The real estate industry is currently ill equipped for the change from DB to DC and needs to begin considering structural changes to allow it to raise capital within the new regime. Simon Mallinson reports
At a high level, without delving into too much detail, there are traditionally two types of pension fund models - the defined benefit (DB) and the defined contribution (DC) models. The defined benefit model aims to provide, as the name indicates, a set of pension benefits that are defined in advance. The benefits at retirement can vary but are often based on a combination of the employees' wage, age, years of employment and other factors.
Often, the benefit is also index-linked to a rise in inflation. There are two key types of DB schemes - funded or unfunded. Unfunded schemes have no assets as such and use contributions from current employees to pay the benefits of retired employees.
Funded DB schemes invest contributions from both the employee and employer into a fund. These schemes can invest part of their assets into direct or indirect real estate via a centralised asset allocation or other decision-making committees.
The DC model is any structure where the contributions from both the employee and employer are paid into an individual account under the control of the employee. The benefits on retirement from this pension fund are dependent on the performance of the investments made by the individual employee.
It is estimated that DC plans now account for 50% of the global pension fund industry and the level is growing rapidly. If it has not yet been reached, the tipping point will be reached very soon, particularly as both the public and private sector take advantage of the economic downturn to loosen the shackles of DB plans on their finances (particularly unfunded ones, but also funded schemes where a growing gap between contributions and distributions have been growing for a number of years).
As ‘promises' within historical DB plans are broken, they become, in effect, de facto DC plans and furthermore, in Asia almost all new plans are DC in structure. Over the next 25 years, perhaps sooner, DB plans are likely to become a niche market, with DC plans dominating the investment landscape.
What does this mean for the real estate industry? There are two key issues to address. First, how to access capital controlled by the individual rather than by a centralised asset allocation committee and, second, how to deal with the redemption requests.
Access to capital
With DB plans the access to capital is reasonably straightforward (whether the capital raiser is successful or not). There is a clear structure in which a centralised asset allocation committee makes a decision to invest in real estate and then either invests directly via its own in-house investment team, or looks for a real estate manager or managers to invest and manage its real estate exposure. It is this centralised committee, or its consultant, with which a real estate investment manager interacts. The points of contact are clear and the relationship can be managed and developed for future investment. Both sides of the relationship benefit - the manager is able to raise capital and the investor has a direct link through to the manager to understand and question strategy and build trust.
Within DC plans the access to capital is less straightforward. Within many DC plans there is a central asset allocation committee (similar to the DB plans). This committee is largely tasked with defining the default or ‘life-style' options that can be chosen by the individual investing via the scheme. Where there is not an allocation committee DC schemes are offered via a ‘fund platform' which provides a range of alternative fund choices as well as life-style options.
To date, these life-style options contain little real estate exposure, and if they do it is often via investments in real estate investment trusts (REITs) rather than via direct real estate funds. It is currently estimated that 80% of individuals within DC plans have chosen some form of default option. For real estate, this means that there is still an opportunity to influence the centralised asset allocation committees that structure the default option. However, the question is then whether the real estate industry has the appropriate investment products to suit these schemes. The key criteria is that individuals in a DC scheme are able to change their choice of allocation at will and therefore it is important for real estate vehicles to be sufficiently liquid to these requests.
At present the real estate vehicles offered are generally designed for retail investors and are very limited in the strategies they offer (mostly UK real estate only). This lack of choice means that DC schemes are able to access only funds that suffer the subscription and redemption volatility associated with retail investors, rather than the more stable funds that most institutional investors favour. The focus on the UK also limits the ability to take advantage of the diversification benefits that international real estate offers.
There are clear lessons from markets such as Germany, with its active open-ended fund market, that have highlighted the volatility and impact of capital flows on real estate funds - particularly where there is a high proportion of retail investors. An individual investor makes decisions that are not the same as the logical asset allocation models used within the centralised processes.
An individual is influenced by the media, friends and family, perceived economic sentiment and other factors that cannot be easily modelled yet have an impact on whether the individual invests or redeems from a particularly fund. While individual DC members are able to change their investment allocations in the same way as retail investors do, there is little evidence at present of them doing so given the ‘life-style' choice most make.
The real estate industry should learn from the lessons in other countries and aim to provide bespoke solutions to DC pension plans. It is clear that real estate funds suitable for DB pension plans are not suitable for DC investors because of the lack of liquidity. Likewise, retail investors require higher liquidity requirements than DC schemes. Therefore, providing bespoke DC funds with a wider choice of investment strategies and subscription and redemption mechanisms suitable for their requirements would be a welcome addition to the industry.
This article raises more questions than it answers. However, what is clear is that the real estate industry needs to rethink some of the fund structures used today to make them suitable for tomorrow's dominant DC industry and secure long-term access to capital.
Simon Mallinson is director, European research, Invesco Real Estate