By Michael Fickes

It has taken years, but REITs are blossoming in the defined contribution market

In recent years, an increasing number of investment consultants as well as NAREIT staff have worked to see that publicly traded real estate equities share the spotlight with other stock and bond fund options in defined contribution plans, such as 401(k) plans. Slowly but surely, those plans have begun to view REITs as a valuable and viable diversification tool.

"We often recommend that sponsors consider a REIT fund option," says Mike Kaplan, a principal with Mercer Investment Consulting. "Most plans have a number of stock and bond fund options. However, these options are just different cuts of the same market. REITs are a good proxy for real estate, which is a unique asset class."

		ERISA Requires Prudent Choices Many plan sponsors have been slow to offer a real estate investment option in their defined contribution plans despite compelling evidence underlining the benefits of investing in publicly traded REITs.

Consultants at CRA RogersCasey agree that the primary driver behind adding a real estate option is diversification. "Another reason is to mirror the allocation approach of the defined benefit plans operated by companies," says Linda McDonald, a director in CRA RogersCasey's alternatives group.

As a result, the number of defined contribution plan sponsors that have added a REIT option is on the rise. At the beginning of 2004, for example, TIAA-CREF added a REIT mutual fund option to its 403(b) defined contribution retirement plans. Within six months, approximately a dozen of TIAA-CREF's college and university plan sponsors had adopted the option.

IBM's Savings Plan, one of the largest corporate 401(k) plans in the country, with about $23 billion in assets, designated a REIT index fund as one of its core building blocks in mid-2003. In other words, each of IBM's four basic investing options—an income fund, a conservative fund, a moderate fund and an aggressive fund—allocated between 5 percent and 10 percent of their total assets to REITs. In July 2004, IBM made its REIT index fund a stand-alone core offering for employees.

The broader 401(k) market also has been giving real estate mutual funds a closer look. When the Profit Sharing/401(k) Council of America (PSCA) surveyed more than 1,100 plan sponsors in 2003 (its most recent study), 11.8 percent said their plans included a real estate mutual fund option, more than double the 4.8 percent of plans offering such an option in 1999.

The REIT Option

Defined contribution plans come in several different formats. Popularly known by sections of the Internal Revenue Code, the various kinds of plans address the needs of different employers and business structures. Colleges, universities and other non-profit organizations, such as those served by TIAA-CREF, typically offer 403(b) plans. Businesses offer 401(k)s, while governmental organizations provide 457(b) and 401(a) plans. In each of these plans, employers and employees specify an annual amount or salary percentage to contribute to individual employee plans. The contributions flow into investment options offered by the plan as directed by employees.

In the early 1990s, defined contribution plans typically offered four or five options to participants. Today, plans offer an average of 15 options.

"If a sponsor wants to add more options today, will another stock or bond fund really give participants more opportunities?" Kaplan says. "Why not think about diversifying through a low correlation real estate fund with returns that fall between stocks and bonds?"

Sponsor and participant interest in REIT funds has arisen from a need for diversification. "The major factor in adding our real estate fund option was to give our participants more choice," says Andrew Duffy, managing director, real estate securities with TIAA-CREF. REIT funds generally produce returns that tend to be higher than bonds and lower than stocks.

What's more, REITs produce relatively high dividend income, on which income taxes can be deferred through a defined contribution retirement plan. If individuals want to invest in anything that pays high dividend income, whether it is stocks, bonds, or REITs, the best place to do it is in a defined contribution plan because of the tax deferral, Kaplan says.

Largest Plan Sponsors of Defined Contribution Plans
	Plan Sponsor (ranked by Defined Benefit Assets)	Real Estate in DB Plans	Real Estate in DC Plans	Defined Contribution Assets	Defined Benefit Assets
				(in thousands of dollars)
1	IBM Retirement Funds	Yes	Yes	20,939,000	39,180,000
2	GE Asset Management	Yes	No	20,336,000	41,286,000
3	Boeing Company	Yes	No	19,638,000	38,592,000
4	General Motors Asset Management	Yes	Yes	18,793,000	70,945,000
5	Verizon Investment Management Corporation	Yes	Yes	15,298,000	39,293,000
6	Exxon Mobil Corporation	Yes	No	13,539,000	6,869,000
7	Lockhead Martin Investment Management	Yes	No	13,113,000	19,827,000
8	Ford Motor Company	Yes	Yes	11,747,000	33,152,000
9	Northrop Grumman Corporation	No	No	10,400,000	15,300,000
10	United Technologies Corporation	Yes	No	10,079,000	10,383,000
11	Citigroup	Yes	No	9,892,500	8,556,700
12	SBC Communications, Inc.	Yes	No	9,884,000	26,656,000
13	Proctor & Gamble Company	No	No	9,435,000	283,000
14	E.I. DuPont de Nemours & Company	Yes	No	9,178,000	13,693,000
15	Hewlett Packard Company	Yes	No	8,286,000	3,528,000
16	AT&T Investment Management Corporation	Yes	No	7,986,000	16,525,000
17	Merrill Lynch & Company	No	No	7,953,900	2,225,559
18	Altria Corporate Services Inc.	Yes	No	7,819,000	8,991,000
19	Shell Oil Company	No	No	7,770,000	5,216,000
20	Pfizer, inc.	Yes	No	7,464,000	4,945,100
Source: S&P's Money Market Directory—2004

Giving REITs a Chance

Within six months of its introduction, the TIAA-CREF REIT fund saw contributions and appreciation drive assets to $48.7 million. According to TIAA-CREF, the real estate option has performed well compared to other new options. Of seven funds introduced in 2004, the most popular was a mid-cap growth fund that now holds $83 million in assets. The least popular new option was a social choice fund with $25.9 million in assets.

In a CRA RogersCasey survey conducted in 2003, the real estate funds in about a half dozen plans (out of 247) have attracted 1,391 participants whose combined real estate assets now total approximately $38 million.

The Mercer Investment Consulting survey found that participants in plans offering real estate had allocated about 4 percent of their assets to the real estate option. "The average plan in the survey offered about 15 options," Kaplan says. "So as one of 15 fund options, real estate, a non-traditional asset class, attracted 4 percent of plan assets. That's not bad."

Liquid Real Estate

Defined contribution plans primarily invest in assets such as stocks or bonds that can be valued daily and the misperception that REITs could not be so valued hurt REITs' inclusion as a retirement option. One of the perceived drawbacks of direct real estate as an option is that it cannot easily be valued daily, according to David Wray, president of the PSCA.

"Since REIT mutual funds can be valued daily, they have become the first choice for real estate," Wray says. "When you invest in a REIT, you buy securities in companies that own real estate."

Kaplan adds that REIT mutual funds are excellent proxies for real estate. "The profits earned by REITs are driven by real estate, and a REIT mutual fund provides an opportunity to diversify beyond stock and bond funds," he says. "It's a chance to invest in something that isn't so closely correlated to existing options."

Diversification among asset classes with low correlations is a key investment strategy. Because stocks generally rise over time, upward movements in uncorrelated stocks will tend to be greater than downward movements. In other words, the return on uncorrelated investments is cumulative, but the risk is not.

While stocks and bonds traditionally have been the staple of defined contribution retirement plans, inclusion of and allocations to REITs are on the rise due to their ability to enhance diversification and reduce volatility. As plan sponsors begin to take steps in the REIT direction, more plan participants will be able to avail themselves of the benefits of REIT investing.

"Everyone should have some percentage of their retirement in real estate," Duffy says. "If you don't, you're leaving money on the table."