That infrastructure in the United States needs improvement is not news. Closing the $2 trillion, 10-year investment gap required to do the job quickly focuses on how to finance it.
One barely tapped alternative is the large pool of capital that resides in the retirement funds of public sector workers—the $4.3 trillion U.S. public pension system. In a new study, we’ve investigated the infrastructure investments undertaken by the largest public pension systems in the country, some of them in dire need of higher and more stable returns to meet their obligations to beneficiaries.
Addressing both the infrastructure and public pension gaps are among the few national issues with bipartisan support in Washington today. They are priorities for taxpayers and for elected officials at the federal, state, and local levels.
Infrastructure assets have features that are appealing to pension investors. They are long-duration and offer some degree of inflation protection. They are not correlated with the other asset classes, so they offer pension funds much-needed diversification. Best of all, they generate steady cash flows to meet the needs of current retirees.
These are among the reasons pension funds have cited when establishing programs to invest in infrastructure. Our analysis bears out most of these benefits. Yet, infrastructure investment programs in big American public pension funds are relatively recent, and they remain very small—averaging less than 1 percent of fund assets among the top 25 U.S. public pension plans.
Accumulating cash flow-generating assets and holding them for a long time is implicit in investment objectives of public investment funds. Yet, when pension funds invest in infrastructure, they use private equity-type funds that often have first-rate expertise, but seek capital gains—not current income—and charge high fees.
The funds usually buy infrastructure assets from other private owners. These investments have generated strong returns in the form of capital gains and benefitted substantially from rising valuations. Infrastructure assets now trade at multiples well in excess of those in other investment classes, such as real estate and private equity. But these investments don’t generate much in the way of the cash flows that pension funds need to support current retirees.
Bottom line: Insufficient U.S. investment in infrastructure as an asset class, using the wrong investment vehicles, and for the wrong purpose. There are better solutions.
To explore ways in which pension capital might evolve into a financing solution for U.S. public infrastructure, we might look to models that have been successful in other countries.
In Australia, “asset recycling” is a financing tool that has been used successfully to “repurpose” infrastructure capital. Public sector agencies sell long-term concession rights on existing infrastructure to investors (including pension funds) and use the proceeds to finance development of new infrastructure. The public sector retains ownership of the legacy assets, receives cash proceeds to develop new infrastructure, and avoids burdening its public finances with more debt. Private investors get a stream of proven cash flows from existing infrastructure over a fixed period of time. The federal government often provides an incentive in the form of a top-up of the proceeds from the concession sale.
True, institutional investors like pension funds are wary of investing in ground-up development. They are properly concerned about cost overruns, delays, and unpredictability of revenue streams. But pension systems are uniquely positioned as informed and influential players in regional and local economies. Just one example: The Quebec pension fund, CDPQ, developed and operates Montreal’s light-rail system and was able to assemble the financial and technical resources and muster the political support to pull it off.
Among the other ways to deal with risk in infrastructure projects involves partnering pension capital with the knowhow of EPC (engineering, procurement, construction) firms, which have extensive experience in designing and delivering new projects. Dutch pension funds, for example, have invested alongside engineering firms in new road construction projects.
Of course, using pension capital on public works requires strong governance to avoid white elephants, waste, and bloated costs. Under the right conditions, private capital can provide necessary transparency and discipline.
And there is an argument for investing pension capital locally. Successful projects generate economic development, which in turn leads to more jobs and more tax revenues—ultimately benefiting sustainable pension finance. And when pension funds invest directly in infrastructure, they don’t run into the political risk of transferring public “crown jewels” to private investors.
Most important is to put in place mechanisms that will allow for an improved flow of investable U.S. infrastructure assets. When that becomes evident to pension fund administrators, they will become more comfortable expanding their allocations to this attractive asset class—perhaps to the 5-10 percent levels that are common in Canada. This will provide hundreds of billions of dollars in incremental financing which will go a long way to reducing our infrastructure gap.