For a decade now, our organization—the Defined Contribution Real Estate Council—has been promoting the inclusion of private (and public) commercial real estate as a way to improve the outcomes for Defined Contribution (DC) plan participants. Over that time, significant progress has been made in establishing best practices and, as an industry, creating investment products that make the asset class benefits more accessible in DC plans.
Approximately $79.4 billion of DC capital is currently invested in private real estate across 18 daily valued real estate products, and both the number of funds and the assets they hold continue to grow. For real estate investment managers with a track record of five or more years of managing DC capital, AUM has grown by more than 40%. As we look ahead to the next decade, we believe the trend towards “democratizing” access to this asset class will continue. There are four primary reasons for this.
Growing ‘institutionalization’ of DC plans
First is the growing “institutionalization” of DC plans. Many large plan sponsors—$1 billion or more in assets—and their consultants have recognized the benefits of including private real estate in the asset mix for both DC and defined benefit (DB) plans, generally allocating anywhere from 5% to 15% of their assets to the asset class. As the benefits of including real estate are more broadly understood and consultants and advisors play a more significant role in mid-size plans, the asset class benefits may extend beyond the biggest end of the market.
There’s another new force that is likely to drive further institutionalization of the small plan market over the long-term. Elements of the 2019 SECURE Act broadened the opportunity to participate in pooled employer plans (PEPs) to more businesses. This will allow smaller plans to join larger, more sophisticated DC programs that will likely operate like mega plans. We can look at Superannuation plans in Australia or master trust providers in the U.K. to see what the future might look like. The involvement of consultants and managers with institutional pedigrees in PEPs will likely drive usage of private real estate in PEP target date and target risk portfolios over time.
Rapid adoption of TDFs
Second has been the rapid adoption of target date funds (TDFs). Early on, stand-alone products were the primary way to introduce new investment options such as private real estate to participants, but adoption was slowed by concerns around liquidity management. That changed when TDFs were approved as a QDIA (following the Pension Protection Act of 2006), which increased the importance of professionally managed multi-asset portfolios, reducing the liquidity volatility associated with direct participant access, and putting more focus on the investment allocation benefits. Larger employers (many with real estate investment experience in their DB plans) now had a more feasible way to incorporate private real estate into portfolios on the DC side. Initially, this was achieved mostly through custom TDFs, limiting usage to larger plans. Then came the next breakthrough: the increased use of TDF collective investment trusts (CITs), which are swiftly replacing mutual funds in DC plans.
A recent Morningstar study (as reported on 401(k) Specialist) confirmed this. It found that $121 billion, or 79%, of the $153 billion of net target date fund inflows went to CITs in 2022. CITs now account for 47% of all TDF strategy assets, up from 45% the year before and just 37% in 2017. Much of this growth has been driven by smaller and mid-sized plans, attracted by the lower costs and greater flexibility.
Best practices framework
Third is the establishment of best practices governing the inclusion of private real estate in a DC real estate solution (as part of a professionally managed portfolio), covering fund structure, liquidity and daily valuation. A generally agreed upon framework for addressing these issues has been established by the industry fostering trust, streamlining the process of selecting and evaluating managers, and helping to eliminate confusion in the marketplace.
Private real estate holdings are not fully liquid, so greater liquidity is achieved with solutions that blend private and public real estate. This includes incorporating a liquidity sleeve to address daily liquidity requirements, typically through publicly traded REITs and cash. Daily valuation processes are representative of industry best practices and employ established principles that have been in use for over 20 years. DCREC’s work on best practices has been significant and will continue as an important initiative.
CIT growth
Finally, we expect to see a broader range of DC private real estate strategies being made available to plan sponsors over the coming years, primarily implemented through CITs. To date, most solutions included in DC plans have been low risk “Core” real estate equities strategies–the beta of the asset class. Over the coming years, these solutions could expand to include real estate debt and higher risk real estate equity, among others.
A decade of research
A decade of research has shown that an allocation to private real estate offers the potential to improve retirement plan outcomes through enhanced diversification, greater stability and downside protection.
The principles supporting the use of private real estate in DC plans have been established and are now being put into practice in hundreds of DC plans, big and small.
An earlier DCREC study found that an allocation of as little as 10% to real estate can significantly improve the outcome for many retirement plan participants. Returns for the asset class have consistently demonstrated a low correlation to the broad equity market while also providing stable income underpinned by long term leases with high credit tenants. And there’s another potential benefit which is now getting closer attention: acting as a potential buffer against inflation over the longer term without increasing plan volatility.
The principles supporting the use of private real estate in DC plans have been established and are now being put into practice in hundreds of DC plans, big and small. There are several key factors contributing to this growth as discussed earlier including the ‘institutionalization’ of DC plans and the development of best practices to remove operational hurdles. Behind these developments is the desire by all stakeholders to improve diversification and retirement outcomes for participants.
As we move forward, additional dynamics including the emergence of PEPs and the shift to CIT target date funds will allow more DC plan participants to realize the benefits of commercial real estate investing. The DCREC will continue to support fiduciaries by fostering best practices, directing research, and providing educational programs.