In terms of your attitude to risk, do you want your pension plan to take on substantial risk in order to achieve large potential returns? When an independent financial advisor asks that question, it is tempting to say: “Hell, yeah.” That is, until you get to this question: How would you feel if you entered into an investment and it fell by, say, 15 percent in value?
This is the stuff of self-assessment questionnaires in personal retirement planning nowadays. Indeed, with the on-going shift in the US from defined benefit (DB) to defined contribution (DC) pension plans, millions of Americans suddenly are confronting these choices when deciding on the most suitable basket of investments.
With DC plans, one elects a portion of salary one is willing to ‘sacrifice’ (that’s the defined part) to be put into a personal, ring-fenced investment pot, and that (hopefully) the employer will match to some degree. The big difference with these DC pensions is that the pension money is no longer pooled together with millions of other savers to form one massive pool of capital ready to be invested. Instead, it is a single little pool, and any losses will be the individual’s to bare, not that of the employer.
401(k) in the US
Why does any of this matter to private equity real estate? Well, the increasingly popular DC plans, or 401(k)s, are leading real estate investment management firms, including those that run opportunity funds, to question how they could possibly capture this army of individual investors. Fund managers know they can no longer rely solely on DB funds as limited partners forever. That is because companies that operate DB pension plans want to wind them down, as many have seen their liabilities mushroom as people live longer. They also would rather see the individual employee take the risk of losses.
In September, several participants at the PERE Global Investor Forum in Amsterdam took note of the rise of the DC pension plan. Nori Gerardo Lietz, founder of Areté Capital, predicted a profound effect on the industry. “DB pensions are going to have to say over the next five years that they really cannot make any more private equity or private equity real estate investments,” she said. At the same time, the shift to DC schemes would end in a “massive consolidation of power” within the consultant community because they are going to be the beneficiaries of outsourced management, she explained.
Kurt Roeloffs, global chief investment officer at RREEF, said no one had yet conquered how to take a higher-risk strategy such as private equity real estate and apply it to DC schemes. “That is going to be a very big prize as those funds get scaled up in size and they do more real estate investment.”
For any manager that can capture DC investors, there is potentially a huge prize. McKinsey & Company, the global consultancy firm, said in a recent research paper that the size of the DC market was likely to double by 2015 to between $7.5 trillion and $8.5 trillion in assets under management. More strikingly still, it said DC funds would become three times larger than the market for DB plans. “Plan providers, asset managers and financial advisors/wealth managers, among others, will enjoy access to a revenue pool projected at $20 billion to $25 billion for the mega 401(k) plan segment alone,” it said.
Obstacles to overcome
Few firms in the industry, however, seem to have made inroads into this potentially huge segment of the investor universe. Peter Lewis, a former senior investment officer at insurance company Liberty Mutual Group and a one -time board member of the Pension Real Estate Association, said part of the reason was that there are some obvious obstacles.
Lewis, who now works at consultant Towers Watson, said one obstacle was the inherent need for liquidity in DC schemes, which doesn’t lend itself to managers of opportunity funds in their traditional closed-ended, 10-year format. In most schemes, the plan beneficiaries have the right to change their allocations. The issue is that closed-ended funds are more natural bedfellows with institutions happy to park their capital for a number of years.
There also are concerns about responsibility for investments changing from professionals to the general public, noted Lewis. “You find that defined benefit plans generally are outperforming,” he proffered. Indeed, the Center for Retirement Research at Boston College found five years ago that DB plans outperformed DC plans by 1 percent per year between 1995 and 2006.
Watson Wyatt (before it become Towers Watson) studied corporate DB plans versus 401(k)s in both bull and bear markets. “During the bull markets of the late 1990s, 401(k) plans outperformed DB plans,” Lewis noted. “Our 2004 analysis of data through 2002 found a reversal of fortune in both the stock market and rates of return, suggesting that DB plans outperform DC plans during bear markets. Our 2008 analysis finds that DB plans outperformed 401(k) plans even in the bull markets of 2003 through 2006.”
Private equity firms prefer DB plans because they can write big tickets to funds and accept they will be committed for years. In testimony before the Senate Committee on Health, Education, Labor and Pensions on 12 July, David Marchick, managing director at The Carlyle Group, fleshed out the benefits: “By pooling savings and risks across beneficiaries, pension plans create economies of scale, which results in lower average costs for investors. These economies of scale also enable defined benefit funds to invest in large investment opportunities.” He went on to say: “DB plans’ economies of scale and wide range of investment opportunities translate directly to higher returns than other forms of savings, including DC plans and individual retirement accounts.”
Nevertheless, as momentum gathers for DC plans, firms had better start preparing for this ‘not-so-clever’ money. In Europe, the situation is much the same as the US, although there may be some hints at progress.
Nick Preston, a senior director at CBRE Investors in London, manages a vehicle called the Defined Contribution property fund, which launched in May this year. Structured as a property authorised investment fund (PAIF), it has a dedicated feeder fund for DC investors. It has been specifically set up to capitalize on the increasing shift in the pension industry, and it is the first time a purely property specialist investment manager has launched a fund for the DC arena, he claimed. The idea is to attract a cornerstone investor and then go out to amass £1 billion of property assets.
Just as in the US, final salary schemes at UK corporate plans have been waning. They have suffered huge problems mainly because people are living longer than in the past. They also have been hit by poor investment returns, leaving the company to fund any liabilities that the pension produces. Some big companies ended up with pension funds far bigger than themselves.
A significant part of CBRE Investors’ overall business is in managing capital on behalf of pension fund separate account clients that have large amounts of money to invest in real estate. However, recognising that sooner or later mature pension clients will likely shut their DB schemes, the firm began to look seriously at the DC market.
“We decided we needed to be able to play in the DC market in order to be successful,” said Preston. “This isn’t something for just the next three or four years, it is for 20 to 40 years. It is still a way off, but it is something that we as a business need to address. It is a big prize because the DC market is growing very rapidly and is likely to continue to grow.”
However, as Preston pointed out, one of the characteristics of a DC plan is that everything has to be priced on a daily basis, as that is the way the industry has developed. “Right now, to be able to accept DC money, we have to be able to price and trade daily,” he said. “All DC money is fed through investment platforms such as those managed by Scottish Widows and Standard Life. Part of the reason they have to trade daily is for fund administration purposes.”
The investment manager needs to invest the pension money as soon as it comes through from the beneficiary when the employee gets paid. As employees are paid on different days of the month, there is a logistical challenge for pension fund managers to get the money invested immediately. That can be achieved more readily if units are priced every day. Equally, when a beneficiary wants to redeem, the investment manager needs to be able to sell immediately. Hence the need for a fund to be open-ended, which of course does not suit closed-ended fund managers.
A further reason why the DC investor is unsuited to opportunity fund managers is that, in the UK, DC schemes are heavily regulated by the Financial Services Authority in order to protect plan beneficiaries, which the regulator considers to be ‘retail’ investors (even though they might have been screened by a professional investment manager). In contrast, a direct pension portfolio that a firm like CBRE Investors might run on a separate account basis is unregulated.
In the UK, there are companies that manage property funds for the DC market, but they tend to be generalist firms. The issue is that the industry is calling for more specialists. This is partly driven by the consultant community, which believes that specialist managers rather than generalists will deliver superior returns in the long run, said Preston.
In answer to all these different factors, CBRE Investors decided to blend direct property investment with REIT holdings in order to offer the necessary liquidity. Still, it has not found a way to offer DC plan beneficiaries a chance to invest in an opportunity fund yet. “I think that will come,” said Preston. “At the moment, it is in its infancy. It is not a particularly good climate to propose a riskier product to the FSA.”
As a result, while managers are becoming increasingly aware of the $8 trillion prize and some are even taking steps to bridge the gap, actually laying hands on it is still a tricky enterprise.