Winter 2010

Fiduciary Responsibility and Underrepresented Asset Classes in Defined Contribution Plans

By Kurt Walten and Matt Bechard, National Association of Real Estate Investment Trusts (NAREIT)

For decades, defined benefit pension plans have been using real estate, including REITs, within their investment portfolios. This is because pension plans, like numerous academics including widely recognized economists and investment experts consider real estate a fundamental asset class that should be included in all investment portfolios along with stocks, bonds and cash.

The defined contribution world, including 401(k), 403(b) and 457 plans, is rapidly catching up with the defined benefit world in terms of the use of real estate, particularly through the use of publicly traded REITs (real estate investment trusts). And for good reason. Studies conducted by the Center for Retirement Research at Boston College, John Hancock, CEM Benchmarking and others have found that defined contribution plans have underperformed defined benefit plans. The CEM Benchmarking study found that a key driver of the underperformance was the fact that certain asset classes used in defined benefit plans, such as real estate, are not always made available in defined contribution plans. In fact, over the eight-year period used for the CEM study, defined contribution plans underperformed defined benefit plans by 1.8% per year. After 25 years, that difference would reduce a defined contribution plan participant’s future account value by 34%.

This raises the question, “are plan sponsors at risk of not meeting their fiduciary responsibility because they are not offering diversifying asset classes (like real estate) in their defined contribution plans already used in their defined benefit plans?” It is a concern that many plan sponsors are working hard to address with their investment offerings.

In terms of investments, the most significant trend in the defined contribution industry is associated with asset allocation products such as age-based (“target date,” “life cycle”), risk-based (“lifestyle”) funds and managed accounts. This is borne out by industry data, including the recently released paper by consulting firm Casey, Quirk & Associates, which states, "...Target-date funds are becoming the core, if not the sole, product of interest within defined contribution plans..." The use of these products allows defined contribution plan participants to take advantage of professional portfolio management and asset allocation expertise found in defined benefit plans.

Due to the enactment of the Pension Protection Act of 2006 as well as other factors, industry experts believe that it is not inconceivable that within the next decade, a vast majority of the assets within the defined contribution market will be invested in these types of products. According to the Casey, Quirk paper, “target-date and target-risk retirement vehicles will attract 80% of new and reallocated flows into defined contribution schemes for the next decade. Target-date funds alone will swell to $2.6 trillion of assets in 2018 from $311 billion in 2008.”

Because of this trend, defined contribution plans will continue to gain greater exposure to diversifying asset classes because investing will be done less by plan participants and more by investment professionals – individuals who understand the importance and value of diversification. These include those individuals who develop target-date funds or advise plan sponsors on these products. In fact, according to PIMCO’s 2009 Defined Contribution Trends Survey, which featured 32 investment consultants including seven of the 10 largest in the U.S., consulting firms are promoting diversification and inflation hedging in defined contribution plans by adding asset classes such as TIPS, REITs and commodities.

The question is: How do REITs fit into this new paradigm? The good news is they fit in very well in part because the primary impediment to their inclusion in the past has been removed. At the time many defined contribution plans were taking off in the 1980s, there was not a simple way to provide participants access to a real estate investment option. Back then, the REIT market did not yet have sufficient size and liquidity to permit defined contribution plans to implement a REIT option. This has all changed in the past 15 years, in what is referred to as the “modern REIT era.” Now, the REIT market offers a liquidity pool deep enough for the largest of pension and defined contribution plans.

The increase in the use of real estate particularly through REITs within asset allocation products has been the buzz in the defined contribution industry. Different organizations in the defined contribution industry have focused on the different benefits of REITs. For example, some have focused on diversification and others on inflation-protection. There has been an increase in both the number of fund families which are using real estate in their target date and risk products as well as an increase in the percentage allocation to real estate within these funds. A 2009 Callan Associates industry survey found that 73% of target-date fund managers surveyed had a dedicated real estate allocation in their offerings. A minority of managers had a dedicated real estate allocation as recently as 2005. In addition, based on a survey of more than 400 defined contribution plan sponsors conducted jointly with the Profit Sharing/401(k) Council of America for the purposes of the Casey, Quirk paper, REITs were identified as the most "highly sought" additional target-date fund asset class by far by respondents of the survey.

Regardless of the reason, defined contribution plans that do not currently allow participants access to real estate as part if their asset allocation offerings are likely to consider providing this access, particularly through the use of REITs. According to the Casey, Quirk research, “plan sponsors increasingly believe that the current array of asset classes that existing target-date options provide is likely insufficient to mitigate the broader array of risks they feel their participants now face, including prolonged longevity, more volatile markets, and potential inflation.”