” said Ros Altmann, a U.K. pensions expert who is director general of The Saga Group, London, a company that offers financial products among other services. “Many funds are switching away from equities. ... If infrastructure and (SME) lending increases, then this should benefit the whole economy and also ultimately help stock markets, too.”
This article originally appeared in the December 24, 2012 print issue as, "EU economies tap pension funds as financing source".