Investing 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.
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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.

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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.

Compliance November 5, 2014

Court Revisits Ruling in Light of Dudenhoeffer Decision

The 9th U.S. Circuit Court of Appeals has revisited its ruling in a retirement plan stock drop suit in light of the U.S. Supreme Court’s decision in Fifth Third Bancorp v. Dudenhoeffer.
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In Harris v. Amgen, the 9th Circuit previously reversed a district court’s dismissal of the case based on a presumption of prudence for fiduciaries of retirement plans that invest in company stock. In that ruling, the appellate court relied on a 2nd U.S. Circuit Court of Appeals opinion that since the plan terms did not require or encourage fiduciaries to invest primarily in employer stock, the presumption of prudence did not apply.

While it still reversed the district court dismissal and remanded the case back to the court, in its most recent decision, the 9th Circuit based its discussion on the U.S. Supreme Court’s finding in Dudenhoeffer that there is no presumption of prudence for employee stock ownership plan fiduciaries beyond the Employee Retirement Income Security Act (ERISA) exemption from the otherwise applicable duty to diversify. This overrode the previous decision that no presumption of prudence applies if the plan does not require employer stock investments.

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With no presumption of prudence, the appellate court addressed the arguments put forth by Amgen that its stock was not an imprudent investment for the retirement plan. The 9th Circuit said Amgen’s argument that the stock was not imprudent because the company was not experiencing financial difficulties and remains strong and viable is “beside the point.” It noted that the fact Amgen is strong, viable and profitable does not mean the company stock was not artificially inflated during the class period defined in the case.

Amgen next argued that the decline in the price of Amgen stock was not sufficient to show it was an imprudent investment. But, the court noted that the question was not whether the investment results were unfavorable, but whether the fiduciaries used appropriate methods to investigate the merits of continuing to invest in the stock.

The Amgen defendants argued that divestment from the company stock would have caused a drop in stock price, but the court found it plausible the fiduciaries could have removed the Amgen Common Stock Fund as an investment option in the plan without causing harm to participants. It said it was unclear how much the stock price would have declined, and removing the fund as an investment option would not have meant liquidation of the fund, just that participants would not have been able to invest more in the fund at an artificially inflated price.

Amgen also argued that it could not have removed the stock fund based on undisclosed alleged adverse information because that would violate securities laws. The appellate court said the central problem is that Amgen officials made material misrepresentations and omissions in violation of securities laws. “If defendants had revealed material information in a timely fashion to the general public (including plan participants), thereby allowing informed plan participants to decide whether to invest in the Amgen Common Stock Fund, they would have simultaneously satisfied their duties under both securities laws and ERISA,” the court wrote in its opinion.

On remand in light of the Dudenhoeffer decision, the Amgen defendants presented a new argument that the Supreme Court established new pleading requirements applicable to cases such as this one. The 9th Circuit noted that the Supreme Court’s citation of cases that had been previously decided indicated it was not articulating a new, higher pleading standard. To the extent that the Amgen defendants were arguing that the Supreme Court decision established new standards of liability to be considered, the 9th Circuit noted that it had already considered in its previous case that fiduciaries are not required to perform an act that would do more harm than good to retirement plan participants.

The 9th Circuit’s most recent decision in Harris v. Amgen is here.

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