The Role Real Estate Can Play in 401(k) Plans

THERE HAS BEEN a growing consensus in the retirement industry that including alternative or non-traditional investment options, such as real estate, in investment menus of defined contribution plans can be beneficial. Specifically, it can act to reduce concentration of equity and bond risk in target date and target risk-type investment funds.

The Defined Contribution Real Estate Council recently conducted a survey of plan sponsors, retirement consultants and target date fund managers that collec­tively represent more than $14 trillion in assets under management or advise­ment. It found that DC retirement plan decision-makers expect to see continued growth in the adoption of alternative investments. Real estate was viewed as the most easily understood and transpar­ent of all the non-traditional strategies that might be included in a diversified defined-contribution portfolio.

It’s now slowly moving to the market­place, as more plan sponsors and con­sultants are embracing custom portfolios and white-label, institutional investment products over off-the-shelf mutual funds. In the last five years, new investment options have entered the market with daily valua­tion and other DC-operational features. At the same time, more real estate options are becoming available to plan participants as a component of target date funds, as well as custom real-asset and diversified inflation-protection strategies.

With this as a backdrop, The Defined Contribution Real Estate Council was es­tablished in 2012 with a mission to educate and promote investment in direct real estate and real estate securities, including REITs, in DC retirement plans.

A separate research study commissioned by DCREC and published by professors Michael Drew and Adam Walk from the Griffith Business School at Griffith University in Brisbane, Aus­tralia, found that when DC portfolios made an allocation of as little as 10 percent to a mix of listed and unlisted real estate, their risk-adjusted returns could be enhanced.

Similarly, the likelihood of improving the probability of achieving desired retire­ment wealth was greater with real estate than without. These results draw on our existing understanding that real estate has different return cycles from traditional stocks and bonds and, as such, has the ability to add diversification, reduce vola­tility, generate income, and, in the case of private or non-listed real estate, provide returns that generally demonstrate low correlation to the broad equity and bond markets.

The Drew-Walk study focused on real estate as a complementary component of a larger multi-asset portfolio with a 40- year retirement horizon, and the resulting impact on performance. The researchers looked at a traditional balanced portfolio of 60 percent stocks and 40 percent bonds, as well as two others that employed target date or lifecycle funds. In simulations, each alternative design included a 10 percent allocation to a real estate blend of 5 percent listed and 5 percent non-listed real estate. The addition of the real estate component was subtracted equally from the stock and bond allocations of the funds. The professors found that by adding the blended real estate allocation to every portfolio across the suite of target date funds, there was a clear reduction in downside risk. Additionally, there was an improvement in overall wealth accumulation over time, without giving up much in the way of expected overall returns.

The researchers concluded that including an allocation to real estate in all scenarios (particularly in the target date designs) achieved similar expected outcomes to those of comparable portfolios without real estate, but achieved these results with better tail risk characteristics and a smoother, less volatile path to the end goal—accumulating retirement wealth to generate sufficient retirement income.

This “smoothness” highlights a fundamental role real estate can play in DC plan portfo­lios–which is that it addresses he tendency of individual plan participants directing their retirement contributions in and out of the market at exactly the wrong time.

Laurie M. Tillinghast is co-president Defined Contribution Real Estate Council. For more information, visit www.dcrec.org.

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