By Jack McAllister

If 401(k) plan values are to rise to their potential, they could use a little more yeast — in the form of REIT stocks

Today, the first wave of Baby Boomers are preparing to retire from their careers with plans to have long, active and financially secure retirements. They also are the first generation that will look toward a new source of assets to provide the bulk of their retirement income, the ubiquitous 401(k) plan. One question being asked by some financial observers is "Will there be enough assets in these accounts to pay for the very long retirements these Boomers are expected to enjoy?"

In 401(k) plans, the plan participant assumes all responsibility for the investment performance of his or her retirement account and the income it will produce. This is a big change from the days when companies guaranteed their employees some level of retirement income for the rest of their lives. Today, Boomers' retirement income will depend upon their individual success or failure as investment portfolio managers.

Studies have shown that these plans are under-performing the traditional pension plan by as much as two percentage points annually. A lack of investment diversification is considered to be the major cause of the under-performance.

Part of a solution to this performance gap would be the inclusion of real estate in these portfolios. Institutional investors have been using real estate as a portfolio diversifier for the last 30 years. Unfortunately, real estate is not an investment choice in the vast majority of 401(k) plans today.

Changing Plan Structures

Since the Employee Retirement Income Security Act (ERISA) of 1975 established defined contribution plans, corporate America has increasingly embraced 401(k) plans as the main retirement benefit vehicle offered to employees. For many, the day of the old-fashioned company retirement check is over. Instead, in a typical 401(k) plan, the company or plan sponsor contributes a certain percentage of each employee's income into an account for each participant, while the employee can make additional, voluntary contributions into their accounts on a pre-tax basis. The plan sponsor decides which investment options are included in the plan and provides a certain amount of information and education to the participant so that he or she can make informed investment choices. Basically, the company's obligation to provide retirement income ends with its plan contribution. The employee makes all his or her own investment decisions, which will directly affect the amount of retirement income he or she ultimately enjoys. This is a big change from when companies guaranteed some level of retirement income to their employees.

Lack of Diversification Creating 401(k)
Under-Performance

Today, defined contribution plan assets total approximately $2.7 trillion, exceeding defined benefit plan assets of $2.3 trillion. Over the last decade, the total assets of defined contribution plans also have been growing faster than those of defined benefit plan assets due to the growing number of plans and the increasing contributions into the plans. Yet, a study by Watson Wyatt in 1998 found that the investment performance of defined contribution plans lagged the investment performance of defined benefit plans by 200 basis points annually. The study suggested that the driving force behind 401(k) plans' large underperformance was the lack of investment diversification in the average plan account compared to the average traditional pension plan. The participants in 401(k) plans seem to concentrate their investments in one asset class or another, and are not yet using the basic concepts of investment strategy and asset allocation, which have been used in institutional portfolio management for the last 30 years. Modern portfolio theory is just that in the 401(k) world—it's just a theory and not a reality. The cost to investors of not managing well-diversified portfolios in long-term accounts such as 401(k) plans can be staggering. For example, $100,000 invested at 10 percent for 30 years grows to be $1,744,940 while the same $100,000 invested at 8 percent for the same period would grow to only $1,006,266. What may seem like a small difference in return for any year (i.e., 2 percentage points) compounds into almost 75 percent more assets over a 30-year time horizon.

Is Something Missing?

A first step toward helping participants build strong investment portfolios would be for plans to offer a more diverse set of investment options. Unfortunately, some investments that offer significant portfolio diversification are still being omitted from the investment choices of many plans. Since the 1970s, stocks, bonds and real estate have been the primary investments used by institutions in their portfolios. Investment research over the last 20 years has demonstrated the superior performance of portfolios that use all three of these investments in various combinations. Most 401(k) plans offer a variety of stock and bond investment options. However, real estate stocks are largely non-existent in most of today's defined contribution plans. Real estate's competitive rates of return, stable levels of risk and low correlation with the investment returns of stocks and bonds offer significant diversification benefits to a well-diversified portfolio. Perhaps participants and sponsors should be asking why 401(k) plans exclude one of the strongest sources of portfolio diversification from their investment choices.

Building Efficient Portfolios

The current investment allocation of the typical 401(k) plan account probably is caused by two factors. One is the nature of individual investors. Most do not have the knowledge, time or interest to learn how to properly manage investment portfolios. Second, current allocations may be partly a historic artifact from the earliest deferred-savings plans offered by the insurance industry, which often included only guaranteed-return investments—much like the old savings account. Today, working people must look at their 401(k) plans not just as a savings account, which it certainly is, but as a long-term investment account, which must produce enough assets to be able to meet an individual's lifetime retirement income needs. For all the investment information and education that has been offered to 401(k) plan participants to date, most plan participants are not focusing on the need to build and maintain efficient portfolios that properly weigh risk and return across multiple investments. The consequences of such oversight may become a big issue when participants realize that they are not achieving the returns they require on their retirement assets to meet the income needs of a long retirement.

In response to this potentially explosive issue, some of the larger plan sponsors have been running their defined contribution plans more like their defined benefit plans by offering participants access to investment advice and the tools required to manage their retirement portfolios in the same manner that institutional investors have managed portfolios for the last 30 years. Still, for all that is being done, some financial observers, providers and sponsors say that the tools and methods are not being used in a consistent manner over time. Simple techniques such as annual rebalancing among asset classes to maintain targeted, portfolio risk levels are not being followed.

Risk and Return

Institutional investors invest in broadly diversified portfolios, meeting their plan liabilities while controlling the risk of catastrophic losses in any one year. Individual investors may not understand the importance of this investment concept. Just remember what happened in 2000.

Growth stocks may have the highest expected return but they also are the most volatile. They can be huge winners and big losers. It's the nature of risk and return. The more return each investment offers, the more risk an investor accepts by owning it.

Today, plan providers and sponsors are looking for ways to help their plan participants understand the reasons for owning diversified portfolios. In the last few years, most plans have increased their investment choices so individuals can con- struct portfolios that match their specific risk and return requirements. In addition, participants in some plans are being given access to Internet-based investment advice providers such as Financial Engines (www.financialengines.com) and MPower (www.mpower.com), which can help them establish investment strategies specific to their needs and provide the tools to create appropriately diversified investment portfolios. For the last 30 years, institutional investors have been using real estate to build diversified portfolios. Individual investors should be using the same strategy in their 401(k) plans.

Real Estate:
Low Correlation = Enhanced Investment

Today, investors can invest in high-quality institutional grade commercial real estate through REITs and public real estate companies. REITs and the public real estate industry have become a significant and active part of the U.S. commercial real estate market.

REITs offer the distinctive investment characteristics of all real estate investments: high levels of income provided by long-term rental agreements and an opportunity for moderate growth in values as rents rise over time. REITs are companies that buy, own and manage all types of real estate and pay out the rental income to investors in the form of high dividends. Numerous studies have shown that REIT investment returns are not highly correlated with the returns of other stocks and bonds. Adding REITs to a diversified portfolio can therefore raise the return and lower the risk or price volatility for most any portfolio. That's an investment option that is currently unavailable to most Baby Boomers in their 401(k) accounts.

Real Estate Makes Sense for 401(k) Plans

Today, Baby Boomers are facing the bright prospect of experiencing the longest, most active and healthiest retirement of any generation in our country's history. They should be prepared to have a significant amount of financial assets to provide the security they will require. Unfortunately, the best methods and practices with which Boomers could meet their long-term investment goals in these accounts are largely misused or absent. That is something both 401(k) plan participants and plan sponsors have a big stake in changing.