What happened?

Most DB pension funds find themselves in one of two states. Accumulation, where there is more money coming in than going out and decumulation where the reverse is true. Depending on what stage in the journey a pension scheme is at, they will have different income needs.

real-estate-property

Managing this cash flow becomes ever more important as closed DB schemes are faced with a steady stream of retirees, all of whom need their benefits paying.

A scheme that doesn’t have enough ready cash to pay members is obviously going to have serious problems. But at the same time persistently low interest rates mean that many pension funds are taking advantage of the illiquidity premia on assets such as property to generate decent returns.

What does it mean for trustees?

Balancing income, growth and protection will grow in importance as DB schemes mature. It is therefore crucial that any trustees thinking about holding property as part of their scheme portfolio carefully evaluate what their endgame is and how far along the journey they are.

Depending on how far along the path to self-sustainability or buyout a scheme is, trustees will need to use property in wildly different ways.

Most will already be aware of the diversification benefits of holding property, but it is property’s income generating abilities that are growing in importance, particularly in a persistently low interest environment where yield is hard to come by. Many core property funds generate around 7% per annum in returns, providing schemes with a good steam of regular income.

Property provides an attractive, very stable stream of income”

Simon Jones, senior investment consultant at Hymans Robertson said: “[Property provides] an attractive, very stable stream of income. If you can rely on that going forward that’s one way of meeting the cash flow requirement of pension funds.”

Different kinds of property investment will generate different levels of income for schemes. David Wise, co-manager of the Kames Property Income Fund argued that regional property may give trustees the best result. He said: “The further away from London you get, the further back in the cycle those properties are and the better those opportunities are.”

Despite the income generating features of property investments, there are situations where the asset class can play a growth or protection role. For example, property where rental price increases are built into a contract can help protect against inflation. Equally, there are some types of property where investors can expect growth as the value of the property increases – particularly in overseas markets.

We don’t think you can be passive in property”

However, Jones cautioned about moving too far afield, as he thinks international property opportunities may not be a good fit for many pension schemes. He said: “Why would we invest in the overseas market if our strategy is driven by income and protection? Do we need that growth exposure? I think the answer from closed DB schemes is likely to be no.”

What next?

Trustees that are interested in increasing their exposure to property need to develop a strategy that is fit for the individual needs. There’s no ‘one size fits all’ approach for investing in real estate. Trustees should also be aware that most property investment strategies will require an active approach.

And although property can play a diverse range of roles, it won’t be right for everyone. In fact, Jones expects that any pension schemes on the path to an insurance-based solution might distance themselves from the asset when they are within five years of their goal.

The reason for this is two-fold. Firstly, because most schemes tend to aim towards bonds and gilts in the run up to buyout, but also because schemes don’t want to be stuck with large illiquid assets while trying to get a deal done. Jones commented: “If a pension scheme sees itself as being able to transfer to an insurance company in the next 3-4 years, it will be starting to try and decrease its property allocation.