Study: REITs have a place in target-date allocations

(updated with correction)

Real estate investment trusts have a place in defined contribution plan target-date allocations, even for funds designed for older workers and retirees, according to research released Monday by Wilshire Associates and the National Association of Real Estate Investment Trusts.

Executives at NAREIT, a Washington-based trade group, commissioned the study because they believed target-date funds were giving up performance by being underallocated to REITs.

Currently, REITs are not included in target-date funds of retired participants, while other target-date REIT allocations range from a maximum of 1.4% for funds designed for the youngest participants to 1% for participants preparing to retire in 2015, according to data on the average target-date allocations as of June 2011 provided by NAREIT.

But optimal allocations range from 18% for the youngest plan participants to 5% for those with an investment horizon of five years, according to the findings of Wilshire Associates, the Santa Monica, Calif.-based consulting firm.

“Wilshire believes there is a benefit from risk diversification and total return and income enhancement” of adding REITs, said Cleo Chang, managing director in the funds management division of Wilshire.

Wilshire found that a target-date fund holding U.S. REITs in the 35 years through 2010 would have produced an ending portfolio value nearly 10% higher than a portfolio without REITs.

An increase in allocations to U.S. or global REITs and listed real estate securities for target-date funds for younger workers resulted in smaller or no allocations to U.S. Treasury inflation-protected securities, high-yield bonds and U.S. small-cap equities, according to Wilshire's white paper on the research.

This indicated that REITs and real estate securities are a more efficient asset class to provide target-date participants with high and stable income, long-term capital appreciation and inflation protection, the paper said.

Wilshire asserts that REITs add income to portfolios of older plan participants. “Part of the feature of REITs is the income component,” Ms. Chang said. “In this low-yield environment, a lot of investors in retirement have a need to generate more current income in their retirement portfolios. REITs can step in and provide that additional (income) component.”

Target-date funds using high yield and fixed income instead would have to go further out on the risk spectrum to capture that yield, she said.

The building popularity of target-date funds in defined contribution plans led NAREIT executives to hire Wilshire to research on how REITs could figure into the funds' asset allocations.

“Assets will continue migrating to the defined contribution side from the defined benefit side as sponsors pull back from the traditional models,” said Michael Grupe, executive vice president for research and investor outreach at NAREIT. “Target-date funds are the most rapidly growing products.”

According to a report from Casey Quirk & Associates, Darien, Conn., released in October, target-date funds are expected to account for 48% of a projected $7.7 trillion U.S. defined contribution assets by 2020, compared with 12.5% of $4.4 trillion in 2010 (Pensions & Investments, Oct. 4, 2011).

“Target-date funds are expected to be the most concentrated holder of assets in the DC market,” Mr. Grupe said. “As we watched this develop, it raised in our minds the question of where does real estate fit into that product mix. If more and more assets are moving to DC-type plans and a growing share is being deployed to target-date funds, what role should real estate play in those funds?”

The analysis only included REITs; equity real estate was not included, he said.

Wilshire used a mean variance optimization, an asset allocation framework, to build target-date funds that included and didn't include REITs. For older workers, it used a modified version of the mean variance optimization — a surplus optimization portfolio — that took into account retirees' future income needs for fixed expenses such as food and housing.

The REIT allocations in target-date funds in the analysis were accomplished by shrinking U.S. TIPS, U.S. high-yield bonds and U.S. small-cap equities. Those asset classes are often used by investors to provide inflation protection, high income and long-term capital appreciation, Mr. Grupe said; the optimizers appear to indicate those attributes could be offered by REITs.

Executives at Russell Investments, Seattle, already are believers in including REITs in target-date funds. Russell includes REITs in target-date fund “real asset” allocations, along with listed infrastructure, commodities and sometimes TIPS.

While not commenting directly on the Wilshire research, Richard Davies, managing director, defined contribution for Americas institutional business based in Russell's New York office, said: “We've been proponents of REITs in multiasset portfolios before it was even fashionable.”

“A lot of large target-date fund providers haven't found religion on REITs and real assets broadly,” said Mr. Davies.

Russell executives consider global REITs and real assets as part of a growth bucket, which typically includes equities as compared to a preservation portfolio, which typically include bonds and fixed income, he said.