Unprecedented changes in the pension scheme industry have led to investment strategy development and design innovations – one key area of focus is Liability Driven Investment (LDI).

January 2015

Key points

  • Continuing innovation in LDI strategies focusing on illiquid assets.
  • Transforming property into an LDI-friendly asset requires an increase in the predictability and security of cash flows.
  • This can be achieved in a number of ways such as pre-agreed rental uplifts, longer leases or targeting tenants with higher credit quality.

LDI and higher-yield assets

Pension schemes have a wide range of LDI products and bespoke solutions at their disposal, with continuing innovation in LDI strategies. In particular, given historically low gilt yields, there is an increased focus on exploring higher yielding illiquid assets that lend themselves to LDI strategies. 

What is LDI-friendly?

Generally speaking, ‘LDI-friendly’ illiquid assets need to produce predictable and secure cash flows. The higher the degree of predictability around the amount and timings of cash flows, the ‘friendlier’ the asset will be from an LDI perspective.

Property assets as effective LDI-friendly investments

A wide range of illiquid assets offer the potential to be LDI-friendly. Take property assets, to which many pension schemes have an existing allocation. Usual features include a relatively short average lease term of around eight years, open market reviews of rent levels, and active management of buildings and tenants. 

The effect of uncertain cash flows…

Uncertainty surrounds the amount and timing of the cash flows an investor typically receives, so traditional property assets cannot be considered LDI-friendly. They are usually labelled ‘growth’ assets (as opposed to a ‘defensive’) in the context of setting investment strategy and investment decisions.

…and how to overcome it

Transforming property into an LDI-friendly asset requires an increase in the predictability and security of cash flows in the form of rents and sale proceeds. This can be achieved in one or more of the following three ways:

  1. Pre-agree rental uplifts with tenants in advance (e.g. fixed uplifts and/or how these are linked to inflation). This will result in a predictable income stream during the term of the lease.
  2. Lengthen the term of the lease to extend the contracted cash flows. This greatly reduces inherent risk, shifting much of the value into the rental income stream as opposed to relying on capital appreciation.
  3. Target tenants with higher credit quality to reduce the risk of default.

Restructuring leases also helps

A fund manager could further enhance the LDI features of property assets by structuring leases to ensure all returns are generated through income distribution. Capital appreciation or depreciation would have no impact on returns if held to maturity. And rental payments cover both the lease and the repayment of capital, similar to a repayment mortgage on a house. 

How does this work in practice?

  • Rent levels and rent uplifts are pre-agreed at the outset with a high quality tenant.
  • At the end of the term, the property is passed back to the tenant for a nominal amount. As a result, there is no impact of the sale proceeds on returns if held to maturity.
  • This is commonly referred to as a fully amortising lease investment. The value of the property is fully amortised over the lease term making it a highly effective LDI asset.

Summary

To make property LDI-friendly, cash flow predictability and security needs to be increased. This can be achieved by investing in high-lease-to-value assets, or by fully amortising leases. In practice, a blended approach could be adopted. Clients might restructure their property portfolios and move into LDI-friendly assets over time This can be done via a segregated route, or through readily available ‘off-the-shelf’ funds.

 

Important Information

Except where stated as otherwise, the source of all information is Aviva Investors Global Services Limited (“Aviva Investors”) as at 3 February 2015. Unless stated otherwise any opinions expressed are those of Aviva Investors. They should not be viewed as indicating any guarantee of return from an investment managed by Aviva Investors nor as advice of any nature. The value of an investment and any income from it may go down as well as up and the investor may not get back the original amount invested.

Nothing in this [document] is intended to or should be construed as advice or recommendations of any nature. This document is not a recommendation to sell or purchase any investment. It does not form part of any contract for the sale or purchase of any investment.

Where funds are invested in real estate/infrastructure, investors may not be able to switch or cash in an investment when they want because real estate/infrastructure may not always be readily saleable. If this is the case we may defer a request to switch or cash in units. Investors should also bear in mind that the valuation of real estate is generally a matter of valuers’ opinion rather than fact.

Issued by Aviva Investors Global Services Limited, registered in England No. 1151805. Registered Office: St. Helen’s, 1 Undershaft, London EC3P 3DQ. Authorised and regulated by the Financial Conduct Authority and a member of the Investment Management Association. Contact us at Aviva Investors Global Services Limited, St. Helen’s, 1 Undershaft, London EC3P 3DQ. Telephone calls to Aviva Investors may be recorded for training or monitoring purposes.

MC3242-V001-361216-A15/0079/03052015