401(k), 403(b) and 457 Plans Increasing Their Use of REITs
For decades, pension plans have been using real estate including REITs within their investment portfolios. This is because like academics, including Nobel Prize winning economists such as Harry Markowitz, as well as investment experts, pension plans consider real estate a fundamental asset class.
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“Basically, there are only four types of investment categories that you need to consider: Cash, Bonds, Common Stocks and Real Estate.”
– Burton G. Malkiel (Princeton), The Random Walk Guide to Investing
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“Real estate is not an alternative to stocks and bonds—it is a fundamental asset class that should be included within every diversified portfolio. Equity, fixed income, cash, and real estate…are the basic asset classes that must be held within a diversified portfolio.”
– Robert M. Doroghazi, The Physician’s Guide to Investing
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David Swensen, Yale University’s Chief Investment Officer (Unconventional Success, 2005) recommends a “basic formula” for individual investors with 20 percent invested specifically in REITs and the rest in equities, bonds and cash (TIPS).
Click Here For “Real Estate as a Core Asset Class” Bibliography
In fact, industry data from sources such as the Pension Real Estate Association (PREA) and Pensions and Investments magazine show that, on average, pension plans have been increasing their real estate investments in real estate equity since 2000 and that a significant percentage (40 percent) plan to increase their allocations going forward.
The defined contribution world, which includes 401(k), 403(b) and 457 plans, is rapidly catching up with the defined benefit world in terms of the use of real estate, and particularly REITs. There are number of reasons why defined contribution plans are currently behind. The main one is that at the time these plans were taking off in the 1980s, there was not a simple way to provide participants access to a real estate investment option. Back then, the REIT market did not yet have sufficient size and liquidity to permit defined contribution plans to implement a REIT option. This has all changed in the past 15 years, in what isreferred to as the “modern REIT era.” Now the REIT market offers a liquidity pool deep enough for the largest of pension and defined contribution plans.
In terms of investments, the most significant trend in the defined contribution industry is associated with asset allocation products such as age-based (e.g., target date, life cycle), risk-based (lifestyle) funds and managed accounts. This is borne out by industry data, including a 2007 survey by Plan Sponsor magazine, which reveals a clear preference for target-date funds. According to the survey, the proportion of plans offering age-based funds jumped from 46.5 percent in 2006 to 87.5 percent in 2007.
Due to the enactment of the Pension Protection Act of 2006 as well as other factors, industry experts believe that it is not inconceivable that within the next decade, a vast majority of the assets within the defined contribution market will be invested in these types of products.
The question is: How do REITs fit into this new paradigm? The good news is they fit in very well. In fact, it’s been the buzz in the DC industry. An example of the buzz is a study called “Popping the Hood: An Analysis of Target-Date Fund Families.” This study analyzes target-date funds and is considered by some to be the definitive source of information on these funds. The study indicates that it covers over 90 percent of the assets in the target-date fund market. One of its key findings was that many target-date fund products are too simplistic in their asset allocation – some use only use stocks, bonds and cash. The study recognizes the importance of using additional asset classes and specifically cites REITs and the diversification benefits they provide.
Different organizations in the defined contribution industry have focused on the different benefits of REITs. For example, some have focused on diversification and others on inflation-protection. However, the fact is that more and more providers and plan sponsors are including REITs in their asset allocation products in the defined contribution plan marketplace. Whereas less than a year ago only a few asset allocation products included real estate/REIT exposure, now it appears that a majority do. An ad hoc survey referenced in the Sept. 1, 2007 issue of Plan Sponsor magazine found that, "...of 24 firms offering target-date and target-risk funds, 14, or 58 percent, currently included a dedicated allocation to real estate.” This trend is expected to continue.
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Why are defined contribution plans using REITs?