PENSION FUNDS – DB to DC
Only big property players can balance paying high transaction costs while keeping charges low
DC pensions are all about low fees. Most providers charge 50 basis points a year all-in to run schemes and with auto-enrollment in force, DC pension providers are under pressure to keep costs low and transparent.
Last month, Legal & General Property announced that it was capping charges for its auto-enrollment workplace pensions at a single 50bps charge, covering both the annual management charge for administering the pension and the default fund charge. NEST’s charge is an even lower all-in 30bps, although it is also charging another 180bps until it covers its set-up costs.
Low fees can be a problem for real estate, which has higher transaction costs than equities or bonds and may deliver better performance if actively managed. However, size helps.“If a manager has scale, it can charge low fees and still have a business that stacks up,” notes Paul Jayasingha, global head of real estate at consultant Towers Watson. “A £1.5bn-£2bn core property fund should be able to charge a fee well below average that is enough to pay investment professionals.”
Moreover, bigger managers can blend fees across a range of investments. In L&G’s case, the mandate it won from NEST involves 70% direct property and 30% global REITs; the latter is cheaper to run, so the blended fee allowed L&G to charge something that came in under NEST’s 30bps wire, but still made sense for the mandate.
Cheapest may not be best
Although DC schemes want to keep costs low, the National Association of Pension Funds says they shouldn’t lose sight of value. When Atkins reassessed and redesigned its default DC fund, it raised its cost from 33bps to 76bps “to accommodate what it believed to be investment strategies that will bring members a better retirement outcome”.
Nick Cooper, a principal at advisory group Townsend, says: “Costs are clearly important when you start to bring in alternatives, be they hedge funds, private equity or other things. I think property holds its own pretty well when you take all costs into account and it continues to do what people want, which is broadly to deliver a steady return.”
But DC pension fund schemes struggle with anything that looks like carry or performance fees. Pete Gladwell, business development manager at Legal & General Property, says: “Real estate is not a passive asset class; you can only beat the benchmark by managing the portfolio – and that costs money. If you are trying to charge two and 20 you will never win any DC capital. The two aren’t compatible at the moment.”
Yet other leading-edge investors in Europe do pay carry and performance fees, and they co-invest, because it expresses alignment between investor and manager. “Some of these arrangements can be beneficial to an investor, but DC just can’t make them work at the moment,” Gladwell notes.
Fund governance is another issue for DC schemes. There is increasing pressure from regulators for providers to ensure they are offering robustly-governed funds.
“REITs have delivered a discipline of producing income on a regular basis, managing that income and all the things that go with that,” says Cooper. “Unless the private funds industry, whatever way it is structured, responds to that, it will lose out. A DC requirement will say: “Why not just buy Land Securities or British Land?’”
Property has pride of place in DC schemes down under
DC pensions are big in both Australia and the US. Australia, where workplace pensions have been compulsory since 1992, has the world’s fourth largest asset pool, valued at nearly US$1.4trn – and 81% of that is in defined contributions schemes.
Unlike most UK DC schemes, Australian funds are significant property investors, with around 10% (US$103bn) in the asset class. The split is around 60% direct property and 40% in REITs and unlisted funds.
This allocation works because Australian funds are structured as trusts, with the trustees being responsible for investment strategy and prudential operation. Hence, they operate more like UK DB schemes.
Real estate is part of the default pension option that most people will chose. For example,
AustralianSuper’s A$48bn balanced default fund can allocate between 0-30% to direct property; its current allocation is 8%.
Moreover, Australia’s superfunds are young. “They are growing and they are compulsory schemes, so they have money going into them all the time, which helps them achieve some of their liquidity needs,”notes Townsend principal Nick Cooper.
Australian pension funds’ real estate investments are mainly domestic, but Jones Lang LaSalle says the giant funds are set to start shopping overseas and will spend A$80bn over the next six years. Australian- Super, for example, plans to raise offshore property’s share of its real estate portfolio from 7% to 20% over the next three years.
In the US, DC pension funds, which include individual retirement accounts and ‘401(k)’ workplace plans, account for 58% of pension assets under management. But their real estate investments have yet to reach Australian proportions; only 34% of DC participants have the option to invest in real estate, and only through quoted REITs.
Nonetheless, real estate and other alternative assets are starting to find their way into US DC pensions, as plan sponsors start taking a DB-style approach to asset allocation and fund selection.