PENSION FUNDS – DB to DC
Defined contribution schemes’ liquidity requirement is property’s problem, reports Alex Catalano
Defined benefit pension schemes, which have been pillars of UK direct property investment for a long time, are gliding towards extinction. Meanwhile, real estate is struggling to fit in with the needs of their alternative: defined contribution pension schemes.
“There is still a fairly high level of apathy from a lot of managers and participants in the market about the shift to defined contributions,” says Andy Dickson, Standard Life’s investment director of UK institutional business. “Our view is that it is a very real force and a very real threat to the real estate market.”
However, DC pension schemes are very much the future; according to consultant Towers Watson, they account for 26% of the UK’s $2.7trn pension assets. They are also growing at a faster rate than DB schemes; 88% of pension schemes offered to new employees are DC rather than DB.
Yet real estate is not yet on the DC radar. Despite the many sound arguments for including property in investment portfolios – namely diversification, stability of income and lack of correlation with other asset classes – the UK’s DC schemes have barely 1% of property exposure, and most of that consists of listed companies’ shares.
“Lack of liquidity is a big, big problem,” says Adrian Benedict, investment director at Fidelity Worldwide Investment. Most DC schemes require their investments to provide daily pricing and daily liquidity. This rules out investing in direct real estate and all but a handful of open-ended property funds.
According to the Defined Contribution Investment Forum, which Dickson chairs, the focus on daily pricing and liquidity prevents DC schemes from investing in the newer, less liquid, alternative asset classes, such as real estate.
DC members at a property disadvantage
“This disadvantages DC members through denying them the benefits of diversification and the illiquidity premium,” says the DCIF.
According to Paul Jayasingha, Towers Watson’s global head of real estate: “In the UK, DC platforms have a disproportionate amount of influence in terms of the arrangements for daily pricing and daily dealing. Many of them have insisted on the need for daily dealing and that has really constrained the type of property strategies that you can invest in. It has led to a suboptimal outcome.”
Towers Watson estimates that over a 40-year period, DC members could get up to 5% bigger pensions if they had diversified portfolios including illiquid assets.
To provide liquidity, the daily-traded real estate funds that invest in direct property also incorporate cash, property derivatives or real estate shares
However, cash drags down their performance; according to the DCIF, this buffer can reduce it by up to 100 basis points. Real estate shares, meanwhile, are far more volatile than direct property and, in the short term, more closely related to equities.
Curiously, there is no regulatory reason for DC pension funds to have daily pricing or liquidity – it is simply the way the DC market has evolved in the UK. In contrast, Australian DC pensions are significant direct investors in property and infrastructure (see panel, p23).
“There is a lot of noise around daily pricing,” says Nick Cooper, a principal at advisory group Townsend. “Is it really what you require? Can you move it back to monthly pricing?”
But there is no ignoring the fact that real estate is an illiquid asset. It is not traded on a public exchange; it takes time to buy and sell, even in a hot market. For example, Legal & General Property’s hybrid managed fund, its DC real estate flagship, is only 75% direct property, the rest being held in cash, derivatives and indirect holdings.
Innovative thinking on fund structures
Jayasingha says Towers Watson has seen some innovative thinking by fund managers. “However, the main problem is having the innovative structure plus the scale. It is difficult to recommend investing in some early stage open-ended funds that don’t have diversity from day one, because the direct property side of those funds has not reached a critical mass.
“For DC schemes, where you want your fund to have liquidity and diversity, it’s difficult to back the promise of an open- ended fund becoming bigger over time.”
Benedict notes: “There have been some creative solutions, but no one is saying we can deliver daily liquidity from a predominantly bricks-and-mortar real estate fund. We’ve seen that in Germany and it failed. We’ve seen it in the UK and it failed in 2008 and 2009.”
The stumbling block is only indirectly regulatory: because contract-based DC pensions taken out by individuals are considered to be retail investments, they have set the tone for all DC pensions – even trust-based ones. Funds that go into the DC sector must be regulated, as must the businesses – mainly insurance companies – that offer them.
“As a platform, we have a responsibility for the funds we carry and the DC saver (or policy holder) is deemed to be our responsibility,” one provider told the DCIF.
“The issue is not whether illiquid assets offer a challenge to daily pricing. The issue is: will illiquid funds blow up in our faces? If a fund goes wrong, we run an execution risk and we will be blamed.”
There is an additional deterrent to insurers adding direct real estate funds to their businesses. Because they carry more liquidity risk, under the Solvency II regime they soak up more regulatory capital. Although a combination of factors has kept DC schemes from investing in real estate so far, there are now countervailing forces at work.
A new study by the Pensions Institute and Henley Business School has researched the asset allocations in DC schemes and the issues surrounding real estate’s role in them. It was commissioned by some big guns – Investment Property Forum, the European Public Real Estate Association, and the Association of Real Estate Funds, together with the Institute and Faculty of Actuaries. This research is providing new ammunition for the push to get real estate included in DC pension schemes.
Alternative assets look appealing
The current low-interest-rate, low-return environment has also increased the appeal of alternative asset classes and their illiquidity premium.
Auto-enrollment, which requires all employers to provide a default pension option for their workers, has concentrated employers’ attention on providing investment strategies and asset allocations that can achieve the best returns for their employees’ retirement.
“We have relatively well-progressed thoughts on what a suite of optimal DC real estate solutions could look like,” says Dickson. “They may or may not encompass some existing funds that we manage, and new strategies. What we are very keen on is the investment outcome.
“That search for sustainable yield and the potential for longer-term growth will ultimately drive an increasing appetite to invest in inherently illiquid asset classes, albeit in a more friendly wrapper or fund structure for the DC market. “We’re in a crossover period of educating and informing, until someone is brave enough to make that leap.”
Real estate may become long-term option by default
Although people who have a defined contributions pension could structure their own investments, very few choose to do so. It has been estimated that instead, 73% of DC members opt to invest their pension in a default fund.
“People don’t want to make investment decisions with their pension, they want to be given the default option,” says CBRE Global Investors director Catriona Hunter. “DC money is pretty sticky and once people invest in their funds, they don’t push it around too much.”
As the number of DC pension schemes in the UK grows, these default investment strategies will garner very large pools of assets under management; according to one projection, in 10 years’ time they will account for 83% of all DC assets.
“There is unequivocally an opportunity to have direct real estate exposure that doesn’t necessarily need the same daily level of liquidity that you have in the current market,” says Andy Dickson, investment director of UK institutional business at Standard Life.
Indeed, the latest research on default funds from the National Association of Pension Funds found that they are considering illiquid investments.
“There is definitely a place for illiquid assets in a large, default fund,” said one respondent. “Surely your default investment money is the longest-term money that there is, so the fact that you don’t have daily liquidity is neither here nor there.”
Pete Gladwell, business development manager at Legal & General Property, says: “That’s the holy grail – to be in that default [fund]. Then you are under the control of an over-arching investment framework and it becomes much more like defined benefit. It is a very, very stable position to be in.”
This is particularly so for trust-based DC schemes, such as state-sponsored pension provider the National Employment Saving Trust (NEST).
“You have a single group of trustees who are making decisions right across the portfolio: equities, fixed income, alternatives,” says Adrian Benedict, investment director at Fidelity. “They will manage their liquidity requirements from different buckets, so if they have a shortfall, they can deliver it from the equities or fixed-income exposure.
“They know that their real estate and other alternatives, like private equity, are less liquid, so they are long term. That’s where real estate does have a much easier opportunity to get onto a platform and the range of options.”
The DC industry’s trend towards simpler, more straightforward choices, with funds structured around target retirement dates or lifestyles, should also help real estate. Over the past decade, these ‘lifestyle funds’ have become popular as a default. These usually combine around four funds, with the blend changing and the risk reducing as the DC member progresses towards retirement.
They generally include a multi-asset diversified growth fund, which in some cases could invest in direct real estate – though it seems none yet do so.
Target-date funds linked to the member’s expected retirement date are also a growing trend. These are similar to lifestyle funds, also gliding towards a less risky asset mix as the retirement date nears. NEST uses this structure for its default funds, with three phases: foundation, growth and consolidation.
“If you have a 20-year target date fund, I think you can do something in real estate,” says Townsend principal Nick Cooper. “You get into a whole different set of conversations. We will probably work more with target-date suppliers. It plays to a longer-term game, which is better for us at this point.”
Drip-feeding property pricing creates a serious plumbing problem
A major obstacle in getting real estate funds into DC pension schemes is purely technical: getting property prices fed into the system.
“If we were designing an infrastructure for delivering DC pensions in the UK and starting with a blank sheet of paper, we would never have requirements for daily pricing,” says Andy Dickson, investment director of UK institutional business at Standard Life. “There is no regulation in place that requires it.”
Catriona Hunter, a director at CBRE Global Investors, adds: “DC is a very automated thing, where you’re planned into a machine and it gets filtered down to a fund in the end, but it all comes down to computer systems.
“Tweaking one of these systems or changing it would cost a fortune for the large life companies that predominate in this arena.”
Adrian Benedict, Fidelity’s investment director of European real estate, notes: “If you put something in there with monthly, quarterly, or semi-annual liquidity, it doesn’t fit the systems.”
The need for daily pricing and trading is largely, but not exclusively, driven by the fact that people’s pension contributions are paid in on different days of the month.
“If you don’t offer daily liquidity, the money is going to have to be warehoused somewhere,” says Benedict. “Who makes that decision? Where is that money? Who is actually responsible for it? And how much performance is lost by not having invested it right away? Those are important operational issues about managing DC capital.”
Pete Gladwell, business development manager at Legal & General Property, says: “A lot of plumbing has to go on behind the scenes to get that kind of product structured correctly. There is a fair bit of process and automation, and risk controls come with that too. You need to get the price from your real estate fund back up the tubes, as it were, to be combined with the other asset classes and out by mid-day. This immediately starts to limit the number of real estate funds you can invest in.”
However, the need for daily liquidity in DC pension funds is being challenged by the Defined Contributions Investment Forum and others.
In Towers Watson’s view: “The question comes down to a trade-off between long- term investment benefits (illiquidity premium and diversification) versus some additional administrative complexity, none of which we believe is insurmountable.”