Real estate funds face w numerous hurdles to entry when serving the DC market. Michael Haddock and Caitriona Hunter explain

Balancing the political reality of substantial government deficits against the demographic reality of ageing populations suggests the inevitable decline of state pension provision over time. This will mean greater numbers having to enrol in private pension schemes. Also, the cost of funding deficits in many corporate pension schemes has driven companies to close their old defined benefit (DB) schemes to new members and migrate employees to defined contribution (DC) schemes, transferring the risk of underperformance to members. All this points to a major change in the pensions landscape.

There are already signs of those changes. For example, in the UK (depending on company size) between October 2012 and July 2013 all employees will be automatically enrolled in their employer's pension scheme unless they choose to opt out. This reverses the present situation where opt-in is required. The overwhelming majority - if not all - of these new schemes will be DC. Along with the accelerating closure of DB schemes and their replacement by DC, this could have major implications for the way that direct investment in property is made.

The trend from DB to DC schemes in the UK has been developing steadily over the last 20 years but the financial crisis has accelerated the move owing to employers having to face up to funding sizable deficits. Significantly, Royal Dutch Shell recently closed its DB scheme to new members, making it the last FTSE 100 company to do so. From 2013, it will offer new employees a DC plan. For any participant in the real estate investment market the question is whether and how this shift will impact on the property sector.

The difference between DB and DC schemes is critical. While they share the intention of taking in savings today to provide an income in the future, the structural and regulatory requirements have important differences. The type of property investments that are suitable for a DC fund could be markedly different from a DB fund and these requirements will change the nature of direct property funds that are used in the DC context.

DC funds have to offer daily pricing and a degree of liquidity that are not required in a DB fund. DC investors are supposed to take a more active interest in the performance of their fund - with the ability to alter asset allocation if they wish. That raises a significant challenge for property that is quite obviously relatively illiquid compared to other assets. Creating a property fund that will meet the criteria for DC schemes is therefore very challenging.

The other likely impact on commercial real estate is the run-down of DB funds as they
close to new accruals. This could be a very protracted process as many DB schemes still have a long time to run. For example, a 35-year-old member of a DB scheme that has only recently closed to new accruals could still be drawing a pension from that scheme in 60-70 years' time. However, by various means, including buy-outs of existing members, managers of those funds are trying to ensure that the run-down is quicker.

Closed DB schemes can also expect to de-risk. As the age profile of members rises, schemes will shift away from riskier growth assets, (eg, equities and property), towards income-generating assets (eg, bonds).

As relative newcomers, DC scheme members are generally young. It might therefore be expected that the investment profile of a typical DC scheme would be structured for growth rather than income. Whether that will actually be the case, however, is less clear and driven by one of the fundamental differences between DC and DB - investors in DB schemes are passive. The individual member does not take on the risk of underperformance of the underlying fund assets, and their interest in how the fund is invested is relatively academic.

In contrast, a DC scheme member takes on the risk of underperformance and so should be incentivised to take a more active interest in ensuring that their contributions are invested in the most appropriate way for that individual's circumstances. Most DC schemes make a point of emphasising the individual's control over how contributions are invested, though this may change as pensions consultants start to exert greater influence over investment choices.

Were individuals to take control over their investments, it could theoretically lead to a very different mix of assets in DC schemes than those that would be selected by a professional asset allocator. This may also mean significantly more volatility (especially in new cash flows) as investors switch between options. In practice, members of DC schemes have, to date, tended to fall into one of three categories:

• The default option - members who take no interest in how their savings are invested and, at most, make a decision between two or three default lifestyle options - largely influenced by age - offered when they join the scheme;
• Self-investors - members who, on joining, study the available options and make a
positive decision about where their money will go, but who rarely - if ever - review those selections;
• Active investors - members who take an active interest not only in the funds in which their savings are being invested, but also regularly review their portfolio performance to optimise the returns they require.

At present, a significant majority (estimates range from between 80% and 90%) of DC scheme members want to avoid making investment decisions themselves and have a default option chosen for them. This could change as more become comfortable with the way in which DC schemes operate. However, it could easily move the other way as the advent of more compulsory pension saving (eg, the auto-enrolment in the UK) delivers scheme members who lack the financial literacy - or interest - to do more than select the default options available to them.

If the majority of members remain in the default option, then the general asset profile of DC schemes should not be that different from their DB predecessors (allowing for the necessary differences as a result of the demographic profile). However, pension regulators have been unimpressed by the way the scheme members have been asked to make choices and the extent to which the default positions have been explained. Pressure from the regulators could therefore lead to a better choice of funds and more active management of the assets held by a scheme as members are provided with easier to understand and more transparent information about the choices available.

Self-investors have, in the past, tended to allocate more to real estate than the professional asset allocator and might well be interested in a residential real estate option if it were available. However, self-investors are also likely to be very sensitive to fee levels (legislation ensures that these are highly visible when the fund selection is being made).

The structural requirements of the DC environment mean that direct property funds need to be carefully constructed to achieve regulatory approval. They need to satisfy liquidity requirements and offer daily pricing. Achieving that with what is an essentially illiquid asset is clearly very challenging.

Property funds entering the DC market have to overcome a number of significant barriers. Each of the DC platform providers will offer investors only a few direct property funds. Given the administrative complexity of DC platforms (thousands of investors, multiple funds, etc), replacing one fund with another is likely to be an unattractive option. Therefore, first mover advantage will be critical to becoming an established direct property fund. Other considerations, such as a demonstrable track record of successful investment will also be critical and erect a further barrier to entry.

Scale, too, will become increasingly important. Critical mass will be generated as a result of the high barriers to entry leading to fewer players in the market managing large funds.
The combination of few, large funds and the liquidity requirements of DC funds means that the asset types that are attractive to a DC fund will change from those that have been acquired by the more diverse DB property funds. In order to maintain liquidity, a real estate fund serving the DC sector will be wary - at least at the outset - of the need to provide liquidity and will probably tend towards the prime end of the property spectrum. It is certainly likely to avoid the more secondary property that has proved very illiquid in the most recent downturn. Over time, as funds grow, the range of property assets will develop to incorporate larger lot sizes at the expense of smaller properties.

Michael Haddock is director, EMEA research at CBRE. Caitriona Hunter is director at CBRE Global Investors