The vast majority of UK pension funds are under-allocated to infrastructure and renewable energy, suggesting that unless there is a further dramatic crash in public equity valuations, the “denominator effect” slowing wider fund allocations to these sectors should have only a limited, and short-term, impact on UK local government pension scheme (LGPS) investment strategies, according to an Infralogic analysis and two sources. 

Overall quarterly fundraising volumes plummeted in 3Q22 in large part due to the so-called denominator effect constraining investment capabilities. When the values of non-infra assets in some institutional investors’ portfolios — the denominator — falls, their infra assets — the numerator in this equation — can grow as a percentage of their overall holdings to or beyond their allocation caps, limiting their ability to continue investing. 

While highly volatile equity markets this year have impacted many institutional investors’ denominators, slowing overall investment in these sectors, most LGPS remain under-allocated to them relative to long-term strategic allocation targets and government plans for increasing investment in infrastructure. 

"The general feeling is that the impact of the denominator effect on LGPS fund allocation will be both short-term and minimal,” said a senior source at a London-based pension fund advisor. “Most of these schemes are historically under-allocated to infrastructure, and investment into the sector hasn’t kept up with increasing allocation targets.” 

Infralogic analysed annual accounts and meeting minutes for 61 UK LGPS from March through October. In total, 85% of the schemes are under-allocated to infrastructure relative to their long-term strategic allocation targets. Only five of the pensions were over-allocated to infrastructure, and four had allocations matching their targets. 

The long push into infra 

The most allocated LGPS vs. its target is the Avon Pension Fund, which has a 7.8% allocation to infrastructure against a 5% target, according to March meeting minutes. Meanwhile, only Brent, City of London and Fife Council had allocations matching their targets. 

At the other end of the spectrum, the City of Westminster Pension Fund has invested only 34% of its infra allocation target — with a 3.7% allocation against an 11% target — while the London Borough of Enfield Pension Fund was only at 31% of its allocation to infrastructure, with a 5% actual allocation against a 16% target. 

That most LGPS funds are under-allocated to infrastructure is not too surprising, and may reflect several macro-economic factors and deliberate efforts to increase infrastructure investment. 

Under a plan announced in 2015 to help LGPS increase their infrastructure investments, UK pensions began pooling their assets in six investment pools beginning in April 2018. Since then, LGPS funds — which still maintain control of their strategic allocations — have steadily increased their infra allocations and allocation targets, with the average actual allocation growing to 5.3% from 2.9% of overall portfolios, according to the Infralogic analysis. 

Conversely, the trend among the UK pensions has been to lower exposure to public equities — particularly UK listed equities. Many pension funds still remain overweight to equities and often use cash generated from selling them to fund infrastructure investments. 

The City of Westminster Pension Fund, for example, recently topped up a commitment to a Quinbrook-managed infrastructure fund through sales of listed equities to which the fund was overallocated, according to documents seen by Infralogic. 

This suggests that valuation hits to public equity portfolios — which make up a large chunk of pension and other funds denominators — have not been as dramatic as anticipated. 

“It would take a significantly greater downturn in the stock markets for pension funds to drastically reduce infrastructure investments,” said the pension fund advisor. “If you look at the [Great Financial Crisis of 2007-2008], for example, even that didn’t stop commitments to infrastructure, and the market now is much bigger and more mature.” 

Inflationary tailwind 

Added to this is a macroeconomic environment, which actually favors investments in infrastructure, as private infra investments are seen as an inflation hedge. 

For example, the Berkshire LGPS fund describes infrastructure investments as providing a “strong hedge against inflation,” while the Cumbria County LGPS describes infrastructure investments as being “positively impacted’ by rising inflation. 

“Many pension funds see infrastructure as key in hedging their portfolios, particularly core infrastructure assets which can offer stable, predictable inflation-linked returns,” said a senior source at another London-based pension fund advisor. “The diversification that infrastructure affords to LGPS portfolios is also a key risk hedge, as so many of these investors don’t have enough exposure to real assets.” 

Indeed, some funds with an explicit inflation link have been targeted by LGPS funds. Abrdn’s Inflation-Linked Infrastructure Debt Fund held a first close last week, backed by several LGPS funds — including a cornerstone investment from LGPS Central, the pension pool which manages the assets of eight Midlands-based pension schemes. 

In late October, the Lothian Pension Fund, the Falkirk Council Pension Fund and the Fife Council Pension Fund acquired GLIL Infrastructure’s stake in IONA Environmental Infrastructure Fund 3. 

Meanwhile, various LGPS funds recently backed IFM Investors’ global open-ended infrastructure fund, IFM Global Infrastructure Fund. 

Little is seen changing this dynamic next year, when annual allocations reset for LGPS funds.