Keeping pace with the DC train
The US pensions industry is further than most in the shift towards defined contribution. Christopher O’Dea looks at the latest efforts to include real estate in its plans
Real estate investment managers are an innovative lot, supplying private capital in often-unique structures to build everything from ports to shopping malls. Now they are aiming to build better retirement nest eggs for defined-contribution (DC) pension plan participants.
The returns from real estate investment can be substantial, the long-term nature of the projects matches the time horizon of retirement investing, and real estate is largely uncorrelated with the equity and bond returns that dominate DC plans. But the benefits of direct real estate investing have largely been the preserve of defined-benefit (DB) plans, despite DC becoming the dominant pension arrangement in the US.
“DC participants should have access to the same options as a DB participant”
Real estate fund managers are working to change that. It is partly a defensive move, as access to DC assets would help cushion potential declines in assets from a shrinking DB sector. At the same time, real estate has several characteristics that appear to be just what is needed in a world of low bond yields, potential inflation, and equity volatility.
A handful of early leaders have tapped DC assets, and some of the world’s leading real estate managers are studying how best to enter the market.
Initial attempts to break into 401(k) line-ups with real estate vehicles modelled on openended mutual funds spluttered. It now appears that direct real estate will help accelerate the delivery of professional asset allocation to individual DC plan members whose investment results have fallen short of those produced by institutional managers.
Plan sponsors initially gained comfort with real estate through offering REITs as an option in 401(k) plans comprised mainly of ‘1940 Act’ mutual funds, says Jeff Felder, senior director, global investor services and strategy at CBRE Global Investors.
Felder says CBRE Global Investors is in a “discovery phase”, exploring DC sponsors’ current requirements for real estate investment. Increasingly, he adds, DC sponsors want their plans to help participants prepare for retirement. They are looking at direct real estate with the view that “DC participants should have access to the same options as a DB participant”.
What is emerging is a shift towards multiasset funds that include direct real estate and other alternatives, managed by consultants or institutional investment firms instead of big retail funds.
Two recent developments have added impetus to this shift. First, The US Pension Benefit Guaranty Corporation in December 2013 hit employers with a 52% increase in the peremployee fee the insurer charges. Second, the Society of Actuaries updated its mortality tables for the first time since 2000, and consultants say the increased lifespans for men and women will add about $150bn (€108bn) to corporate pension liabilities of $2trn. These factors will push more plan sponsors to seal off liability for DB pension plans, replacing them with 401(k) retirement plans, or outsourcing pension plan management to insurance companies.
For the past 30 years, private real estate managers have “thrived” by managing assets from public plans and insurance companies, says George Pandaleon, president at Inland Institutional Capital Partners.
Pandaleon believes DC assets should grow substantially in the coming years, and predicts that a switch from DB to DC in the public sector could occur much sooner – and faster – than many real estate managers expect. That would add to the flows from the corporate sector. “Defined contribution plans are going to be where the growth is,” he says. While the industry is still experimenting, he suggests that asset-allocation vehicles, such as target-date funds, could enable real estate managers to tap flows from individual investors.
Attracting capital from a range of sources might not sound like much of a challenge. After all, strong retail demand for real estate in 2013 pushed inflows to non-traded equity REITs to a record level of $18.7bn, double the amount raised in 2012. But non-traded REITs primarily tap retail assets through independent brokerdealers, a limited channel where high sales commissions and limited liquidity for investors’ holdings pose obstacles to reaching the broader market.
Most retail assets are held in accounts that are part of DC retirement plans. Assets in DC plans topped $5.1trn at the end of 2012, according to the Investment Company Institute, the trade group for mutual fund companies. More than half ($2.9trn) was allocated to mutual funds.
The public sector could add to new asset flows. The 100 largest public plans in the US had assets of $2.6trn in 2013, according to pension consultant Milliman. But those plans face liabilities of $3.77trn. In states such as Illinois, underfunding of public pension plans has already forced legislators to introduce 401(k)-style DC options for new and some active workers.
Pandaleon says real estate managers who can tap DC assets will hold a “golden ticket”. Punching that ticket will require innovation to devise a product format that adequately addresses liquidity and valuation requirements for the US 401(k) world. As a long-duration asset often involving private-market transactions, real estate does not readily lend itself to a daily liquidity model.
Real estate managers are experimenting with solutions. Approaches to date have clustered around three broad product-development strategies. These include:
• Hybrid funds that adjust sales loads and tweak other features of non-traded REITs in an effort to spur sales to a wider range of commission- driven advisers.
• Mutual-fund approaches in which non-traded funds adopt pricing and other features usually found in registered fund vehicles in an effort to appeal to fee-only financial advisers and 401(k) platforms.
• Institutional approaches that seek to deliver the performance of commingled real estate funds to DC plans through separate accounts or target-date funds.
Each approach has merits. But “one consistent theme is how to help manage the importance of liquidity by pairing less-liquid direct real estate with REITs for full liquidity in a ‘blended’ product strategy”, says Rob Best, senior managing director, new business development for Principal Real Estate Investors.
“Managers are quickly learning and adapting to the investment demands of DC”
An ambitious effort was Clarion Property Partners Trust (CPPT). Launched in 2011, the fund was a pioneering attempt “to address wellknown shortcomings associated with traditional non-listed REITs – principally, lack of liquidity, the rigidities implicit in a closed-end, finite-life, fixed-price investment, and high fees”, according to Clarion letters filed with the Securities & Exchange Commission.
To control costs, CPPT charged a management fee of 0.9% and a performance fee of 25% of gains that only applied after the manager, CPT Advisors, a unit of ING Clarion Partners, delivered a 6% minimum return. The maximum sales charge of 3% was significantly below the prevailing rate for non-traded real estate vehicles at the time. Despite the modest cost structure, the fund only reported $13m in net offering proceeds in its March 31, 2013 SEC filing. The fund was liquidated in June 2013.
The CPPT fund grappled with the liquidity question. In early 2012, the fund asked the SEC for permission to shift its redemption policy towards the ‘net redemption’ policy used in retail mutual funds that offer investors the ability to redeem their entire position at net asset value (NAV) on any business day. Redemptions in CPPT were originally subject to a quarterly limit of 5% of the prior quarter-end NAV. In 2012, the fund asked to revise its policy to set the 5% limit based on net redemptions in order to improve liquidity for investors. The rationale for the change was to “provide greater liquidity to the company’s stockholders without requiring the company to allocate a greater portion of its portfolio to cash, cash equivalents and other liquid assets that typically produce a lower return” than real estate.
Another approach is being tried by The Blackstone Group which in January filed with the SEC for permission to market a non-traded real estate vehicle, the Blackstone Real Estate Income Fund II.
Blackstone’s structure appears aimed at intermediary firms and fee-only financial advisers rather than 401(k) plans, but moves towards retail fund standards. Instead of a sales commission, the fund will pay an ongoing ‘12(b)-1’ fee of 25bps, a flat annual marketing fee that is included as an operational expense in a traditional mutual fund’s expense ratio. The fund will have a 1.5% expense ratio, and a 15% performance fee. While a marketing fee of just 0.25% seems razor-thin in the non-traded REIT world, it shows the cost-sensitive nature of the retail channel.
One of the largest institutional real estate mangers, Prudential Real Estate Investors (known as Pramerica in Europe), has been pursuing the DC channel for about five years. Pramerica is investing strategically. In 2011, it hired David Skinner, JP Morgan’s head of DCIO institutional sales, to spearhead its DC push. Skinner was instrumental in launching the Defined Contribution Real Estate Council (DCREC) during 2013. The group aims to persuade plan sponsors and consultants to add commercial real estate as a DC investment option.
On the investment front, Pramerica invests 75% of DC assets through a separate account in its institutional co-mingled funds to achieve exposure to the real estate asset class. To provide liquidity, Pramerica holds up to 25% in publicly-traded REITs and cash.
That might cause concern in the DC world; in a video on its website, ‘Commercial Real Estate in Your DC Plan’, Pramerica notes that REITS are not a good substitute for direct commercial real estate investments since REITs tend to track the equity market and trade like small-cap stocks. Pramerica clearly states that the ability to make daily withdrawals from its Prudential Retirement Real Estate Fund (PRREF) is not guaranteed, and redemptions could be delayed if the fund does not have sufficient cash available. While cautioning investors about potential illiquidity, Pramerica last year retained Chicagobased Real Estate Research Corporation to determine the daily value of PRREF’s direct real estate investments.
Pramerica notes that DC plans can access its direct real estate expertise through asset allocation strategies such as target-date funds. The fact sheet for PRREF shows assets of $468m at 30 September 2013, although it does not indicate whether that is all from DC clients. And the Callan Glidepath 2020, a target-date fund designed for employee benefit plans and managed by the investment consulting firm, had a 12% allocation to PRREF at 31 December 2013 – the fund’s second-largest allocation to a single manager of any strategy.
Perhaps the oldest DC real estate solution is The Principal US Property Account, a direct real estate option that Principal Global Investors has managed for The Principal’s 401(k) clients since January 1982.
The account pursues a core real estate strategy focused on generating much of its total return through income, investing in high-quality buildings in major market locations. The strategy is available to both DB and DC plans in an Insurance Company Separate Account format. As of 31 March 2014, gross assets totalled $6.2bn, with approximately 70% DB and 30% DC.
The US Property Account was designed as an option for 401(k) investors and has historically been run to service this customer base, including striking a daily net asset value, offering daily liquidity during periods of full market liquidity and charging a single fee. Principal believes the retirement investing market is undergoing a “secular shift from DB to DC”, says Best. “Real estate managers are quickly learning and adapting to the investment demands of DC in a variety of ways, including hiring dedicated DC practitioners to join their real estate teams.”
Innovations in the DC market are likely to push through improvements in achieving a balance between liquidity and potential returns from real estate. But managers may not have to achieve the full daily liquidity of mutual funds, says Hewitt’s Ennis Knupp.
In a detailed report on DC adoption of alternatives, the consultant says that, although most DC plans allow participants to trade daily, only 14.5% of DC participants made a trade in 2012, and “most law firms we have encountered interpret ERISA 404(c) to require participants to be able to transact at least as frequently as quarterly”.
In the end, performance might attract DC investors to professionally managed structures including direct real estate. “Target date funds have begun to address the most egregious portfolio design failures by individual participants,” says a JP Morgan real estate team analysis of DC plans. “With DC participants largely running their own portfolios, the outcomes have not been nearly as good as DB plans,” the bank says. Between 1998 and 2012, the median DB plan outperformed the median DC plan by 100bps with substantially less risk. The good news for real estate managers hunting DC assets is that “diversifying assets such as real estate would have helped the most” in overcoming that shortfall.