For Pension Funds, the Answer Isn't Higher Yields

I was at a meeting last week where an executive from a leading pension fund consultant talked about the conundrum facing plan sponsors investing in real estate. Desperate to close yawning funding gaps for increasing numbers of beneficiaries, these institutional investors are back scrounging for higher yields—yields that by the way real estate just can’t and won’t deliver on an ongoing basis.

At the same time, requirements to pay out generous pension and benefits packages to public employees mean an increasing number of states and local governments teeter on the edge of bankruptcy—whether their pension maestros can achieve these higher yields or not. Major cities, including New York, must reduce teachers and fire fighters to keep paying retirees, who by contractual right can start collecting fat lifetime pensions in their 40s when they have enough service under their belts. Many private companies, meanwhile, have scuttled defined benefit plans and left employees to manage their own 401K plans, because the defined benefit requirements eat into profits and are unsustainable.

Powerful public employee pension unions will fight tooth and nail to retain benefits, although giving in on two-tier systems which will pay less to new workers. But ballooning numbers of baby boomer retirees are where the immediate problem festers. Politicians and unions will confront the unpalatable choice—more jobs cuts or curtailed pensions for retirees, and probably some of both. There’s no other way out.

Certainly, looking to real estate is not the answer to pump up returns. Plan sponsors, who stayed in core property funds or got back in early, have been gratified by low teens returns expected for calendar year 2010. They have benefited from asset managers’ decisions to take sharp write downs at market bottom and recent cap rate compression for properties in top markets. But few observers expect returns to stay as robust through 2011, given problematic demand for space, except maybe in the apartment sector.

And how many times, do investors need to be re-taught the lesson of the past three years? Essentially real estate is an income plus investment—registering annualized returns in the high single digits. It’s better to buy-and-hold prime properties, managing to keep occupancies high, than to engage in opportunistic trading strategies, which can distort market pricing and eventually hit a brick wall of significant losses. It’s very hard for investors to know when to sell out of opportunistic strategies and even more difficult to hold back from reinvesting gains from early successes. Pension funds, in general, suffer repeatedly from timing misplays despite all the advice from consultants they hire for backside covering. At present, plan sponsors queue up to get into the limited number of core funds after missing out on recent gains, when last year many were lining up to get out of these very same accounts.

Pension funds also over leveraged in the 2005-2007 period to compete for acquisitions just at the point in the market cycle when they shouldn’t have been using so much debt. Now at market bottom—the best time to use leverage—they have turned skittish.

So what’s going to happen? I expect that over the next decade, state and local governments will pare back pensions for all retirees over the strenuous objections of unions—that’s the only way to solve the severe underfunding. What happened to GM workers will happen to many public employees. And just maybe, plan sponsors will be able to ratchet down their return expectations for real estate and hew to an appropriately more conservative investment tack. Otherwise, they will be disappointed… again.

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A marketing communication strategist who turned to real estate analysis, Jonathan D. Miller is a foremost interpreter of 21st citistate futures – cities and suburbs alike – seen through the lens of lifestyles and market realities. For more than 20 years (1992-2013), Miller authored Emerging Trends in Real Estate, the leading commercial real estate industry outlook report, published annually by PricewaterhouseCoopers and the Urban Land Institute (ULI). He has lectures frequently on trends in real estate, including the future of America's major 24-hour urban centers and sprawling suburbs. He also has been author of ULI’s annual forecasts on infrastructure and its What’s Next? series of forecasts. On a weekly basis, he writes the Trendczar blog for GlobeStreet.com, the real estate news website. Outside his published forecasting work, Miller is a prominent communications/institutional investor-marketing strategist and partner in Miller Ryan LLC, helping corporate clients develop and execute branding and communications programs. He led the re-branding of GMAC Commercial Mortgage to Capmark Financial Group Inc. and he was part of the management team that helped build Equitable Real Estate Investment Management, Inc. (subsequently Lend Lease Real Estate Investments, Inc.) into the leading real estate advisor to pension funds and other real institutional investors. He joined the Equitable Life Assurance Society of the U.S. in 1981, moving to Equitable Real Estate in 1984 as head of Corporate/Marketing Communications. In the 1980's he managed relations for several of the country's most prominent real estate developments including New York's Trump Tower and the Equitable Center. Earlier in his career, Miller was a reporter for Gannett Newspapers. He is a member of the Citistates Group and a board member of NYC Outward Bound Schools and the Center for Employment Opportunities.