Defined contribution pensions will come to dominate in the future but they require daily liquidity. Christine Senior investigates what this means for real estate
It is clear that, by and large, defined benefit (DB) pension funds are in terminal decline and defined contribution (DC) schemes will eventually replace them. DC funds are likely to eclipse their older brethren in size and value some time in the not too distant future. So for real estate to play a role in pension investing in the future, it has to be in a form that is accessible to members of DC pension schemes. Property is well established in DB scheme portfolios but its place in DC schemes is less clear.
There are two aspects to the role of real estate in DC pension schemes: as an element in a default fund (for pension scheme members who do not make active investment choices); as an option in the self-select offerings of DC schemes (where scheme members make fund choices to construct their own personal pension portfolio).
Given the widespread lack of engagement with pensions, default funds will probably become the most important gateways for listed real estate to enter the arena of DC investments.
The fact that DC funds are required to provide daily dealing and pricing raises a barrier to the types of products that can be offered. Any type of property fund, other than listed, is effectively ruled out of DC offerings.
This was a factor in the design of Legal & General Property’s Hybrid Property fund, launched in 2011, which is marketed as a suitable fund for the DC market. It has an asset allocation split 70/30 between the L&G’s UK Managed Property fund and LGIM’s Global REITs index tracker fund.
The 50% growth in the fund last year shows the demand for such a product. Pete Gladwell, L&G Property’s product development manager, says: “There are lots of reasons why property is fantastic for DC. What people have struggled to do is structure a wrapper or product that enables DC to gain access in a daily-priced, daily-dealt manner. The addition of the global listed fund enables that access with a greater amount of liquidity. And there are clear benefits in that management charges are lower, the spread is reduced, and you get international diversification.”
Despite the success of the fund, other managers have not been rushing to offer a similar format.
The introduction of auto-enrolment and the National Employment Savings Trust (NEST) in the UK will boost DC coverage and raise public awareness of pension saving. It will take time to build but when fully up and running over the coming decade the amount of savings in DC will be substantial. But unlike in DB schemes, investments build slowly in the regular accumulation of small amounts of cash on a monthly basis.
Can listed real estate expect to get a slice of the increased inflows of investment money? Listed property could have an important role to play as an element of a default fund, if consultants and trustee boards can be persuaded of its benefits. Default funds already dominate pension fund choices by members and this trend, if anything, is likely to be accentuated with auto-enrolment.
Gladwell says that getting a property fund accepted as an element of the default fund is what is important, because that is where the biggest inflows are likely to be. “It’s the default that’s the holy grail, particularly because the new cash that will come from auto-enrolment is from individuals who are yet to be enrolled,” he says. “These people are typically less financially aware than those who already have pensions, so they are even more likely to go for the default and trust the new super trusts, like NEST, or their trustee board or consultant to have made the right allocation decision.”
If getting accepted as an investment within the default fund is the holy grail, it seems the quest could be quite a long one. Many consultants have yet to be convinced of the usefulness of listed real estate.
Phil Page, client director at Cardano, has reservations. “We have generally steered clear of using property in default funds,” he says. “In a default fund you are trying to get something reasonably diversified. Usually the core of DC has some equities for long-term growth, so by putting in property companies listed on the stock market we think the diversification benefit is relatively poor.”
Alistair Byrne, senior investment consultant at Towers Watson, is also lukewarm about using listed securities. “From an investment perspective, we prefer to diversify using direct real estate funds rather than listed securities,” he says. “However, the requirement from fund platforms for daily liquidity in DC funds provides a constraint that means REITs are usually more suitable. Ideally, we would like the requirement for daily liquidity to be eased so that we can have more flexibility in the asset classes and vehicles we use.”
An indirect way REITs and listed securities are finding their way into default funds is as
part of a diversified growth fund, or an absolute return fund, which are popular as default funds, or more likely as an element in a default fund.
The UK Pensions Regulator has produced guidelines for DC pensions, which are not
prescriptive, but suggest that DC investment strategies should produce “good member outcomes”.
Andy Dickson, investment director, UK institutional business at Standard Life Investments, says one way to achieve this is to have greater diversification in the overall investment strategy. “A complementary part of that would clearly be real estate,” he says. “We are seeing some consultants taking action on that basis. Typically, the direction of travel to date has been harnessing diversified growth funds or absolute return strategies, and often these strategies can have an allocation to listed real estate within the overall mix. We are also seeing some consultants constructing bespoke investment strategies and putting in a specific allocation to listed real estate as a portion of that overall diversified portfolio. That can be a 3%, 5% or 10% allocation.”
Towers Watson is one of the consultants that have been taking this route. Byrne says: “For a number of large DC clients we have created bespoke diversified growth portfolios targeting an inflation-plus return. These invest in a range of passively managed asset class funds, from global equities to alternative asset classes. Typically, these portfolios will include a 5-10% allocation to a global REITs fund. In addition, some of the diversified growth funds from external managers that we have recommended to clients as part of their default strategy have an allocation to REITs.”
The requirement for daily liquidity demanded by the DC platforms is reckoned by many to be unnecessary and a hindrance to greater diversification.
“It’s not that members are saying I want daily liquidity,” says Page. “The average member doesn’t buy and sell shares on a daily basis; most DC members hardly ever look at their pension. What would probably make property funds – generally, not just listed property shares – more attractive is if we could loosen the industry standard of requiring daily liquidity for DC funds. There are some types of vehicles that just don’t fit very well in a daily liquid format.”
It’s a point of view that has plenty of support. Dickson says: “If you were starting with a blank sheet of paper, setting up a savings plan for 30 or 40 years, why would you want daily pricing? You don’t have it in DB, why would you have it in DC? It’s by accident rather than design. It’s the delivery mechanism being used – the platforms – that require that daily pricing.”
This is something that the industry is already beginning to tackle. A year-long project sponsored by European Public Real Estate Association (EPRA), the Institute & Faculty of Actuaries, the Association of Real Estate Funds (AREF) and the Investment Property Forum (IPF) is looking at the whole question of DC and real estate against a background of the decline of DB schemes and the consequent rise of DC. One of the topics coming under scrutiny is whether the requirement for daily liquidity in real estate funds for DC is really necessary.
The DC model which requires daily pricing and daily liquidity doesn’t sit well with an illiquid asset like real estate, says Paul Richards, head of the European real estate boutique within Mercer’s manager research team. “One of the ways round that is to use listed property, other ways are to have funds with cash in or lots of properties that are small which you can sell at short notice, or derivatives, or put listed securities alongside buildings inside the portfolio.
“The reason for the project is to see if this means in 20 years’ time there won’t be any unlisted funds; no pension funds will invest in real estate; it will all be through property securities. Or is there something else that can be done.”
What has emerged from the research is that daily liquidity is more for administrative reasons than for investment reasons. Richards says: “I think the requirement for daily liquidity isn’t for an investment reason, it’s not because people are trading the portfolio every day – most tick the default box. It’s partly because as schemes get larger something is happening every day – someone makes a contribution, someone joins, someone leaves, someone has a pension payment, every day. That has to be averaged across the whole portfolio. The second thing is those payments may be a tiny part of whole portfolio but the software administration means it has to be averaged across every asset.”
A solution could be to move towards the Australian model for superannuation funds, says Richards. “Australian superannuation funds are DC and have similar constraints but they will have quite a lot of illiquid assets in there. There will be daily liquidity from cash or liquidity from the equities and bonds they hold which are traded daily. The illiquid assets are held and traded as often as they need to be, which sometimes may not be very often.”
But if that format becomes the norm in Europe, it doesn’t bode too well for a more important role for listed real estate securities in DC.
Even so, the US and Australia have shown that listed REITs can have a place in DC pensions schemes while Europe lags, perhaps a consequence of DC itself lagging in importance in comparison to DB in Europe. There are lessons to be learnt from the experience elsewhere.
Fraser Hughes, research director at EPRA, says: “If you look at figures NAREIT has produced in the past, you see the growth of REITs or listed real estate in DC schemes over the last 15 years or so. I think NAREIT has done a good job at educating and promoting the sector to those schemes. That’s a process we are in at the moment which is tied in with the growth of DC schemes in Europe. We believe that listed real estate can fit nicely in that type of vehicle. It’s about education and a growing market and helping those schemes understand the benefits of listed real estate as part of the overall asset allocation.”
But there is one important misconception that clouds the view of the nature of DC investments and that works against greater acceptance. DC money is often considered “hot money”, therefore not the kind that managers welcome, according to Gladwell.
“There is a natural thought process among consultants and schemes that if you have DC money in your fund it will be hot money, so you might have to hold more cash in your fund, and you might experience more redemptions,” he says. “I see DC as a long-term accumulation of capital. DC schemes don’t want to keep changing their allocations. They need daily trading so they can put money in each day, but it gradually builds like a snowball, which is what managers want.”