As pensions move from DB to DC, property investment options should evolve too, to ensure a key role for the asset class in the future. Stephen Ryan examines some key issues
Pension schemes and life insurance companies that provide pensions constitute a significant source of capital for property markets. At present, defined benefit (DB) pension schemes globally hold more assets than defined contribution (DC). However, DC assets are growing more quickly - for example, it is worth noting that the largest pension scheme in the US is now a DC scheme (Federal Thrift). At some point during the current decade it is likely that DC assets worldwide will exceed DB assets, especially if more countries introduce some form of compulsory or ‘soft compulsory' DC arrangement, as the UK and Ireland are planning to do.
A right pair
Pensions and property make a good pair, as property exposure within a pension portfolio can deliver four very desirable outcomes: diversification, high income, attractive total return and an element of inflation hedging. And these outcomes are just as important to DC as to DB. However, the format of property investments that suit DB schemes is not necessarily right for DC, because the two forms of pension are very different in certain key aspects:
• Investment decisions are made centrally in DB plans but in DC decisions may be made at two levels. First, the trustee or life insurance company level, then at individual member level;
• DC schemes are younger and on average smaller than their DB counterparts;
• Manager incentive fees, helpful for aligning interests, are difficult to administer in DC;
• There is a greater need for liquidity in DC pensions to cater for such events as investment switches, annuity purchase and life styling arrangements.
Importance of DC default options
DC pension schemes typically include a default investment strategy for members who feel unwilling or unable to make an investment choice on their own. The most popular default strategy (outside Australia) is a life-styling strategy, which adjusts the asset allocation as the member nears retirement. Sometimes known as target date funds, such strategies tend to hold growth assets such as equity and possibly property in the early and middle parts of a member's career, switching gradually to a more defensive mix of cash and bonds in the later stages. The process of moving from growth assets to defensive assets is called the ‘glide path'. The ability to move smoothly from the growth phase to the defensive phase depends on liquidity and this is where property can pose problems.
This is a very important issue as the bulk of money invested in DC plans could end up in life-styling (‘target date') strategies. In a recently released study of DC in the US, the consultant McKinsey said: "Over the next five years, we expect target-driven solutions to capture $1.7trn (€1.2trn) of flows and account for 60% of all DC assets and revenues." If property investment cannot be successfully adapted to the needs of such strategies, DC schemes and its members fail to enjoy the benefits of property investment, and the property market loses an important source of capital.
Property returns in DC
Property returns can be accessed in various ways, the most practical ones for a DC pension scheme being:
• Pooled funds holding properties;
• Pooled funds holding REITs.
The liquidity constraints of pooled funds holding properties are problematic, both for life-styling switches but also where members are allowed to switch between funds. For example, a pooled fund might delay all exits by six months or more at times when the market is suffering from illiquidity. This is not just a problem for switches - it is also a real issue at retirement in those markets where annuity purchase is compulsory on retirement.
The second option (pooled funds holding REITs) on its own has a liquidity advantage, of course. Nevertheless, its short-run volatility and potentially higher correlation with equity markets make it less diversifying within the member's account than unlisted property. A better approach for DC plans might be to combine unlisted and listed into a DC-friendly property offering, and we are aware of several new investment initiatives in this area in Europe.
Australia's ‘super' (superannuation) market, which is dominated by DC, provides some useful pointers in this regard. Property is popular but the format varies by scheme size. The largest schemes (such as industry-wide DC schemes) tend to hold more unlisted property than listed, whereas medium funds mix the two in roughly equal measure and the small schemes prefer listed on its own. Where a DC fund offers risk-profile funds (for example, a moderate growth fund, a balanced growth fund and a high growth fund) the property weighting will be different in each one. Table 1 shows a sample of Australian DC risk profile funds and their respective weightings in listed and unlisted property.
No need to go alone
Another approach might be to link property with other asset classes, in combinations that best meet the differing objectives within the DC market. For example, in the pre-retirement phase the objective is long-term real growth. Unlisted and listed property combined with TIPS, commodities and possibly infrastructural equities are attractive here. In the post-retirement phase steady income is the objective, so a mix of income-producing property with fixed income might fare better.
No room for complacency
As noted, the largest pension scheme in the US is no longer CalPERS (a DB scheme) but Federal Thrift, which is DC. What is its property weighting? Zero. There is no guarantee that DC pensions will feel the need to include property in their default options or elsewhere. A new format of property investment that goes beyond traditional pooled funds would make inclusion of property much easier. Without new thinking in this area, property investment by DC plans will be restricted to REITs, or there may be no property investment at all.
Stephen Ryan is a senior investment consultant at Mercer