DC switch may cut off flow of pension income to property


Industry to research how property can meet the needs of DC pension funds, reports Alex Catalano

The traditional pension scheme in the UK was a defined benefits one. But this is a dying breed; defined contributions (DC)schemes are taking over. DC pensions now account for £700bn, or 35% of the UK’s private pensions, and are set to grow massively (see panel below). This migration to DC pensions has enormous implications for UK real estate, because property is difficult to slot into DC schemes. It plays a very minor role, accounting for around 1% of assets under management.

It is a concern for the property industry that was highlighted late last year at the IPD/ Investment Property Forum Brighton conference and which has led a group of industry bodies to commission research into property’s role in private pension schemes. “The problem we have is that the administrators of DC schemes are demanding daily liquidity,” says Neil Turner, head of property fund management at Schroders. This limits their real estate allocation to REITs or a handful of daily dealt ‘balanced’ real estate funds run by pension providers.

Adrian Benedict, investment director at Fidelity Worldwide Investments, says: “Outside REITs, your ability to deliver a genuine daily priced and daily liquid fund is nigh on impossible. That is the big issue at the heart of providing a direct property solution for the DC market.” Jan 13, p10 pieTo provide liquidity, daily dealt funds hold a buffer of tradeable property securities or cash. “But the underlying real estate behind them is very illiquid,” Turner points out. “We’ve all seen cases where open-ended, daily dealt property funds in the UK, and in Germany and the Netherlands, have had issues.”

Indeed, many of Germany’s much-vaunted open-ended, daily dealt property funds were unable to withstand a run of redemptions following the 2008 financial crisis and froze investors in for years. Most are now in the process of a staged liquidation, selling off an estimated €20bn of real estate. “The implicit assumption is that daily dealt property funds are less risky than a property fund with less liquidity, but I completely disagree with that,” says Turner.

Property is “a long-term proposition”

“Many of these major pension investment decisions are being made by people with 20-30 years ahead of them in a career before they enter into retirement. Real estate is a very interesting asset class as a long-term proposition. We know it is inherently illiquid, but if you want exposure to real estate for 20-30 years, you shouldn’t really be worried about daily liquidity.”

However, convincing regulators and pension providers of this may be difficult. Benedict says:”If you turned around to the Financial Services Authority and said: ‘We’ve got a lot of money in this fund but we can’t get it out’, you can imagine what the reaction would be. That needs to be addressed. “The real estate industry cannot simply assume that we can re-engineer existing solutions. Anything we propose for DC members needs to have true liquidity, even in extreme market conditions.”

Turner For webThe implicit assumption is that daily dealt property funds are less risky than ones with less liquidity, but I disagree” Neil Turner, Schroders

Concern about DC pension funds’ approach to real estate has led the IPF and the Association of Real Estate Funds (AREF) to team up with industry body The Actuarial Profession to commission major research into the issue, by The Pension Institute at Cass Business School and Henley Business School, University of Reading. The aim is to produce a clear data set on the shape of the DC market and evaluate the future role of real estate investment by private-sector pension schemes.

The results are expected this autumn. “We all know real estate is a sensible part of the asset mix for anyone’s retirement provision,” says AREF chief executive John Cartwright, “but if between the regulator and providers of DC pensions, the offer is limited, that doesn’t assist investors. Property has a lot more to offer.” ended property funds when they are first offered as collective investments.

“These are valid choices for people who want to take a long-term perspective,” Cartwright says. “I remember when out-of-town retail was considered a bit risqué. “It would be a shame if providers of DC pensions weren’t able to offer those products now – by the time people want their money out of pensions in 25 or 30 years’ time, those parts of the market may well be mainstream, but those people won’t be benefitting. There’s a lot of capital growth made by people being early adopters.”

The limited geographic spread of property funds suitable for DC pension schemes to invest in is another problem. Douglas Crawshaw, senior investment consultant at Towers Watson, says: “As investment consultants, we advocate the significant benefits of diversifying globally. The trouble is that there aren’t any pure DC-compliant international real estate funds. There are hybrids, where you have a UK direct fund combined with a passive global real estate securities fund.”

New launches target DC market Last year, both Legal & General and CBRE Global Investors launched property funds for DC pension providers. L&G’s Hybrid Property Fund invests 70% of its capital in L&G’s UK managed property fund and the balance in L&G’s Global REITs Index Tracker fund. “That’s one solution,” says Crawshaw. “But if we want to tap the potential of the switch from DB to DC pensions, we have to come up with a solution to global diversification that can offer alternatives that are wider.”

One possible solution to the DC conundrum could come via pension providers such as the National Employment Savings Trust (NEST), a public body set up last year to provide and manage workplace DC pensions for the self-employed and employers. They can choose to delegate their pension management to NEST. “As a trust-based scheme, NEST can manage the liquidity within a broader pool,” says Benedict. “So they can afford to take a view on cashflow and park the capital in less liquid asset classes to diversify and achieve enhanced performance. This type of capital is the only source within the DC space that can deal with the lack of liquidity of a bricks-and-mortar fund. Contract-based schemes will always require some kind of liquid hybrid solution.”

Property looks like a hard sell to DC schemes’ retail investors

In the coming years, millions more people will be automatically enrolled into DC pension schemes. Since October, most UK companies are now legally required to set up a pension for their employees.

Most of these will be DC, bringing five to nine million additional people into the system. DC schemes can be personal – taken out by the individual – or employer-sponsored workplace ones, where the employer facilitates the payment of contributions. But typically – and this is an important point – the legal contract is between the individual and the pension provider, usually an insurance company.

Thus with contract-based DC pensions, individual members have a certain level of control and decision-making – including the choice of which investments to make, when to make them and the ability to exit them.

Crawshaw: “If real estate doesn’t match DC schemes’ requirements, then the industry could have a problem”

However, most people in DC pension schemes do not actually exercise this choice, but select the default option, where the allocations and investments are handled by the pension provider. Because the contract is between the member and the provider, DC fund members are considered individual retail investors, even if they are in a group workplace scheme and have chosen the default option.

So when making property investments, the pension providers stick to the vehicles that are considered suitable for retail investors: REITs and unit-linked ‘balanced funds’ that offer daily pricing and liquidity. They have a fiduciary duty: if they invested DC members’ pension contributions into funds or investments that can’t be exited quickly if needed, such as direct property, they would come under fire, not just from the members, but also the Financial Services Authority.

In contrast, DB pension funds have historically been significant investors in UK real estate, mainly directly but also indirectly. But as DB schemes mature and wind down, they will be selling this real estate.

Douglas Crawshaw, senior investment consultant at Towers Watson, asks: “If DC pension schemes aren’t able to buy the assets sold by the DB schemes because of liquidity requirements, who will? You can’t just rely on international investors like sovereign wealth funds.

“If one set of pensions is going to be replaced by the other over time and real estate doesn’t match the requirements of DC schemes, then the industry could have a problem. It will have a knock-on effect on the value of real estate overall and potentially even on the whole economy.”