Pensions find new sources of long-term cash flows

An upside of higher rates for pension schemes is a reduction in the value of future liabilities. Many defined benefit (DB) pensions in Europe are taking advantage of this to derisk portfolios by locking-in higher-yielding, public investment grade fixed income assets, according to Nuveen’s 2024 EQuilibrium survey. This is freeing them up to explore more private investments and, in some instances, these investments are also playing into schemes’ environmental and social objectives.

A new interest rate regime

Post-pandemic inflation triggered a steady increase in base rates in many European economies. They began edging higher in late 2021 in the U.K. and summer 2022 in the eurozone, having been anchored at ultra-low and even negative levels since the global financial crisis in 2008.

The Bank of England and the European Central Bank’s base rates reached peaks of 4.5% and 5.25% respectively between the second half of 2023 and the summer months of 2024. While rates have been cut, they are expected to remain at elevated levels. More than 80% of pension investors in Europe agreed that we are in a higher-for-longer rate environment in our survey.

With higher base rates equating to a higher discount rate, the funding position of many DB pension schemes has improved. Responding to this, alongside regulatory changes to facilitate alternative investing in some countries, we’re seeing pension schemes pursuing a range of private asset classes that offer higher yields and long-term cash flows.

The following section highlights four of these investment themes, several of which also serve environmental and social goals.

Infrastructure debt

Over 40% of German pensions and U.K. public pensions are planning to increase allocations to private infrastructure. This isn’t surprising given the capital needed to transition economies to lower carbon energy sources. According to McKinsey, $275 trillion in cumulative spending on physical assets is needed through to 2050.

Many countries are looking to decarbonise their energy generation and transmission, electrify transportation and encourage renewables such as wind and solar power. Providing debt financing for these infrastructure projects has the potential to align with net zero commitments and portfolio decarbonisation plans, while also providing a stable income stream and diversification.

The resiliency of infrastructure debt makes it an attractive option for pension funds. Infrastructure assets typically provide essential services or goods required for basic economic activities. This translates into relatively stable, long-standing and inelastic demand, and the ability to pass most or all input cost increases, providing coverage from inflationary pressures.

Debt financing for these assets helps overcome the primary challenge of sourcing the large amount of capital for the initial build. And then over the asset’s life, they can generate substantial cash flows, facilitating the borrower’s ability to repay the debt.

The need to transition is happening at a time when energy demands are growing significantly around the world, partly due to the ubiquity of digitalisation and the exponential growth in artificial intelligence uses. We expect these trends will support infrastructure debt as an asset class for decades to come.

C-PACE (Commercial property-assessed clean energy)

C-PACE is a U.S. state policy-enabled financing mechanism. It secures repayment through a senior, special assessment on the underlying property, allowing commercial property owners to obtain low-cost, long-term and fixed-rate financing for commercial real estate projects related to energy efficiency, water conservation, renewable energy and resiliency.

While a relatively new form of investment for European pensions, other institutional investors in Europe and the U.S. are attracted to C-PACE’s duration profile, credit quality (which is typically investment grade) and low risk (given its seniority). It also provides exposure to sustainability-themed investments and impact opportunities. And it’s another way to add diversification to portfolios.

Over the coming years, we anticipate the C-PACE market will continue to grow, with new C-PACE policy and program launches expanding the addressable market of eligible buildings. In 2015, only a handful of U.S. states had C-PACE programs. Today, over 30 states have active programs with completed projects. Increasingly, real estate investors and tenants are demanding more sustainable buildings, a trend that will further support demand for C-PACE loans. And while it creates buildings that are better for the environment, it can also reduce operating expenses and benefit real estate values.

Direct lending

Direct lending, also referred to as private credit, is now widely recognized as an alternative asset class that can deliver stable returns for institutional investors with low and/or negative correlations with other asset classes.

Private credit plays the vital role of providing capital to companies unable to access public markets – this has been a huge gap in the market since banks largely withdrew from the direct lending business after the global financial crisis.

Nuveen’s private capital specialists Churchill and Arcmont focus on lending to industry-leading middle market businesses. These are companies with stable cash flows and earnings in the region of $10 to $100 million. They usually operate in defensive sectors, providing products and services that are in demand no matter the stage of the economic cycle. With a large and reliable customer base and good supplier relationships, these often highly cash generative businesses are well placed to service interest payments and pay back loans.

Pension investors are allocating to direct lending for several reasons. As debt, it is an income stream, usually with some inflation protection given the floating rate feature of senior loans. With low or negative correlations with public market returns, it provides diversification. And as private market assets are generally not marked to market, they are less exposed to headline and other risks that can rock public markets.

Natural capital

Natural capital, which is how we group farmland and timberland investments, share similar characteristics. The combination of low volatility investment returns and a competitive performance track record means natural capital investments can help preserve capital through economic cycles. Yield stability comes from a relatively inelastic demand for many timber and agricultural crops and steady, predictable cash flows generated by long-term contractual commitments (e.g. offtake agreements, leasing and service contracts). Timberland and farmland are also well known for their superior inflation-hedging ability as rising prices lift cash yields and, over time, capital appreciation rates.

Beyond the advantageous financial characteristics, demand for investments in sustainably managed timberland and farmland is increasing. Today approximately half of global pension plans (and 44% of European pension schemes) hold timberland or farmland according to our survey. Investors are attracted to their intrinsic ability to remove carbon from the atmosphere, the potential for greenhouse gas emission reduction, and the preservation of natural capital assets and the ecosystem service benefits that flow from them.

For more insights into how pension funds are investing, download the Equilibrium survey.