The growing phenomenon of ‘de-risking’ among UK pension funds has often implied a broad move out of risk assets. But Alistair Jones and Mark Callender ask whether property should be spared
De-risking has been a key trend for UK pension schemes over the past 10 years. In an attempt to attain and retain higher funding levels, allocations to growth assets such as equities and real estate have been reduced, while holdings of bonds have risen. However, is blanket de-risking across growth assets, or even a move wholly out of real estate, necessarily the best way to reduce risk?
Pension schemes usually have an objective to grow their assets to meet their liabilities valued on a conservative, low-risk basis. Unfortunately, over the past couple of years, many scheme deficits have widened, mainly as a result of lower than expected interest rates increasing the size of liabilities. This means that, for UK schemes that have conducted a valuation over the past year, it is expected that recovery plans will be extended by an average of three-and-a-half years1.
With longer recovery plans and longer time horizons to full funding, this is a good time to look again at longer-term asset classes. Assets like real estate that are projected to achieve attractive returns over extended periods may be more appropriate than ever to help close deficits.
The value of pension schemes’ liabilities and deficits depends heavily on the underlying assumptions used. The latest data from The Pensions Regulator show that the average actuarial assumption used to discount UK liabilities is the yield on index-linked Gilts plus 1.05%2 . If assets outperform index-linked Gilts by more than 1% a year over the long term, then this should help close deficits. In fact, figure 1 shows that UK property has outperformed index-linked Gilts by around 2% per year since 1982 and over the long term has achieved real total returns of about 4% per year.
Furthermore, although the equivalent yield on UK real estate3 has fallen since 2009 and now stands at 6%, the gap between it and long-dated Gilts is still high by historical standards at between 3.5% and 4% (see figure 2).
In addition, the Investment Property Forum expects the return on UK real estate over the next four years to be 5.9%4 per annum, or over 3% above long-dated Gilt yields. Real estate yields are also at relatively attractive levels compared with other assets such as equities and corporate bonds. Real estate therefore looks like a useful asset to help schemes reduce their deficits over the long term.
The benefits of real estate do not stop at performance. The asset class has both growth and liability matching characteristics. As we have seen, real estate has attractive potential returns that are often superior to bonds – indeed, they are more like those from a growth asset such as equities. Yet real estate also has a stable income stream similar to that of bonds. Tenants have a legal obligation to pay rent, whereas dividend payments are discretionary. In this regard, it can be thought of as something of a hybrid, lying somewhere between defensive and growth assets (ie, bonds and equities).
A defined benefit pension scheme’s liabilities are a mix of fixed and inflation-linked projected cash flows, often mainly the latter. Consequently, cash flows out of a scheme are projected to increase with expected inflation and in the UK these liabilities are often valued using index-linked Gilts, which also rise in value as inflation expectations rise. Real estate can potentially also help match these inflation-linked cash flows.
To understand why real estate works as a matching asset it is worth looking at how it is priced. Commercial properties are valued by projecting the expected rental cash flows from leasing the building. They are then discounted using an equivalent yield determined by an independent valuer. Expectations of a property’s future rent and rental growth therefore drive its projected cash flows and thus its value over the long term. In the short term, market conditions are still an important consideration and can cause capital values to be more volatile.
For instance, during the global financial crisis, real estate capital values fell sharply, along with most other assets, as the equivalent yield jumped from 5.4% to 8.1%. By contrast, the income return from commercial property (akin to the dividend yield on equities) has been stable at 5-7% and has underpinned real estate returns over the long term.
An example of a property’s projected rental cash flows is shown in figure 3. The cash flows are discounted at the yield expected to be earned in the future. They are compared with the discounted cash flows of a sample pension scheme. The figure shows that real estate can act as a reasonable cash-flow match for liabilities. Both streams broadly increase with inflation over time. The liability cash flows are somewhat longer than those for the real estate income. However, to be conservative, only three 10-year leases with fixed rents have been assumed for the sample property. In practice, the property’s cash flows may well be longer if the building is kept refurbished to ensure that it does not become obsolete.
Using more optimistic assumptions, the cash flow match can be better still. And, as discussed, these rental cash flows tend to be uprated periodically (typically upwards only every five years), so there is an in-built hedge against inflation over the long term. The match between real estate and pension cash flows is not perfect. Rental cash flows are discounted using real estate equivalent yields, while liability cash flows are often discounted with reference to Gilt yields. Over the short term, these yields can move apart, creating a mismatch. However, this tends to be the case whatever asset is used to match pension scheme liabilities, except for Gilts.
Assets such as infrastructure debt, ground rents and long-lease property are often invested in to match long-dated cash flows, but they offer a weaker fit when it comes to interest rates and all are typically lower yielding than mainstream commercial real estate.
Consequently, schemes that invest in general real estate assets are able to obtain broad cash-flow matches and still give the manager the flexibility to pick sectors and buildings where they see value to help deliver performance.
Long term, Gilts and real estate yields have moved broadly in parallel, so the matching ability of the latter works out reasonably well, particularly if real estate is held as part of a wider portfolio.
Real estate vs corporate bonds
Similarities can be drawn between real estate and corporate bond income streams. One of the risks associated with corporate bonds is default – that is, a bond’s issuer becomes bankrupt and can no longer afford to pay its coupons and the redemption proceeds. Clearly, owners of real estate face similar risks if their tenants get into financial difficulties. However, these risks are reduced with real estate because new tenants can be found and the interruption to the income stream is temporary.
“Real estate’s high level of income can give its returns a stability that is helpful for pension schemes to close deficits in the later phases of their flight paths. And real estate offers a reasonable match with long-term pension liability cash flows”
The story of 25 Bank Street in Canary Wharf in East London illustrates this. The office was originally designed for Enron, the former US energy group. Following its collapse, the property was re-let to Lehman Brothers, the ill-fated investment bank, until it, too, collapsed during the financial crisis. Despite these unfortunate events, the building was successfully re-let to JP Morgan, which is still the occupant. It is clear that, even if tenants fail, desirable properties in good locations can still generate an income, whereas bond holders and shareholders can lose most or all of their capital, as happened to lenders and investors in the cases of Enron and Lehman.
Moreover, the potential cash flow matching of real estate assets may be more suitable for pension schemes than that of corporate bonds. The shape of real estate rental cash flows is closer to pension scheme cash flows than that of the UK corporate bond universe, as figure 4 shows. Furthermore, as the majority of UK corporate bonds are not inflation-linked, real estate offers much better inflation sensitivity. Today the yield on real estate of about 6% is substantially higher than the 3.5-4% available from UK investment-grade corporate bonds, as figure 2 shows.
So how should trustees view real estate in the light of these arguments? The direction of travel in recent years for UK defined benefit pension schemes has been to de-risk out of growth and into matching assets. Indeed, many schemes have ‘flight path’ de-risking plans in place where the switch is made automatically as funding levels hit specified thresholds. Clearly, it would be tempting simply to sell and move into bonds, thereby cashing in on the rise in property values and apparently reducing risk at the same time. However, that would be to lose the very valuable – and rare – growth and matching characteristics of real estate in the de-risking process.
One option, instead, would be to recognise that real estate covers both sides of the equation and therefore maintain current allocations through the de-risking plan. Another possibility is to build into the plan a progressive move out of assets with high expected total returns into those that offer a better cash-flow match and have attractive yields. In the former category, one might put assets such as equities and, in the latter, one may put real estate.
Real estate’s high level of income can give its returns a stability that is helpful for pension schemes to close deficits in the later phases of their flight paths. Real estate also offers a reasonable match with pension liability cash flows.
1 The Pensions Regulator’s Annual Funding Statement May 2015 (Tranche 10 expected positions) www.thepensionsregulator.gov.uk/doc-library/statements.aspx
2 The Pensions Regulator Annual Funding Statement analysis for schemes with valuation dates in the year to 21 September 2013. The median outperformance of the real discount rate over the 20-year real government spot rate is shown.
3 The IPD UK all property equivalent yield which makes an assumption regarding the re-letting of property at the end of leases. The equivalent yield is used over the initial yield because, from an actuarial perspective, it is judged comparable to the redemption yield on a bond. The income received from a property investment may differ from the equivalent yield because of the impact of fees and gearing.
4 IPF UK Consensus Forecasts August 2015 www.ipf.org.uk/resourceLibrary/investment-property-forum-uk-consensus-forecasts-summary-report–august-2015.html
Alistair Jones is a member of the UK strategic solutions team and Mark Callender is head of real estate research at Schroders
Portfolio De-Risking: Still a role to play
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Portfolio De-Risking: Still a role to play