Need for Pension Funds’ Move Into Real Estate Called Critical
“Investment” versus “speculation” is very much in the beholder’s eye--and few beholders have a more conservative eye than the country’s pension plan administrators.
And, while it’s a long way from being a giant step forward, the mere presence on the Los Angeles city ballot June 4 of a proposition that would permit the city’s three retirement systems to invest--for the first time--in real estate may be a significant, if long overdue, upgrading of its role as a safe haven for “sacred” money.
The move into real estate, local pension administrators say, has become particularly critical in light of Mayor Tom Bradley’s recent call for a five-year divestment of as much as $1 billion of city-controlled assets--the lion’s share of it in pension funds--from banks and businesses with ties to South Africa.
More than a mere request that such an investment redirection be considered, Bradley subsequently put teeth in it by threatening to remove fund commissioners and administrators defying it.
Caught between this and their legal responsibility to direct their investments to the maximum benefit of fund participants, local fund administrators fear that a South African ban would sharply restrict badly needed diversification in all three funds. Real estate, they feel, could prove a viable, nonpolitical, way out.
But, despite nudging by Congress as long ago as 1974--specifically in the Employee Retirement Security Act (ERISA), passed that year--which encouraged pension plans to diversify their investment portfolios to include real estate, the move to do so has been sluggish, at best.
-------------------------------------------------------------------------- Despite nudging by Congress as long ago as 1974, the move to include real estate in investment portfolios has been sluggish, at best.
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Of the roughly $1 trillion now held by public and private pension plans nationally on behalf of workers, according to Dee Birschel, a researcher for the International Foundation for Employee Benefit Plans in Brookfield, Wis., only about 5.5% of these assets in 1984 were invested directly in real estate--down from 6.8% the year before--and far below the traditional involvement in real estate of European pension plans.
Even on this small base, according to Gary Mattingly, general manager of the local $1.7-billion fire and police pension system, corporate pension plans have been about twice as aggressive as public pension plans in plunging into direct real estate investments.
“About 70% of the corporate plans with $1 billion or more in assets,” Mattingly said, “have some real estate holdings. But among public retirement systems of comparable size only about 30% have any real estate investments at all.”
In Los Angeles, the proposal that will be put before the voters in June would permit the Department of Water and Power, the city employes retirement system and the fire and police pension system to invest as much as 20% of their assets--totaling about $4 billion in all--directly into real estate investments. (All three, in common with virtually all other pension plans, nationally, have had minimal investments in mortgage-backed securities for some time, but these fixed-interest, bond-like holdings have, at best, only a kissing-cousin relationship with real estate.)
The proposal to permit broader investment diversification in the city’s pension plans was first made in November, 1983, Mattingly, a prime mover in the drive, continued, “and then an expert advisory committee was formed the following February to study it.”
And Richard Rosenthal, a Venice realtor and a member of that blue-ribbon committee, said: “There was never any disagreement on the committee about the soundness of the idea--Mattingly and the others had researched the subject thoroughly--and our primary job was to draft the language of the charter proposal, lay down the ground rules and that sort of thing.”
Among the ground rules, in addition to the 20% maximum investment in real estate, is a 5% maximum investment in any one project, and no investment in real estate unless it has first been recommended by one or more qualified independent real estate advisers--including the opinion of a qualified appraiser as to fair market value (except for investments in investment pools). The advisory board also turned thumbs down on investments in any project or program in which the adviser(s) has a direct or indirect interest as an owner, investor, principal, agent or employee.
The latter is particularly critical in the administration of public pension plans--far more so than in private, corporate, pension plans--to counter ever-present suspicions of City Hall cronyism. As one veteran pension administrator put it: “When you’re investing what is largely the public’s money, you’ve got to be like Caesar’s wife--totally above suspicion.”
Currently, Los Angeles’ three city retirement plans operate in very much the same way--basing retirement benefits on both the workers’ income and years of service--and functioning under the same constraints as to the types of investments that they can make with their members’ (and the city’s) contributions.
Stocks, Bonds Anchor Fund
Mattingly’s police and fire pension system, for instance, has about 9,500 active members and a comparable number of retirees (and survivors) receiving roughly $15 million a month in benefits.
Police and firefighters may retire after 20 years of service at 40% of their pay, or 55% after 25 years, or the maximum of 70% after 30 years of service.
And, under the present city charter, Mattingly’s investments are basically confined to stocks, bonds and short-term, money-equivalents--no more than 70% of the fund, for instance, can be in common stocks, and then only in the stock of companies that are nationally listed and that have paid dividends for each of the preceding five years. As a consequence, the police and fire pension fund is currently 60% invested in stocks, 35% in bonds and 5% in money-equivalents.
“Mayor Bradley’s divestment request, if we do, indeed, put it into effect,” Mattingly said, “would severely limit our diversification. It would mean that we would be unable to invest in the stocks or bonds of about one half of all major U .S. corporations because that’s the percentage of them with some financial interests in South Africa.
Real Estate a Big Plus
“So, in order to maintain our current diversification--or increase it, as we would like--we definitely could use real estate as the vehicle making it possible.”
There is nothing in the proposal that would limit the city’s three pension funds to making real estate investments anywhere in the world. “But,” Mattingly added, “from a practical standpoint, I can’t see us looking at foreign real estate for a long, long time and, even then, certainly not in South Africa.”)
The Los Angeles City Employees Retirement System ($1.3 billion in assets with 18,000 active members and 8,000 regular retirees), according to Jerry Bardwell, general manager, is currently one-third invested in stocks and two-thirds in bonds.
The Department of Water and Power Retirement Plan ($1 billion in assets with 10,000 active members and 7,500 retirees), according to plan manager Richard W. Goss, is currently 55% in bonds, 30% in stocks, 8% in mortgage-backed securities and 7% in cash-equivalents.
Yield All-Important
And, since the yield on their investments is a major factor each year in the ability of the funds to meet their benefit commitments, how well--or poorly--they do in this regard directly effects the city’s (and the taxpayers’) contribution to them.
While the administrators of all three city retirement plans have enthusiastically endorsed the ballot proposal, only the police and fire departments plan--upon voter-approval--to go immediately into real estate. “Although,” he added, “it might take us as long as five to 10 years to get the 20% fully committed to real estate.”
Both the DWP’s Goss and the city retirement system’s Bardwell see no immediate change in investment direction but, as Bardwell put it, “our board is interested in having the authority (to invest in real estate) so that when the opportunity is right for us, we can do it. We’re not too interested at the moment, although, historically, real estate hasn’t been as volatile as stocks and bonds, and the yields have been comparable.”
In addition to the greater diversification that Mattingly sees in real estate investments, the field’s traditional role as a hedge against inflation is, he added, another important plus.
“Like almost all pension plans, our retirees get an annual adjustment in their pensions tied to the Consumer Price Index, and in one year alone, in the late ‘70s, their pensions went up 17%. A low inflation rate is definitely good for any pension plan, but we can’t always count on it.”
Despite this classic inflation-hedge role, however, real estate’s reputation for volatility has been a major deterrent to wide-scale acceptance of it as an investment medium by both private and public pension plans, all sources contacted on this matter agreed--despite the lack of hard evidence that, compared to stocks and bonds, it is volatile. Another deterrent--justifying a pension investment in a real estate project that might go sour.
As Charles Jackson, president of Los Angeles-based American Benefit Plan Administrators, and the president-elect of the International Foundation of Employee Benefit Plans, put it, “trustees of any pension plan are serving with a significant fiduciary responsibility and, since they have nothing to gain personally, they want to invest in things that are very secure so that no one can look back and say ‘you made the wrong decision.’ ”
“Prudent Man” Rule
In the same legislation--the Employee Retirement Security Act of 1974--in which Congress urged more diversification into real estate--it also increased the personal liability of trustees (up to, and including, jail terms) for violations of what is known as “the prudent man rule.” For handling pension funds, that is, in a way that might be construed as recklessly im prudent.
“ If a trustee makes a wrong decision on the stock market,” Jackson said, “he can always fall back on the state-of-the-economy argument and compare what his fund has done compared to the performance of indices like the Standard & Poor’s 500-Stock Index or the Dow Industrial Average. It’s different with real estate.”
Jackson’s American Benefit Plan Administrators, the country’s largest such company, serves as the trustee for about 350 pension plans, nationally--predominantly in the private sector--with offices in 21 cities and administers $5 billion in assets.
“I’m highly in favor of real estate investments for pension funds myself,” he added, “although I’m not in a position to make that kind of decision for my clients. But, with the right kind of research, and expert advice, they should do very well.”
While historic performances for the real estate market aren’t as readily available, nor as widely accepted, as comparable indices for both the stock and bond markets, research submitted to the city’s Real Estate Investment Advisory Panel by Mattingly of the police and fire system suggests that during the economically erratic period between 1971 and 1983, real estate proved dramatically less volatile than either stocks or bonds.
Based on comparisons compiled for Mattingly by the investment firm of Goldman Sachs & Co., the performances of the Standard & Poor’s 500-Stock Index, Salomon Brother’s Bond Index and Prudential Insurance Co.’s commingled portfolio of 600 real estate properties (worth $4 billion) were charted for from 1971 through 1983. In terms of annual, average rate of return on each, the outcome was fairly predictable--10.9% a year for stocks, 7.6% a year for bonds and 10.8% for real estate.
But, during that 13-year period, according to the Goldman Sachs study, there were wildly fluctuating rates of returns for both stocks and bonds. A negative return marked three of the 13 years for stocks and a negative return marked four of the 13 years for bonds. The worst year for stocks was 1974, with a drop of 22% (the best year, 1975, with a gain of 35.1%). The worst year for bonds was 1974, with a drop of 1.4% (the best year, 1982, with a gain of 42.2%).
During the entire 13-year period, however, the Prudential Real Estate Index never showed a negative return even in the otherwise disastrous real estate market of 1982 when the rate of return dropped to only 4.3%. In two of the 13 years (1979 and 1980), the real estate index showed an annual rate of return, respectively, of 22.7% and 21.1%.
“The real estate troubles in 1982,” realtor Rosenthal of the city’s study panel said, “were never in well-financed commercial real estate, but in those deals that were thinly capitalized--highly leveraged investments at a time of rapidly accelerating interest rates.”
And, since the city charter prohibits any of the three pension funds from going into debt, it also rules out any of the above troubles by requiring the fund managers to make all of their real estate investments in cold cash.
The Goldman Sachs study of annual returns on Prudential’s real estate investments also parallels the experience of the Southern California Development Foundation, an affiliation of pension funds representing 14 Southern California trades.
The foundation is unusual in that it flies wildly in contradiction to the national trend toward minuscule (or no) investment in real estate. The pivotal Carpenters’ Pension Trust, spearheading the foundation, has no less than 71% of its $700 million in assets invested in real estate and even the much smaller painters’ union has a full 50% of its $7 million in assets in real estate.
“Had it not been for real estate, the Carpenters Pension Trust would have had an awful time, years ago, in meeting its actuarial assumptions,” according to John W. Bernard, who has chaired the Development Foundation since its inception about 20 years ago. Bernard is chairman and chief executive officer of Alhambra’s Moran Co., parent firm of Moran Construction Co.
“From the very beginning,” Bernard said, “we felt that it was not only wise to invest in real estate from an investment standpoint--after all, the whole point of a trust is to make money--but to use it to put people back to work at the same time.”
Historically, he added, each of the 14 trusts--which the Development Foundation serves as a clearing house--has averaged a yield of about 11% a year on its real estate investments.
“And it would be higher than that,” Bernard said, “except that for many years we were bound by the state’s 10% usury limit, and so we’ve got a lot of real estate still on the books at yields like 9 7/8%.” (The Legislature didn’t repeal the 45-year-old 10% usury law until 1979). “And then, too,” he added, “we’ve got some old, low-yielding bonds on our books going back about 20 years or so when we were new at the game; they are almost valueless today.”
Informally constituted, the Southern California Development Foundation representing the 14 trusts (and headed by five trustees from management and five from labor) meets monthly to consider real estate presented for its consideration by approved brokers.
“Say it’s a $10-million project,” Bernard added. “It’s presented in detail and any trustee interested in it can express interest at that time. Let’s say the carpenters’ adviser has analyzed it, and likes it, so the carpenters might indicate a $4 million interest in it, and another might come in for $2 million.”
Within the next 30 days, Bernard said, each trust that has expressed an interest is visited by the broker who goes into vastly more detail--and undergoes more analysis.
“Once the deal is sealed,” he added, “Transaction Trust Number So-and-So is set up with contributions from the participating funds which the bank holds and distributes.”
Branching out into real estate for the city’s three pension funds, Mattingly concluded, would bring a badly needed diversification for all of them and would flatten out heretofore wide and unpredictable swings in investment performance--from an annual return of 8% in 1982, for instance, to an unrealistic 47% in 1983, and then to a crashing negative 6% return in 1984.
