Pensions Act brings liquidity to the surface

Last year's Pensions Act was one of the most important pieces of UK legislation affecting pension funds. The act requires a test of whether funds have sufficient assets to meet promises to pay pensions. The legislation is likely to affect the investment policies of pension funds and possibly, make them more conservative in their approach.

A recent survey undertaken for the Investment Property Forum, sought to shed light on the likely impact of the legislation on commercial property investment. The first stage was to find out how the investment community regards property as an investment asset. Just why do fund managers buy property in the first place?

One of the most important reasons for holding property is the security of income it provides, which was cited as important by 86 per cent of respondents. After all, companies still have to pay the rent even if they have stopped paying dividends to share-holders.

Also one of the most important reasons for investing in property is portfolio diversification, cited by 84 per cent of respondents.Property generally behaves differently from the bond or equity markets, which helps fund managers to spread their risk. That said, the majority of respondents also felt that overseas equities could help diversify a portfolio more effectively than property.

It was also felt by 68 per cent of respondents that property was, in principle, a good match for pension-fund liabilities. As a real, long-term investment, property is generally regarded as a good match for long-term salary-linked pension liabilities.

The biggest problem that emerged from the survey was liquidity. Property was regarded as difficult and expensive to buy and sell compared with equities or bonds. More than three-quarters of respondents felt that this was either an important or very important consideration for investing in property.

If the Pensions Act reduces the matching characteristics of property or exacerbates the problems caused by illiquidity, there may be, a reduction in property investment.

If, on the other hand, pension funds need to move to investment portfolios which match their liabilities better, want more diversification or require the secure income stream from property investment, the impact of the act could be beneficial.

On balance, most of those interviewed inclined towards the former view. In the survey, 35 per cent of respondents felt that property investment would become less attractive as a result of the act and 3 per cent felt that it would become more attractive. The remainder was neutral.

Interviews with senior managers led us to believe that, overall, the investment community was somewhat, but not substantially, negative.

At the heart of the problem is the Minimum Funding Requirement (MFR) which all pension funds will he required to meet under the new law.

The requirement exists to test whether scheme members, in the event of a wind-up, would have sufficient funds to obtain benefits accrued by investing a cash sum in a personal pension, under given assumptions about returns.

The funding requirement requires an annual valuation of assets and liabilities. Assets are valued on an open-market basis.

The snag is that liabilities - promises to pay future pensions - will be calculated by reference to a mix of gilts and equities. Property is excluded from the equation.

The net effect is that, although property is generally regarded as a good match for pension-fund liabilities, the way the requirement has been designed implies that it is not.

If UK equity or gilt values fall, it is possible to adjust the valuation basis of the liabilities to take account of the possibility of higher future expected returns from UK equities and gilts.

However, if property values fall, the funding position of the pension fund will worsen the market value of the scheme's assets will have fallen but the possibility of higher expected returns from property, when valuing the liabilities, must be ignored.

Because property is ignored when valuing liabilities, fluctuations in property values will lead to the funding position of the scheme being more volatile. This problem could be compounded by illiquidity. Investors may be unable to move quickly out of property markets which they expect to fall to avoid the consequent impact of falling market values on their funding position.

The answer is for pension funds to hold property indirectly, through property shares, or in a securitised form. However, pension fund managers do not believe that there is an acceptable indirect vehicle available.

Property shares have the twin advantage of being liquid and forming part of the equity market index (and hence part of the benchmark under the requirement).

However, investors tend to regard them as a substitute for other equity investments rather than for property, and their tax treatment is also a problem for pension funds.

Is the Pensions Act all bad news for property, then? Certainly not. While there clearly is a problem with the requirement, most schemes are, in fact, fully funded at their last actuarial valuation. Fully-funded schemes will not have to make dramatic adjustments to their investment strategies.

Also, it is the belief of many actuaries that the whole debate surrounding funding may well focus more attention on asset/liability matching.

Many schemes probably have too little property investment from a matching point of view. This debate may, therefore, remedy any negative impact of the act on property investment.