By Jack McAllister

What's Being Done to Correct the 401(k) Problem?

Companies are not waiting for Congress to act; instead leading firms are fixing their 401(k) plans...and real estate stocks are part of the solution

For the third straight year, 401(k) plans are losing money and investors who look to their 401(k) accounts as their primary source of retirement income are left searching for answers. The continuing uncertainty about the U.S. stock market makes the task of saving for retirement and achieving financial security particularly challenging. Everyone from legislators to line workers is asking that something be done about the country's retirement plans.

There are major efforts in Congress to examine, evaluate and re-design the structure and operation of the nation's defined contribution (DC) plans, but many companies are not waiting for Congress to solve the problem. These firms are implementing changes to their plans to help correct the current structural deficiencies that exist and inhibit plan participants from successfully managing their 401(k) accounts—and real estate stocks are increasingly part of the solution.

Changing the Status Quo

Large corporations have been managing retirement plans for decades. These companies' defined benefit (DB) plans are invested to meet the long-term obligation of paying retirement pensions to employees. Run by professional investment managers, large pension plans invest across a broad group of asset classes to lower their overall portfolio risk while achieving the investment returns required to fund the plan's liabilities. Today, many leading companies that understand the fundamentals of portfolio management are making the needed changes to their defined contribution plans so that their employees have a complete set of investment tools to manage their individual 401(k) accounts.

One of the major contributors to the significant decline in 401(k) account values is the current practice by participants to concentrate their investments in only a few investment options. Recent surveys estimate that the average 401(k) plan has 10 to 12 investment options but their participants choose to invest in only three to four on average. The chosen investments are typically various equity mutual funds, all of which are often highly correlated with each other and thereby offer little investment diversification to the investor.

As part of the re-examination and improvement of their current 401(k) plans, plan sponsors and their advisors are embracing a return to the fundamentals of successful investing in which diversification plays a major role. To give their employees the highest probability of reaching financial security in retirement, companies are altering their plan's investment choices to better reflect the asset classes professional investors use.

Real estate has been used for more than 30 years as a source of current income and portfolio diversification in DB pension plans. To increase the investment diversification in the nation's DC plans, leading companies are adding a real estate investment trust (REIT) option to their plans, thereby bringing real estate stocks into the 401(k) investment lineup for the first time. In addition, real estate generates high current income and is well positioned as part of a tax-deferred savings plan.

Coming on Board

While changes are beginning to take place, there is still a long way to go before the nation's workers are able to use real estate securities as one of the means to build well-diversified 401(k) accounts. Two of the latest converts to recognize the benefits of REITs for diversification are Verizon, which has the third-largest 401(k) plan in the country with more than $20 billion in assets, and Ibbotson Associates, the asset allocation specialist.

Last year, Verizon undertook a major review and asset allocation study of its defined contribution plan, which resulted in the addition of a dedicated REIT mutual fund in January 2002. Ibbotson Associates, which completed its review of REITs' role in diversified portfolios last year, added a REIT option to its corporate 401(k) plan earlier this year. Other leading companies that have REIT options in their plans are Dow Chemical, Ford, Eastman Kodak and General Motors.

Corporations are not the only plan sponsors realizing the benefits of including REITs. Some state retirement systems that have established DC plans are also adding a REIT option, including the State Teachers Retirement System of Ohio. There is still work to do before every worker can use real estate stocks to help them reach their retirement goals, but the change seems to have begun and the trend appears set in place.

Pushing for Change

The inclusion of REIT options in the country's DC plans cannot come soon enough for the 401(k) investor. Today, U.S. defined contribution plans hold approximately $2.3 trillion of investment capital, but those investors are effectively blocked from investing in the securities of the REIT industry. The National Association of Real Estate Investment Trusts (NAREIT) has launched a 401(k) initiative to help speed the opening of the 401(k) universe to real estate investing, stressing the ability of REITs to offer dividends and diversification to these investors.

As NAREIT president and CEO Steven A. Wechsler told CNBC earlier this year, "There are far too many investors missing out on REITs' diversification benefits. To change the status quo, NAREIT is committed to challenging the inertia, bias and misguided assumptions of many DC plan decision makers."

Identified as one of its top organizational priorities, NAREIT's corporate leadership has chosen to get directly involved in asking corporate executives in other industries, whose companies offer defined contribution plans, to request a REIT option from their DC or 401(k) providers. The goal of the 401(k) initiative is to ensure that every 401(k) plan participant has the ability to invest in commercial real estate through the use of real estate securities.

"It will take significant doses of education, persistence, resources and commitment by industry leaders to succeed," Wechsler says. "And while it is a bit early in the initiative to measure progress, several prominent corporations have already seen the wisdom of including a real estate choice in their 401(k) plans."

Making It Happen

In addition to plan sponsors, some of the largest 401(k) plan providers are realizing the benefits of including REIT mutual funds in their basic plan offerings. The Principal Financial Group, the largest provider of 401(k) plans in the country, recently launched two new defined contribution plan platforms, one for corporations and another for non-profit groups. Within both platforms, the Principal Real Estate Securities Fund is an investment option available to its clients.

T. Rowe Price makes their real estate securities fund part of its basic defined contribution plan offerings for clients. TIAA-CREF, the largest provider of investment services to the nation's education and research communities, has formed a new registered mutual fund that will be dedicated to investing in real estate securities and made available to the 401(k) marketplace. Barclays Global Investors, one of the largest institutional money managers, has joined the movement to incorporate real estate investing into the defined contribution world by announcing recently its plan to offer its first collective REIT vehicle specifically for the DC marketplace.

Table 1: Rates of Return Compound annual rate in percent
	REITs	Large Stocks	Small Stocks	Bonds
1972–2001	12.5	12.2	14.9	8.9
1982–2001	12.8	15.2	13.8	12.1
1992–2001	11.6	12.9	15.6	8.7
Source: REITs—NAREIT Equity Index; Large Stocks—Standard & Poor's 500®; Small Stocks—Ibbotson U.S. Small Stock Series; Bonds—20-year U.S. Government Bond.

Learning from the Pros

The benefits of including REITs in 401(k) plans has not been lost on the portfolio managers of those mutual funds dedicated to investing in real estate securities. "In today's world of lower equity returns, income and diversification look pretty darn good. Obviously the individual investor should look to REITs for the income, diversification benefits and the reasonably low correlation," says David Lee with T. Rowe Price. "They should be looking into REITs for their defined contribution accounts for diversification. But the key is diversification, and it's not meant to be the bulk of their allocation, but a component of their allocation."

Kelly Rush with Principal Capital Management also believes the key is a meaningful exposure to REITs, which will serve to minimize portfolio return volatility while not sacrificing returns. "Models used to determine optimal portfolios clearly illustrate that REITs can make a difference," he says. "The attributes of competitive returns, low correlation and low volatility are very valuable when identifying ways to invest your money."

However, on the downside, Rush says adding REITs to defined contribution plans is a slow process. "It's not surprising that the defined contribution world has yet to fully embrace REITs," Rush says. "When you consider that the modern REIT really only started about a decade ago and during much of that time people have been focused on technology stocks, it is not surprising there is still more work to be done. With the historical data supporting the case for REITs it should only be a matter of time before we see widespread use of REITs in defined contribution plans."

Analyzing the Returns

A key component of that education has been provided by a landmark study completed last year by Ibbotson Associates. Ibbotson examined REITs' entire historical data to quantify the benefits of using them in multi-asset portfolios (as highlighted in the article, "On the Rise," in the May/June 2001 issue of Real Estate Portfolio). The analysis received widespread attention in the press and throughout the investment community, generating new or increased allocations to real estate securities by pension plans and other institutional investors. This year, Ibbotson has updated its original study with data through 2001.

As seen in Table I, for the time period 1972–2001, REITs earned a compound annual return of 12.5 percent outperforming the S&P 500, which returned 12.2 percent, and long-term government bonds, which returned 8.9 percent. Ibbotson also found that over the 10-year period from 1992 to 2001 (as seen in Table 2), investors who had allocated 10 percent to 20 percent of their diversified portfolio to real estate stocks would have increased their compound annual returns by up to 1.3 percentage points in portfolios of similar risk.

Table 2: Optimal Portfolio Performance Over Time Hypothetical value of $1,000 invested over 10 years, 1992–2001
		Selected Constrained Portfolios
Risk (Std.Dev.)		7%	8%	9%	10%	11%
REIT Allocation	0%	10.0	11.1	12.0	12.7	13.3
	10%	10.8	11.7	12.6	13.2	13.7
	20%	11.3	12.2	13.0	13.6	14.1
		Hypothetical value of portfolio after 10 years
	0%	$2,594	$2,839	$3,106	$3,306	$3,486
	10%	2,789	3,024	3,335	3,455	3,611
	20%	2,917	3,162	3,395	3,579	3,740
Difference with 20% REITs		12.5%	11.4%	9.3%	8.3%	7.3%
Note: This is for illustrative purposes only and not indicative of any investment. Past performance is no guarantee of future results. Source: Ibbotson Associates, Inc.

Based on the study, it is clear that the downturn in defined contribution plan assets is attributable, in part, to the fact that many plan participants do not diversify their investments across a broad range of asset classes. Instead, they concentrate too much of their account on similar types of investments.

Many investors think that by simply spreading their account among a variety of common-stock mutual funds they have a well-diversified investment portfolio. Yet, the returns of U.S. common stock funds typically have a high correlation with each other, which means the price changes of those stock funds move in the same direction or track each other over time. Thus, today's 401(k) accounts are not diversified among many dissimilar investments or asset classes.

This is another example of having all of your eggs in one basket. When the stock market began to fall in 2000, many plan participants didn't have other types of investments that could stabilize their portfolios by offsetting the decline in stock values.

It is apparent that many well-informed plan sponsors and providers are leading the charge to change the nation's 401(k) plans for the better. And these changes are having direct impact on the way Americans allocate their retirement savings. Increasingly, REITs are seen as part of the 401(k) solution.