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The Markets November 5, 2014
The Case for Real Estate in DC Plans
Adding a 10% real estate exposure to defined contribution
retirement plan portfolios can enhance the risk-return outlook and dampen volatility
for participants, a new study suggests.
Reported by John Manganaro
According to the Defined Contribution Real Estate Council (DCREC), which advocates for the use of direct commercial real estate and real estate security investments within defined contribution (DC) plans, an allocation of 10% of participant assets to a mix of listed and unlisted real estate leads to better long-term outcomes. In short, the DCREC suggests real estate can be used to address sequence of return risks that can damage DC retirement savers’ lifetime income prospects when market downturns occur close to the retirement date.
As explained in the DCREC report, “A Path to Better Retirement Outcomes: Allocating Real Estate Assets to Retirement Portfolios,” the sequence of portfolio returns plays a critical role in the ability of DC plan participants to achieve sustainable retirement income. The sequence of returns is especially important when the participant is late in the accumulation phase or early in the transition to retirement, at which point a sharp drop in portfolio asset values cannot be made up with additional wage deferrals. To address this, retirement plan participants traditionally move away from riskier equity investments in favor of fixed income to address the potential of a late-career market downturn, the DCREC report notes.
Adding real estate holdings as part of this transition process from equity to safer assets can help smooth the impact of market setbacks on near-retirees, the report explains. This effect is achieved because real estate investments tend to be less correlated with market returns.
In addition, buying long-term real estate holdings can help younger DC investors avoid adverse responses to temporary market setbacks—for example, switching out of risky assets and moving out of the market altogether when volatility increases (see “DC Participants Get Jumpy on Equity Holdings”).
The DCREC says its recommendations are based on a study covering historical market data from January 1976 through the start of 2014. Study authors first examined a variety of DC-style asset-allocation programs that came into popularity during the study period, including target-date and target-risk portfolios. The simulated portfolios ranged from 100% stocks to a 60/40 stock/bond blend. The researchers then examined the impact a 10% allocation to real estate (split evenly between listed and unlisted real estate) would have had on each portfolio.Based on these simulations, the authors concluded that the portfolios which included real estate achieved similar outcomes over the test period, and in some cases they even delivered better results than their no-real estate counterparts. Importantly, the 10% real estate portfolios achieved similar returns with much better tail risk characteristics, the DCREC says, and the return path for these portfolios tended to be smoother leading up to the retirement date and potential annuitizaiton of assets.
The study also notes that listed real estate holdings, most often represented in DC plans by real estate investment trusts (REITs), can provide an easily implemented exposure to the asset class due to their liquidity and prepackaged diversity. REITs are also valued similarly to stocks and bonds, leading to better adoption among plan sponsors when compared to unlisted real estate.
Interestingly, the DCREC study suggests unlisted real estate has a number of characteristics that should make it attractive as an asset class to plan sponsors. For example, unlisted real estate usually has return characteristics similar to higher-yield bonds but with significantly lower reported risk than many stocks. At the same time, the study authors point out that unlisted real estate tends to pay regular income with low volatility and correlation to listed markets. In addition, some types of unlisted real estate have demonstrated inflation-hedging characteristics, the DCREC says, potentially making the asset class a reasonable defensive asset from the perspective of a liability-driven investor.
Despite these factors, adoption of unlisted real estate within DC retirement plans has been relatively weak, the study finds. This situation could change, however, as the myriad retirement risks faced by plan participant are driving plan sponsors to search for new and innovative investing opportunities.
More research and information about the Defined Contribution Real Estate Council can found be at www.dcrec.org.