Don’t shoot the pension fund managers!

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Long-term investment in infrastructure needs a better policy mix

by Professor Simon Deakin, Assistant Director of the Centre for Business Research

George Osborne‘s attempts to encourage British pension funds to invest more in infrastructure projects are to be applauded. Canadian and Australian pension funds have already invested heavily in infrastructure, but UK funds are still reluctant investors. Why?

Pension fund trustees have a fiduciary duty to get the best return for scheme members after taking due account of risk. Government cannot and should not dictate how or where and how these funds invest their assets. If government wants pension funds to engage with the long term needs of the UK economy, it must first understand the particular pressures they face as investors.

Pension funds must invest for the very long term because their beneficiaries, the scheme members, will be receiving their pensions decades after making their contributions. As investors, however, the pension schemes cannot just take the long view. They must balance risks and returns over the investment cycle, which in practice means taking advantage of liquidity when it is available and making the most of opportunities for profit taking when they arise. Thus it is implausible to believe that the interests of pension funds are automatically aligned with the public interest in sustainable infrastructure. The right incentives and structures need to be put in place to support infrastructure investment.

What can be done? We need to address both sides of the issue. On the one hand, an acceptable division of investment risk between pension funds and the government must be found. On the other, the risks associated with the organisation of large-scale infrastructure projects – so-called construction risk – need to be better understood and managed.

Let’s take investment risk first. There is demand, on the part of pension schemes, for long-term investments which will provide a stable return. An asset class based on infrastructure investment may well provide part of the answer. Government would need to play a role in inflation-proofing and underwriting part of the financial risks. From the government’s point of view, infrastructure bonds which operate in a manner similar to inflation-proofed gilts could be a feasible option, but not if they result in private investors just shifting long-run costs on to the public finances in the manner of PFI (‘moral hazard’). Getting this right, and avoiding the pitfalls of PFI, will require a high degree of transparency and trust on both sides in coming months if a viable solution is to be found.

Now let’s consider construction risk. Pension funds argue that too many large construction projects don’t deliver, pointing to cost overruns and delays in completion on projects like Wembley stadium and the Jubilee Line extension. For this reason, they are more enthusiastic about investing in so-called brownfield sites, involving the maintenance of existing infrastructure, than in building new capacity. Yet new capacity is precisely what is needed in areas such as energy, transport and waste management.

From the pension funds’ point of view, the government could solve the problem of construction risk for them by simply underwriting potential losses. The difficulty with this is not just that the Treasury has limited capacity to take such an open-ended risk, but that to do so on an open ended basis would risk repeating the ‘moral hazard’ problem associated with PFI.

At least part of the solution must lie in addressing construction risk at its source, in the way projects are managed. Enormous strides have been made in recent years in managing the risks of large infrastructure projects, with the construction of the Heathrow Terminal 5 building leading the way. Lessons from Terminal 5 and other successful projects have been embedded in the procurement process and contractual design of the construction of the 2012 Olympics site. The construction industry has been actively promoting good practice through modifications to the standard-form contracts used in infrastructure projects. The government has encouraged this process and needs to continue doing so.

The issue of infrastructure investment has wider lessons for economic governance in the UK. The question George Osborne needs to ask is: what can be done to encourage an investment regime that more effectively internalises the risks of complex projects, not just in infrastructure but more generally in innovative areas of manufacturing? Getting infrastructure investment right is therefore a twin-track process. The role of government is not to impose solutions on finance or industry, but to identify good practice and encourage information exchange and dialogue between the two sides. If the government sees its role in these terms there is every prospect of a workable set of solutions emerging.

On the finance side, this means thinking about the way that pension funds are structured and governed, and about the role played by asset management firms and other market intermediaries in the investment process. Are the right structures and incentives in place for pension funds and their agents to represent the interests of scheme beneficiaries in stable returns which also bring wider benefits to the UK economy?

On the corporate side, some thought needs to be given to whether company law and associated regulatory measures, such as the Takeover Code, are sending boards of listed companies the right signals.  A legal and regulatory regime which is widely, if arguably incorrectly, interpreted as requiring listed companies to prioritise short-term shareholder value, is not compatible with the country’s long-term investment needs. Are Britain’s corporate governance arrangements, so long held up as an example to the world, part of the reason for the continuing decline in investment in R&D by UK firms, by comparison to our competitors, and for the presence of no more than a handful of globally successful British manufacturing companies when Germany and Japan have a dozen or more each?

This blog post also appeared on the FT’s Economists’ Forum website >

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