Pension funds offer benefits to infrastructure and asset owners
Pioneers Canada and Australia hold lessons for SA as Treasury starts talks with the savings industry
To keep pace with the requirements of economic growth, poverty alleviation and urbanisation it is estimated that upper-middle-income economies such as SA need to spend 2%-3% of GDP a year on new infrastructure.
Studies have gone as far as to quantify the relationship between infrastructure investment and growth: a percentage point increase in potential GDP growth requires investing 1% of GDP in infrastructure.
Weak infrastructure can slow a country’s growth and competitiveness; it can also cause loss of lives, disease and diminish the overall quality of life.
Historically, the public sector has been central to the ownership, financing and delivery of infrastructure services. Public funding of infrastructure in developing economies, through budget allotments and retained earnings of state-owned enterprises (SOEs), still accounts for most infrastructure expenditure. Yet this source of financing is being squeezed; government budgets in many countries were strained after the global financial crisis; Covid has made the situation much worse.
Funding from multilateral development agencies and other donor funding is unlikely to fully fill this gap, for the same reasons. Governments in developing countries have thus been working hard to attract public-private partnerships (PPPs) for infrastructure investments. In a public-private partnership, the state changes its role from owner and provider of public services to purchaser and regulator of them. The private sector comes in as financier and manager of infrastructure.
Due to PPPs, since the mid-90s private sector funding of infrastructure has become a well-established, growing trend in developed and increasingly in developing countries. In SA, the best examples include renewable energy projects, as well as the Bakwena toll roads, for which the infrastructure was successfully provided, maintained and the concession will soon be returned to the government for resale.
In terms of the potential sources of private sector funding, globally, long-term bank financing of projects has been constrained by tighter financial regulations (Basel III, for example). This has created a gap for institutional investors such as insurance companies and retirement funds. There are several good reasons why infrastructure investments are attractive to these long-term investors. The appealing qualities include high barriers to entry and limited competition; inelastic demand for services; long duration contracts with predictable cash flows, often inflation-linked; and economies of scale and low variable costs.
Large funds have the advantage of scale; they can afford specialist investment expertise and advice, as well as a well-resourced governance model
As interest in infrastructure has grown during the past two decades, so have the types of vehicles for making the investment. Traditionally, infrastructure investment by retirement funds involved buying and selling shares or bonds of companies operating in the infrastructure sector; and they may also have owned property in the sector. New-style infrastructure investing tends to include infrastructure private equity funds as well as specialist debt funds (with a mix of infrastructure bonds, loans or mezzanine debt). The most common route for retirement funds is to invest indirectly, via fund vehicles.
Despite the attractiveness of infrastructure assets to retirement funds, there are barriers, on both the supply side and the demand side, which make it difficult for retirement funds to invest. Supply-side barriers could include lack of investable infrastructure projects and lack of privatisations. Demand-side barriers could include lack of investment expertise, lack of scale and resources, and preference for liquidity. Earlier this month, the National Treasury initiated an important conversation with the savings industry, with the objective of assessing how regulation might be able to remove one or more of the demand-side barriers.
In trying to make this assessment, we are fortunate that there are relevant experiences from which we can learn. In this regard, two retirement systems stand out: those in Australia and Canada. Since the early 1990s, Australian and Canadian pension funds have been pioneers in infrastructure investing. They also have the highest asset allocation to infrastructure, of about 5% (though there is a wide dispersion in the infrastructure allocation across investors — a few of them with levels above 10% and many at 0%).
In terms of lessons for SA, there are three important similarities between the two countries: the acceptance of limited liquidity by pension funds; a clear relationship between a retirement fund’s size and its percentage allocation to unlisteds; and a mature public-private partnerships (PPPs) market.
Most Australian retirement funds are defined contribution (DC) schemes, with nearly 90% of assets in DC funds. It is also one of the world’s fastest-growing retirement systems. In a DC system, individuals have the option to switch between retirement funds. This requires the interim valuation of illiquid assets and the provision of liquidity, both potentially significant challenges. In addition, the drive towards low-cost, default DC funds can be an unintended deterrent for investing in more complex asset classes such as infrastructure. As Australian funds are generally growing and therefore cash flow positive, these challenges have been easily overcome.
Most Canadian pension funds are defined benefit (DB) schemes; about 95% of pension assets are in DB funds. Many of these DB plans are maturing, with negative cash contributions. In theory, this could have resulted in higher risk aversion and derisking. But that did not happen; for the past fifteen years, Canadian pension funds have thus averaged returns of nearly 5% per year, while their US counterparts have averaged returns of only 0.5% per annum.
A striking feature in both countries is the importance of the size of the pension schemes for investment in illiquid assets, including infrastructure. Large funds have the advantage of scale; they can afford specialist investment expertise and advice, as well as a well-resourced governance model. Both countries have a highly fragmented pension scene but also boast several large retirement funds of global scale.
In Australia, some of the largest funds have had infrastructure allocation percentages in the double digits, for their default option. In Canada, the average allocation of larger pension funds is about 10%. In both countries, apart from investing in listed privatised utilities or buying municipal bonds, there is little to no infrastructure investment activity by smaller and medium-sized funds.
On the supply side, both countries were early adopters of public-private partnerships during the early 1990s. In Australia, a vast proportion consisted of urban toll roads and tunnels, as well as communications networks, and ports and airports. In Canada, after initially lagging in the use of PPPs, there have been signs of a strong pickup in the health-care, road and justice systems sectors. Opportunities in water and rapid transit are expected to increase.
The experience of these two countries shows that the growth in the supply of bankable projects, coupled with a favourable retirement fund regulatory environment, yields long-term benefits for both infrastructure development and asset owners.
In SA, the first step is the development of an infrastructure project pipeline. This will include renewable energy projects, toll roads and water projects. In this regard, it is encouraging that we now have Infrastructure SA (ISA), which will facilitate project preparation and rollout.
The next step is a regulatory environment that encourages greater investment into illiquid assets, particularly infrastructure private equity and specialist debt funds, by the largest SA retirement funds.
• Khojane is chairperson and Campher CEO of the Association for Savings and Investment SA.
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