One of the biggest pension funds to be invested in income trusts is the Toronto-based Ontario Teachers’ Pension Plan, whose income trust holdings total $2.2 billion and generated about $1 billion in income for the fund in 2004. Bob Bertram, executive vice-president, investment, for Teachers’, says when the plan began investing in income trusts back in 1999, it expected to get a higher rate of return than the stock market offered at that time.
Those expectations have definitely been met, he says, pointing to the qualities that attracted Teachers’ to income trusts in the first place: “One big advantage is the fact that the income trust shareholder is far more engaged than they would be in a normal, corporate business,” he says. That is because their unique structure gives the shareholder a lot more control.
“Management of an income trust has to flow a very significant portion of cash flow to the unit holder,” he explains. “In order for them to reinvest in their businesses or in another business, they have to ask for shareholder approval. On the other hand, in normal corporations, management could accumulate cash and spend it on what they want.” Bertram says this accountability imposes a discipline on income trusts that isn’t always there in corporate-listed companies.
THE LOOPHOLE FACTOR
One other factor that has kept some plan sponsors away from income trusts is the tax advantage on which the structure is founded: they don’t pay corporate tax thanks to a loophole in Canadian tax laws. This issue came to a head last year when the federal government threatened to put a 1% cap on the amount a pension portfolio can have invested in the asset class in an effort to plug any possible leaks in the corporate tax base. Public outcry prompted federal Finance Minister Ralph Goodale to back off the proposed cap. However, Goodale is still consulting the investment community on business trust tax issues and the Department of Finance is expected to release a consultation paper soon.
While no one can be sure what the federal government will do next, research suggests that the reasoning behind the proposed limit on pension investment might be unfounded. A study submitted to the federal government in April 2004 by the Pension Investment Association of Canada(PIAC), notes the disadvantages of the cap on pension investment could far outweigh the benefits. PIAC’s research showed that the proposed limit would save the Feds a mere $17 million a year. Weighed against the negative economic impact such a cap would have on income trust businesses, PIAC’s study concluded that Ottawa’s proposal would be detrimental to the overall Canadian gross domestic product.
Paul Halpern, a professor of finance with the Rotman School of Management at the University of Toronto, has researched the role of income trusts in Canadian capital markets for years. Halpern believes that over time, income trusts present no real threat to the federal tax base: “In the long run, the people in the pension fund pay taxes when they take their money out. So when you present value this, it’s not clear that there is a tax loss.”
Income trust veteran Stephen Pincus, a partner with Goodmans LLP in Toronto, believes that given the success of the income trust market and the strong returns compared to other types of stocks, it doesn’t make sense to cap pension investment. “Why should pensioners be prejudiced in that way,” he asks. “It seems terribly unfair.”
Pincus also notes that their inclusion in the TSX Composite Index marks a huge step forward. “For managers benchmarking their investments against the S&P/TSX Composite Index, it’s going to make a big difference,” he says, explaining that there are approximately 60 income trusts included in it, accounting for roughly one third of the income fund sector and about one quarter of the companies in the benchmark Canadian index.
Stephen Rotz is vice-president of corporate development with the Davis + Henderson Income Fund and Ontario vice-president of the Canadian Association of Income Funds in Toronto. He believes income trusts are now such an integral part of capital markets that institutional investors who shy away from them are putting their plan members at a disadvantage. “By not investing in income trusts, you’re missing out on the opportunity to provide your beneficiaries with proper diversification,” he says. “Without income trusts, you won’t get diversification in the Canadian equity markets.” Indeed, he explains, income trusts have been essential to the growth of key Canadian sectors such as real estate and oil and gas. At the same time, monthly cash distributions mean a better opportunity for plan sponsors to fund their liabilities on the other side of the balance sheet.
The question remains: just how do income trusts fit in a pension portfolio? There’s no magic answer when it comes to asset allocation, according to Teachers’ Bertram—particularly because of their unique qualities. “Income trust returns have the stability of a bond cash flow and yet they have the underlying risk of an equity,” he says. That can make it difficult to take a simple approach to asset allocation and income trusts. Instead, Teachers’ uses a risk-based approach to show an individual income trust fits into its portfolio. “We define how much risk an income trust is adding to our total fund and whether we’re getting rewarded for the additional risk we’re taking on,” says Bertram.
Another challenge is the number of sectors and businesses encompassed by income trusts; they can’t be viewed through a narrow lens. “We talk about income trusts as a homogenous class, and newspapers list them as a class called ‘income trusts,’” says Bertram. “People have to understand that the income trust market is heterogeneous— not homogeneous.” At Teachers’, says Bertram, choosing an income trust that will outperform the market means active selection based on close scrutiny of the businesses. “We look at the stability of the business itself and the nature of the business they’re in,” he explains. Teachers’ also looks closely at the quality of management—asking if the trust’s cash flow is sustainable and if they can pay what they say they can.
GOVERNANCE REFORM
Management quality is key and many high-profile investors—Teachers’ included—have ardently been drawing attention to the need for governance reform among income trusts. Indeed, their complex structure can make it difficult to pinpoint whether or not management’s decisions are aligned with the best interests of the trust’s unit holders. In an effort to encourage greater clarity, Teachers’ has closely monitored the governance landscape and, says Bertram, the fund is looking to the industry to improve standards across the board. “We would like to see the same governance standards among income trusts that apply in a similar situation for a publicly-listed company,” he says. “Since the income trust market is not homogeneous, you get different governance structures depending in the type of trust.”
In response to these concerns, income trusts are moving toward change. For example, the Canadian Securities Administrators adopted National Policy 41-201, designed to encourage greater transparency and disclosure within the industry. In addition, groups of large investors are helping to encourage income trusts to implement sound governance standards across the board. While income trusts have generally made big improvements over the last few years, Rotz believes their basic structure necessitates good governance. “Income trusts are held to a higher standard,” he says. “If you’re not generating real cash, the investing public will figure that out pretty rapidly—and you will be forced to suspend distribution.”
To ensure an income trust can continue to provide the steady, stable cash flows it promises, there are specific characteristics for which investors should be on the look out. Goodman’s Pincus cautions that not all businesses are suited to the income trust structure, so investors need to do their homework. “Strong income trusts are based on businesses that tend to be dominant in their market sectors,” he explains. “They also have good margins and strong management.” In addition, Pincus says investors should look for predictability around an income trust’s capital expenditures, ensuring they aren’t subject to volatility due to factors such as currency or commodity prices. Look for growth opportunities as well, he urges, since this will drive steady cash flows in the future.
While the future definitely looks bright for income trusts, the question remains: will more plan sponsors step up and invest in them? As Pincus points out, “Plan sponsors missed the bullet train years ago. Now with(the S&P/TSX Composite Index’s)inclusion of income trusts, they’ll be forced to re-examine their investment policies and realize they should get up to speed on the sector.” Whether or not the train has left the station, plan sponsors will surely be hearing more about income trusts in the years ahead.
Caroline Cakebread is a freelance writer in Toronto. ccakebread@yahoo.ca
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