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I recently took part in a webinar with Owen Haggith-Khonje, Managing Director from SEI Investments, and Matthew Griffen, Senior Portfolio Supervisor at Manulife who runs Hancock Timberland and Farmland Fund LP to discuss how pension trustees can include these types of real assets in their strategy and why they might want to.
The reason for this focus is defined benefit (DB) pension scheme trustees are looking to balance the need for inflation-linked income and greater asset diversification with environmental, social and governance (ESG) requirements. Often, trustees need to look beyond traditional asset classes and consider an allocation to infrastructure to help solve these challenges.
The ESG opportunities & challenges
ESG considerations have grown in importance for pension trustees managing DB schemes, who are now subject to extensive ESG requirements. Regulations have made larger pension schemes report on the climate risks and opportunities of their investments, under the framework determined by the Taskforce for Climate-related Financial Disclosures (TCFD). Smaller schemes are expected to follow suit in the future.
As a result, more money is being directed towards investments with strong ESG characteristics, as pension trustees look to reflect responsible investment beliefs in their portfolios. Over time, it’s likely these investments will provide the longer-term growth pension schemes need.
Timber and agriculture investments positively contribute to solutions for four of the greatest ESG challenges the world is facing over the next decade:
They could provide pension trustees with an opportunity to enhance the ESG characteristics of their portfolios. However, the potential ESG upside of these investments should be considered alongside the inherent climate risks. Investment in significant areas of land can be exposed to acute climate events such as wildfires and flooding, as well as longer-term risks due to climate change. Therefore, it’s important to invest in a diverse portfolio from a geological perspective to help mitigate these risks and ensure the manager has carried out a detailed climate risk assessment for each underlying investment.
A further challenge for pension trustees is translating these ESG factors into the reporting needed to meet current regulatory requirements. There are significant data challenges in terms of accessing accurate and up-to-date ESG information on investments as well as considering the most suitable metrics to report on the portfolio. The debate continues on what ‘standard’, universal ESG metrics should be, with definitions and regulations constantly evolving. This makes it hard for pension trustees to construct a framework to assess the ESG attributes of an investment.
The financial opportunities & challenges
Whilst the ESG aspects of an investment are important, the financials must also be attractive and withstand scrutiny. Investments such as timber and farmland can offer pension trustees meaningful expected returns, low correlation to more traditional assets and offer some inflation protection on the cashflows generated.
This all seems quite appealing. However, from a DB scheme perspective, it’s vital to compare the liquidity and investment time horizon of any investment against the scheme’s cashflow requirements and long-term funding objective. Depending on the size of cashflows and how soon they are needed, this type of investment may not be appropriate (or it could be included in the income generating part of the scheme’s portfolio). It’s important for trustees to undertake due diligence to fully understand the cashflow profile of the investment and scenarios where this could change.
DB pension schemes thinking about buy out may not want to consider illiquid assets. For schemes where the long-term objective is self-sufficiency, or buy-out is at least five to ten years off, illiquid investments may well be attractive. There’s an expected additional return for illiquid investments, the illiquidity premium, to compensate investors for locking up their assets. However, pension trustees must ensure they’re comfortable with having assets tied up in this type of arrangement as, for example, changing market conditions could accelerate the timeframe for achieving buy out.
This goes beyond just risk and return and it’s essential to look carefully at all the different elements of managing a DB scheme’s portfolio on a day-to-day basis. This is especially true right now when markets are in a state of flux, with high inflation and equity market volatility. In this challenging economic environment, it’s important to make sure commitments are not eating into the portfolio’s liquid asset classes.
The opportunities for the future
Looking forward, there will be opportunities with population growth and trends towards different types of crops and foods such as tree nuts and insects, which will see farmland diversify. With timber, there is continued growth and trends towards construction and eco construction.
These investments can tick a lot of boxes for pension schemes as part of a diversified portfolio, especially as ESG becomes more important. They can provide long term stable growth, but schemes need be in it for the long term too.
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