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The Case for Private Real Estate Debt in Retirement Income Solutions

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The Case for Private Real Estate Debt in Retirement Income Solutions Strike the Balance: The Case for Private Real Estate Debt in Retirement Income Solutions Retirement Income and Defined Contribution Plans The defined benefit pension plan has steadily declined as the mainstay of the retirement system in the United States, replaced by the defined contribution plan. A study by The Employee Benefit Research Institute (EBRI), Tracking the Shift in Private-Sector, Employment-Based Retirement Plan Participation from Defined Benefit to Defined Contribution Plans, 1979–2017, shows this dramatic shift. PERCENTAGE OF PRIVATE-SECTOR WAGE AND SALARY WORKERS PARTICIPATING IN AN EMPLOYMENT-BASED RETIREMENT PLAN, BY PLAN TYPE, 1979-2017 Without a guaranteed monthly pension payment in retirement, American workers are forced to create their own “retirement paycheck,” largely from defined contribution plans and other savings. This can be a daunting task given the complexities around retirement income planning: social security timing, withdrawal rates, annuitization choices, and investment options. Thankfully, employers have noticed and are beginning to help. The Pension Protection Act of 2006 Reforms solidified the allowed plan sponsors to enhance retirement plan design to help boost employee contribution and defined contribution saving rates with new features like automatic enrollment, automatic savings escalation and retirement plan as the automatic investment in target date funds. These reforms solidified the defined contribution retirement plan as the main retirement savings vehicle for most American workers. main retirement savings vehicle Today, plan sponsors are not only focused on helping employees accumulate assets for retirement, but are also helping employees in retirement generate a steady income stream. Sponsors who once preferred that retirees move their assets out of the company plan upon retirement are seeking to retain these assets in plan. According to Callan’s 2020 DC Trends Survey, 75% of plan sponsors seek to retain retiree assets. Increasingly, plan sponsors are offering income solutions and enhancing withdrawal options to meet retiree needs. Based on PIMCO’s 2020 DC Consultant Survey, 63% of consultants work with plan sponsors that are supportive of adding, or currently offer, retirement income solutions to participants. Plan sponsors’ move to a holistic approach to American workers’ retirement was further reinforced with the passage of the SECURE Act of 2019, which granted safe harbor for certain retirement income solutions. NOVEMBER 2020 1 Strike the Balance: The Case for Private Real Estate Debt in Retirement Income Solutions Risks and Considerations The shift from defined benefit to defined contribution has moved all of the responsibility (and risk) for income in retirement from the plan sponsor to the participant. Participants face a myriad of complex questions, risks and considerations when entering retirement. Will I have enough money to do the things I want to do in retirement? Will I outlive my assets? Should I take social security now or defer? Will I retain control of my assets? These questions, and many more, weigh heavily on retirees’ minds. Wrapped up in these questions are underlying risks faced by all participants: LONGEVITY RISK Will I outlive my assets? In some ways, the social security system was designed to be the perfect solution to longevity risk when accompanied by a company sponsored defined benefit plan. Retirees today are faced with more difficult choices as many are not covered by a defined benefit plan. The choice to take social security at 62, 65, or 70 has considerable implications. Interestingly, most retirees chose to “self-insure” against longevity risk by drawing on income and maintaining principal. A study by the Employee Benefit Research Institute, “Asset Decumulation or Asset Preservation? What Guides Retirement Spending” in April 2018 found that the median ratio of household spending to household income for retirees of all ages hovered around one, inching slowly upward with age. This suggests that majority of retirees had limited their spending to their regular flow of income and had avoided drawing down assets. LIQUIDITY RISK Are my assets “locked up” or do I retain control? Retirees can chose to buy longevity insurance by purchasing an income annuity that guarantees a consistent income steam. Annuitization however, takes control of the assets out of the retiree’s hands and is an irrevocable decision. INVESTMENT RISK Are my assets at risk? Will I lose principal? Considering most chose to self-insure against longevity risk, retirees must carefully choose investment options that generate enough income to match spending, but also protect against principal drawdowns. Importantly, there is no single product or solution that can solve for longevity, liquidity and investment risk. Rather a combination of solutions and plan design features will help mitigate these risks. Features such as offering automatic periodic withdrawals from the plan can help when participants are looking to create a retirement paycheck. Plan sponsors should also consider making available a robust offering of standalone and professionally managed solutions, including annuity based options, geared towards durable income. Plan sponsors and consultants today are packaging these solutions in a “retirement tier” while supporting the offerings with enhanced communication and education. Retirees must balance two competing objectives; generating a durable income stream while protecting principal against market drawdowns. With current market rates at near historic lows (see exhibit 2), retirees face challenges finding investment options that will match spending rates. NOVEMBER 2020 2 Strike the Balance: The Case for Private Real Estate Debt in Retirement Income Solutions EHXIBIT 2: PUBLIC MARKET CURRENT YIELDS 6% 5.66% 4.90% 4% 1.75% 2.03% 2% 1.24% 0.85% 0% US 10 year Bloomberg US S&P 500 Bloomberg JP Morgan ICE BofA US High Treasury Barclays US Barclays US Emerging Markets Yield Aggregate Index Corporate Index Governemnt Bond Source: Wall Street Journal Bond Benchmarks, November 2020 Private Real Estate Debt In an environment where public markets offer persistently low yields, plan sponsors, consultants and retirees are likely considering ways to enhance public fixed income returns. Adding private real Private real estate debt may estate debt as a component of a well-designed retirement income solution may be a way to enhance returns, decrease enhance income returns, decrease volatility, and increase diversification while adding inflation sensitivity. volatility, and increase diversification DEFINING THE ASSET CLASS Underlying every debt investment is an exchange of risk and return between the lender, who provides the debt, and the borrower/owner, who controls the equity. Private debt strategies focused on commercial real estate bring the additional benefit of tangible, physical collateral which supports the lender’s position. Real estate assets may experience changes in cash flow and liquidity but almost universally retain a portion of their value, and more importantly, the lender has a priority claim on cash flow since interest payments are made before equity distributions. As a result of this preference, income is the primary driver of returns for private debt investors. Private “core” real estate debt investments are generally comprised of 1st mortgages made on all types of commercial property assets: apartment communities, commercial office buildings, medical office facilities, senior housing communities, self-storage facilities, warehouse projects and retail shopping centers. Private commercial property lenders represent one of the smallest (but fastest growing) segments of the overall US commercial mortgage market. The Federal Reserve reports total outstanding commercial mortgages of more than $4.4 trillion, of which Heitman estimates approximately 7% are provided by “private” lenders outside the traditional sources of banks, life insurance companies, securitization vehicles, and government housing enterprises. 1. Private debt capital is desired by borrowers for a myriad of reasons, but is generally utilized to fill voids left by traditional lending sources, and to provide borrowers with speed and flexibility. In exchange, the private lender charges a return premium on its capital. NOVEMBER 2020 3 Strike the Balance: The Case for Private Real Estate Debt in Retirement Income Solutions CAPITAL POSITION Exhibit 3 details the capital position of the borrower (equity holder) and lender (debt holder) in a typical commercial real estate debt transaction where the loan to value (LTV) is 75%. LTV is an important risk factor in property debt investing as it details how much protection the lender has to equity loss. Losses in collateral value affect the equity holder immediately as shown on the yellow shaded area. This initial loss borne by the equity holder servers as a buffer against loss for the debt holder. The lender does not experience loss until the equity loss exceeds 25% in this case (blue shaded area). EXHIBIT 3: IMPACT OF VALUE CHANGE ON DEBT AND EQUITY Many investors are already familiar with property as part their real estate assets portfolio, but may not appreciate how private real estate debt can fit in the context of their real estate equity holdings. Private real estate debt Exhibit 4 shows investor capital positions for three real estate strategies: core equity, core debt and creates a more defensive value-added equity. These capital stacks show how each strategy uses
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