Our new monthly columnist, Alastair Ross Goobey, recently retired head of Hermes, argues that the market should be trying to create bond products
Over a long career in investment management, I have often chastised property professionals for their often-expressed view that, no matter what the current exposure of their clients to the asset class, they should always have more. The recent performance of property vis … vis other assets, such as UK or overseas equities and bonds, might give further life to this argument.
Unfortunately, steering investment portfolios by the rear-view mirror has never proved a successful formula. The fact that the average property portfolio has now outperformed over a three- and five-year period does not mean that this will be the case over the next five years.
What I want to concentrate on is the opportunity that property has as an asset class in meeting some of the real problems that pension funds face. This is not a tactical asset mix question, but a much more fundamental case for property in the light of the dramatic change in environment for final salary/defined benefit pension schemes.
The days of the final salary scheme seem numbered. A combination of higher taxation, increased longevity, the changing profile of jobs themselves and regulations have all made the risk too high for many companies. Most of the largest companies have now closed their final salary schemes to new members.
These schemes will not shrink in value very quickly, but they represent a huge potential risk still for the sponsor companies. Should the membership live five years longer on average than anticipated, or the investment returns prove lower than those assumed in the contribution rates, then the liability could possibly dwarf the sponsor’s ability to pay.
Some companies, with large positive cash flows, and a pension fund of a reasonable size vis … vis their own value and balance sheet, will remain unruffled. For those where a sudden call for additional cash might cause real embarrassment, other solutions are needed.
Pensions liability
The new accounting standard FRS 17 has highlighted the volatility of the assets being held to meet the pensions liability. FRS 17 has no effect on cash flow or pension contribution rates, but it highlights the gearing involved.
The problem with equities as assets to meet these liabilities is two-fold: they are volatile and, increasingly, they do not pay reasonable dividends. Instead, investors rely on more uncertain capital growth for returns.
Many pension schemes have increased their exposure to bonds, which not only pay out income and are less volatile but also match the liability measures increasingly adopted.
This does not mean that such investors believe that bonds will outperform, or even give such good long-term returns as equities. It simply reduces risk for the sponsor, even if, in cash terms, the same pension promise will cost more to meet.
There is an asset class that provides income at a higher level than equities, and indeed than bonds, even allowing for depreciation. These assets even hold out a reasonable prospect for increasing that income over time, and a portfolio of them is less volatile than equity shares. It is, of course, property.
Sponsor’s attitude
Property’s shortcoming is that it is not the benchmark against which liabilities are measured.
The Myners Review concluded that every pension scheme should develop its own benchmark, related to its liabilities and the sponsor’s attitude to risk. I fear that, even if this is done, as it should be, the fund manager faces a terrible fate.
Fund managers are measured against their own benchmark, yes, but there are also “shadow” benchmarks, such as the peer group, and, at its most basic, whether money has been made or lost. It is impossible to meet all three all the time.
Consequently, it would take what Sir Humphrey Appleby would call a “courageous” decision for a scheme to increase its exposure to property as a strategic move out of equities, instead of simply following the herd into bonds.
Yet most of us understand that at least part of the income received from a property let on a long lease to a good covenant has bond characteristics. The actuaries often seem to understand the bond-like nature of much property income better than the property valuers and other professionals.
It cannot be impossible for them to reflect that understanding in the way property is treated for liability-matching purposes.
If that is not possible, the market should be striving to create bond products, backed by property income, with upside. Convertibles, or bonds with warrants, would meet the bill. Pension funds would then be able to invest in higher-yielding, well-secured bonds and have an equity “kicker” – nirvana.
