Leading Experts Discuss Retirement Security and Savings Trends

By Christopher M. Wright

More than 10,000 a day. That's the rate at which America's 76 million baby boomers will retire over the next 20 years. Underfunded pension plans, less-than-complete 401(k) coverage, a negative personal savings rate, and questions regarding the sustainability of Social Security are all causing anxiety about whether boomer retirements will be adequately funded. At the same time, people reaching age 65 can expect to live approximately another 18 years. It is foreseeable that the generation will come up short in their retirement finances.

The British Turner Commission correctly concluded that people simply will have to work longer and save more. Alex Pollock American Enterprise Institute

Finding safe, high-yield investments for retirement purposes has never been more important. An extra 1 percent annual return can add years to retirement spending. With people living longer and needing more funds to finance their retirement, Portfolio asked several experts for their thoughts with respect to the latest trends for retirement savings as well as the role of REITs in funding America's retirement needs.

Portfolio spoke with Jamie Behar, managing director, real estate and alternative investments at GM Asset Management Corp.; Ann Combs, assistant secretary of the Employee Benefits Security Administration of the U.S. Department of Labor; Thomas J. Fontaine, Ph.D., CFA, senior portfolio manager at AllianceBernstein; John Greenberg, CFA, acting chief investment strategist of the Maryland State Retirement and Pension System; Jim Keagy, managing director of Barclays Global Investors; Alex J. Pollock, resident fellow at the American Enterprise Institute; Amos J. Rogers III, managing director, portfolio manager–REIT investment strategies at The Tuckerman Group/State Street Global Advisors; John Rother, policy director at the American Association of Retired Persons; and Todd Sinai, associate professor of real estate at the Wharton School, University of Pennsylvania.

REITs have made real estate a viable option for defined contribution plans because of their liquidity and diversification. Ann Combs Employee Benefits Security Administration Retirement in the future will become even more varied and individual, reflecting the diversity of interests and means that will characterize the retired population. John Rother American Association For Retired Persons

Portfolio: Given where we are today, how will retirement of the baby boomer generation differ from that of their parents?

John Rother: The upper half of the boomer cohort is better educated, more informed, and has more economic resources than their parents. Many will survive into their 90s. They probably will have more "good years" of health and functional ability. They expect more than simply leisure from their retirement years. They will demand choice and quality across a range of interests. They are looking for intellectual stimulation, opportunities to engage in their communities, the opportunity to network with neighbors like themselves, and part-time meaningful work options. They will expect to be active and to be enjoying the same standard of living that they had prior to retirement.

Of course, there will be others less fortunate who will have inadequate savings and no meaningful pension beyond Social Security. They will need to work well into their retirement years. They also will need affordable housing options and a network of social services to help them maintain their independence. In many ways, their retirements may be less satisfactory than the experience of their parents.

Alex Pollock: It will be longer and represent a greater proportion of life than it did for past or will for future generations. A typical boomer who started work at 22, retires at 62, and expects to live to 82 would have 40 years of work and 20 of retirement—a "work-to-retirement" ratio of merely two-to-one. This ratio is at a historical low and now must rise.

For the typical family, investing a portion of their net worth in securitized real estate is a no-brainer. Todd Sinai Wharton School, University of Pennsylvania We have learned that nearly 90 percent of employees lack the knowledge, interest and/or time to make successful investment decisions. Jim Keagy Barclays Global Investors

With a work-to-retirement ratio of only two-to-one, the required savings rate to finance retirement is too high. People will work longer—as many around the world wish to do anyway, according to an HSBC Bank international survey.

Portfolio: Internationally, are countries converging or diverging in the way they handle retirement funding?

Pollock: Other countries also are reforming their retirement funding structures. The British Turner Commission correctly concluded that people simply will have to work longer and save more. When you focus on it, it is a remarkable idea that while in good health and perfectly capable of working, people should expect to be paid while spending long years in idleness.

Jim Keagy: The United States is not alone in facing a retirement crisis. This is a global, social and economic crisis. Many countries are far worse off than the United States. European countries have set high expectations for government support for both income and healthcare. Some emerging Asian economies have barely started preparing for the future.

Because REITs and direct real estate don’t perfectly correlate with stocks and bonds, by holding both you can get more diversification. John Greenberg Maryland State Retirement and Pension System

Rother: Most advanced countries have built a tiered retirement income system based on a universal social insurance floor, supplemented by occupational and individual pensions and savings. The balance, however, varies from country to country. A common theme today is the need to encourage longer work lives as a way to sustain these systems. Almost every country is raising its retirement age, adjusting benefits or working to make older workers more attractive to employers.

Portfolio: What other noteworthy trends are occurring with respect to retirement and retirement funding?

Pollock: Corporate pension plans are widely underfunded. They are guaranteed by the government's Pension Benefit Guaranty Corporation, which is itself insolvent. Public pension plans are also widely underfunded. Social Security is unfunded. Prevailing ideas of retirement funding—like the concept of "retirement"—date from the late 1940s and are unsustainable.

We believe that we can achieve better returns on our REIT portfolio through an active management approach, rather than through index investing. Jamie Behar GM Asset Management Corp.

Rother: Retirement in the future will become even more varied and individual, reflecting the diversity of interests and means that will characterize the retired population. Those with highly valued skills will still be attracted to high-wage firms that offer defined benefit pensions, but other firms will switch mostly to defined contribution savings plans.

These defined plans, however, will take on more and more of the characteristics of traditional pensions, such as automatic enrollment and professional investment management, to address their current shortcomings. Work in more flexible forms will be a growing part of retirements, blurring to some extent the distinction between career status and full retirement. With the doubling of the over-65 population in the next 25 years, retirees will become even more the focus of attention in politics, in the marketplace, and in the community.

REITs can play a key role in a retirement savings portfolio, such as a target-date fund, and we’re encouraged to see other target-date providers adding REITs to their funds. Thomas Fontaine Alliance Bernstein Real estate provides investors a unique asset class that offers both capital appreciation and current income. Amos Rogers The Tuckerman Group/State Street Global Advisors

Portfolio: How has retirement funding evolved and what's on the horizon?

Keagy: Defined benefit (DB) plans worked well for large companies during a more paternalistic era when employees stayed with companies for long periods of time, and retirement benefits were an important form of compensation. Today, DB plans are rapidly losing their importance. Americans are not good savers; we live in a "debtor nation" with mounting credit card debt and adjustable-rate mortgage balances. This leaves 401(k) plans as an essential source of retirement income.

Thomas Fontaine: This is a pivotal year, possibly the most important since 1974 when the industry was transformed by the Employee Retirement Income Security Act (ERISA). The recently enacted Pension Production Act 2006 and Department of Labor language to promote the use of auto-enrollment, auto-escalation and target-date funds as a default option will greatly enhance retirement security for millions of Americans. A focus on providing better outcomes for plan participants will drive innovation and improvement to defined contribution (DC) plans.

Portfolio: What role should real estate equity and REITs play in retirement saving and investing?

Ann Combs: ERISA does not specify asset classes for investment in employer-sponsored retirement plans. Rather, ERISA requires that investment portfolios are broadly diversified to minimize risk. This allows for expansion of investment options into all types of investment vehicles. Real estate does, and will continue to, provide an investment opportunity for retirement plans, both through REITs and direct investment, as part of a broadly diversified portfolio.

Direct real estate investment is more common, and better suited, to defined benefit plans. REITs have made real estate a viable option for defined contribution plans because of their liquidity and diversification. They will continue to play a role although the take-up rates by participants are very low. This suggests more needs to be done to educate workers about the characteristics and benefits of real estate as part of a diversified portfolio.

Jamie Behar: Both private and publicly traded real estate equity should be included as a separate asset class in any well-diversified portfolio with a long-term investment horizon. Over the long term, REITs have performed in line with private real estate in terms of risk and return. So from an investment standpoint, we consider our REIT portfolio to be an integral part of our overall real estate portfolio. REITs provide the additional benefit of enhanced liquidity, and represent a way to quickly and more efficiently gain exposure to specific geographic regions, property sectors and strong management teams.

Keagy: Real estate equity belongs in 401(k) plans for the same reason it belongs in DB plans: appreciation potential, income, inflation protection and its low correlation with other asset classes. Until REITs came along, the problem was how to get real estate into 401(k) plans. REITs make it easy. Many DB plans have the scale and the staffing needed to invest in real estate directly, and they have been doing so successfully since the 1980s. REITs afford individual investors with the same institutional-quality real estate, across all property types and markets.

Todd Sinai: It depends on the wealth of the client. For the typical family, investing a portion of their net worth in securitized real estate is a no-brainer. Direct ownership of real estate takes a lot of time, effort and hard work to generate a decent return. People tend to recall how much money they made on an investment but don't deduct paying themselves a decent wage for their time. Plus, direct ownership of real estate, at the individual level, has tremendous amounts of idiosyncratic risk.

Unless an individual truly enjoys owning and operating real estate, they are better off investing in securitized real estate equity. Of course, the calculation for portfolio managers at a pension fund is quite different. Such funds enjoy enough scale that they can diversify property-level risk and more efficiently utilize staff. There, the trade-off is between the illiquidity of direct ownership versus the benefits of diversifying into the kinds of properties that REITs do not own widely.

Portfolio: We've touched on some of them, but what are the main benefits of including a real estate allocation in retirement plans?

John Greenberg: Because REITs and direct real estate don't perfectly correlate with other stocks and bonds, you achieve more diversification when you add real estate to portfolios of stocks and bonds. A well-designed REIT portfolio can offer more liquidity and broader exposure than many direct real estate strategies, and the REIT income stream can be attractive to plan sponsors seeking investments to assist paying current benefits.

Sinai: The obvious answer is diversification. While it would be surprising if REITs' historically high returns and low volatility can persist at the same levels, the low beta of most REIT sectors make them a prime tool for diversification even at lower average rates of return. The tax advantages of REITs also favor retirement investors. An investor can defer taxes for longer periods because REITs essentially are untaxed at the corporate level by holding REITs in a tax-favored vehicle (such as a 401(k) or a pension fund). By contrast, holding most any other asset in a tax-deferred account avoids individual-level taxes but still leaves an investor's returns taxed at the corporate level.

Amos Rogers: Real estate equity provides investors a unique asset class that offers both capital appreciation and high current income. The benefits to a broad-based portfolio are lower volatility, greater current income and enhanced returns. REITs in particular offer investors liquid and diversified access to real estate as an asset class and are a great way to obtain "core" real estate exposure. Direct real estate investments don't offer the same liquidity or diversification. However, particularly in today's very competitive market, it can provide access to more value-added or opportunistic real estate investments.

REITs' unique tax structure demands that they distribute almost all of their income as dividends annually. This provides a steady dividend return that has become very attractive to investors looking for current income as they approach retirement. Real estate also has been a strong hedge against inflation given the market nature of the underlying rental income stream. These benefits have become attractive attributes to investors.

Behar: From an asset allocation perspective, returns on both publicly traded and private real estate exhibit a negative or low correlation with returns on other asset classes, thereby enhancing portfolio diversification and long-run returns. Additionally, real estate investments generally provide high current income vis-à-vis stocks and bonds and, assuming balanced supply/demand conditions, serve as a more effective hedge against inflation. Both traditional defined benefit and personal savings plans should benefit from an allocation to real estate investments.

Portfolio: What should the real estate allocation be in the typical retirement plan? How does that break down into REITs versus direct real estate, domestic versus international, etc.?

Sinai: A reasonable allocation to real estate would be in the 5 percent to 10 percent range, whether in REITs or direct real estate.

Behar: Most DB plans are increasing their allocation to alternative asset classes, with the largest allocation generally going to real estate equity. I think that a long-term allocation to real estate of 8 percent to 10 percent, including both private market investments and publicly traded securities, is a reasonable target. This is easier to achieve today both because of the growth of the REIT market over the past 15 years, and the increasing globalization of real estate capital markets.

With respect to allocation within the real estate portfolio, assuming publicly traded real estate remains in relative parity with the private market, a long-term target allocation of 20 percent to 30 percent to publicly traded real estate appears reasonable. The allocations to U.S. and non-U.S. real estate, as well as the allocation between developed and emerging markets within the non-U.S. portfolio, will depend on the relative attractiveness, in terms of both the expected returns and perceived risks, of those respective markets over time.

Rogers: We are seeing real estate portfolio allocations increase in general as investors recognize the diversification and return benefits that real estate offers. Traditionally, portfolio allocations have been in the 5 percent to 7 percent range and we are seeing these targets move up closer to 10 percent to 15 percent. While REITs represent only a small percentage of total real estate investments today, somewhere around 15 percent, this will certainly increase given the liquidity and diversification that REITs offer. International real estate markets represent 50 percent of the total global marketplace for real estate securities. Although global investments are small today, we fully expect to see global REIT allocations grow as well.

Fontaine: Our target-date retirement funds are unique in that their strategic allocation to REITs is 10 percent throughout life and we invest in REITs globally.

Keagy: Ideally, participants will gain REIT exposure through their lifecycle fund, because they will get it at an appropriate level relative to other asset classes. Barclays Global Investors' strategies offer about a 7 percent exposure to REITs at the 2045 level and just under 3 percent at the retirement level. This allocation is revisited constantly and will change with market conditions across asset classes.

Portfolio: Are you seeing the reported trend among U.S. retirement plans away from standard U.S. real estate investments and toward increased value-added, opportunistic and global real estate allocations?

Greenberg: Many institutional investors are increasing their allocations to value-added and opportunistic investments. Given the remarkable growth of international REIT and private real estate markets, we believe there are many compelling opportunities in these markets.

Behar: With returns available on core U.S. real estate investments continuing to moderate, due perhaps to the influx of capital away from more traditional asset classes as returns for those assets have moderated, it is likely that sector-specific investors will allocate an increasing proportion of their real estate portfolios away from core and toward investments with higher risk and return expectations, both in the U.S. and abroad. Fortunately for U.S.-based investors, this is becoming easier to achieve given the growing transparency and maturation of real estate markets globally.

Rogers: The development and expansion of REITs on a global scale has been significant; the global real estate securities market is now in excess of $700 billion in market cap. REIT structures are in place in over 20 countries and are about to be adopted in additional large markets such as the U.K. and Germany. The correlation of real estate returns across local markets is very low, which means strong diversification benefits.

Fontaine: A strategic allocation to REITs in a tax-qualified retirement portfolio can be highly beneficial, since U.S. REITs offer strong return potential, yet can be diversifying to other asset classes. Global REITs can offer even further diversification: the income generated from a shopping mall lease in Australia is likely to be uncorrelated to other investments in a typical U.S. retirement portfolio.

We currently have more than 50 percent of our REIT portfolio invested outside of the U.S. A common misconception is that investing outside of one's home country—whether it is in stocks, bonds or REITs—is riskier, but the truth is that a global opportunity set has the potential to both increase return and decrease risk.

Keagy: We will probably see global REITs in 401(k) plans within a decade. Even DB plans are just starting to explore global real estate opportunities. An important benefit of some U.S. REITs is that they are investing overseas, so investors are getting some international real estate exposure that way.

Portfolio: Where do things stand in terms of adding real estate as an option to a larger number of 401(k) plans, and how far will this penetration go?

Combs: A survey by the Profit Sharing/401(k) Council of America indicates that in 2004 15.6 percent of profit sharing and 401(k) plans offer a "real estate fund," but on average just 0.3 percent of assets are invested in these funds. Clearly, there is an opportunity for growth. One way that real estate can play a role in 401(k) plans is as part of the default investment option. DOL is currently developing a fiduciary safe harbor regulation for default investment in plans that have an automatic enrollment feature. With automatic enrollment, the choice of a default fund is critically important because many employees placed in the fund are likely to leave their assets in the default fund.

We are considering allowing employers to use more appropriate investment alternatives, such as target-age funds, balanced funds or professionally managed accounts as defaults. Real estate could be incorporated into a default option, either as part of a broadly diversified fund or through a professionally managed account.

Behar: NAREIT has made a lot of progress on this issue in recent years, as an increasing number of plans are beginning to offer a REIT fund as an investment option. GM's 401(k) plan offers two REIT investment options and, on a combined basis, these funds have attracted about 3 percent of total plan savings. Given the attractive diversification and current income characteristics that REITs offer in comparison with traditional equity fund options and as the public real estate market continues to expand, we would expect this allocation to grow over time.

Rogers: Real estate is becoming more prevalent as an option in DC investment plans, although it is still only represented in a small percentage of plans. REITs are also finding their way into balanced fund offerings such as lifestyle or lifecycle funds. We currently manage REIT funds for 10 large DC clients and have seen those assets more than double over the past 12 months. In addition, we recently added our U.S. REIT fund and our European Real Estate Securities fund into recently introduced Dutch retirement programs as part of broader, balanced fund offerings.

As investors recognize the diversification and income benefits of real estate, not to mention the asset class' outperformance over the past several years, more investors are requesting real estate options. This investor interest is in turn focusing plan sponsors and plan administrators on expanding their offerings.

Fontaine: REITs can play a key role in a retirement savings portfolio, such as a target-date fund, and we're encouraged to see other target-date providers adding REITs to their funds. A plan sponsor, however, should carefully consider how participants might use a stand-alone REIT investment option: it's difficult enough to educate participants on traditional asset classes and REIT education could add an additional hurdle.

Keagy: There has been extensive research by BGI and others on participant behavior. We have learned that nearly 90 percent of employees lack the knowledge, interest, and/or time to make successful investment decisions. This finding holds true for a wide range of participants, from factory workers to senior executives.

Lifecycle funds are the ideal solution for most employees. BGI launched the industry's first lifecycle funds in 1996. The best lifecycle funds in our opinion also offer exposure to REITs and Treasury Inflation-Protected Securities [TIPs]. Also, best in class 401(k) plans should have automatic enrollment, an automatic escalation program that allows participants to contribute more out of future raises, and a lifecycle fund as the default option.

Portfolio: Could you talk a little more about the efforts needed to educate 401(k) plan sponsors and participants as to the benefits of real estate and REITs as an asset class.

Behar: Individual investors may tend to view "investable" real estate as predominantly residential real estate. As is evident in the current market environment, single family homes and condominium units are performing quite differently compared to commercial property investments. Inclusion of a REIT-dedicated investment option in 401(k) plans, coupled with basic education of plan participants by plan sponsors on the merits of investing in publicly traded real estate companies, would serve to improve the diversification and current income characteristics of the participants' savings portfolios.

Keagy: Education is an important part of a "best in class" 401(k) plan. The best educational programs offer employees two simple choices: lifecycle funds; and high quality building blocks for employees who have the knowledge, interest and time to be their own chief investment officer. Most employees, prudently, select lifecycle funds and they are well served by this decision.

Portfolio: What's better for handling real estate in retirement portfolios today: Indexing or active management?

Rogers: Indexing offers investors broad-based access to the real estate asset class diversified by both geography and property type. As more variables impact the performance of the REIT market, it becomes increasingly more difficult for active managers to outperform in all market environments.

Indexing is a smart option for investors who don't have a strong conviction about their active manager's strategy or style, or who don't have broad manager choices in their plan. Historically, index managers have outperformed a majority of the active managers.

Keagy: An indexed approach to real estate is best for most individual investors, and indexed REITs are the best way to populate lifecycle funds.

Behar: We believe that we can achieve better returns on our REIT portfolio through an active management approach, rather than through index investing. We are active investors in both the private direct and public real estate securities markets and, for each of those portfolios, we tend to emphasize geographic regions, property types and operators which we believe can generate superior returns in comparison with the broader real estate market. Taking an active rather than a passive approach to investing has produced better-than-market returns for us over time.