This chapter discusses the conditions under which assets earmarked for retirement can support the economy during and in the aftermath of the COVID‑19 crisis. It considers how pension providers may invest the retirement savings of their members in distressed companies or in long‑term recovery projects, while upholding their fiduciary duty to invest in the best interest of members. It also discusses the investment vehicles that pension providers may use to invest and meet financing needs in the economy.
Strengthening Asset-backed Pension Systems in a Post-COVID World
5. How assets earmarked for retirement can support economies and benefit members
Abstract
COVID‑19 containment measures have weighed heavily on economic activity around the world. To limit the spread of the virus, most countries have enforced lockdowns of varying degrees and lengths during 2020 and 2021, causing business disruptions and large reductions in activity levels. As a result, most economies have experienced unprecedented contractions in real gross domestic product (GDP). In the OECD area, real GDP fell by 10.5% in the second quarter of 2020 and 4.9% for 2020 as a whole. The Q2 2020 fall is the largest drop ever recorded for the OECD area, significantly larger than the 2.3% fall recorded in the first quarter of 2009, at the height of the financial crisis (OECD, 2021[1]).
To bring economies back on their feet, countries will need private capital to support businesses and finance recovery projects. To cushion the blow of the COVID‑19 crisis, governments implemented quick, large and innovative support measures, subsidising workers and firms. As a result, government budget deficits are elevated and public debt is set to rise to exceptionally high levels in many countries (OECD, 2021[2]). However, the path to recovery requires more spending to support the transition of capital and workers from impaired sectors and businesses towards expanding ones. Furthermore, investment in infrastructure, such as hospitals, housing, schools, renewable energy and digital networks could create jobs and deliver tangible assets that will fuel long-term economic growth. Moreover, investing in environmental, social and governance (ESG) long-term sustainable projects would also support economies in the long term. Given budget constraints, there is likely to be calls on private institutional investors such as pension funds to play a bigger role in financing the economic recovery.
This chapter discusses the conditions under which assets earmarked for retirement can support the economy during and in the aftermath of the COVID‑19 crisis. It considers how pension providers may invest the retirement savings of their members in distressed companies or in long-term recovery projects, while upholding their fiduciary duty to invest in the best interest of members. It also discusses the investment vehicles that pension providers may use to invest and meet financing needs in the economy. These discussions apply to all types of pension providers, i.e. pension funds, as well as insurance companies, banks and investment managers operating in asset-backed pension systems.1 Although the focus is on the post-COVID‑19 recovery, the analysis is also relevant for future crises, and also to sustainable, and ESG investment opportunities.
Pension providers can play a role in supporting the economy. They already have experience in investing in the economy, as they purchase a range of assets to diversify their exposures, and their scale and long-term investment horizon allow them to consider long term, including illiquid, investments. Many pension providers are also seeking out investment opportunities that can deliver higher returns in a low interest rate environment.2
However, challenges exist. A paucity of opportunities, regulatory barriers and lack of capability can impede pension providers’ involvement in supporting the economy. The current crisis also brings new risks that pension providers need to consider before investing amid pressures to financially support domestic businesses and projects. Strong governance, appropriate investment and risk management strategies, and suitable investment opportunities are essential to ensure that pension providers invest in the best interest of members in a way that supports businesses and stimulates an economic recovery. In addition, pension providers can use various investment vehicles to gain exposure to investments that support the economy, such as COVID‑19 bonds, instruments that provide immediate financing to businesses and governments, and instruments that can help finance a recovery. Indeed, there is already significant use of instruments such as these. For example, governments, companies and multinational organisations raised billions of US dollars globally from selling COVID‑19 bonds, or debt whose proceeds are broadly earmarked for work linked to the pandemic.3
The chapter is structured as follows. Section 5.1 explains why pension providers can play a role in supporting the economy. Section 5.2 describes the obstacles and risks that pension providers face when considering investments in businesses and recovery projects. Section 5.3 then presents solutions to overcome these challenges, by reviewing the elements of the governance and investment frameworks that safeguard people’s retirement savings when pension providers consider new investment opportunities. It then describes the steps that policy makers could take to ensure that suitable investment opportunities are available to pension providers. Section 5.4 discusses the different investment vehicles that could allow pension providers to support businesses and gain exposure to investments that contribute to the economic recovery. Finally, Section 5.5 concludes with policy implications for pension providers and policy makers to foster greater investment to support the economy, while ensuring that these investments are in the best interest of members.
5.1. Pension providers can play a role in supporting the economy
Investing in the economy is part of the business of pension providers. Pension providers collect and invest contributions with the sole objective of financing the retirement benefits of the plan members and beneficiaries. Pension providers may invest indirectly in the economy through government bonds. However, proceeds from these government bonds may not only help to finance public expenditure, they may also help to balance the general government budget. Pension providers also invest in the economy directly, through equities (listed and unlisted) and corporate bonds. In 2019, equity investment represented 30% or more of total investment in 15 OECD countries, with a maximum of 82% in Poland.4 Direct corporate bond holdings represented 15% or more of total investment in 9 OECD countries, with up to 32% in the Slovak Republic.5 Overall, when also including investments in land and buildings, loans, hedge funds, private equity funds and structured products, total direct investment in the economy represented more than half of total investment in Australia, Austria, Chile, Colombia, Finland, Iceland, Lithuania, the Netherlands, New Zealand, Norway, Poland and Switzerland (Figure 5.1).
The COVID‑19 crisis may offer good and novel investment opportunities for pension providers. Some pension providers may be looking for other asset classes than government bonds to generate returns. New opportunities may arise to invest in the economy. The crisis has prompted a number of companies to issue new shares or new debt to raise money amid a financial crunch.6 As long as pension providers expect that purchasing these shares and bonds is in line with their investment strategy and fiduciary duty, they can invest in such securities to help mitigate the impact of the COVID‑19 crisis on businesses, while delivering good returns to their members.
Beyond equity and bond investing, alternative investments are likely to play an important role in financing the post-COVID‑19 economic recovery. Investment in new infrastructure, such as hospitals, schools, renewable energy and digital networks, could provide good returns, while also creating jobs and delivering tangible assets that will fuel long-term economic growth. Real estate may also be a promising asset class for pension providers in some countries. Rescue packages amounting to trillions of dollars have been announced around the world to help individuals and businesses weather the COVID‑19 storm and have squeezed governments’ budgets. As governments face a reduced capacity to finance alternative investment projects, there may be a greater role of pension providers in this area. Equally, by making such investments, pension providers can manage risk through greater diversification of investments.
Figure 5.1. Pension providers’ direct investment in the economy in selected OECD countries, 2019
Notes: Data include both domestic and foreign investments. Data refer to pension plans through pension funds, pension insurance contracts or other financing vehicles, depending on the structure of each asset-backed pension system and data availability for each country. “D” means direct investment; “D+I” means direct investment plus indirect investment through collective investment schemes (CIS). For some countries, the look-though of CIS investment and/or the split between corporate and public bonds are not available; investment in some underlying asset classes is therefore under-estimated for these countries.
Source: OECD Global Pension Statistics.
Pension providers are natural investors in less liquid, long-term assets such as infrastructure. Infrastructure investment can provide stable and regular cash flows over the long term, thereby providing an alternative to fixed-income instruments to match pension providers’ cash requirements. In addition, cash flows can be inflation linked, making them a natural inflation hedge for pension providers that need to manage inflation risk. Pension providers can also take advantage of an illiquidity premium rewarding them for exposure to less liquid, long-term assets such as infrastructure. Moreover, infrastructure investment can help pension providers to diversify their portfolio across asset types and geographies. Finally, holding investments over the long term can reduce turnover within portfolios and thereby lower transaction costs.
However, data show that current levels of investment in infrastructure projects from pension providers are still low, suggesting there is room to increase allocations. In 2019 for example, direct equity investments in infrastructure projects (e.g. transport, utilities and energy, communications, social infrastructure) and unlisted infrastructure equity funds only represented 2% of pension funds’ total investment in Israel and the Netherlands, and 1% in Austria and Portugal (OECD, 2020[3]). Among large pension funds around the world, direct infrastructure investment in the form of unlisted equity and debt represented 1.3% of total assets under management in 2017. Among those investing in infrastructure, allocations ranged from 0.1% to 10.1%, and were usually below the targets established by the funds (OECD, 2019[4]). Given the overall low levels observed, increasing interest from pension providers in infrastructure, and potential to meet target allocations, there is scope for pension providers to increase their allocations to infrastructure investment to finance the economic recovery.
Pension providers could also support the economy by investing in small and medium sized enterprises (SMEs). SMEs play a major role in the global economy and are being severely affected by the COVID‑19 pandemic given their higher levels of vulnerability and lower resilience due to their size. Surveys on the COVID‑19 impact on SMEs show that more than half of SMEs faced severe losses in revenues, while one‑third feared they would be out of business without further support within one month, and up to 50% within three months (OECD, 2020[5]). Pension providers could complement banks to help SMEs cope with urgent liquidity needs. However, pension providers’ engagement in SME financing remains, so far, limited (OECD, 2015[6]) and some shortcomings still need be addressed to allow pension providers to invest in these businesses. In particular, as this chapter discusses, given the heightened risks of investing in SMEs, there is a potential role for policy makers to help ensure pension providers make any such investments prudently and in the best interests of members.
Finally, the COVID‑19 crisis may accelerate the integration of environmental, social and governance (ESG) factors into the investment policies of pension providers. Many countries target recovery projects that are in line with sustainability goals, building on an existing global trend that has seen a strengthening of ESG considerations for investment decisions. For example, the funds of the EUR 750 billion EU recovery plan will be used to reach the EU’s objectives of climate neutrality and digital transformation, as well as to offer social and employment support. The OECD recommends that recovery plans should be designed to “build back better”, meaning that they should lead to investment and behavioural changes that will reduce the likelihood of future shocks and increase societies’ resilience to them (OECD, 2020[7]). If the ESG characteristics of the projects financed by such recovery plans are made clear, this could facilitate the integration of ESG factors into investment policies.
5.2. But challenges to further support the economy exist
5.2.1. General obstacles to investing in businesses and recovery projects
Several obstacles may impede pension providers to be more involved in supporting the economy. These include the existence of regulatory barriers or the absence of regulation where it is needed, limited investor capability to handle complex investments, and a lack of investment opportunities and clarity of government policy.
Regulatory barriers
Investment regulation may impede pension providers from investing in securities and instruments that may help with the economic recovery. Some countries do not impose any quantitative investment limits and require pension providers to invest according to the prudent person rule, which ensures that investments are carried out in a prudent manner considering the best interest of members and beneficiaries. This is the case in Australia, Austria, Belgium, Canada, the Netherlands, New Zealand, Norway, the United Kingdom, and the United States. Other OECD countries set investment ceilings or caps, sometimes in addition to the prudent person rule, limiting the share of the portfolio that can be invested in particular securities or instruments.
Among OECD countries with investment restrictions, most set limits for equities, corporate bonds, real estate, loans and private investment funds (Annex Table 5.A.1 in Annexe 5.A). Caps may vary according to the fund, in particular when plan members can select their investment strategy. Therefore, funds that are more conservative have lower caps in riskier asset classes, and vice‑versa. In some countries, the regulation completely forbids pension providers to invest in some asset classes, such as loans (Colombia, Greece, Italy, Korea, Latvia, Lithuania, Mexico and the Slovak Republic) or real estate (Lithuania and Poland).
Most countries have stricter limits for investments not traded in regulated markets. Investment limits are more stringent for unlisted securities than for listed ones in many countries. For example, in Finland, there is a limit of 10% for investments in unlisted equities but a 50% limit for listed equities for voluntary company and industry-wide pension funds. Lower caps for unlisted equities compared to listed equities also exist in France, Germany (for Pensionskassen), Hungary, Korea, Slovenia, Spain and Sweden. Unlisted bonds are also capped in Estonia, Latvia and Sweden. Finally, most countries put ceilings on investments in private investment funds. When investment in private investment funds is not forbidden, the ceiling may be as low as 5%, such as in Chile, Colombia, the Czech Republic, Greece and Hungary.
Some of these limits may represent a barrier to SME financing or infrastructure investment. For example, private credit (loans by pension funds), unlisted bonds (private placements of debt) and private equity represent important market-based instruments for SME financing and tend to be tightly curtailed for pension providers. Similarly, low limits for unlisted equities and unlisted infrastructure funds affect the capacity of pension providers to invest in infrastructure projects. In particular, some of the largest pension funds around the world have reported regulatory challenges to increasing their infrastructure allocation. For example in Hong Kong (China), pension funds can only invest in listed markets, while funds in Chile and Romania mention regulatory constraints as barriers to infrastructure investment (OECD, 2019[4]). It is noteworthy that in Denmark, a country without quantitative investment limits, allocation to unlisted investments for pension and insurance companies represented 27% of total investment by June 2020 (Danmarks Nationalbank, 2020[8]).
Accounting standards as well as funding and solvency regulations may reduce allocations to listed equities. Mark-to-market valuations and risk-based solvency and funding regulations may affect investment strategies in two main ways. First, using market interest rates to discount liabilities creates a higher sensitivity of liabilities, and hence of solvency or funding levels, to market conditions. In order to reduce the volatility of solvency and funding levels, pension providers may have an incentive to hold more fixed-income securities. Second, under risk-based solvency and funding regulations, asset classes with a higher volatility, such as equities, are subject to a higher capital charge or reserving. This may lead pension providers to reduce exposure to such asset classes. Severinson and Yermo (2012[9]) show that the introduction of fair valuation principles and risk-based funding regulations led pension providers in Denmark, the Netherlands and the United Kingdom to move away from listed equities towards fixed-income securities and alternative investments, in particular private equity, hedge funds, real estate and unlisted infrastructure equity.
Finally, the absence of regulatory barriers can also deter institutional investment. A strong rule of law and a robust and transparent regulatory environment are key drivers in investors’ decisions regarding which jurisdictions to invest in (OECD, 2014[10]). Weak institutions create uncertainties about the quality of regulations and therefore increase country risk (Hammami, Ruhashyankiko and Yehoue, 2006[11]). Another key deterrent to investors’ willingness to engage in long-term investments is any perceived risk of political instability or political pressures on regulatory schemes (OECD, 2014[10]).7 Potential investors may also perceive a risk that political considerations might encourage governments to engage in riskier projects than is in the public interest (Hammami, Ruhashyankiko and Yehoue, 2006[11]).
Additionally, too few limits on individual savers to switch investments may also reduce pension providers’ appetite for illiquid investments, particularly those without a readily ascertainable market value, such as infrastructure. Members of defined contribution asset-backed pension arrangements generally can switch providers. They can also usually choose from a range of investment options with varying risk profiles, and transfer between the different options available within certain limits. However, this means that pension providers may be exposed to significant outflows, reducing the expected duration and investment horizon of their investment strategy. Pedraza Morales et al. (2017[12]) find a correlation of over 0.5 between fund flows across providers and holdings of short-term and more liquid assets in Chile, Colombia and Mexico. The correlation with respect to the volume of transfers across investment options within a provider was lower in all countries, except for Chile. This suggests that pension providers may hold more liquid and short-term assets in order to accommodate for unexpected outflows, reducing the part they can invest in long-term assets.
Limited investor capability
Some investments may require specific skills and expertise that some pension providers may lack. A number of risks are typically more relevant for alternative investments (e.g. hedge funds, private equity, real estate, commodities, structured products and infrastructure), such as liquidity risk, integrity risk, operational risk, limited transparency, valuation weaknesses, control issues, counterparty risk and conflicts of interest (Stańko and Ásgrímsson, 2017[13]). Analysing these risks often requires sophisticated methods of risk management and analysis, as well as scale and dedicated resources. Small and medium-sized pension funds, or more generally funds that do not have well-developed in-house investment and risk management teams, may lack the capability of investing on their own in alternative investments.8
Lack of objective information and quality data may further complicate the task. In particular, historical data on infrastructure deals are scarce and often proprietary. Without a suitable benchmark panel data, pension providers may not be in a position to assess the different degrees of risk of a certain project or its different phases (OECD, 2014[10]). Similarly, a shortage of data on creditworthiness, financial performance and financing track record of SMEs is one of the most significant impediments to market-based SME financing, especially through debt instruments. Moreover, lack of standardised reporting by SMEs impedes comparability and does not allow investors to perform comprehensive and well-informed analysis on the underlying exposures (OECD, 2015[6]). Innovative techniques using artificial intelligence and machine learning models could reduce such information asymmetries by using big data to assess the creditworthiness of ‘thin file’ clients and provide credit ratings to ‘unscored’ clients with limited credit history or lack of tangible collateral. It should be noted, however, that such techniques and the use of inadequate data in lending can raise risks of disparate impact in credit outcomes and the potential for biased, discriminatory or unfair lending. What is more, tail events, such as the COVID‑19 crisis, give rise to discontinuity in the datasets that are used by machine learning models and are practically difficult to overcome at this stage (OECD, 2021[14]).
Non-traditional assets also tend to be more expensive to manage. Arrangements to invest in alternative assets can be complex, calling for greater scrutiny, analysis and monitoring compared to other financial products. As such, high fees have been a deterrent to these kinds of investments for some time. This is particularly the case for SME financing, as investors need to build capacity to deal with the huge amount of heterogeneity among businesses. Moreover, pension providers lacking the scale or capability to invest directly in infrastructure projects can use unlisted infrastructure funds. However, these funds tend to charge high fees to investors for providing access to diversified pools of infrastructure assets (Belt and Nimmo, 2013[15]).
Lack of investment opportunities and clarity of government policy
Lack of clarity of government policy, in particular in the infrastructure sector and on ESG, as well as the lack of investment opportunities, are impediments for pension providers to invest in recovery projects. Where governments do not make political commitments over the long term, or where they are fragmented across different levels of government, investors can be deterred from including infrastructure in their long‑term investment strategy. Further, lack of clarity on investment opportunities can make it harder for pension providers to make long-term decisions (Della Croce, 2011[16]). Pension providers need a clearer understanding of the government’s infrastructure plans beyond the political cycle. For example, the Australian Institute of Superannuation Trustees mentions regulatory uncertainty, especially in sectors such as renewable energy, as a barrier to invest in new infrastructure projects (AIST, 2020[17]). Similarly, a survey of retirement schemes in the United Kingdom revealed that many had misgivings about the availability of appropriate domestic opportunities. They stated they would invest elsewhere if the right opportunities that meet their investment strategy and risk/return profile were not available.9
Lack of awareness from entrepreneurs about market-based financing possibilities for SMEs and issuance costs also limit the number of investment opportunities in this area for pension providers. SMEs are often not aware of alternative means of finance available through the markets, beyond bank lending. In addition, they often lack the skills to face the process of bond or equity issuance, for which costs can be disproportionately high. This drives down the number of issuances (OECD, 2015[6]).
5.2.2. Risks in the current context
The primary objective of pension providers is to invest assets earmarked for retirement in the best interest of plan members. Not fulfilling this objective creates a long-term risk to societies, as people may not have enough to live on in retirement and may need to rely on public safety nets. The COVID‑19 crisis may bring additional risks, beyond the general obstacles described earlier, that pension providers need to consider when investing in businesses and recovery projects, especially when they may weaken the requirement to act in the best interest of members. There may be calls on pension providers to invest in instruments to support the economic recovery, but at the cost of potentially generating lower returns relative to other investment opportunities with the same risk profile or increasing concentration. In addition, pension providers may deviate from their strategic asset allocation to seize investment opportunities. Finally, measures taken by governments to grant contribution holidays and help members access their savings during the crisis may reduce room for investment in illiquid assets.
Risk of prioritising the economic recovery at the detriment of the best interest of members
There have been calls on pension providers to use savings earmarked for retirement to address the impact posed by COVID‑19 on the economy, investing in recovery and ESG projects. Pension providers could play a more active role in the current economic situation as long as the risk-return profile of the corresponding investments is acceptable. Some sectors have been hit hard by the lockdown and ensuing social distancing measures, such as civil aviation, tourism, and cultural and leisure sectors. Suggestions that pension providers could support companies in these sectors to help cushion the blow from the COVID‑19 crisis abound. However, these investments may yield poor returns, as the outlook for some companies may be negative. Indeed, consumers may have changed some of their habits, reducing permanently the demand for certain goods and services. For example, air travel may not go back to pre‑pandemic levels, as enhanced video conferencing capabilities may permanently reduce the need for physical meetings at work. There is a risk that investing in such sectors may deliver poor value for members, or worse than they otherwise would have gotten from other investments. In turn, this could reduce trust in asset-backed pension arrangements.
A fast and strong economic recovery is in the best interest of members, but bailing out ailing companies is not the role of pension providers. The pressure may be particularly strong for industry or sector-wide pension funds to invest in their own industry or sector, as their members can only continue to save for retirement if they remain employed. In addition, a faster economic recovery should lead to a faster recovery of financial markets and therefore of asset values. However, there should be a clear delineation of roles between the government and pension providers. The role of the government is to help businesses keep workers when it is expected that demand for their goods and services will eventually recover, or to help workers retrain so they can take new jobs that are more needed in the post-crisis economy. The role of pension providers is to select investment opportunities that will deliver good risk-adjusted returns to their members to finance their retirement income. The fact that pension providers may face a shrinkage of their membership base because the sector needs to downsize following the crisis should not interfere in their investment decisions.10
Pressures to invest in local businesses or infrastructure projects may also be strong for public pension funds, public pension reserve funds, as well as mandatory pension funds. Governments, as well as the population, may believe that pension providers that are financed at least partly with public money, or collecting mandatory contributions from employers and workers, should take a more active role to help with the economic recovery. To maintain good relations with their stakeholders, pension providers might give in to government and public (soft) pressure to support national initiatives to help meet financing gaps for long-term projects, such as infrastructure investments, aimed at stimulating the economy. Infrastructure projects can come with significant benefits, such as diversification, low volatility, and cash yields in the future. However, infrastructure projects can be complex and pension providers need to make sure that they understand all of the implications of the investments. Moreover, infrastructure may be overvalued due to increased demand or because future returns are overestimated. Pension providers should not blindly trust public investment projects, and should exercise their due diligence to assess expected returns.
Concentration risk
Channelling more funds into the domestic economy might reduce geographical diversification of the portfolios of pension providers. There have been signs of pressure for pension funds to invest domestically. For example, in March 2020, the Icelandic Pension Funds Association urged pension funds to limit their purchases of foreign investments over the following three months. In consultation with the Central Bank of Iceland, pension funds stopped purchasing foreign currency from 17 March 2020. This was partly to reduce instability over the Icelandic krona as the country’s export revenues were projected to decline temporarily.11 This issue is particularly relevant for small economies. However, geographical diversification can be an important feature to consider to bring down investment risk, as more waves of the virus are affecting various regions of the world differently and at different times, allowing lower returns in some regions to be potentially compensated by higher returns in others. To the contrary, geographical concentration in one economy may imply greater investment losses in the event of a new lockdown in that economy.
Systemic concentration risk may also arise if many pension providers invest in the same sectors or projects due to government/public pressure or herding behaviour. If all or several pension providers of a country invest in the same projects and these projects perform badly, then they will all suffer investment losses at the same time, potentially reducing trust in the pensions industry.
Liquidity risk
Measures to provide employees and employers with short-term relief may create liquidity constraints and reduce pension providers’ capacity to invest in illiquid assets. Pension providers need to hold cash and liquid assets in their portfolios to address liquidity demands from regular benefit payments and exceptional withdrawals. They also count on contribution inflows to manage liquidity needs. However, certain countries have allowed employers and/or employees to defer or even stop contributions to asset-backed pension arrangements to provide them with short-term financial relief. In addition, members who lost their jobs or experienced a reduction in working hours can more easily access their savings early to weather financial hardship in a number of countries (see Chapter 2). Not only may this force pension providers to act pro-cyclically by selling assets in falling markets and materialise losses, it also increases liquidity demands. These measures jeopardise the capacity of pension providers to invest in long-term, illiquid assets, such as infrastructure, as they need to keep a larger share of the portfolio in liquid assets. These measures may also create a precedent for future withdrawals, so that pension providers might not trust that assets will be locked away for the long-term going forward, further reducing their appetite for long-term investment.
Deviation from the strategic asset allocation
Finally, the current crisis offers new investment opportunities but may spur pension providers to deviate from their strategic asset allocation. In order to seize opportunities that could potentially fetch higher returns, for example to participate in new infrastructure projects, pension providers may increase the overall risk profile of their portfolio. The investment strategy may no longer be in line with the investment objective of the pension provider, increasing the risk that it will not deliver on its promises. Moreover, pension providers should not pursue complex investments, e.g. private equity, if they do not have the expertise to conduct the same risk assessment as for any other type of investment.
5.3. Overcoming challenges to investing requires strong governance, appropriate investment strategies and suitable investment opportunities
Strong governance and appropriate investment strategies will help ensure pension providers act in the best interest of members when they invest in projects supporting the economy. The OECD Core Principles of Private Pension Regulation provide governments, regulators and supervisors with high-level guidance on the design and operation of asset-backed pension systems (OECD, 2016[18]). They aim to strengthen the regulatory framework around asset-backed pensions in order to promote the sound and reliable operation of asset-backed pension plans. Core Principle 3 on “Governance” and Core Principle 4 on “Investment and Risk Management” are particularly relevant to address some of the issues identified earlier, as they set out the characteristics and behaviours that regulators should encourage in the governance frameworks and investment policies of pension providers, respectively. In particular, ensuring the accountability and suitability of the governing body of pension providers, defining an appropriate investment policy, designing a sound risk management strategy and having appropriate investment regulations can all contribute to safeguarding members’ assets while supporting the economy at the same time.
5.3.1. Accountability and suitability of the governing body
A governing body should be accountable to members and beneficiaries, and should guarantee that investment decisions are at arm’s length from governments. Core Principle 3 recommends that every pension provider establishes a governing body to administer the pension fund. The governing body should ultimately be responsible for the protection of the best interest of members. Its fiduciary duty towards members includes prudent and efficient investment of the assets, as well as exercising due diligence in the investment process. Mechanisms for achieving accountability and transparency include robust public reporting and a publicly available code of conduct governing the actions of employees, officers, and board members of pension providers. The accountability of the governing body may be reinforced through the legal liability of any actions that are inconsistent with its fiduciary duty. The governing body should therefore not bend to government or public pressure to make a particular investment if this is not in the best interest of the members of the pension provider.
Independence also guarantees that decisions taken by the board are based solely on the mission of the pension provider. Core Principle 3 recommends that adequate internal controls are in place to promote the independence and impartiality of the decisions taken by the governing body. In selected Canadian public pension funds for example, independence from government is enshrined in legislation and is enabled by a strong board member appointment process and the protection of fund managers to allow them the appropriate autonomy (The World Bank, 2017[19]).
Good governance should also ensure that the members of the governing body have the appropriate skills and experience to understand the different products that they may invest in. According to Core Principle 3, members of the governing body should be subject to minimum fit and proper standards in order to ensure a high level of integrity, competence, experience and professionalism in the governance of the pension provider. In addition, they should collectively have the necessary skills and knowledge to oversee all the functions performed by the pension provider, including investment management. In the event that they lack sufficient expertise to assess particularly complex investments such as infrastructure, derivatives, private equity and others, they should either seek expert advice or reject the investment. In case they seek advice, the governing body should be able to understand the advice, and in any case the governing body keeps ultimate responsibility for the decision of whether or not to invest in the product. These requirements regarding suitability and expert advice should ensure that the governing body only pursues investments that it fully understands.
5.3.2. Well-defined investment policy
Having a well-defined investment policy should avoid a situation whereby the pension provider would engage in unsuitable investments. According to Core Principle 4, the governing body of a pension provider has to define an investment policy in a written statement. That investment policy should establish clear investment objectives for the pension provider consistent with its retirement income objective and specific attributes (e.g. liabilities, risk appetite of members and the plan sponsor). Among other things, the investment policy should identify the asset allocation strategy for the pension provider. Deviations from the asset allocation strategy may be tolerated, but the investment policy should clearly identify when and to what extent such deviations may happen. The investment policy should therefore establish limits to the extent to which a pension provider may deviate from its strategic asset allocation by seizing opportunities for new investments.
In addition, the investment policy should provide a clear framework regarding investments in non-traditional or less transparent asset classes such as infrastructure, as well as investments in non-regulated markets, such as unlisted securities (Core Principle 4). The investment policy should detail the circumstances under which the pension provider might pursue such investments (e.g. the rationale, investment limits, and vehicles to use). This should be in line with the investment regulations in place as well as the level of expertise of the governing body in the area of alternative investments.
The investment policy should also be regularly reviewed and potentially updated to reflect changes in the investment environment. Core Principle 4 recommends the governing body to periodically review the investment strategy to determine whether there is a need to change the policy. If new opportunities arise and can adequately fit in the strategic asset allocation to pursue the investment objective, it would be legitimate to revise the investment policy by including new instruments in the available asset mix, if permitted. For example, the investment policy may not allow infrastructure investment because at the time of setting up the fund, such investments were not available or suitable for the pension provider.
5.3.3. Sound risk management strategy
Existing risk management strategies should already allow pension providers to identify all material investment risks. Core Principle 4 states that the governing body of a pension provider should establish an investment risk management process to support the achievement of the investment objectives. The OECD/IOPS Good Practices for Pension Funds’ Risk Management Systems12 note that “an effective risk management system is comprised of strategies, processes and reporting procedures necessary to identify, measure, monitor, assess, control and report, on a continuous and an ad hoc basis, all material risks, at an individual and an aggregated level, to which the pension fund or plan is or could be exposed, and their interdependencies”. Material investment risks include risks related to movements in interest rates or other market prices, credit risk and liquidity risk. A sound investment risk management strategy should ensure that all the risks related to a particular investment product are considered and assessed before investing in such a product, and that a mechanism is put in place afterwards to control and monitor those risks on an ongoing basis.
5.3.4. Appropriate investment regulations
Investment regulations could guide the definition of the investment policies of pension providers, in particular with respect to investments in alternative assets. When legal provisions stipulate maximum levels of investment by category, Core Principle 4 recommends that these provisions address the use of more complex and less transparent asset classes, taking into account their utility and the risks of their inappropriate use. Annex Table 5.A.1 shows that many countries indeed establish specific limits for non-traditional investments. Such limits sometimes apply in addition to the prudent person rule. This is not the case, however, in countries only requiring pension providers to invest according the prudent person rule. In addition, Stańko and Ásgrímsson (2017[13]) find no significant differences in the supervision of pension funds’ investments in respect to traditional or non-traditional investments (including no specific guidelines for non-traditional investments). This may be because in some jurisdictions, direct investment in non-traditional investments is not allowed or because non-traditional investments are still insignificant.
Investment regulations should also evolve over time to allow pension providers to adapt their investment strategies to new challenges and new products available. In particular, Core Principle 4 warns that quantitative portfolio limits should not inhibit adequate diversification, nor the ability of pension providers to implement optimum investment strategies. They should therefore be regularly assessed and amended as necessary. In particular, investment in alternative asset classes may be gradually relaxed as pension providers improve the skills of their investment teams. Table 5.1 provides the example of Mexico, where the investment regime for pension funds gradually introduced new asset classes. This gradual shift was accompanied by an increased sophistication of investment teams in pension funds. For example, pension funds incorporated new domestic certifications for staff members performing the analysis of alternative instruments and increased the number of staff members with certifications from international bodies (FIAP, 2018[20]).
Some countries have recently increased regulatory limits to allow pension providers to invest more in alternative asset classes and to support the economy during the COVID‑19 crisis. For example, in Chile, the Productivity Law promulgated on 25 October 2016 allows pension funds to invest directly in alternative assets.13 Alternative assets include instruments, operations and contracts related to real estate, private equity, private debt, infrastructure and other assets established by the investment regime. The maximum limits were established between 5% and 15% of assets depending on the type of fund. In April 2020, the Central Bank of Chile increased the caps for alternative assets to help diversify investments and improve risk-return prospects.14 As of October 2020, Swiss pension funds have been able to invest up to 10% of their assets in infrastructure. The investment category for infrastructure was initially grouped together with hedge funds, private equity, insurance linked securities and commodities, jointly capped at 15% of total investments. Infrastructure is now separated and has its own 10% limit to allow pension funds to expand their exposure to infrastructure. To support financing for start-ups and innovative companies during the COVID‑19 crisis, Icelandic pension funds are temporarily allowed to own up to 35% of the units or shares of venture capital funds (instead of 20%), as long as these investments do not exceed 1% of pension fund assets. This authorisation is valid until 1 January 2025. Israel has amended some investment regulations applying to institutional investors in response to the COVID‑19 outbreak. Institutional investors can now hold up to 49% of a single corporate bond series (instead of 25%), and up to 7.5% of the means of control of other investors (instead of 5%). This change intends to support capital markets and the economy. Lifting these investment restrictions should, however, go hand in hand with strong governance, clear and well-described investment policies and risk-management strategies, to ensure that investments are made in the best interest of members. Finally, Colombia loosened a limit on investment in private debt. This would help channel money to SMEs, which were particularly hit by the crisis.
Table 5.1. Evolution of the investment regime for Mexican pension funds since 1997
Source: CONSAR.
Risk-based requirements present an alternative approach to quantitative investment limits. They do not impose hard restrictions on investment, but instead impose a higher risk charge for investments with a higher level of risk, providing an incentive to better manage risks. Investment regulations for pension providers tend to focus on qualitative requirements with respect to risk management processes, in particular the prudent person principle and fiduciary duties. However, few jurisdictions have fully implemented risk-based capital requirements for pension funds (OECD, 2015[21]). Some jurisdictions also continue to apply quantitative investment limits alongside risk-based requirements.15
Investment regulation may also include self-investment limits to reduce conflicts of interest and pressures to invest in a particular company or sector. Table 5.2 shows that most countries impose investment limits on securities issued by employers sponsoring occupational pension plans. A 5% limit is common when there is a single employer sponsoring the plan, while many countries set a 10% limit when the sponsoring employer belongs to a group. These limits are in line with the recommendations in Core Principle 4. Only Germany, Italy and Slovenia address the case of several employers sponsoring the same plan. Italy has different limits in the case of multi‑employer funds and industry-wide funds. This helps to address issues related to potential pressures arising from governments or the public to invest in the sector or industry in which the members of the pension fund work.
Table 5.2. Investment limits in securities issued by employers sponsoring occupational pension plans, selected OECD countries, 2019
As a percentage of total investment
Notes: DB means defined benefit; DC means defined contribution.
Source: OECD Annual Survey of Investment Regulation of Pension Funds and Other Providers.
In addition to ensuring the adequate regulations are in place, policy makers can facilitate the mobilisation of private capital towards long-term investment. In particular, they can set up public-private partnerships (PPPs), provide financial incentives and promote special vehicles for investment in alternative assets. Doing so can help make projects available that would suit the investment parameters of pension providers.
5.3.5. Availability of suitable investment opportunities
Policy makers across OECD countries have taken steps to ensure that suitable investment opportunities are available to pension providers, particularly for alternative asset investments. The steps to ensure suitable investment opportunities involve making the right projects and partnerships available, providing financial support for investments, and helping set up investment vehicles or platforms.
Policy makers could encourage greater institutional investment in public projects simply by making regular investment opportunities available, and through transparency and clarity about their long-term strategic policy frameworks. This is in line with Principle 1 of the G20/OECD High Level Principles of Long-Term Investment Financing by Institutional Investors (OECD/G20, 2013[22]). A limited pipeline of opportunities can be a hindrance to investment in infrastructure. Furthermore, pension providers need clarity on the government’s long-term infrastructure plans to inform their investment strategies. Having national infrastructure plans is one way governments can clarify to investors their political commitment to infrastructure over the long term (Della Croce, 2011[16]).
One key way to attract investors such as pension providers to invest in long-term assets is by setting up public-private partnerships (PPPs) that balance the benefits of such investments with potential moral hazard problems.16 PPPs are contractual arrangements where the private sector provides public services based on a pre‑agreed risk and profit sharing with the public sector, and where the public sector retains planning and control functions (OECD, 2014[10]). Depending on how self-sustainable the projects are, different projects will need different arrangements for the government’s financial contributions. Generally, the greater the government’s financial contributions to PPPs, the greater the propensity for the private sector to invest.17 While in the past PPPs have shown good results in terms of cost efficiency, recent data and academic research have demonstrated that excessive risk taking by the public sector discourages the private sector from carrying out careful risk analysis and risk management, leading to moral hazard and ultimately to lower value for money for the public sector (OECD, 2014[10]). This can place significant burden on taxpayers. As such, there is a case for public authorities to better weigh the competing considerations and rebuild trust in PPPs, for example by balancing these moral hazard problems with the benefits of such investments.
Public authorities could also take steps to make investments more financially appealing to pension providers, while bearing in mind the trade‑offs in doing so. There are many examples of OECD countries providing financial support to attract private investors, although in drawing on those examples, governments should conduct their own due diligence regarding those expenditures and consider the opportunity costs. Examples of financial support initiatives include:
The public sector subsidising projects through contributions or grants, whose purpose is either to reduce the private commitment or to increase the return of an otherwise unprofitable project (OECD, 2014[10]). Grants during the construction phase can decrease the initial contribution that lenders provide to the project, leading to higher returns for the private sector. Contributions during the construction phase can also include the provision of public assets (asset recycling) and/or the possibility to use public land for free during the period of the concession (OECD, 2014[10]). Subsidies during the project’s operational phase are also a means to stabilise or increase revenues to the private party. Examples are feed-in tariffs in the renewable energy sector (i.e. forms of subsidy paid to the producer of renewable energy to incentivise them to move away from conventional fossil fuels), the provision of a floor protection against drop in traffic volumes in the transportation sector, and a minimum rental payment in students’ accommodation/social housing projects. Another example is the public sector contributing to debt service, where the public entity pays a portion of the interest payment or margin that the project bears during the amortisation period of the loans. Alternatively, it can provide tax relief during that period (OECD, 2014[10]). Grants, loans, and tax relief directed towards clean energy projects are particularly relevant in the current context, where many OECD countries have directly linked such support to a green recovery.
The public sector offering guarantees or back-up liquidity facilities to infrastructure creditors to overcome structural problems incurred during its development or to guarantee cases of refinancing risk (OECD, 2014[10]). Examples include the liquidity back-up facility of the 2020 Project Bond Initiative started by the European Union and the European Investment Bank (EIB), the unconditional UK Guarantee Scheme, and the Singapore Government guarantee on debt via the Infrastructure Guarantee Fund (IGF) (OECD, 2014[10]). However, while government backing and guarantees are useful to secure financing from private investors, they may also have a high fiscal cost over the medium to long term in case they are exercised that needs careful assessment.
Providing indirect investment to encourage private financing. This can include co‑investment with the private sector. The objective of such an agreement is to get a level of return proportional to the risk taken in the project. The co‑investment can take the form of equity, subordinated debt, a debt contribution, or indirectly via investment vehicles for infrastructure (OECD, 2014[10]).
Making debt financing for infrastructure projects more attractive. Examples include through tax incentives for infrastructure bonds (such as the Build America Bonds) or for governments to change the risk profile of investments by providing subordinated debt, thereby boosting a project or portfolio’s credit rating (2011[16]).18
Public authorities could directly intervene in the market by promoting or providing the seed capital to set up suitable investment instruments or platforms. Governments can provide the seed capital to set up investment funds that make it possible for pension providers to gain exposure to investments. The Pan African Infrastructure Development Fund, the Philippine Investment Alliance for Infrastructure fund, and the Marguerite fund in Europe are all examples of institutions that pool institutional capital, set up through seed money from governments (OECD, 2014[23]).
Alternatively, policy makers can also promote greater pooling and collaboration between institutional investors in order to create institutions with sufficient scale. Governments themselves can help set up an investment platform for pension providers to pool their investments. The greater scale this brings can help investors build the expertise they need to implement a broader investment strategy and undertake better due diligence and risk management. Pension providers can also benefit from collaboration through lower fees, a spreading of risk, and access to investments with longer time horizons. Over time, such investment can in turn also boost demand for alternative investments and encourage better alignment between pension providers and the industry.
5.4. There are a number of investment vehicles pension providers can use to support the economy
Pension providers can play a role in meeting the financing needs created by the COVID‑19 crisis to address the accompanying shocks to the economy, as well as those created by environmental, social and governance (ESG) objectives. However, pension providers can only invest in a way that supports businesses and promotes economic growth, and do so in the best interest of their members, if appropriate market structures exist for these investments to happen.
This section examines the types of financing instruments that can allow pension providers to gain exposure to investments that support the economy. This section explores two broad areas where financing from pension providers can help mitigate the effects of the crisis. The first involves investing in instruments that aim to meet the immediate needs of businesses and governments in direct response to the crisis situation. In this context, the COVID‑19 crisis has seen some investment vehicles, such as COVID‑19 bonds, emerging precisely to channel funds towards expenditure programmes that address the pandemic’s effects. Traditional instruments that provide financing to governments and businesses, such as government bonds, corporate bonds and equities, have also seen increased issuances in response to the crisis. Pension providers continue to invest in such vehicles, which are often a core part of their investment strategy. However, the current context has also led to greater interest in other investment vehicles that provide support to SMEs, which do not have the same access to financing as larger companies.
The second broad area of interest for pension providers is in providing financing for investment in long‑term assets such as infrastructure or real estate, which could play a particularly important role in promoting economic growth to aid in the recovery. These instruments would also help pension providers to get involved in ESG and sustainable investment opportunities. Pension funds in some jurisdictions already invest in large‑scale long-term assets that can serve this purpose, although the choice of investment vehicle can vary significantly. In other cases, there may be a case for pension providers to newly explore such investment opportunities, spurred on by a greater appetite to participate in a recovery and the economic case for investing in projects with good return prospects.
This section explores the different options that are available to institutional investors like pension funds to provide financing under the two broad areas mentioned above. It provides examples of the investment vehicles available, other than government bonds, to outline the different avenues for supporting the economy during and as the world emerges from the crisis. Notwithstanding, this distinction is not a firm one, and some instruments, such as investment in listed equities can apply to both phases.
5.4.1. Financing instruments to meet direct needs arising from the crisis
As the experience of the 2020 crisis has shown, shocks trigger a need for urgent financing to support governments, businesses and individuals. Financing needs arise to address the first priorities of crises, such as the need for medical care and rapid economic rescue packages. Businesses also can face cash shortages and may need urgent support. Pension providers can help meet these financing needs via different investment vehicles. In particular, 2020 saw the emergence of COVID‑19 bonds to support programmes aimed at addressing the essential priorities of the crisis. Other financing instruments can act as more direct financing vehicles. Corporate bonds and listed equities typically expose investors to debt and equity financing for larger businesses. Other instruments, such as private equity, securitised SME loans and SME covered bonds also make it possible for investors such as pension providers to provide financing to smaller businesses.
COVID‑19 bonds to support programmes addressing the effects of the pandemic
COVID‑19 bonds have quickly emerged as a leading means of providing financial support to stakeholders in need of immediate financing. COVID‑19 bonds can carry a bond label – such as a social, green or sustainability-linked bond label – or can be a non-labelled thematic bond. The year 2020 saw a particularly notable boom in social bond issuances because of the large number of COVID‑19 bonds that are labelled as social bonds.19,20 Much of the proceeds from COVID‑19 bonds have been to help finance the wide‑reaching public sector spending programmes to address the impacts of the pandemic. Governments have spent a great deal on surges in their health care system capacity, labour market and business support programmes, restructuring public facilities and cities for pandemic safety, improving supply chains and trade through digitisation, and so on. COVID‑19 bonds have also emerged as a way to deliver assistance to businesses that have seen pressures to their existing functions, such as due to business downturns, and to businesses that may need loans or cash injections to continue to operate. Other businesses also need to make investments to transform their operations so that they are able to function under the new environment and meet consumer demands for safer spaces (e.g. restaurants refitting for social distancing, offices needing to set up remote working operations, hiring staff to enforce social distancing rules). Finally, some businesses have seen added demand for services, such as businesses producing medical equipment or doing research. The COVID‑19 bonds that have been issued to date aim to meet one or many of these financing needs.
All types of issuers in debt capital markets can issue a COVID‑19 bond, including supranational entities, governments, the financial sector, and businesses. For example, with respect to issues of Social Bonds related to COVID‑19, the International Capital Market Association states that any entity can issue the bond as long as all the four core components of the Social Bond Principles are addressed.21 It also requires that the use of proceeds of the bond goes exclusively towards addressing or mitigating social issues wholly or partially emanating from the coronavirus outbreak.22
The majority of COVID‑19 bond issuances have come from supranational entities such as development banks. Many have issued multi-billion dollar programmes to help governments’ efforts to respond to and contain the spread of the coronavirus. Many supranational entities such as development banks have high credit ratings and have preferred creditor status, making their bonds attractive investment opportunities. As such, they would fit into pension providers’ investment policies. Examples include the bonds issued by the World Bank’s International Bank for Reconstruction and Development, the International Finance Corporation, the Development Bank of Latin America, and the Nordic Investment Bank. The bonds have common themes, in that they all broadly aim to provide financial support to health care systems, domestic labour market solutions, or loans to businesses.23 Some pension funds stated that they purchased COVID‑19 bonds. The Nordic pension funds PKA and Folksam have invested EUR 1 billion in development bonds from the World Bank.24 The Swedish pension funds Skandia and Länsförsäkringar have also invested SEK 450 million and SEK 380 million respectively in the Sustainability Awareness Bond issued by the EIB.25
Governments around the world have also issued COVID‑19 bonds. While most governments have raised capital for their spending programmes through issuing sovereign debt via traditional standard bond issuances, others have issued bonds whose proceeds are specifically tied to addressing the impacts of the pandemic.26 For example, the European Commission has issued social bonds to cover the costs directly related to the financing of national short-time work schemes, and other similar measures they have put in place as a response to the pandemic. The bonds were purchased by pension providers, including PGGM and APG in the Netherlands and Sampension in Denmark.27 Guatemala issued a social bond to finance social investments that included its response to COVID‑19. The expenditure programmes included providing medical insurance to students, promoting preventive health and medical practices, supporting health recovery in hospitals, and other COVID‑19 related investments approved under the law (Republic of Guatemala, 2020[24]).The Latvian Government has established a fund with a target size of at least EUR 100 million to provide liquidity and capital support to large enterprises in Latvia affected by the pandemic, through debt and equity instruments. The state will provide an investment of EUR 50 million in the fund and the commercially managed Latvian pension investment funds will contribute the same amount. The fund also aims to attract private investors (European Commission, 2020[25]).
Different private sector entities in the finance sector have also issued COVID‑19 bonds since the crisis began. The Cassa depositi e prestiti (CDP), an Italian investment bank, issued a EUR 1 billion 3‑ and 7‑year dual-tranche COVID‑19 Social Response Bond. Its aims were easing access to credit – both directly and indirectly through the banking system – for Italian SMEs intensely affected by the pandemic, and supporting public administrations and local authorities to implement health care support measures (Cassa depositi e prestiti, 2020[26]). Bpifrance issued a COVID‑19 Response corporate bond to alleviate the impact of the pandemic on French companies. Its purpose was to assist companies in France with ongoing cash flow difficulties to finance their operations and costs related to their employees (Bpifrance, 2020[27]). The Dutch pension fund, ABP, announced that it invested in this bond.28 Japan’s biggest lender, Mitsubishi UFJ Financial Group, has announced its intention to issue sustainability bonds worth USD 1.42 billion, aimed at raising funds from individual investors to help smaller companies and hospitals tackle the pandemic.29 The Korean bank Kookmin Bank issued a COVID‑19 bond, stating that it intended to use 90% of the proceeds to extend loans to SMEs affected by the virus, small offices, and home businesses.30 Bank of America sold a USD 1 billion four‑year COVID‑19 bond to help finance the health care industry as it tackles the pandemic. It will pay investors a yield above benchmark Treasuries, which is broadly in line with the bank’s existing non-COVID‑19 bonds.31
Some large businesses have also raised financing by issuing bonds to finance efforts to combat the pandemic or develop new lines of business. Such issuances differ from standard corporate bonds in the sense that the proceeds are specifically linked to pandemic relief. The drug maker Pfizer issued the first biopharmaceutical COVID‑19 bond, issuing USD 1.25 billion in 10‑year bonds. One purpose of the bond is to make capital investments in manufacturing and development for medicines and vaccines (Pfizer Inc., 2020[28]). Similarly, Getinge, a Swedish medical technology company, developed a COVID‑19 financing framework in line with the International Capital Market Association’s Social Bond Principles. The company stated that the proceeds will be allocated to financing the production of medical supplies such as ventilators, extracorporeal life support (ECLS) equipment, and intensive care equipment.32
Corporate bonds
Corporate bonds are standardised securities that finance the balance sheets of corporations (OECD, 2015[29]). Like direct investment in listed equities that are issued by private companies, corporate bonds are a way for companies to access cash during crunch times. Purchasing such bonds is one way pension providers can support businesses, as long as such investments are likely to yield returns and are in line with their investment strategy. Most have inflation-linked payments. Instead of bearing the risks of an individual project, corporate bonds’ investors bear the risk of the issuing corporate entity. Thus credit-worthiness is determined by an issuer’s general ability to service the debt, making them less risky than project bonds (discussed below) (OECD, 2015[29]). Corporate bonds have broad appeal to institutional investors. They tend to have long-term tenors, allowing borrowers to gain access to long-term financing. As such, they are core holdings in most investment portfolios and provide an alternative to lower-yielding government bonds.
Pension providers can also access bonds issued by SMEs, especially through private placements and bond funds. Public corporate bond markets are not well suited for smaller SMEs. This is because the costs related to reporting requirements associated with bond issuance together with the cost of obtaining a credit rating are disproportionately high for SMEs when compared to the overall size of the average deal. Thus, this market is suited mostly to the upper segment of the SME size spectrum (OECD, 2015[6]). Private placements offer an alternative to public corporate bond issuance, as they do not require a formal credit rating or reporting requirements. Privately placed bonds are negotiated and placed with a small number of mostly institutional investors in countries where a framework for such instruments exists (e.g. France, Germany and the United States). In theory, privately placed bonds can cater to the needs of small issuers, as there is no minimum size limit. In practice, however, the instrument still serves the upper end of the SME size spectrum, according to market observers (OECD, 2015[6]). Finally, SME bond funds are collective investment schemes that pool together bonds issued by SMEs (public or private placement). Such funds address the scale problem that constrains institutional investors’ appetite for SME bonds and allow further diversification by pooling the bonds together (WBG, IMF and OECD, 2015[30]).
Listed equities
Pension providers could help mitigate the impact of the COVID‑19 pandemic on businesses by investing in listed equities such as those of companies particularly affected by the downturn. The crisis has prompted many companies to issue new stock to raise money amid a cash crunch. If purchasing shares in such companies is in line with pension providers’ investment strategy, and if they expect returns on the investment, investing in such securities is one way pension providers can support businesses. In recent years, new investment vehicles such as index funds have been created for those not able or willing to make their own investment.
Although listed equities are mostly issued by large companies, pension providers can also invest in equities issued by some SMEs. Public equity markets are better suited to high-growth, innovative SMEs, where unpredictable cash flows and lack of track record renders bank lending difficult. Some countries have also developed specialised SME equity platforms, or growth markets, targeting smaller issuers as an alternative to main exchange listings. Such exchanges seek to alleviate the burden and cost of regulatory compliance that may deter SMEs from listing. The lighter requirements apply to performance, disclosure and governance to cater to SMEs’ inherent characteristics (OECD, 2015[6]).
Private equity investment
Pension providers could use private equity to purchase the illiquid equity securities of operating companies, always bearing in mind the requirements for strong governance, well-defined investment policies and sound risk-management strategies. Such instruments are particularly relevant for SME financing, especially for start-ups, technology-based companies and those with exceptionally high growth prospects. The equity is not publicly traded. In exchange for their capital, private equity investors take ownership stakes in the companies. Private equity investors typically hold these securities for a period of three to seven years with the expectation of generating attractive risk-adjusted financial returns upon exiting the investment. Private equity investment encompasses various stages of investment, such as venture capital in early-stage companies (e.g. start-ups), growth equity in more established companies looking for expansion capital, or buyouts in the latter stages of a company’s growth. However, a key deterrent to investing in such securities is the lack of transparency around these arrangements, which can make it difficult for pension providers to conduct a thorough analytical process to inform investment decisions.
SME loan securitisation
SME loan securitisation offers pension providers the possibility to indirectly finance SMEs. It consists of the transformation of SME loans, which are illiquid in nature, into tradable securities that institutional investors can buy.33 Through securitisation, a bank or SME lender bundles a package of SME loans into a pool (“portfolio”) and sells the portfolio to capital market investors through the issuance of securities by a special purpose vehicle (SPV). The securities are backed by the loan portfolio (The World Bank Group, 2020[31]).
There are several benefits of using SME loan securitisation, for both SMEs and pension providers (OECD, 2015[6]). SME loan securitisation allows banks to partially transfer credit risk to the market while achieving capital relief. As a result, capital is freed up and can potentially generate additional loans to SMEs. Pension providers can diversify their investment portfolios and get exposure to the SME asset class, while still achieving potentially attractive returns, in line with their investment objective. Indeed, investors can select in which tranche of the loan to invest depending on their risk profile.34
SME covered bonds
Similarly to loan securitisation, covered bonds provide pension providers with an indirect tool to finance SMEs. Covered bonds are debt securities issued by a credit institution that are backed by a dynamic cover pool of high quality assets (WBG, IMF and OECD, 2015[30]). Investors have double recourse to the issuer and to the cover pool. So, unlike with loan securitisation, covered bonds remain on the balance sheet of the bank. This feature creates asset encumbrance and limits the issuance of covered bonds as compared to loan securitisation. However, one advantage of the covered bond system is the high quality of the “cover pool”, which is based on strict standards imposed by regulations. In particular, such standards include precise definitions of eligible collateral. This helps to ensure the homogeneity of the cover pool and the quality of the underlying loans. This allows pension providers to invest in the asset without the need for extensive due diligence on the underlying assets.
Insurance linked securities
Insurance‑linked securities, such as catastrophe bonds, are debt instruments issued to fund a special-purpose entity that assumes insurance risk. Under such instruments, the proceeds from a bond sale are placed in the special purpose entity to back the assumed risk and generate a market and risk return. The occurrence of catastrophe events that exceed a pre‑defined trigger leads to a pay-out of some or all of the proceeds from the bond to the issuer.35 Pension funds are important investors in insurance‑linked securities which usually provide exposure to a risk that is not correlated with financial market performance. According to one estimate, pension funds from around the world have invested more than USD 22 billion in insurance‑linked securities since 2006.36 Insurance‑linked securities provide an important source of capital for the insurance sector (as reinsurance and retrocession capacity) which supports the ability of the insurance sector to assume risk from policyholders.
The COVID‑19 crisis has accelerated the shift to a “hard market cycle” for insurance and reinsurance coverage – that is, higher prices and lower coverage limits for policyholders. It has also brought to light a significant gap in insurance coverage for the revenue losses faced by businesses forced to close or otherwise curtail their activities as a result of the public health measures implemented to slow the spread of the virus. The insurance‑linked securities market has contributed to reducing insurance and reinsurance market cycles in the past (OECD, 2018[32]). And it could potentially play a similar role in the aftermath of the crisis. Additional investment in this market by pension funds could therefore support the economic recovery by contributing to lower insurance costs and contributing greater insurance availability, including for losses not currently covered in insurance markets.
5.4.2. Instruments to finance investments that promote economic growth
Pension providers can be key investors in asset classes aiming to promote economic growth and thus stimulate crisis-hit economies. Such investments are different to those that aim to address the immediate priorities in a crisis, as discussed above. Rather, there is already much discussion about sustainable and ESG investments, in real assets, projects, companies or funds and how they can help to create jobs or generate lasting productivity improvements to reinvigorate post-COVID‑19 economies. Some pension fund investors have already indicated a willingness to participate in such efforts. For example, the Australian Institute of Superannuation Trustees (AIST) declared that it stands ready to invest in affordable housing in Australia, given the shortage of affordable housing in the country and the competitive returns that this asset class tends to deliver when properly structured (AIST, 2020[17]).
In this context, many countries have also discussed how alternative investments, particularly green infrastructure investments, will be a core part of the recovery. These views are in line with the OECD’s calls for a sustainable, resilient recovery from the crisis with investments and projects that aim to “build back better”. The significance of long-term sustainable investments in building resilience against future crises is also recognised (OECD, 2021[33]). The UK Government, for example, has pledged to invest in an infrastructure revolution including green projects as a way of lifting the economy out of the crisis.37 Similarly, the French Government has announced a “big green recovery plan”, with a post-COVID‑19 economic stimulus package focussing on an “ecological transition” and “greening the economy”. There is already significant discussion on the role that private capital will play in such efforts to mobilise investment in similar areas. And indeed, some pension funds have already indicated a willingness to participate in a greener recovery. For example, the London Pension Fund Authority has agreed to divest from fossil fuels and increase its green investments, in line with the city of London’s pledge to finance green energy, buildings, transport and other investments to help it recover from the pandemic and tackle climate change.38
This section describes the vehicles that investors typically use to finance long-term investments that can have the effect of promoting economic growth. The investment vehicles include different forms of direct unlisted equity investment, listed equities, unlisted infrastructure funds, government, municipal and sub-sovereign bonds, project bonds, debt funds, and green bonds.
Direct unlisted equity investment
Direct unlisted equity investments are those which are made directly in stand-alone assets, bypassing fund managers (OECD, 2015[29]). Direct investment can give pension providers ownership and control over alternative asset classes such as infrastructure, real estate, and private equity. Only the largest investors can invest directly in such large‑scale projects, making some pension providers good candidates to undertake these investments.
Canadian and Australian pension funds have pioneered direct investment in infrastructure in OECD countries, although direct investment is also growing in Europe. The OECD Annual Survey of Large Pension Funds and Public Pension Reserve Funds showed that Canada had two of the largest investors in infrastructure by investment size. The Canada Pension Plan Investment Board, for example, invested over USD 20 billion (7.5% of total investments) in unlisted infrastructure equity in 2017, and 99.8% was through direct investment or co‑investment (OECD, 2019[4]). Australian pension funds have also been pioneers in the field since the early 1990s, and their financial industry coined the term “infrastructure as an asset class” (Inderst and Della Croce, 2013[34]). Unlike in Canada, the majority of unlisted infrastructure investment in Australia happens through unlisted infrastructure funds, but direct investment is growing. In 2017, three of the largest Australian superannuation funds, AustralianSuper, Hostplus, and CBUS, reported having invested 48.3%, 22.6%, and 10.6%, respectively, of their unlisted infrastructure investments as direct investment (OECD, 2019[4]). Some European pension funds have also started investing directly in infrastructure. The Dutch pension fund PGGM exemplifies this trend. It stated that it would increase its direct investment to reduce cost, to take control of decision making at the asset level, and to have assets that matched its liabilities in a way that seven‑to-ten year unlisted infrastructure funds could not deliver (van de Brake, 2017[35]).
Despite its growth in some regions, direct investment poses challenges for many pension providers. Direct investment requires scale, good governance to oversee complex investment programmes, the organisational structure and compensation model to attract a talented in-house investment team, and long‑term patient capital (The World Bank, 2017[19]). Some projects also require pension providers to engage in a competitive tender process, and it can be expensive, time‑consuming and laborious to submit individual bids (Belt and Nimmo, 2013[15]).
Canadian pension funds are a good example of those who have these characteristics, making them the leading example of direct investing in alternative asset classes. Key characteristics include operating at arm’s length from the government, and having large amounts of assets under management and therefore the scale to make direct investments. Other important characteristics are having highly diversified investment portfolios, and having an ability to attract and remunerate the talent they need (The World Bank, 2017[19]).39 However, these Canadian pension funds tend to have good in-house investment teams given their scale, which can have a relatively high fixed cost that is often excessive to small and medium sized pension funds.
Direct unlisted equity investment through collaboration
Since direct unlisted equity investments can be quite large, in particular for infrastructure projects, it is becoming more common for institutions such as pension providers to pair up with other investors or even fund managers to collaborate for investment. Some pension providers collaborate to benefit from a better alignment of interest with other pension providers having common investment horizons, lower fees, get better control of the characteristics of the investment, pool local knowledge, and share risk (OECD, 2015[29]).
Collaboration can take many forms. It can involve co‑investing on an ad-hoc basis, such as alongside a general partner, with the pension provider being the limited partner. Alternatively, pension providers can form a joint owned fund manager or an investment instrument.
Some pension providers enter into co‑investments with partner investors on an ad-hoc basis. That is, they enter into the agreements without entering into a formalised permanent collaboration vehicle. The California Public Employees’ Retirement System (CalPERS) is an example of a pension fund with extensive experience with the use of co‑investments. It has historically teamed up with a number of different investment manager general partners for its private equity investments.
Other models of collaboration include institutional investors jointly owning a fund manager. The UK’s Pensions Infrastructure Platform (PIP) was set up by the UK’s National Association of Pension Funds (now the Pensions and Lifetime Savings Association) to channel investment by UK pension funds into UK infrastructure. It is open to all UK pension schemes. Similarly, the Global Strategic Investment Alliance (GSIA), a global co‑investment alliance platform, was launched in 2012 by the Ontario Municipal Employees Retirement System (OMERS), one of Canada’s largest pension funds. The GSIA was designed to gather like‑minded investors (mainly pension funds) to directly invest in infrastructure assets. An example from Australia is IFM Investors, which is owned by 27 pension funds and other investors and has an independent investment board. The initiative has been broadly successful and has amassed a significant portfolio of assets worth AUD 140.4 billion in June 2019. Its success also comes from its ability to pool a common risk appetite and invest in a variety of deals, allowing for diversification and more stable long-term returns. IFM was also able to overcome the costs of the competitive bidding process, since the cost of each unsuccessful bid was spread over a large number of participants (Belt and Nimmo, 2013[15]).
Another interesting model of pension funds’ collaboration is the syndicated model developed by the Canada Pension Plan Investment Board (CPPIB) and the Ontario Teachers’ Pension Plan (OTPP). The model involves a large institutional investor taking the lead by investing directly in a project. Then, the lead investor creates an option for others to opt in by structuring a vehicle and setting a minimum investment requirement for additional investors. This allows larger investors, who tend to have greater capacity to lead an investment process in larger, and therefore less competitive projects, to do so without necessarily investing on their own (Belt and Nimmo, 2013[15]). Subsequent investors then share the lead investor’s costs proportionately. The approach is a good way for smaller investors to access direct investments while circumventing infrastructure funds. However, each investor still needs to do their own due diligence, which some smaller investors may not be capable of.
More recently there have been examples of pension funds owning companies themselves, such as infrastructure companies. Polhem Infra is a Swedish company founded in 2019 and is jointly owned by the AP Funds, which manage funded capital in the income‑based pension system in Sweden. Polhem Infra’s focus is direct investment in unlisted Swedish or Nordic infrastructure companies in the private and public sectors. As another example, Globalvia, a transportation infrastructure developer, is 40.8% owned by the Netherlands’ PGGM, 40.3% owned by Canada’s OPTrust, and 18.9% owned by Britain’s USS. It oversees a portfolio of highway and railway projects across Europe and the Americas.
Hybrid forms of direct unlisted equity investment through regulated structures
Some other countries use hybrid forms of domestic unlisted equity investment through regulated structures. In Namibia, the supervisory authority NAMFISA, recently devised Regulation 29, requiring all pension funds to invest in unlisted Namibian companies through regulated vehicles (The World Bank Group, 2020[36]). The supervisor also introduced a high level of regulatory oversight for investment managers and investment vehicles (special purpose vehicles, SPV). Regulation 29 established a compulsory allocation to unlisted assets with a minimum of 1.75% and a maximum of 3.5% of assets under management. Pension funds have to invest directly through SPVs, rather than directly investing via asset managers. While requiring investments in certain asset classes is not in line with the OECD Core Principles of Private Pension Regulation, the World Bank notes that the small percentage of required direct investments made it possible for them to be accommodated within existing investment strategies (The World Bank Group, 2020[36]).
Another example of investment through regulated structures is how the Mexican system allows investment in alternative assets. Mexican pension funds can currently invest in alternative assets through Development Capital Certificates (CKD), Investment Project Certificates (CERPI), Real Estate Investment Trusts (Fideicomiso de Infraestructura en Bienes Raíces, FIBRA) and Infrastructure Investment Trusts (FIBRA-E). CKDs are investment trusts that issue securities for obtaining resources destined for financing one or more projects, or for the acquisition of one or more companies. The securities grant their holders the right to participate in the revenues the asset generates and give the holders equity rights. A seat is provided in the technical or investment committees of the CKD for every 10% held. The CERPIs emerged in 2016 to complement CKDs. The difference between the two is that the CERPIs do not require the approval of the Technical Committee or the Certificate Holders’ Meeting to make investments. This gives the general partner greater flexibility. In 2018, 8% of pension administrators’ portfolios were held in CKDs and CERPIs. Over the years, these structures’ availability has led to an increase in infrastructure investment and a reduction in exposure to government debt (FIAP, 2018[20]). FIBRAs are owners of diversified real estate portfolios that they rent and manage. The products are distributed among the investors as dividend pay-outs. Investors buy a certificate acquiring part of the equity of the FIBRA, which comes with administrative rights (votes) and economic benefits such as dividends (Poó Rubio, Rocha Chíu and Lara Poó, 2020[37]). FIBRA-Es are investment vehicles similar to FIBRAs, except they allow sponsors to securitise energy or infrastructure projects.
Unlisted infrastructure funds
Unlisted infrastructure funds are structures like private equity funds, which invest by constructing a portfolio of investments and charging fees to investors. Most unlisted infrastructure funds are traditional closed-end private equity type fund structures, managed by the general partner of the fund (GP), often an investment bank or investment management firm. Institutional investors like pension providers participate in unlisted infrastructure funds as limited partners (LPs). The GP invests capital commitments to the fund in various infrastructure assets on behalf of the LPs, selecting assets and managing the day to day operations of the fund.
A key shortcoming of infrastructure funds is that the lifespan of the vehicle they offer is often too short term (often 5‑10 years), which some pension providers may view as a misalignment of interests. Pension providers have also criticised them for charging high fees. This has motivated some larger pension providers to invest directly. However, the vehicle remains relevant for smaller pension providers and those lacking the scale or capability to engage in investments directly. Its primary benefit remains that it allows pension providers to access diversified pools of infrastructure assets without having to build in-house investment expertise or make large capital commitments (Belt and Nimmo, 2013[15]).
Notwithstanding the shortcomings, unlisted infrastructure funds remain the preferred mode of investment in infrastructure in many parts of the world, like in Europe. Investments in unlisted infrastructure funds accounted for 61.8% of total investments in infrastructure assets of the pension funds surveyed by the OECD.40 In addition, funds based in Europe, particularly those based in Spain, Ireland, Germany, and the Netherlands tended to use funds rather than direct investment (OECD, 2019[4]). Australian superannuation funds, on the other hand, tended to use a mix of investment funds and direct/co-direct investments, with a slight tilt toward investment funds. Examples of large unlisted infrastructure funds are those offered by Macquarie Infrastructure and Real Assets, which partners with more than 650 pension funds, sovereign wealth funds, and insurance companies to manage their long-term savings (Macquarie, 2020[38]). Its largest funds include the Macquarie European Infrastructure Fund II, Macquarie Infrastructure Partners, and Macquarie European Infrastructure Fund IV.
Listed equities
Investing in listed securities is also one of the simplest ways pension providers can get exposure to long‑term asset classes. Investors can buy a stake in publicly listed companies that operate in particular sectors such as infrastructure or real estate or buy shares in publicly listed funds investing in those asset classes. Alternatively, pension providers can invest in listed funds traded on a stock exchange. Listed funds are similar to unlisted funds in that an external manager invests on behalf of investors in various assets. While the fund is publically listed, the assets invested in by the fund may or may not be listed (OECD, 2014[23]). The model makes it possible for both retail and institutional investors to gain exposure to these assets. However, these financial products lost some favour after the global financial crisis, due to revelations of high levels of debt and investors having to pay inflated fees (OECD, 2014[23]).
Listed indexed funds are another way pension providers can gain exposure to long-term assets. Such funds track the performance of listed companies in the asset classes that are available in established stock-market indices. They allow for passive asset management. Examples include the S&P Global Infrastructure Index and the MSCI Core Real Estate Index. However, a shortcoming of such indices is that it is not always clear how a particular asset class is defined and whether the index reflects the true exposure that investors seek (OECD, 2014[23]).
Investments in shares in listed companies and funds have pros and cons. They deliver greater liquidity than other investment vehicles and can make it possible to diversify across geographical regions and sectors. However, a key disadvantage of these approaches to investment is that doing so might lack the benefits that are most desirable for pension providers’ infrastructure investments. Namely, publically listed companies may have a higher correlation with pension providers’ existing equity investments, making the portfolio less diversified (Belt and Nimmo, 2013[15]).
Government, municipal, and other sub-sovereign bonds
Government, municipal, and other sub-sovereign bonds are bonds issued by public entities in capital markets in order to finance the construction and operation of an infrastructure asset. Issues are sponsored by federal governments, local governments and sub-sovereign entities such as government agencies and multi-lateral development banks that bear an implicit backing of the sovereign entity (OECD, 2015[29]).
There are two main types of government and municipal bonds: revenue bonds, which are payable from specific project-related revenues, and general obligation bonds, which are paid from general appropriations. Since general obligation bonds are linked to the creditworthiness of the borrower, rather than the infrastructure asset, they may not be considered infrastructure finance (OECD, 2015[29]). On the other hand, payments from revenue bonds are directly linked to an infrastructure project, so they are treated as a market-based instrument to finance infrastructure and do not contribute to public deficits (OECD, 2015[29]). Municipal bonds typically have lower interest rates than comparable corporate bonds (Chan et al., 2009[39]).
Revenue bonds are sold directly to investors through fixed income markets, have long maturities, and are rated by major rating agencies. Their long-dated maturities and high credit quality make them good instruments to assist in pension providers’ liability driven investments and duration hedging. This type of borrowing is common in North America, where revenue bonds are one of the main sources of debt financing of public infrastructure (Chan et al., 2009[39]). In the United States, they are mainly issued by quasi-government authorities, cities, towns, districts, and local authorities. The favourable tax treatment of municipal debt instruments in the United States has contributed significantly to their growth.41
Project bonds
Project bonds are standardised securities that finance individual stand-alone infrastructure projects. They can be issued in public markets, or placed privately. Project bonds are a growing area of project finance and provide a potential solution to finance brownfield projects with long-term debt. Project bonds can be more risky than corporate bonds, because the risk of loss can be higher for a specific project compared with a diversified portfolio of projects (OECD, 2015[29]).
Project bonds are set up by a project company’s special purpose vehicle (SPV). The SPV is a distinct legal entity which is formed as part of the project finance procurement process. Project bonds most commonly cover the operational phase of the project, which is when the project starts to generate a cash flow (rather than the construction phase). The project bond can be a straight bond, whose creditworthiness is linked directly to the cash flow performance of the SPV, or it can carry credit-enhancement mechanisms. Until the global financial crisis when the model collapsed, the most common credit-enhancement mechanism was mono-line insurance.42
There are a number of examples of pension funds investing in project bonds, especially in Latin American countries such as Chile, Colombia and Peru. Many of the project bonds used to be wrapped by mono-line insurance. However, there have also been newer cases of project bonds with guarantees. For example, Chile has issued government-guaranteed revenue floors for transportation infrastructure with revenues relying on use through tolls. They offered either a total guaranteed revenue (where the present value of revenue was guaranteed) or a minimum guaranteed revenue (where, if revenue is below a pre‑agreed fixed threshold, the government makes up for the shortfall) (Credit Agricole, 2018[40]). To illustrate, the rehabilitation of the Ruta 5 highway project involved a pre‑agreed revenue stream paid directly by the Chilean Government in the event that revenues from toll collections are below a pre‑agreed minimum (Credit Agricole, 2018[40]).
Debt funds
Pension providers can provide financing to real asset and ESG investment projects through debt funds, which are now an alternative to traditional debt from banks. Project finance is a long-term loan structure where the project’s cash flows repay a loan. In recent years, banks have reduced their lending appetite due to increased capital constraints and regulatory restrictions (Rothschild&Co, 2020[41]). Debt funds are investment vehicles created as mutual funds or non-banking financial companies that give investors exposure to debt markets for investments in asset classes such as infrastructure or real estate. They are a way of investing in assets that are relatively safe but generally offer higher yields than corporate bonds. They are also an opportunity to invest in senior debt over equity (OECD, 2014[23]). Debt funds pool lenders, lowering each investor’s risk compared with direct lending. Although the market for debt funds is still small compared with private debt in some places (like Europe), recent years have seen significant growth.43
Debt funds are increasingly trying to attract assets from pension providers. Schroders recently announced that it would launch a UK-dedicated infrastructure debt fund, with a focus on UK pension funds and insurance companies. The fund aims to target junior loans in the transport, energy, environmental, social infrastructure and telecoms sectors to find higher yielding opportunities (Schroders, 2020[42]). Similarly, Macquarie’s infrastructure debt platform recently raised EUR 2.95 billion predominantly from UK corporate pension funds, local pension schemes and insurance companies.44 The fund stated that it attracted maturing defined benefit schemes and insurance companies who aimed to increase their exposure to inflation-linked infrastructure debt to better match their liabilities. Investors had also been attracted to the prospect of higher returns and the lower risk profile of the asset class when compared to corporate debt. UBS Asset Management has also launched its second infrastructure debt fund with EUR 448.4 million of seed commitments from insurance companies and pension funds from nine investors spread across five European countries and Japan.45 Brunswick Real Estate secured investments from Norway’s largest pension company, KLP, in its real estate debt fund focussing on sustainable property development. Similarly, real estate debt funds managed by entities such as ICG-Longbow and Allianz Real Estate have increasingly reached out to pension funds to join their investment vehicles.46
Green bonds
Green bonds are a subset of corporate bonds, project bonds, and sub-sovereign bonds that finance investment in green assets such as clean energy. Green bonds can be originated through development banks, governments, municipalities, corporations, banks (as covered bonds) or by SPVs as project finance and asset backed instruments (OECD, 2015[29]). In general, proceeds can go toward new or existing projects that are meant to have positive environmental or climate impacts. From a financial markets perspective, green bonds are not different from other project bonds or debt instruments. However, green bonds are sometimes treated differently due to their growing appeal and potential role in financing clean energy and climate change initiatives.
The OECD Annual Survey of Large Pension Funds and Public Pension Reserve Funds showed a growing number reported allocations to green investments. Funds based in Europe, namely Belgium and Sweden, reported the largest allocations to green bonds (OECD, 2019[4]). Green bonds are becoming increasingly relevant as some governments around the world have committed to the idea of building back better or even building back greener.
5.5. Policy implications for pension providers and policy makers
As economies around the world grapple to emerge from the recent economic and health crisis, there are growing calls for greater private investment to help fuel a recovery. Pension providers, i.e. pension funds, as well as insurance companies, banks and investment managers operating in asset-backed pension systems, are potential candidates to invest funds earmarked for retirement in such a way that helps the economy.
Pension providers can play a role to further support the economy given that they already invest significantly in businesses. Investments in equities and corporate bonds directly finance companies and represent the main vehicles through which pension providers invest in the economy. In addition, pension providers can invest directly or indirectly in instruments to finance SMEs. Finally, investment in long-term assets and ESG investment opportunities is likely to play an important role in financing the post-COVID‑19 economic recovery, and pension providers are natural investors in illiquid assets due to their long-term investment horizon.
However, several obstacles and new risks may impede greater involvement by pension providers in supporting the economy. Lack of investment opportunities, regulatory barriers and limited investor capability to handle complex investments are general obstacles to investing in businesses and recovery projects, in particular infrastructure. New risks and uncertainties have also emerged with the COVID‑19 crisis. There may be calls on pension providers to invest in companies or projects that may generate poor returns. Pension providers may also deviate from their strategic asset allocation to seize investment opportunities. Finally, measures taken by governments to provide relief to plan members during the crisis increase the need for liquidity and may reduce room for investment in illiquid assets.
Strong governance and appropriate investment strategies are essential to ensure that pension providers invest in the best interest of members. Pension providers should invest in projects to support the economy as long as they do not generate lower returns relative to other investment opportunities with the same risk profile, and they do not unduly increase the overall risk in the portfolio. Ensuring the accountability and suitability of the governing body of pension providers, defining an appropriate investment policy, designing a sound risk management strategy and having appropriate investment regulations can all contribute to safeguarding members’ assets while investing them in businesses and recovery projects.
Moreover, policy makers can take steps to ensure that suitable investment opportunities are available to pension providers. Public authorities can facilitate the mobilisation of private capital towards long-term investment by setting up PPPs, providing financial incentives and promoting special vehicles for investment in alternative assets.
Finally, pension providers can only invest in a way that supports businesses, promotes economic growth, stimulating a recovery, and supporting ESG objectives if appropriate market structures are in place. Pension providers can direct financing to support entities and initiatives that address immediate financing needs, but they can also be involved in investments aimed at stimulating an economic recovery as countries emerge from the crisis. To do so they can use different channels, financial structures and instruments. They can invest in COVID‑19 bonds that channel funds towards key expenditure programmes. They can also provide direct support to businesses affected by the pandemic through corporate bonds, listed equities, private equity, SME loan securitisation and SME covered bonds. But pension providers can also play a role in investing in a way that generates long-term economic growth after the crisis, including ESG opportunities. The vehicles that investors typically use to finance long-term investments include direct unlisted equity (whether alone, through collaborative arrangements, or other hybrid forms); listed equities; unlisted infrastructure funds; government, municipal or sub-sovereign bonds; project bonds; debt funds; and green bonds.
A number of policy implications can be derived from the analysis, for both pension providers and policy makers, to make sure that pension providers can play an active role in supporting the economy during and in the aftermath of the COVID‑19 crisis. At the same time, these investments should ensure the protection of members and their interests, compliance with investment rules, and the stability of pension providers. These considerations apply to any situation where pension providers can play a role in investing and supporting the economy like in sustainable investment and environmentally friendly programmes.
5.5.1. Implications for pension providers
Do not engage in investments that are beyond available assessment capabilities
Pension providers lacking the skills and expertise to appropriately assess the risks and potential rewards of new investment opportunities should not engage in those investments. There can be a temptation for pension providers to seize opportunities for new investments, particularly one‑off private equity ventures, during the recovery. While such opportunities may offer promising returns, pension providers should scrutinise them with reference to the same risk assessment standard as any other investment. If the pension provider does not have the expertise to conduct such assessment for complex investments, then it should not pursue them.
Carefully assess new investment opportunities
Pension providers should take care when investing in distressed companies. They should only do so if they genuinely expect a return to normal for that company and have a fair degree of confidence in the future value for the investment. For instance, there can be legitimate cases for investment in firms that were investment grade prior to the crisis but were in sectors particularly affected by the downturn. Indeed, perceptions of short-term risk might skew investments’ merits when in fact focus should be on long-term investment horizons. However, any such investments should be founded on a firm expectation that the company is capable of weathering the storm and generating long-term returns on investments.
Pension providers should also check that recovery projects are in line with their investment objective and fiduciary duty. Governments can have many different motivations for engaging in large‑scale investments. They can have social, political, environmental or development reasons. Not all those motivations coincide with a value for money approach. In addition, infrastructure investments may be overvalued due to increased demand or because future returns are overestimated. As such, pension providers should take care to only engage in projects that are consistent with genuine returns to members.
Act in accordance with investment and risk-management strategies
Pension providers should stay the course of their investment strategy. All pension providers should have an investment policy establishing clear investment objectives consistent with their retirement income objective and liabilities. It is important that pension providers adhere to these investment objectives to be able to deliver on their promises. In particular, pension providers should maintain diversified investments, both domestically and globally. The uncertainty that comes with a pandemic brings new risks to consider when it comes to which jurisdictions or sectors to invest in, but also adds to the case for geographical diversification. Domestic investment should also be diversified across sectors. Pension providers should, however, remain agile in their asset allocation. As such, the investment policy may need to be reviewed to check whether adjustments are necessary given the new investment environment.
Pension providers should also stay the course of their investment risk management strategies, but potentially consider any additional risks stemming from the current crisis. Rules for analysing and selecting potential investments should not be changed on an ad-hoc basis. Pension providers should apply the existing investment analysis rules and due diligence standards. Investments should remain in line with investment objectives, the fund’s desired risk-return profile, a pre‑determined asset allocation strategy, liquidity needs, as well as risk management procedures. Sound risk management strategies allow pension providers to identify, measure and monitor all material risks related to investment. However, given the circumstances, pension providers may need to take extra care to consider added risks such as heightened credit and currency risk where relevant.
Explore opportunities for partnerships with issuers of investment instruments
The recent crisis has highlighted the benefits of greater collaboration between pension providers and issuers of investment instruments. Pension providers can establish longstanding partnerships with organisations such as development banks, which seek to attract financing from impact investors. Such partnerships can help better align the interests of organisations that aim to deliver financing solutions quickly (such as with the recent issuance of COVID‑19 bonds) with pension providers’ investment strategies. As an example, the Japan Government’s Pension Investment Fund has entered into partnerships with the European Bank for Reconstruction and Development and the World Bank to strengthen their capital market co‑operation and to better integrate ESG considerations in their investment strategy.47
5.5.2. Implications for policy makers
Ensure the independence of pension providers in their investment decisions
Governments should take any opportunity to reinforce the independence of entities managing people’s retirement savings. By doing so, policy makers will avoid any perceptions of interference, including soft pressure, in what should be independent decisions by pension providers. If governments nudge pension providers into investments that eventually deliver poor returns, the population could blame both governments and pension providers for misusing their retirement savings in times of crisis. This could erode confidence in asset-backed pension systems, push members out of asset-backed pension arrangements and hurt retirement income adequacy.
Promote suitable investment vehicles
Policy makers could consider structural solutions to develop the market for investment vehicles, with a view to encouraging investments that help stimulate a post-COVID‑19 economy. They could, for example, provide direct financial assistance to create investment funds aimed at investing in infrastructure assets. They could also promote greater pooling and collaboration between institutional investors in order to create institutions with sufficient scale to better analyse the available data and potentially explore new investments such as in infrastructure and SME financing markets.48 Both solutions would help smaller pension providers to have access to a range of new asset classes.
Enhance the quality of data to assess investments
Policy makers could help pension providers gain access to better quality data to assess investments. Pension providers often view a lack of reliable data as a barrier to investing. While data challenges have tended to be a greater issue for more opaque investment classes like alternative assets, they can also be an impediment for pension providers to invest in newer instruments such as COVID‑19 bonds. Government departments and research bodies can play a key role in collecting and disseminating data to help in this respect. Institutional investors could be encouraged to report their recent allocation to and performance of different assets following standardised classifications and methods.49Governments can also mandate requirements to provide information and data on key activities (Della Croce, 2011[16]). Alternatively, a third party, such as an independent private sector operator, could be responsible for collecting information, standardising how performance is measured and reported, and distributing it to potential investors (Inderst, 2009[43]).
Similarly, policy makers could set up and maintain central depositories of high quality, easily accessible and standardised information around SME creditworthiness. Information around the creditworthiness of SMEs is particularly important given the high heterogeneity of the SME sector. However, SME entrepreneurs may be less prone, willing or able to share sensitive risk information. In addition, sourcing and monitoring SME financing entails a significant fixed cost for market participants. Central credit registers and Data Warehouses, owned and operated by central banks or financial supervisors for example, could address this issue (OECD, 2015[6]).
Adjust investment regulations
Governments could relax investment restrictions that limit investment in less liquid assets. In line with the development of skills and experience in the investment team of pension providers, policy makers could gradually increase investment ceilings for private equity or alternative asset classes such as real estate and infrastructure. Risk-based regulation presents an alternative approach to quantitative investment limits. It does not impose hard restrictions on investment, but instead imposes a higher risk charge for investments with a higher level of risk, providing an incentive to better manage risks.
Regulations could also better account for the nature of different investments in solvency calculations for defined benefit plans.50 There is sometimes a perception that infrastructure investment regulations do not fully account for the particular business model of infrastructure investment and their lower default and higher recovery rates as compared to more traditional investments in corporate loans and bonds (OECD, 2014[10]). Moreover, regulations that require market valuations for solvency calculations may discourage investment in infrastructure, which do not typically trade in a secondary market. As such, there can be a case for governments to adapt regulatory structures to account for the long-term nature of some asset classes, so that investments can better align with the purpose and objectives of a pension plan.
Enhance pension providers’ capabilities to invest in different asset classes
Policy makers could improve the skills of members of the governing board of pension providers through targeted educational initiatives. In some cases, board members simply do not have the technical skills to assess complex investment decisions, and may not have any experience with some asset classes. As such, they may be reluctant to invest in something new, such as a COVID‑19 bond or an SME covered bond. And indeed, it would not be appropriate for boards to make decisions on investments they do not fully understand. Specific training and education programmes for board members could boost their understanding of investments, so they could later on feel comfortable to engage with new instruments and asset classes.
Governing body members may alternatively choose to outsource investment decisions to external bodies, particularly if the board itself lacks the skills and knowledge to take certain new investment decisions. However, doing so should not absolve a governing body of responsibility for those decisions. Rather, they should again ensure they are capable of understanding advice from external parties and undertake due diligence processes in outsourcing arrangements. Again, training and education programs can help prepare governing bodies to oversee and approve any outsourced tasks, and undertake appropriate due diligence processes.
Promote a favourable environment for long-term investment
Governments should provide regulatory certainty to investors. Investors look at fundamental conditions when deciding where and how to invest. Their investments will likely outlive political cycles, and they require a high degree of certainty about government policy to feel safe in their investments. As such, clear and stable regulation, efficient procurement procedures, and practical support for projects such as certainty of timing are all important factors for investors that governments can help secure. Governments seeking to build investors’ confidence in long-term investment could also provide clear evidence of independence in terms of their choice of projects for investment as well as any financial support they provide. A robust system of checks and balances by the legislature can also bolster trust in governments, building investors’ confidence to invest in a jurisdiction.
Governments should also promote transparency when designing long-term projects. Some governments will invest in nation-building projects in an attempt to revive economies. Many of these projects will rely on PPPs. Where they do, governments should be transparent about the rationale for the project, the potential benefits to investors, risks, and uncertainties. Co‑ordination between different financial regulators, central banks and ministries of finance can also further financial stability and better investment governance. Policy makers should provide as much information as possible for pension providers to make decisions about whether investments are in the best interests of members. This can include providing confidence intervals or probability curves for expectations around future returns, results of stress tests, etc. Notwithstanding, the timing and value of returns from large‑scale sustainable investments are often very uncertain.
Ensure appropriate alternative investments are available and financially attractive
Governments could seek to better understand and account for institutional investors’ desired risk and return profiles when selecting projects for which they seek private capital. Mismatches between the risk and return profiles that investors look for and the projects that are available have at times been a deterrent to investment by pension providers. The key way governments can influence the risk and return profile of investments is through the design of PPPs, which dictate how risks and profits are shared between the private and public sectors.51 Governments should better account for the desired risk and return profiles of pension providers to ensure enough projects are available to encourage their participation. They could consult potential investors early in a project’s life to facilitate private investment in long-term investments such as infrastructure. Large‑scale investments can be optimised if representatives from the pensions industry act as partners when governments deliberate on the scope and financing of the investments. The Australian Institute of Superannuation Trustees believes that such early-stage consultation between governments and pension funds could overcome some of the barriers that currently limit the deployment of institutional capital for infrastructure projects (AIST, 2020[17]). However, they should also carefully assess how to balance the share of returns between the public and private sectors in PPP operations to avoid excessive risk taking by the public sector and moral hazard from the private sector.
Governments could also encourage direct private financing for alternative investments through effective subsidies, bearing in mind the trade‑offs of doing so.52 This can take the form of grants, contributions, guarantees, back-up liquidity facilities or tax relief. While government subsidies are useful to secure financing from private investors, including pension providers, they may also have a high fiscal cost over the medium to long term and should therefore be carefully assessed. Notwithstanding, financial public support is not the most relevant factor investors look at when deciding to allocate resources to infrastructure in a given country. Empirical evidence has shown that more important factors are a clear institutional framework, transparent bidding and awarding procedures, a robust rule of law, and the absence of political interference (OECD, 2014[10]).
Limit early access to retirement savings to promote long-term investing
Finally, policy makers should carefully consider the effect that policies granting early access to retirement savings accounts have on investment policies. Not only do such policies pose adequacy concerns, they also limit pension providers’ capacities to invest in long-term, illiquid assets (OECD, 2020[44]; OECD, 2020[45]). Pension providers need to hold more cash and liquid assets to face potential withdrawal requests. This leaves less room for other illiquid investments that could support businesses and boost the economy.
Annex 5.A. Quantitative investment limits for pension funds
Annex Table 5.A.1. Quantitative investment limits in equities, corporate bonds, real estate, loans and private investment funds, selected OECD countries, 2019
As a percentage of total investment
Notes: DB means defined benefit; DC means defined contribution.
Source: OECD Annual Survey of Investment Regulation of Pension Funds.
References
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Notes
← 1. Reserve funds may also invest their assets to support the economy, but their mandate is different from the one of pension providers, in particular because they do not have members. Although some of the discussion in this chapter is also relevant for reserve funds, they are mostly outside the scope of the analysis.
← 2. However, many countries have been raising interest rates since the end of 2021 to contain inflation (OECD, 2022[53]).
← 3. https://www.wsj.com/articles/investors-channel-over-150-billion-into-coronavirus-bonds-11591178004
← 4. The look-through of collective investment schemes (CIS) is not available for all countries. Total equity investment may therefore exceed the 30% threshold for some other countries when counting the part of their CIS investment in equities.
← 5. This does not include corporate bond investment through collective investment schemes.
← 6. During the 2008 crisis, several pension funds invested in distressed debt, which are below investment grade obligations of issuers in weak financial conditions (see for example https://www.newyorkfed.org/education/talf101.html and (Jain, 2011[46])). However, there is no data to check whether those investments have paid off.
← 7. Lack of certainty is one reason why investors have criticised private finance initiative (PFI) projects in the United Kingdom – investors have grown to mistrust PFIs at times, due to constant pressure to renegotiate or terminate contracts (Hall, 2009[47]).
← 8. Section 5.4 presents arrangements that could make it easier and cheaper for such entities to assess and manage their risks.
← 10. However, they may have to adjust their investment strategy to reflect new levels of cash flows.
← 11. This measure was initially supposed to last for three months, but was further extended for another three months until 17 September 2020.
← 13. Subsequently, in October 2017, the Pensions Commission issued regulations that finally allowed pension funds to invest in these kinds of instruments.
← 14. The least conservative fund (fund A) may now invest 13% in alternatives, up from the previous limit of 10%, set in 2017. Fund B’s alternatives exposure was increased from 8% to 11%; fund C from 6% to 9%; and fund D from 5% to 6%. The investment limit for fund E, the most conservative fund, was maintained at 5%.
← 15. Some jurisdictions may also not have (fully) implemented risk-based capital requirements for pension funds because of existing security mechanisms, such as sponsor support and pension protection schemes.
← 16. Although some infrastructure projects are purely private transactions (particularly in the energy sector), PPPs are still the dominant type of infrastructure project.
← 17. However, there is some evidence showing that in some cases higher public sector involvement has led private investors to perceive a risk of political interference in the project (OECD, 2014[10]).
← 18. Build America Bonds were taxable municipal bonds that featured federal tax credits or subsidies for bondholders or state and local government bond issuers. Build America Bonds were introduced in 2009 as part of the American Recovery and Reinvestment Act with the goal of creating jobs and stimulating the economy. The Build America Bonds programme expired in 2010.
← 19. Peeters, Schmitt and Volk (2020[48]) and https://www.ai-cio.com/news/pandemic-spurs-investor-interest-social-bonds/
← 20. https://esgclarity.com/COVID-19-fuels-social-bond-issuance-will-they-overtake-green-bonds-in-2020/
← 21. The four core Social Bond Principles are: use of proceeds; process for project evaluation and selection; management of proceeds; and reporting.
← 22. https://www.icmagroup.org/assets/documents/Regulatory/Green-Bonds/Social-Bonds-Covid-QA310320.pdf.
← 23. The World Bank issued a USD 8 billion 5‑year global benchmark bond aimed at financing sustainable development projects and programmes, including member countries’ efforts to prevent, detect, and respond to the rapid spread of COVID‑19 (The World Bank, 2020[49]). The International Finance Corporation has issued a USD 1 billion 3‑year social bond that aims to support the private sector and jobs in developing countries affected by COVID‑19 outbreak. The European Investment Bank has issued a EUR 1 billion Sustainability Awareness Bond which aimed to alleviate the social consequences of COVID‑19 by financing health care systems and labour market solutions. The Development Bank of Latin America (Corporación Andina de Fomento, CAF), issued a EUR 700 million 5‑year COVID‑19 Response social bond to support its member countries’ COVID‑19‑related relief and recovery costs. The proceeds will be allocated to health care systems and emergency economic support to tackle the COVID‑19 crisis (CAF, 2020[50]). The Nordic Investment Bank (NIB) has issued a EUR 1 billion Response Bond. It aims to use the proceeds of the bond to finance projects that alleviate the social and economic consequences of the COVID‑19 pandemic in NIB’s member countries. It is mainly focussed on promoting the efficient operation of health care systems and provides financial support and labour market solutions to alleviate supply chain frictions (Nordic Investment Bank, 2020[51]). The African Development Bank has issued a USD 3 billion social bond called the Fight COVID‑19 Social bond. It was aimed at lessening the severe economic and social impact on countries and companies in Africa’s group members. This includes the financing of access to health and essential goods, services and infrastructure. The Caisse Française de Financement Local (CAFFIL), a French public development bank, issued a 5‑year covered bond aiming to directly or indirectly fund sectors affected by the pandemic.
← 24. https://www.ipe.com/news/nordic-duo-invests-in-world-banks-1bn-COVID-19-linked-bond-issue/10045104.article
← 26. It should be noted that there are still no market practices to guide issuers and investors on COVID‑19 bonds, unlike the frameworks that exist for bonds like social bonds and green bonds. While some COVID‑19 bonds might fall within the ambit of social bonds, this is not necessarily the case. As such, potential purchasers may not be able to accept the label at face value and instead analyse bond issuances on a case‑by-case basis.
← 27. https://www.ipe.com/news/pension-funds-and-the-eus-inaugural-sure-bonds/10048538.article?utm_campaign=159245_22.10.20%20ipe%20daily%20news&utm_medium=email&utm_source=IPE&dm_i=5KVE,3EVH,C5K8L,DP39,1
← 33. Pension funds in some jurisdictions can also provide loans directly to companies, including SMEs. Minimum credit ratings may be required, such as in Israel (Annex Table 5.A.1 in the Annex).
← 34. Pension providers may get a credit rating agency to provide some risk analysis, thereby avoiding the need for direct communication with the SME. Alternatively, if they do not want to rely on credit rating agencies, they need to run all the data analysis of the underlying loans in-house, provided that data are available.
← 35. A trigger could be an indemnity trigger based on the cedant’s losses or a non-indemnity trigger based on a loss index, modelled loss estimate or the parameters of the event
← 36. https://www.artemis.bm/pension-funds-investing-in-insurance‑linked-securities-ils/
← 38. https://uk.reuters.com/article/global-cities-investment-climatechange/cities-promise-to-divest-from-fossil-fuels-to-boost-green-recovery-idUSL5N2GJ2TM
← 39. The World Bank study looks at four Canadian pension funds and finds that exceeding USD 15 billion allows them to make direct investments.
← 40. See also Prequin (2016[52]).
← 41. Income from investing in municipal bonds is generally exempt from Federal and state taxes for residents of the issuing state. While the interest income is tax-exempt, any capital gains distributed are taxable to the investor.
← 42. Mono-line insurance is a credit-enhancement mechanism that was common prior to the onset of the global financial crisis. A wrapped bond bears the credit rating of the mono-line insurer. For instance, an insurer with a AAA rating would confer a AAA rating on a wrapped bond.
← 43. https://realassets.ipe.com/infrastructure/infrastructure-debt-funds-come-of-age/10043408.article
← 44. https://realassets.ipe.com/news/macquarie-pulls-27bn-for-uk-infrastructure-debt-strategy/10046404.article
← 45. https://realassets.ipe.com/news/pension-funds-insurers-back-ubs-ams-new-infrastructure-debt-fund/10023733.article
← 46. https://realassets.ipe.com/news/icg-longbow-raises-500m-for-uk-senior-real-estate-debt-fund/10043149.article
← 47. https://www.eib.org/en/press/news/eib-engages-for-more-clarity-within-g20-framework-on-sustainable-finance-in-co-operation-with-gpif
← 48. In line with Principle 2 of the G20/OECD High Level Principles of Long-Term Investment Financing by Institutional Investors
← 49. In line with Principle 7 of G20/OECD High Level Principles of Long-Term Investment Financing by Institutional Investors.
← 50. In line with Principle 4 of G20/OECD High Level Principles of Long-Term Investment Financing by Institutional Investors.
← 51. See the discussion on risk and return profiles in OECD (2014[10]).
← 52. In line with Principle 5 of the G20/OECD High Level Principles of Long-Term Investment Financing by Institutional Investors.