By Art Gering

Although a large number of companies invest in real estate in their defined benefit plans, many deny their employees the same advantages in their 401(k) plans

Corporate America has a unique way of looking at real estate securities. On one hand, real estate and real estate stocks are a common holding in many professionally managed defined benefit, or pension, plans. On the other hand, employee-directed defined contribution plans, the most common of which is a 401(k), seldom offer participants a comparable opportunity to invest in real estate. However, there are some exceptions.

To fulfill the retirement needs of its large and diverse workforce, General Motors now offers 70 investment options in its employee savings plan. Among those, two real estate mutual funds are included in the investment lineup.

"We wanted the options to offer some degree of portfolio diversification," says Charles Tschampion, managing director of General Motors Asset Management Corp. "And REITs provide a good diversification benefit."

Unfortunately, for the publicly traded real estate industry as well as most 401(k) participants, much of corporate America has not yet embraced GM's enlightened view of real estate securities. Fewer than one in eight firms, or 11.8 percent, offer a real estate mutual fund as an investment option in their 401(k) plans, according to the Profit Sharing/401(k) Council of America (PSCA).

In another survey of defined contribution plans, consulting firm CRA RogersCasey uncovered similar results in a survey of its 260 plan sponsor clients. According to the survey, real estate (equities and mutual funds) represents between 1.5 percent and 4.5 percent of total assets in the sponsors' defined contribution plans.

To change this under-representation, the REIT industry has launched a campaign to broaden its investor base. This initiative focuses on defined contribution plans, specifically 401(k) plans, which constitute the majority of retirement assets for many Americans.

		REITs: A "Prudent" Choice In the fall 2002 issue of the Journal of Pension Planning & Compliance, Evan Miller makes a compelling case for the inclusion of REITs in defined contribution, or 401(k), plans. Miller, a partner with Hogan & Hartson LLP, establishes that the use of REITs by 401(k) sponsors is a powerful tool "against claims of imprudence in picking investment options."

The Seeds of Change

The timing for initiating this effort could not be better. For starters, after a three-year bear market, 401(k) plan participants are beginning to look at their quarterly statements again. Encouraged by articles in the popular business press and a parade of experts appearing on the likes of CNBC, participants are beginning to consider rebalancing their portfolios.

In the courtrooms, class action suits involving the defined contribution plans of Enron and WorldCom, each beset with a heavy allocation to company stock, are putting portfolio diversification, low correlation and other principles of modern portfolio theory on the table. Real estate securities have a strong pedigree in this area.

The REIT industry clearly has a role in the transformation that is slowly evolving in the 401(k) universe. But first, it's important to understand the role commercial real estate traditionally has played in defined benefit portfolios and, most importantly, defined contribution plans.

In a defined benefit plan, an employer pays a retired worker a benefit based upon a formula that takes into account a worker's length of service and average salary in the years preceding retirement. Most often the plan is funded entirely by employer contributions. However, a defined contribution plan is, in effect, a savings account maintained by the employer for each participating employee; worker participation is voluntary.

The most common defined contribution plan is a 401(k), into which an employee makes pretax contributions through a payroll deduction. Some employers partially or entirely match these contributions, either with cash or company stock.

Any firm that sponsors either a defined benefit or defined contribution plan must abide by standards established under the Employee Retirement Income Security Act (ERISA) of 1974. The common reading of ERISA instructs defined contribution plan sponsors (i.e., the companies) to create an investment option set that includes a stock option, a fixed-income option and a cash option. Plan sponsors rely upon the advice of plan providers and consultants to build an investment option menu that covers these asset classes, ever mindful to choose "prudent" investment options.

		Pension Bill Passes House H.R. 1000, the Pension Security Act, passed the U.S. House of Representatives in May by a 271 to 157 vote. A similar bill awaits consideration by the Senate.

Selective Choices

Often companies do not include real estate mutual funds in their defined contribution plans, yet they regard real estate as a core investment for their defined benefit plans. The number of well-known Fortune 500 companies with this double standard is alarming. Of the 20 largest defined contribution plan sponsors, only three offer a real estate option.

BellSouth holds REIT stocks in its defined benefit portfolio. "We feel these stocks fit well with the diverse portfolio that makes up our pension investments," a company spokesperson says. However, the firm does not offer a real estate mutual fund in its 401(k) plan.

"Our plan's investment options provide an array of strategies and exposure opportunities to global stocks and the U.S. bond market," the spokesperson explains. "The investment options provide participants ample opportunity to diversify their portfolios among assets with unique risk, return and correlation characteristics."

The Boeing Co. also includes real estate in its defined benefit plan, according to the "Money Market Directory," but real estate is nowhere to be found among the 11 investment options offered to non-union, salaried workers in the firm's 401(k) offerings, according to a company spokesperson. Similarly, DuPont has real estate in its defined benefit portfolio, but doesn't offer its employees a real estate option in their 401(k).

"A lot of companies have not opted for real estate funds as part of their 401(k) lineups," remarks Peter Di Teresa, a consultant with Morningstar Associates. "It's often a case where companies don't see a need for it. In coming up with a diversified slate of options, they may decide real estate funds are not a top priority."

Over the years, real estate has been an asset class that is difficult to include in plans, says David Wray, president of the PSCA. "Real Estate was difficult to value. Today, because you can invest in real estate through REITs, some firms have begun to treat it as an asset class and have picked it up for their plans."

Much sleep can be lost trying to understand why firms commit their own money to real estate in their defined benefit portfolios but don't allow employees the option to invest in real estate through their defined contribution plans. Understanding why a real estate investment option is excluded from nearly 90 percent of all 401(k) plan lineups and what needs to be done to correct this inconsistency requires exploring how corporate America views real estate and how 401(k) plans are designed.

Real Estate Allocation of 20 Largest Plan Sponsors Ranked by Defined Contribution Assets

Plan Sponsor	Real Estate in DB Plan	Real Estate in DC Plan	Defined Benefit Assets*	Defined Contribution Assets*
Verizon Investment Management Corp.	YES	YES	$48.5	$24.6
GE Asset Management	YES	NO	$44.8	$23.1
Boeing Company	YES	NO	$41.0	$22.5
IBM Retirement Funds	YES	NO	$38.6	$20.6
Lucent Technologies	YES	NO	$34.8	$20.5
Delphi Corporation	YES	NO	$6.1	$20.1
General Motors Asset Management	YES	YES	$70.3	$18.3
Exxon Mobil Corporation	YES	NO	$4.8	$14.7
Ford Motor Company	YES	YES	$35.8	$13.0
Lockheed Martin Investment Management	YES	NO	$20.7	$12.9
AT&T Investment Management Corp.	YES	NO	$22.7	$11.6
Procter & Gamble Company	NO	NO	$0.3	$11.1
SBC Communications	YES	NO	$28.7	$10.7
E.I. DuPont De Nemours & Co.	YES	NO	$15.3	$9.7
Citigroup	YES	NO	$8.0	$9.6
United Technologies Corp.	YES	NO	$9.6	$9.4
Philip Morris, Inc.	YES	NO	$9.5	$8.9
BP America, Inc.	YES	NO	$5.5	$8.6
Hewlett Packard Company	YES	NO	$3.3	$8.1
Shell Oil Company	NO	NO	$6.0	$8.0
* $ in billions. Source: NAREIT. Data through end of 2002 from "Money Market Directory." Note: IBM Retirement Funds has a real estate option in its lifestyle funds.

Asset Class or Sector Fund?

Among the numerous equity and fixed-income mutual funds, more than 70 are dedicated to investing in real estate securities, according to the National Association of Real Estate Investment Trusts (NAREIT). Morningstar even lists real estate funds as its own category in their fund categorization system. It would appear that there are enough investment vehicles available to offer 401(k) participants exposure to real estate, but plan sponsors often view this option as a sector fund—a tag that, by itself, is not fully informative for individual investors and that is proving to be an obstacle.

Plan sponsors typically do not offer sector funds, says Ralph Kimmich, director of benefits and compensation for Southwest Airlines. Kimmich adds that most 401(k) plans "tend to stick with some fairly basic core products along the risk spectrum."

According to Morningstar's Di Teresa, sector funds show up in some 401(k) plans, but usually because employees ask for them. Plan sponsors and their consultants often view sector funds as counterproductive in building a diversified portfolio because they see sector funds as overlapping other broad equity funds. For example, if a plan participant invests in a transportation sector fund, many of the issues in that fund could be included in a large-cap equity fund the participant also might hold, thus duplicating those holdings.

"However, I would make a distinction with REIT funds," Di Teresa says. "With REITs, you're talking about a distinct asset class."

Asset classes produce investment performance characteristics that are distinct from other asset classes and returns that have a low correlation to other investments. "REIT funds are not going to behave like other equity funds," Di Teresa says.

Additionally, approximately 95 percent of the assets in the REIT industry are commercial real estate, suggesting that REIT stocks behave more like an "asset class" than "sector-specific" stocks, although they possess characteristics of both, according to Jack McAllister, NAREIT's vice president of investment affairs.

However, looking at real estate securities as an investment in real estate has its downside in the eyes of some.

"If the plan participant is a homeowner, one could argue that they have a lot invested in real estate already," Kimmich says. "If the participant is trying to diversify his investments, you probably wouldn't want to put more money in real estate."

However, a recent study by the research firm Hartrey Advisors suggests that commercial real estate and homeownership are very different. Their study, "Home Ownership and Investment in Real Estate Stocks" (published in the Journal of Real Estate Portfolio Management), details how both homeowners and non-homeowners can benefit from an allocation to REITs. According to the study, written by Hartrey President Jack Goodman, the correlation of quarterly returns from 1976 to 2001 for REITs and owner-occupied housing was 0.12, lower than the correlation of REITs with bonds, and large, small and international stocks. Goodman details how investment portfolios with a REIT allocation and an allocation to owner-occupied housing provide a higher return and lower risk than a similar portfolio without REITs.

On the Menu

Compensation and benefits executives, the frontline in the world of 401(k) plans, might be amenable to logical explanations for why real estate is an asset class and how investment in real estate benefits plan participants. Some have already heeded the message.

Five years ago, only 3 percent to 4 percent of all 401(k) plans included a real estate option, relates Wray of the PSCA. Today, that percentage is roughly three times higher at 11.8 percent. From 2001 to 2002 alone, the percentage increased from 8.6 percent of plans to 11.8 percent. The increase occurred during a period when fund choices proliferated. This development has implications for the REIT industry's ongoing efforts to be included in every 401(k) plan.

Securing a place on the investment menu is an important objective for the real estate securities industry and NAREIT. But what may be more important is ensuring that the real estate option doesn't get lost in the mix and is placed at eye level for participants to see.

From 1998 to 2001, the average number of offerings in 401(k) plans increased 20.5 percent, according to findings from the Vanguard Center for Retirement Research and reported in a study by Sheena Sethi-Iyengar, an associate professor at Columbia University. Today, plans contain an average of 15 investment options, according to Gerard Mullane, a principal with the Vanguard Group.

Sethi-Iyengar's study reveals that 401(k) plan participation rates drop off dramatically in instances where more than 10 fund options are offered. "The act of making a choice from an excessive number of options might result in ‘choice overload'" and the participant not making any decision at all, she says.

On average, most participants invest in less than three mutual funds, Mullane adds. "Most participants don't take advantage of that many investment options," he notes.

Jim Stoeckmann is a senior project manager at World at Work, a 25,000-member professional association for compensation and benefits executives. As the person in charge of the 401(k) plan for the organization's 108 employees, he has found that most employees are not well versed on investment fundamentals.

"The average employee is not that sophisticated when it comes to constructing their 401(k) portfolio," Stoeckmann says.

Quality Over Quantity

When Sethi-Iyengar visited plan sponsors to conduct her research, she often found investment choices were listed beginning with the money market option. Regardless of the number of options provided, participants most frequently selected the money market option.

"One interpretation of that is to say that people are going for the least risky option," she says. "Another interpretation is that people are just going for the first option on the list."

Unfortunately, the situation for plan participants may be worsening, or at least not improving. Some 83 percent of plan sponsors polled earlier this year by human resources consultancy Hewitt Associates reported that simplifying investment options will not be a priority in 2003; 63 percent said the number of 401(k) investment options will remain the same and 33 percent reported the number of options actually will increase.

Offering many investment options is an effective tactic employed by companies to meet the diverse investment and retirement needs of their workforces. Where these firms often fall short, however, is ensuring that investment menus have options with low correlations of returns that enable participants to maximize their returns and lower risk.

"They may think having eight U.S. stock funds plus international equity, a bond option and a cash option represents full diversification," NAREIT's McAllister says. "However, because the correlations of returns to most stock funds are so high, what appears to be a diversified set of options is an illusion."

McAllister contends companies fail to measure the correlation of investment returns between different investment choices when assembling their 401(k) menus. If they performed this analysis, real estate mutual funds might become a more common option in investment lineups.

"There is a certain amount of inertia on the part of companies that inhibits adding a real estate investment option," Mullane says.

As an example, Freudenberg-NOK, an automotive parts manufacturer, has a 401(k) plan with $120 million in assets. The firm, which employs 5,000, recently completed a periodic review of its plan and replaced three fund options with three new alternatives. However, the company still does not offer a real estate mutual fund among its 11 options.

"We like to look at the historical returns and the overall value of the fund," when considering fund options, says Leesa Smith, the firm's vice president of treasury and financial services. Freudenberg-NOK focuses on providing its plan participants, who Smith describes as "very conservative investors," with the "main asset classes on the risk spectrum."

"We don't specifically focus in on the correlation," she adds. "I think we get to the same place looking at the specific asset classes."

In the past, the company has added small-cap and mid-cap stock funds because employees have asked for them. "To be honest, we haven't had any inquiries for REITs," she says, adding that her workforce may understand and feel more comfortable with more mainstream funds.

Employee Demand and Third-Party Advice

Participant input may have greater relevance to plan sponsors in building investment option menus than, say, correlation studies. While this approach may carry some whiff of "inmates running the asylum," it would be a mistake for the REIT industry to ignore the power of employee demand.

"Employers listen very attentively when employees say, for example, ‘we need a tech fund or more bond offerings,'" Stoeckmann says. "And they would listen very attentively if employees said they needed a REIT index fund."

"It's reasonable to respect employee demand, but not if it means chasing trends," Di Teresa adds. "Consultants can help by providing a long-term perspective on the appropriateness of specific options."

Ultimately, the professional financial services community may create opportunities for real estate mutual funds to be included in more plan participants' investment portfolios. On the legislative front, the House of Representatives recently passed the Pension Security Act. Under the law, workers will have a greater opportunity to diversify their 401(k) portfolios and increased access to qualified, third-party investment advice.

"The bill would liberalize plan sponsors' ability to deliver investment advice to plan participants," McAllister says. "Plan sponsors would still be exempt from being responsible for how those investment decisions turn out."

Currently, 50.6 percent of companies offer their workers third-party investment advice, according to the most recent survey by the PSCA. The reasons firms cite most frequently for not offering investment advice reflect concerns about fiduciary liability, selecting a competent advice provider and the ability to monitor the effectiveness of the advice. The House bill would address some of those concerns.

The availability of qualified investment advice to 401(k) plan participants suggests that participant-directed investments may begin to use strategies akin to the informed decisions made in defined benefit plans. Many would agree with Vanguard's Mullane when he states "a professional investment advisor is likely to recommend an allocation to real estate in the context of a balanced, well-diversified investment portfolio."

As the REIT industry's campaign for inclusion in a greater number of 401(k) investment lineups unfolds, it's important to recognize the tremendous amount of work that lies ahead. For every General Motors that offers a real estate option, there is a Boeing, DuPont and more than eight other firms that do not offer their workers such a choice.

Much hard work has already been done by the industry to get the message out about REITs. However, more effort and time is needed to reach a wider audience and ensure that those plan sponsors with a real estate allocation in their defined benefit plans also provide a real estate securities fund in their defined contribution plans.