Defined benefit plans have long been a major go-to source of pension capital for private real estate managers due to their size and sophistication. But defined contribution plans have been quietly gaining in stature and are increasingly keen to capitalize on the benefits of investing exposures to alternative assets, including real estate.
Though DC schemes have long existed across geographic jurisdictions, they have now reached an inflection point in their growth trajectory. For the first time, DC assets have edged DB assets in value, according to the 2019 Global Pension Assets Study, conducted by global advisory Willis Towers Watson’s research center, the Thinking Ahead Institute. The study estimated DC assets in 2018 represented more than 50 percent of the more than $36 trillion total pension assets of the seven largest pension markets – Australia, Canada, Japan, the Netherlands, Switzerland, the UK and the US. Furthermore, DC asset growth has been outpacing that of DB assets, a rate of 8.9 percent over the last 10 years compared to DB’s 4.6 percent.
One byproduct of this growth is an escalating appetite from DC pensions to invest more like their DB cousins, adding alternative asset classes. The UK’s National Employment Savings Trust – the country’s workplace DC pension scheme created in 2008 as part of the country’s Pensions Act – has lately been awarding more investment mandates to alternative asset managers.
But NEST is among a notably small section of pensions around the world betting big on bricks and mortar. In fact, the Defined Contribution Institutional Investment Association estimated just $25 billion of DC capital was allocated to private real estate in the US as of 2017. This compares with the $2.9 trillion in the 2017 US institutional real estate market, as estimated by market index and research firm MSCI. And if all of the $25 billion in US DC real estate capital were committed to one manager, this hypothetical manager would still only rank third on the 2019 PERE 100 list— behind Blackstone and Brookfield, which raised an estimated $55 billion and $30 billion, respectively, over the last five years.
Nevertheless, investors like NEST are demonstrating how increasing private real estate exposures is high on the agenda. In September, it awarded a global private real estate credit mandate to Paris-based manager Amundi alongside an infrastructure debt mandate to New York-based manager BlackRock. The investor announced it would initially commit up to £500 million ($622 million; €563 million) across the two managers over the next 12 months. The initial loans made by Amundi are fully seeded by NEST, and deployment started this month. NEST will also consider co-investment opportunities down the line, following real estate outlays made since 2013 to the manager of London-based insurer Legal & General. Indeed, it has a 6.7 percent exposure to UK and global property via Legal & General Investment Management’s LGIM Hybrid Property Fund (70/30).
“If we can make the commercial challenges work in terms of fees, Nest will begin to look like very sophisticated sovereign wealth funds or DB schemes, rather than the more pedestrian DC funds that you’ve seen in the UK and the US up until this point,” Stephen O’Neill , head of private markets and investment proposition at NEST tells PERE.
Indeed, the majority of funds that NEST currently backs are large, institutional commingled funds, according to O’Neill. Swiss bank UBS is another manager with which it has backed vehicles.
Begin with a promise
According to Greg MacKinnon, head of research at the Pension Real Estate Association, differences between DC and DB plans begin with the initial promise made to the underlying beneficiaries. Unlike DB plans, DC plans do not promise a fixed payout every month to participants. Rather, each worker contributes a fixed amount and that sum, coupled with market dynamics, will determine an individual’s retirement savings, Mackinnon says. This means companies that choose DC plans face less performance risk, but a need to provide daily liquidity for participants.
DC plans have been hesitant to engage alternative investment exposure, owing largely to their inexperience in the sectors. In the US especially, where the DC market is considered less sophisticated than the more mature Australian market, many schemes are reluctant to adopt alternatives because of the risks inherent with such uncharted waters, particularly litigation risk. Indeed, some DC schemes hesitate to add real estate through fear of being sued by participants, according to David Skinner, global head of manager PGIM Real Estate’s defined contribution practice. He concedes, however, that while there have been lawsuits around DC schemes, conflicts have often focused on fees, not the addition of new asset classes for investments.
MacKinnon believes DC plan asset diversification and a resultant allocation into direct real estate will increase as they mature, though that may take some time without any legislative intervention. In 1992, Australia introduced a reform package which included a mandatory employer contribution to the employee’s superannuation plan, a private pension plan. Similarly, the UK passed the Pensions Act in 2008, which facilitated automatic enrolment into a workplace pension scheme. These legislative changes have led to accelerated growth for both DC markets and, subsequently, real estate in becoming a more established asset class, according to MacKinnon.
Litigation fears and a lack of regulatory tailwinds are among factors preventing DC capital from having a bigger presence in private real estate. But arguably the biggest hurdle that most DC schemes face in accessing private real estate market assets is fees, says O’Neill. UK DC funds, for instance, are subject to regulation capping annual management fees at 75 basis points of funds under management. Within their default arrangements the regulation specifies how one calculates total costs passed on to participants. This means performance fees, administrative fees and custodial fees are factored into the total expense ratio and that makes alternative asset classes, including real estate, seem unaffordable, he explains. Consequently, he advises managers to find ways to bring costs down and structure a simple, transparent, all-in fee to make the accounting challenge simpler for DC schemes.
NEST currently has £8.5 billion in assets under management and is growing at about £5 billion each year, taking in £400 million-£450 million a month on a net basis, according to O’Neill. Its sheer size has given the scheme negotiating power to ensure fees stay within budget, but it took a number of years before it reached an inflection point that triggered steep growth. “If you want to access this vast pool of very patient DC capital, then you need to rethink your pricing structure,” O’Neill says to managers. “Maybe think about bringing your margins in on the basis that it’s going to become reliable, patient revenue.”
DC schemes are fee-sensitive – more so than other investor types – but the benefits of private real estate should ultimately outweigh fee costs, reckons MacKinnon. After conducting research comparing private real estate allocation benefits with and without fees, MacKinnon found the cost of fees on DC plans do not substantially detract from the benefits.
“If you want to access this vast pool of very patient DC capital, then you need to rethink your pricing structure,” Stephen O’Neill, NEST
Fees can be mitigated by keeping allocations to real estate low, according to Susan Kolasa, JPMorgan portfolio manager. The investment bank offers an off-the-shelf target date fund that includes real estate as a part of a diversified portfolio. Kolasa, who has oversight over the firm’s DC real estate effort, says real estate can improve downside protection and reduce volatility, even with an exposure as low as 5 percent.
At this point, many DC schemes are not necessarily interested in alternatives like real estate to chase yield. Rather, the benefits of volatility reduction and downside protection due to the asset class’s illiquidity remains a focus because the risk appetite of participants tends to be conservative. The long-term return objective for NEST’s target date funds, where 99 percent of its members’ money is invested, is to beat the country’s Consumer Price Index by 3 percent after charges.
O’Neil admits the CPI-plus-3 percent target looks modest. In comparison, the average return assumption for US public pensions is 7.27 percent, according to a brief published by the National Association of State Retirement Administrators in February 2019. The investment scheme could allocate 100 percent to mid-market public equities and expects a return in the region of CPI-plus-4 percent, or CPI-plus-5 percent, if risk mitigation is not a priority, he says. Unlike DB plans that have explicit long-term annuity-like liabilities to hit, NEST’s goal is to deliver the best asset mix at the minimum possible level of risk, he explains.
Valuation over liquidity
One common misconception relating to DC plans, possibly dissuading private real estate managers from engaging, is the prospect of needing to provide daily liquidity to mirror the buying and selling abilities by DC participants, according to MacKinnon. But he argues when private real estate is included within a greater multi-asset strategy, daily liquidity is not necessary because beneficiaries tend, in practice, not to make day-to-day decisions about allocations. Rather, managers adjust liquidity in their multi-asset class funds for their participants by adjusting exposures to a range of asset classes, some carrying more liquidity potential than others.
“The adoption of real estate in DC plans has certainly picked up in a really material way. We expect it to continue on that trajectory. But it’s an evolution not a revolution” Susan Kolasa, JPMorgan
JPMorgan, Nuveen and PGIM each provide off-the-shelf DC products accessible to the public where private real estate is a sleeve within a greater multi-asset strategy. For example, the JPMorgan Life Diversified Growth Fund has a 5 percent allocation to property; Nuveen’s TIAA-CREF Lifecycle 2015 Fund offers a 4.7 percent allocation to real estate, while PGIM’s Prudential Day One 2025 fund currently allocates around 6.1 percent.
While the issue of liquidity can be handled by manipulating asset allocations within a greater multi-asset strategy, daily valuation is still a requirement for DC investors. DC plans need the capability to report the value of an individual’s retirement portfolio at any given moment, MacKinnon says. Daily values are also necessary to keep track of the constant flow of capital committed to plans and because plans need to know the price at which their money is being invested, he adds.
Though the private real estate industry has yet to reach a consensus about the best way to provide daily valuations on a portfolio, MacKinnon has observed a number of daily value real estate products have already come to market. For instance, most of the US open-ended ODCE funds, the largest real estate funds in the world, are looking at offering some type of daily value if they have not already, he says.
Notably, manager BentallGreenOak – which took its daily value real estate fund live in 2017 – says while the product was created for DC investors to use as a diversifying sleeve in a multi-asset class strategy, the daily valuation also appealed to DB investors. Coming up on its three-year track record, the fund now holds $150 million of commitments from 11 investors, a mix of DC and DB plans seeking enhanced valuation. One US public pension committed to the fund because quarterly valuations, which have been the standard for open-ended core funds, were not seen as frequent enough to support its goal of issuing pension checks every month. It did not want to write monthly checks based on a stale values, BentallGreenOak managing director Josh Samilow says. Investors can get 10 percent of their investment back intra-quarter because the fund keeps around 12 percent of the daily value fund in liquid investments like REITs or cash. This limited liquidity is not a problem when part of a greater multi-asset strategy because DC plans can dip into their public securities allocation for quick liquidity, he explains.
Evolution, not a revolution
Most of the growth in the DC market has happened over the last three years as consultants of plan sponsors have added teams dedicated to understanding real estate and more managers have reached out to DC plan sponsors, according to Skinner. He predicts that over the next 5-10 years, DC capital will be a more sizable and meaningful source of capital for the real estate industry. In 15 years, DC plans will be the main source of capital for private real estate managers, according to a report by accounting firm KPMG, ahead of DB and other institutional money.
“The adoption of real estate in DC plans has certainly picked up in a really material way,” Kolasa says. “We expect it to continue on that trajectory. But it’s an evolution not a revolution.”
It took a few decades from the 70s and 80s for DB plans in the US to adopt real estate in a meaningful way, and DC plans will likely move at a similar rate, according to MacKinnon. In Australia, DC is more established and have been compulsory for workers since the 1990s. Subsequently, nowadays the average real estate allocation for DC plans in Australia is 9 percent, comparable to the 10 percent real estate allocation for US DB plans, he says. He believes DC plans in the US and UK will follow suit over time. “It’s a matter of making [plan sponsors] aware of the benefits in the same way DB had to be made aware of the benefits of the asset class back in the early days of that sector,” MacKinnon says.