Pension schemes shifting from DB to DC have three choices: pooled funds, bundled funds or REITs. Shayla Walmsley reports

The gradual European shift from defined benefit (DB) to defined contribution (DC) schemes has combined controversy with inevitability. Despite continued disputes, such as that surrounding a recent UK government report making the case for an end to public sector DB schemes, DC schemes account for more than 30% of European pension assets, with average annual growth of 6.3% since 2004, according to calculations published in August by Cerulli Associates.

But what does it mean for those schemes' real estate portfolios? Broadly speaking, there are two issues. First, there are few real estate vehicles either created for DC schemes or meeting the regulatory requirement for liquidity. Second, the differences are arguably more than regulatory; DC investors just do it differently.

In the UK, the trend is unexceptionally towards more, rather than fewer, DC schemes. Nick Preston, senior director at CBRE Investors, points to DB liabilities that were "crippling" companies in now rapidly closing schemes. Accelerating the UK shift towards DC schemes is pressure from the government for more saving in pensions to take the burden off the state pension. At the same time, companies are shifting towards DC to lighten the cost burden of employer-sponsored retirement provision.

In DB schemes, the employer runs the pension fund and invests directly or via collective investment schemes. It takes a chunk of money - between £50m and £100m - to invest directly. The challenge is to create a property fund that can accept individual investors but that can deal with the intricacies of DC schemes, such as daily pricing and monthly valuations.

In fact, Invesco research director Simon Mallinson argues on page 40 that the industry is ill-equipped to deal with the shift precisely because of the liquidity requirement for daily pricing.

From now on, says Preston, the focus will be on liabilities. "It will all be in pooled funds. It will be a direct investment but the conduit won't be segregated accounts; it will be a collective investment schemes structure with many small investors in it," he says.

CBRE Investors launched a property fund aimed at the DC market. The fund, which will invest directly in the UK property market, was its first excursion into specialist management of DC assets.

But what's so good about property-specific fund managers - or even property-specific funds? It may be that DC-focused funds will be bundled, especially for schemes focused on lowering operational costs, for instance.

Diversification returns
Arguably, the specialist advantage is overplayed. According to Simon Chinnery, senior client adviser at JPMorgan Asset Management, low-risk, low-growth asset classes ill-serve DC pension holders except at the last stretch before retirement. In contrast, he says, diversified growth investors - dressed-up de-correlators, with the focus on asset allocation rather than asset selection - identify real estate and infrastructure as essential, interest-rate sensitive hedges against inflation, even in default DC options.

He says that across the industry he is noting an increase in diversified growth funds. "There are now around 200, compared with a handful in the early days. They do different things. What they have in common is that they're appropriate for DC schemes because they have an asymmetrical approach to investment. They limit the downside.

"In DB schemes, trustees spend their time worrying about funding. If they mess up, their concern is about getting to a fully funded position. In DC schemes, investors want a return but they are driven to look at the source of the return without losing money."

He argues that DC schemes' benchmark is cash, "but long-term, delivered over a cycle of five to seven years". Failing that, DC pension-holders want equity-like returns without equity-style volatility.

"They needed a big dollop of equities to mix and match and add value. Investors wanted a tie-in to the benchmark. But there is still volatility, which DB trustees can ride out. With lifecycling, you don't want your fund to plummet 30% just before you retire."

DC investors want a bundle of real assets, including real estate, without necessarily wanting to understand what's in the bundle, says Chinnery. They're likewise attracted to infrastructure because it is predictive and offers a long-term yield. A diversified growth fund is "the deal you get with REITs - the ability to dodge bullets".

Asset classes are so last year
How DC investors perceive real estate as an asset class is changing because how they see investing per se is changing. In a recent report, ‘Exploiting uncertainty in investment markets', sponsored by Citi and Principal Global Investors, Amin Rajan argues that a new style of asset allocation "will blend caution, diversification and opportunism. Liquidity and capital protection will top the client agenda. Beta will absorb the lion's share of the new assets."

In other words, the focus has shifted away from stellar returns towards hedging unrewarded risks and managing the rest.

In the 1990s, DB schemes mostly had 60/40% equities/bond portfolios. After the 2000-02 bear market, they increased their allocations to alternatives. From now on, the shifts from investing to liability matching and from strategic to dynamic allocation will accelerate.

Rajan suggests that portfolios will spread across five buckets. The first will hedge out unrewarded risks, such as inflation rates. The other four will pick up the rest. The second will target low-cost beta, reflecting low confidence in active funds. The third will target medium-term buy-and-hold investments. The fourth will target absolute return funds. The fifth will target opportunistic funds aimed at the dislocation in debt and private equity markets.

"They underline a vital point: traditional diversification is history, while the new one is heavily nuanced," says Rajan.

Where does this leave real estate? In theory, its risk-hedging characteristics, like those of infrastructure, put it in at least two of these baskets. If investors want to add asset classes with low correlation and risk-adjusted returns, real estate tops the list.

In addition to Rajan's assertion, there is another, more nebulous (and probably questionable) factor identified as conditioning DC schemes' approach to real estate. At its crudest, the argument is that pension holders in these schemes are just not bright enough to handle their own investments.

Paul Verdin, a strategy professor at Solvay Business School, earlier this year warned against allowing "less financially educated" scheme participants to make investment decisions. In his introduction to ‘Growth and value creation in asset management', he argued that, in contract-based DC schemes, "we are going in a direction where the final decisions are delegated to the least educated". In fact, the sector's raison d'etre "should be that the professionals know better, and do a better and more efficient job than the final customer".

Economists Kai Fachinger and Wolfgang Mader depart from rational agency, pulling in behavioural economics to argue in a 2007 paper that "people are only boundedly rational and often achieve sub-optimal outcomes" because, in short, they opt for the default, rarely change their options, rely on past performance and are, quite simply, not as clever as they think they are.

Even observers less inclined to see it this way agree that DC investors just think differently. Even if it weren't for the liquidity requirement, professional wisdom has it that, left to their own devices, DC pension-holders' default is to reach for equities like novice ice skaters clinging to the rink's edge.

Arguably, add too much diversification and you get poor diversification. What DC schemes tend to do, then, is negotiate what Janet Yang of Northern Trust described a couple of years back as "a delicate balance between paternalism and participant autonomy". The danger is that while optimising the DB portfolio via the inclusion of alternatives such as property and infrastructure, scheme sponsors minimise the real estate portfolio in DC schemes because it's more hassle.

Run to REITs
The US has implicitly recognised the dilemma. "That's where the US is going, with funds taken care of by professional managers," says Kurt Walten, senior vice-president of investor affairs at the US National Association of Real Estate Investment Trusts (NAREIT).

In any case, pro-fund advocates raise the question: why not invest in (daily priced)
property equities? That's pretty much what 401(K) plans - DC schemes' US counterparts - have done.

PIMCO's 2009 survey of DC trends found that consultants recommended the inclusion of REITs as a means of diversification and inflation hedging. Compelling data from the ‘Profit Sharing/401K Council of America' (PSCA),* published in September, show the number of pension schemes that include a commercial real estate option increased from 24.8% in 2008 to 33.4% in 2009. A study last year from Callan Asssociates found that 73% of target-date fund managers had a real estate allocation, mostly via REITs.
"At the beginning of the 401(K) trend, REITs' market cap wasn't big enough to accommodate them. There has been a big catch-up," says Walten.

The schemes themselves started out with bonds and fixed income, then equities and, over time, it evolved to include other asset classes.

"The fact that REITs are a good inflation hedge is the biggest focus," says Walten. "When you put together a portfolio, it has a basis of US stocks, then you figure out which asset classes you want to add, according to three factors: rates of return, volatility, correlation."

The argument against is the fact that REITs are equities - complete with equity (volatility) risk, despite some research that indicates that, long term, they behave more like property than securities.

Walten acknowledges that REITs are correlated to small-cap valuations, "but, if you compare them, there's sufficient diversification that you would want both in your portfolio".

What happened in the US will likely happen in Europe. The first-generation glide path was simple - stocks, bonds and cash. The second-generation glide path is "more sophisticated and more diversified", says Walten. "Product developers look at what the other guys are doing. If you look at the data, you'll see you should have REITs and other asset classes in your portfolio."

What you don't know, you don't miss
Some observers, including Walton, have argued that sponsors that run both kinds of scheme and include real estate within the DB scheme but not the DC scheme could well be guilty of fiduciary neglect.

Those invested in the DB scheme (albeit indirectly) benefit from the manager's decision to diversify via an inflation-hedging, low-correlating asset class. DC offerings are, by definition, more streamlined. According to Walton, this raises the possibility that plan sponsors are at risk of not meeting their fiduciary responsibility because they are not offering diversifying asset classes (such as real estate) in their DC plans already used in their DB plans.

So what happens if, as a sponsor, you have both? Take the BBC, which in June announced a review of its £8.23bn (€10.16bn) defined benefit scheme, complete with £2bn deficit. The DB scheme, which is 10% invested in real estate, will likely close to new members at the end of the year, with a DC scheme set up to replace it. The BBC did not respond to requests for clarification on the role of real estate in the new scheme, although the DB scheme's trustees pointed out in a statement that they, the trustees, would have no role in it.

Combine Walten's telling remark on generational increase in sophistication and Rajan's argument for something similar in schemes' broader approach to diversification, add Preston's prognosis that demand is coming from investment consultants and we have what amounts to a consensus.

"Investment consultants have encouraged fund managers to do this for a number of years because it provides better investment choices," says Preston. "The accusation is that the DC choice is fairly unimaginative. There is an element of truth but it's only recently that DC schemes came into the spotlight."

*53rd annual PCSA survey of profit sharing and 401(K) plans