Seeking to cut or at least reduce the rate of increase in contributions into the state pension fund, the State Retirement System is looking to add some real estate to its mix of investments.

Director Paul Matson said a study that Retirement System staff completed last fall suggests that putting up to 6 per cent of fund assets in real estate could increase returns by 10 basis points, or one-tenth of 1 per cent. While that may not sound like much of a boost, a fund with $21 billion in assets could add another $21 million to the pot. Those estimates take into account the expenses and the effect of inflation.

The current contribution rate of the pension portion of the State Retirement Fund is 5.2 per cent of gross pay. Employees and the state contribute to the pension fund.

Because of declining returns on bonds, which traditionally have made up 30 per cent of the total investments, “we looked at private equities [that is, investments in companies that are not publicly traded], hedge funds and real estate,” Mr. Matson said.

“We ran a whole series of simulations and determined that a 6 per cent allocation in real estate would slightly increase our expected returns but would also have a mitigating effect on volatility,” or how much the price of an investment rises or falls in the short term. The simulations used computer models to answer “what if?” questions about the returns that might be expected from the addition of investments the State Retirement Fund doesn’t now buy, such as real estate.

“We thought real estate would not add any risk – possibly even reduce risk – but would marginally increase the expected rate of return,” Mr. Matson said.

Investing in private companies and hedge funds has a number of drawbacks. Making investments in private equities would require a much larger staff devoted to closely examining the financial condition of companies on a continuous basis. Hedge funds, which are vehicles somewhat like mutual funds but require much larger investments, are virtually unregulated compared to the regulatory oversight given to mutual funds, stocks and bonds.

“We saw problems with transparency in hedge funds and the lack of any reliable historic data” on returns, Mr. Matson said. Hedge funds also have much larger transaction fees, which ultimately diminish returns.

Bonds

Most of the allocation for real estate will come out of the portion of the fund that has traditionally been invested with fixed-income securities, such as U.S. Treasury bonds. Those kinds of investments were yielding about 4.5 per cent when the investment study was completed last August, and yields have since fallen to 4 per cent.

The Retirement System will still keep some money invested in bonds, but the allocation will drop to 28 per cent of the total from 30 per cent. The allocation devoted to foreign stocks also will drop, to 15 per cent from 17 per cent, while the fund will continue to keep about 53 per cent in the stocks of companies based in the United States.

Mr. Matson said the proposal to add real estate to the mix of investments still needs approval by the five-member Investment Review Committee and then the nine-member Retirement System Board.

“I would expect we will take it to the investment committee in May and probably to the full board in June,” Mr. Matson said. “Once the full board approves that package, then we go down the implementation route.”

Investment Won’t Focus On Arizona

That route likely will see about 90 per cent of the real estate allocation in direct investments, diversified by types of real estate – retail, office buildings, industrial centers, and multifamily housing – and across different regions of the country, mostly in the major metropolitan areas, Mr. Matson said.

The Retirement System will respect the adage, “don’t put all your eggs in one basket.” Mr. Matson anticipates most investments will range in size of $10 million to $50 million, so that any one piece of property will represent somewhere between 1 per cent and 5 per cent of the total real estate investments.

“One thing we don’t want to do is end up with only six prime properties in a few locations,” Mr. Matson said. The Retirement System intends to invest only in properties within the United States. The fund won’t exclude Arizona from the mix, but neither would it get a largely disproportional share of investment, so that an economic downturn in the state wouldn’t disproportionably diminish the return.

Of those direct investments, the fund will be looking to put up 90 per cent to 99 per cent of the capital, with the rest involving participation of the property managers or other partners.

“Another consideration is liability issues,” Mr. Matson said. “I want to make sure there’s no liability flow-through to the fund. We will be looking to buy a building and hold it through an operating company. So if there’s a problem with a building that creates some liability, it ends up with a limited liability holding company rather than being able to flow through to the ultimate heir, which in this case would be the State Retirement System.”

While 90 per cent of the real estate buys will be by direct investment in properties, the remaining 10 per cent will be in real estate investment trusts [REITs]. REITs operate somewhat like mutual funds, but instead of investing in stocks or bonds, the pooled funds are put into real estate. REITs can diversify across a number of real estate sectors, or concentrate on an area, such as office buildings, medical facilities or retail centers. REITs are traded on exchanges like stocks, so they have a liquid, ready market for buying and selling.

“Long-term, REITs follow the trends in real estate,” Mr. Matson said, “but in the short term, they’re affected more by the stock market,” which would allow the retirement system to take advantage of short-term changes in prices when buying and selling.—