March 11, 2014
Interviewed by: Zoe Hughes
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From Defined Benefit to Defined Contribution

The shift from defined benefit to defined contribution plans in the U.S. is inevitable and will happen much faster than you’d expect, George Pandaleon of Inland Institutional Capital Partners argues.

The shift from defined benefit to defined contribution plans in the U.S. is inevitable and will happen much faster than you’d expect, George Pandaleon of Inland Institutional Capital Partners argues.

DB to DC: Inevitable and It Begins in Two Years

With George Pandaleon of Inland Institutional Capital Partners

Is the shift from DB to DC pension funds going to take a generation to enact?

George Pandaleon, Inland Institutional Capital Partners:

I think that’s a common perspective that I don’t agree with. I have an alternative view that this will happen a lot faster than we think. It may be that the funds are still there, but they’re going to be managed very differently. If you look at the history of corporate plans, in many cases once they determine that they no longer have a defined benefit plan, they will just freeze the plan. No new participants, no new contributions.

At that point, they can make some very precise determinations of what the future run-off of that fund is going to be. They don’t need alternatives at that point. They simply invest in interest-bearing securities of some sort. I think it’s generically referred to as liability-driven investing. The need for growth of the underlying corpus, if you will, is much reduced. Once one or two of the big states or municipal plans goes this direction, which I think is inevitable-, I live in Illinois. It may very well that Illinois is one of the first ones, simply because they have the biggest problem. I think there’s likely to be a bit of a domino effect and it could unravel pretty quickly.

How quickly will we see the change?

Pandaleon: I wouldn’t be surprised to start seeing that kind of thing happen in the next two to three years. Once it starts, the political world gets comfortable with it somehow and a consensus develops that this is the direction to go, as it has in corporate America. I think there could be significant reductions in the available capital to private equity real estate over the next five to ten years.

What impact will this have on private equity real estate capital raising?

Pandaleon: We’ve already seen some pretty big impacts in the shift toward more net distributions than contributions. During the baby boomer generation, most of these funds were getting lots of new contributions of capital from the employees. Now, those employers are starting to retire and we’ve seen a big shift toward cash flow orienting investments, investments that have some liquidity. That, I think is a trend that’s likely to continue. I don’t know that it will accelerate, but I don’t think it’s going away. I don’t think there’ll be a wholesale shift back to the bulk of the funds being in opportunistic real estate, for example. I think you’ll see a continuing increase in core mandates and so forth.

What’s the appetite among DC plans for real estate?

Pandaleon: I think that’s proving to be very difficult. One of the big reasons for that is the people making decisions about what your investment opportunities are for your 401K plan at ABC Corporation, they’re not investment people. They’re usually HR people with an attorney sitting by their side reminding what their liabilities are if they do certain things that are perceived as being added risk. There has not been a good job done to educate the individual investor over the years about how to manage a 401K. Interestingly, if you talk to CIOs and board members of various municipal plans around the country, they are absolutely convinced, and I think they may be right, that the individual investor really isn’t qualified and isn’t going to get qualified and they’re going to make bad decisions. So, there’s been some discussion about how to put a defined benefit professionally managed wrapper around a 401K so that people aren’t put in a position of having to make these decisions.

In the meantime, people are putting certain types of funds into 401K plans for individual investors and employees to choose from and they tend to go toward the things that are the most conventional and the safest for them. Not necessarily the safest investments, but the things that minimize the corporate liability. So, there’s a big risk aversion there and alternatives create more risk for them, no two ways about it. If you’re letting people invest in a private real estate opportunistic fund of some sort, well, what about Mrs. Smith down in accounting who puts her entire 401K into that thing. Then, it turns out to be 110 percent levered and the debt market freezes and everybody, they’re going to go back to the corporation and say, “Hey, you shouldn’t have put those cookies in front of me because you knew I was going to eat them! You should have protected me from myself.” I think that’s a very big impediment to getting real estate into a large-scale 401K plans.

Will this lead to a decrease in capital allocations to alternatives? 

Pandaleon: I think that’s a possibility, unless we get creative and figure out new ways to capture or to tap that capital, or other forms or other sources of capital. If you combine these impediments on the defined contribution side, with the trends on the defined benefits side toward less aggressive investing, I think we’re already seeing it. I think the reason that these 500 closed-end opportunistic asset allocator fund managers are having so much difficulty raising capital is there just isn’t the demand there that there used to be.

Is tapping the retail investor the key to overcoming this change? What are the challenges?

Pandaleon: There are a number of regulatory hurdles, first and foremost. You have the need for daily pricing and daily liquidity if you want to tackle 401K programs. That’s a real challenge for real estate. I think we’ll figure out the valuation component pretty quickly. The real challenge in my mind is the liquidity piece because in order to maintain liquidity promise, if you will, and be able to deliver on that, you need to hold back a fair amount of cash or have a very large corporate balance sheet backstop of some sort. I think that most investment managers aren’t capitalized to a point where they could backstop it, so it’ll have to be held inside the fund. Most of the early structures that we’ve seen have something on the order of 20 percent cash marketable securities. That significantly dilutes their current return, which is the primary appeal to the individual investor. That 6 percent dividend is really crucial. And when all of a sudden, it’s only a 3.5 or 4 percent dividend, then you start to wonder why you’re investing in real estate. You can invest in a lot of things that generate that kind of a yield, without all the difficulties and lack of liquidity and so forth.

That’s a fundamental issue. It also favors some solutions that have been brought to bear by some large financial institutions where they are backstopping it in a sense. But that creates issues, too. If they’re too successful, then their backstop becomes a big source of risk.

How do managers capture retail investors?

Pandaleon: Either way you slice it, whether it’s the current non-traded REIT channel, through broker dealer financial planners, or you start looking at these big corporate 401K plans, it’s a completely different distribution system. It’s one that involves a lot more boots on the ground. They’re much higher costs. Anything that goes to an individual investor is going to be much more scrutinized by regulators. So, there are all these different factors and, yes, the costs of launching something like that are quite high and there’s a lot of risk before you find out whether you’re actually going to be successful.

We’ve already seen one of those, what around my company we refer as the daily NAV REITs. We’ve already seen one of those get pulled from the market, and none of them have really generated much traction to date. Even the ones that are sponsored by the big insurance companies that actually do manage 401K plans for corporations have failed, with one exception, to generate a lot of traction.

What about the distribution network?

Pandaleon: That’s a significant problem. These products, the daily NAV REITs, for the moment, are really being focused on the large wire houses that work on more of an asset management fee basis, as opposed to brokerage commissions. That’s the channel. It’s not really the exact same channel as the independent broker-dealers, which is where most of the non-traded REITs have been sold.

It’s very difficult to wean them off of their 7 percent commissions. And it’s interesting, just as a side note, the non-traded REITs are often criticized as being very fee-heavy and they are. The thing that people miss is that that fee is not going to the sponsor. The fee is going to the broker-dealer. It’s going to the financial advisor who sells you these securities.

If you have an overall load over the life of one of these funds, a good one is around 10 percent, 7 percent of that is going to the broker-dealer advisor who sells you the security. So, many of the issues are early in the distribution channel, as opposed to in the sponsorship.

Will crowdsourcing and the JOBS Act change capital raising in the US?

Pandaleon: I think that the implications of what’s called the JOBS Act, which is this opening toward modern methods of communication in marketing securities, is, potentially, a huge game-changer. Nobody is quite sure what the rules are yet. They’ve promulgated the law but they haven’t given all the specifics. But is it becoming clearer that there is a willingness to engage or have the investment sponsors market directly to the consumers.

To some extent, that dis-intermediates the existing broker-dealer channel. We at Inland have a very large syndication business. It’s just the old-time syndication business that used to be a very primary way of financing real estate pre-1986. We’ve never left that business. It’s gotten bigger and smaller over the years. Right now, it’s booming and there’s tremendous demand among individual investors, high-net worth investors, family offices for access to property specific real estate opportunities. The JOBS Act could really allow for significant growth in that market and we just have to see how the regulatory environment plays out.

Can crowdsourcing ever work for the discretionary, commingled fund?

Pandaleon: I think that the commingled fund multi-investor discretionary product could also be marketed that way. Where we are seeing the demand from that market place right now is for more property-specific transactions. And the non-traded REITs are where the commingled capital, if you will, is going. That could definitely shift. That market really hasn’t been tested. It’s all new. The syndication business has always been there, but these new marketing techniques that the regulators have, appear to have adopted a willingness to prove, could change that.

What about risk appetite for retail investors?

Pandaleon: We have found that there is a much bigger appetite for steady, dividend-producing real estate than there is for more risky real estate. Having said that, we have also found that there is demand for access to development opportunities and so forth. It’s just much more limited. The bulk of the market, particularly, non-accredited investors, the true individual investor, they really love that monthly dividend. That’s really what makes it go. If you don’t have that, it becomes exponentially more difficult to raise the capital.

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