Vol. 48, No. 2
Consider adding these funds to your 401(k) investment option list to help workers reach a sunnier retirement.
Employees are getting used to opening up their 401(k) statements each quarter and seeing losses. The equities market—where the bulk of 401(k) plans are invested—has been on a downward track for a couple of years.
But 401(k) participants looking for ways to help stem those losses may be interested in a little-known and underused investment that has been posting consistent gains in this down market—real estate investment trusts (REITs), vehicles that essentially securitize the owning and/or operating and/or financing of real estate. A REIT mutual fund specializes in owning publicly traded REITs.
However, few 401(k) plans offer any kind of real estate investment option—approximately 6 percent of plans in 2000, according to the Profit Sharing/401(k) Council of America (PSCA) in Washington, D.C. And the amount of money invested overall in real estate is extremely small, says David Wray, PSCA’s president—less than 0.1 percent of all assets in all plans.
Evan Miller, a partner at the Washington, D.C., law firm of Hogan & Hartson LLP, notes that a majority of 401(k) plans are heavily weighted toward domestic equity funds. “It’s not unusual for companies to offer an option mix that could have 12 to 15 investment options, most being mutual funds invested in domestic equities,” he says.
But that may change. Wray says 401(k) plan sponsors are beginning to express an interest in adding REITs to their plans as a way to help participants diversify in this choppy market.
Ibbotson Associates, a Chicago-based investment consulting firm, is one of those plan sponsors that recently looked into REITs—after seeing the results of its own study on these investment trusts in 401(k) plans, a study requested by the Washington, D.C.-based National Association of Real Estate Investment Trusts (NAREIT). The study showed that adding REITs to a wide selection of diversified portfolios from 1972 to 2000 boosted compound annual total returns by as much as 0.8 percent compared with non-REIT portfolios.
“We thought the results of the REIT study were impressive,” says Michael Henkel, president of Ibbotson. “A REIT in a 401(k) plan makes a lot of sense; [REITs] have a high yield and diversify the investments nicely.” Ibbotson rolled out a REIT mutual fund to its 125 employees on July 1, 2002, through its 401(k) vendor, Boston-based Fidelity Investments. Henkel recalled thinking, “If it makes sense for the investors we advise, then [we should] add it to the plan.”
Plan sponsors deciding if it makes sense for them as well should keep in mind the benefits of REIT mutual funds but should do proper due diligence on their vendor’s track record and make sure their employees understand how the investment trusts work.
Historically, REITs have not been offered to 401(k) plan participants for a number of reasons, say the experts. But the primary reason is that although REITs date back to the 1960s, it is only in the past few years that they have matured as investment vehicles appropriate for a 401(k) plan.
“Publicly traded REIT mutual funds were almost non-existent in the early 1990s, so most of the larger 401(k) plan vendors did not have a REIT mutual fund to offer their clients until two or three years ago,” says Miller. Because the vast majority of investment options in 401(k) plans are mutual funds offered through 401(k) vendors, says Miller, the lack of availability on this level meant the investment trusts rarely were offered in plans.
But today there are at least 50 publicly traded REIT mutual funds, and nearly all of the large 401(k) vendors, such as Fidelity; the Vanguard Group in Valley Forge, Pa.; and Principal Financial Group of Des Moines, Iowa, now have REIT mutual funds available to 401(k) clients.
For example, Vanguard began offering a REIT fund in May 1996 when it added the Vanguard REIT Index Fund to its investment lineup, says Gerry Mulline, a principal with the Vanguard Group in Malvern, Pa. For the year ended Sept. 30, 2002, the return on the Vanguard REIT Index Fund was 8.54 percent. Average annual total returns were 13.45 percent for three years and 3.67 percent for five years. Currently more than 150 of the 1,400 plans for which Vanguard provides record-keeping services use the REIT fund; the fund was added by 35 plans in the first three quarters of 2002.
A REIT mutual fund may be an appropriate investment vehicle for a 401(k) plan because its risk and return characteristics are different from stock and bond mutual funds, and it provides a hedge for employees, says John Shanklin, a consultant with Segal Advisors in Chicago. “When you are trying to invest money over time and want the highest rate of return for an acceptable level of overall risk, the best way to accomplish this goal is to diversify and not have one type of asset class,” he says.
The key to diversification, adds Miller, is to have two or more investments that react differently in various kinds of economic settings. For example, although equities are posting double-digit losses this year, real estate investments have posted gains—the two operate independently of each other. REITs, he says, allow participants to diversify without significantly reducing potential returns or significantly increasing risks.
“In this day and age where we have a mercurial domestic equities market and are looking at continued prospects for declines, the ability to add a fund that will diversify the investment mix and that will not increase risk or reduce ability of good returns should be considered,” Miller says. And, he adds, REIT funds are less risky than international securities funds or hedge funds and easier for participants to understand.
More REIT Benefits
In addition to helping participants diversify, REITs have other features that make them attractive 401(k) investment options. REIT yields tend to be much higher than bond yields, and, because 401(k) accounts are tax-deferred, those high yields are also tax-deferred, Henkel says.
A REIT mutual fund in a 401(k) plan also could help HR managers sell their 401(k) plans to their workforce. “Employees are clamoring for an investment option that performs well in an environment where domestic equities don’t,” says Miller. An HR manager “has to look into offering options that look good next to poorly performing equities,” he adds.
Miller also says that because REITs are essentially investments in real estate, they are fairly easy for HR to explain to participants.
It should be noted, however, that an investment in a REIT is not a direct investment in real estate but an investment in a company that manages real estate, says Wray. “The success or failure of a REIT depends on the companies in which the REIT invests and [the investment trust’s] management,” he says, pointing out that REIT mutual fund investments are akin to bond fund investments. “In a bond fund, returns depend on the expertise of the bond fund manager,” adds Wray. It’s not the guaranteed return that comes with most individual bonds. Likewise, he says, REIT fund returns depend on the expertise of the fund’s management, and this should be explained to participants. (For more information, see the “The REIT Journey,” right.)
Employers also need to stress to employees that, like any investment, what does well today may not do well tomorrow. “If the S&P  turns up,” says Miller, “it’s possible that REITs won’t perform as well.” And employees should understand that REITs are sensitive to interest rate changes.
Another benefit to plan sponsors is that REIT funds are low-cost, notes Mulline. For example, the Vanguard REIT Index fund costs 28 basis points—about a quarter-percent of an account’s value—while the typical large-cap equity fund charges more than 100 basis points—more than 1 percent.
Offering a REIT in a 401(k) investment lineup also may help protect employers in the event of 401(k) litigation. Generally, 401(k) plan sponsors attempt to shield themselves from some fiduciary liability by allowing participants to invest their account balances. Under section 404(c) of the Employee Retirement Income Security Act (ERISA), a fiduciary is not liable for losses that result from employees’ own investment decisions. According to Miller, “404(c) protects the fiduciary from the employee’s failure to diversify.”
But that does not mean fiduciaries are completely off the hook. A plan sponsor still can be liable if it fails to appropriately pick the right investment options for that plan. “Plan fiduciaries who put together investment options for 401(k) plans need to construct an option base that gives participants the ability to put together a diversified portfolio,” says Miller.
If, in litigation, a company can demonstrate that its named fiduciary acted prudently in offering an appropriate investment set to participants, then it should protect the fiduciary from a particular employee’s failure to diversify, says Miller.
Is a REIT Fund Right for You?
While REITs have many attractive qualities, plan sponsors should do a thorough analysis to determine if a REIT fund is appropriate for their plan. The first step is for a plan sponsor to review the plan’s existing investment mix, says Miller, to see how it is performing and to analyze the current asset allocation characteristics. “If the investment mix is primarily domestic equities, then you probably need to offer another asset classification that will perform well when equities are not,” he says.
The next step would be to set up a meeting with the current 401(k) vendor, he says, and to ask if it offers a REIT mutual fund. If it does, then the sponsor needs to conduct an analysis of the fund. “You should ask the vendor to do a correlation study to show how these funds perform in comparison to the funds currently offered,” he says. If the results show that the REIT fund’s returns balance out the other funds’ returns, then the next course of action is to present the information to whoever has the authority to add or subtract funds to the plan, adds Miller.
Also, Mulline and Wray point out, REITs work best in plans that already have at least 12 other investment options. “A REIT is not one of the first six to eight funds that should be offered if you are building a plan,” Mulline says. REIT funds are narrowly focused on a single market sector, he points out, and the core options need to be more broadly diversified.
While both Shanklin and Miller say that they are talking to clients about adding REITs to their 401(k) plans, both acknowledge that there is currently no great rush. But, says Shanklin, that is sure to change if the stock market continues on its current downward track. REITs’ impressive returns over the past few years will surely lead many employers to at least consider them, he says.
Elayne Robertson Demby is a freelance business writer in Weston, Conn.