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Discretionary and Non-Discretionary Real Estate Investment Accounts:
A Primer for Trustees

By Stanley L. Iezman

Published in International Foundation of Employee Benefit Plans, Employee Benefits Digest, September, 1999 Copyright International Foundation of Employee Benefit Plans


Trustees of Taft-Hartley trust funds who develop a separate account real estate investment program oftentimes wish to retain control over the investment decisions. While control may be desirable from an operational standpoint, as many trustees have the knowledge and ability to positively impact the real estate investment process, it is important that trustees understand the distinction between creating a discretionary account, a non-discretionary account, or a quasi-discretionary account. Further, the trustees need to understand the legal and financial implications to the trust and the trustees when they become involved in the investment process, and the possible impact on the performance of the investment portfolio.

This article briefly explains the fundamentals of discretionary, non-discretionary and quasi-discretionary pension plan investment accounts, and the consequences of each within the context of a separate account real estate investment program. It is important to note that the issue of discretion rarely, if ever, is involved in the creation of a stock or bond portfolio, a commingled investment fund, such as a group trust, or a limited liability entity such as a limited partnership. It would be very difficult, if not impractical, to require a stock or bond manager to seek prior approval from the trustees for the acquisition or disposition of an individual stock or bond. From a practical standpoint, the stock and bond manager is expected to appropriately invest the allocated funds and to implement the investment strategy properly. The penalty to the stock or bond manager for poor performance is typically termination.

Additionally, a general partner of a real estate limited partnership or other commingled entity does not typically seek approval from the limited partner investors for the acquisition of a real estate asset or the implementation of an investment strategy, as the general partner would most likely have difficulty implementing the investment approach timely or effectively. In addition, the limited partners would, under state law, arguably be acting as a general partner through their participation in the investment process and their limits on liability could be lost. Clearly, pension funds that seek limited liability protection by investing in a commingled fund do not want to sacrifice this protection by having approval rights over investments.

Real estate, however, has some unique attributes in the minds of pension plan trustees, in large part because real estate is tangible and most trustees understand some aspects of real estate investing, while stock investing is much more ephemeral. Many trustees, like to "feel" and "touch" their investments, and real estate clearly encourages trustees to kick the dirt. Therefore, trustees generally feel they are more capable to participate in a real estate discussion than in a securities discussion, and allows the trustees to feel much more comfortable with the real estate investments being made by the investment manager, and lends an aura of control to the trustees. Thus, the notion that trustees all own their own home and believe that understanding real estate investing is easier than stock investing creates, in many cases, the impetus to create a non-discretionary real estate separate account.

Non-Discretionary Separate Account

A non-discretionary separate account is very simply the granting of authority to a real estate investment manager to engage in the acquisition, asset management, and disposition of real estate investments on behalf of the pension plan, but with controls imposed on what actions the investment manager can or cannot take without prior approval of the trustees of the pension plan. Typically in the non-discretionary relationship, the investment manager acts according to an investment strategy that is agreed upon by the investment manager and the pension plan. However, the investment manager may not have the authority to purchase or dispose of a property, or implement major investment decisions, without the prior review and approval of the board of trustees of the pension plan.

In a non-discretionary account, the investment manager is often required to submit the proposed real estate acquisition to the board of trustees for approval prior to acquisition, as well as submit an investment plan and strategy that must be agreed to by the trustees concurrently with the acquisition. Often an investment manager is required to submit an annual budget and operating plan for approval by the trustees of the pension plan prior to their implementation. Any variances in the budget above a certain amount, e.g., $5,000 per item, may require further trustee approval unless those expenditures have been approved within the business plan.

This type of an account works well where the pension plan has adequate staff with significant real estate expertise that is capable of reviewing investment decisions, has the time to review investment decisions, and where the approval process has been designed to facilitate quick and efficient decisions.

A non-discretionary account imposes a significant time commitment and obligation upon the trustees of the pension plan, and/or their chief investment officers or staff. They must ensure that the investments made by the real estate investment manager are appropriate, that the investment process is properly monitored, managed, and operated, and that the investment strategy is being properly implemented. They must also keep abreast of market and product trends communicated by the investment advisors.

Pension plans who elect to operate under a non-discretionary relationship need to be mindful that since the decision-making process by the investment manager will be further burdened by an additional level of scrutiny at the pension plan level, any delays in making decisions may prove costly to the pension plan. In most cases, the investment manager will be required to prepare an investment summary on the proposed acquisition, disposition or other significant investment decision that outlines all of the pertinent facts surrounding the investment, which may take two to three weeks to complete. The investment summary must then be submitted to the trust’s staff for review that adds additional time to the decision process. Presuming that the staff of the pension plan concurs with the results, the investment summary is then submitted to the board of trustees of the pension plan for further review and approval. If the staff or investment officer does not concur with the recommendation or requires clarification on various issues, even more time will be required to complete the investment package for trustee review. Unfortunately, this entire process may take up to 60 days or longer in some cases, and real estate is a business where investment decisions must be made quickly. Typically this process must occur while the property is under some contractual right such as a critical, time-limited, due diligence period. If, for example, a potential acquisition was not under contract, it could be sold to another buyer and the costly acquisition and due diligence process would have been for naught. Thus, most managers of non-discretionary accounts must execute a letter of intent for acquisition that contains a provision for an atypically long due diligence period that allows the investment manager the time to obtain the necessary approvals.

It is also important to point out that the investment manager who is going to tie up an asset for acquisition in a non-discretionary account must typically find a seller who is willing to allow the property to be tied up for a longer period of time, not knowing whether the investment manager will be given the "green light" to purchase the property by the pension plan. If the seller agrees to tie the property up under a non-binding agreement, and the pension plan does not give approval to the transaction, the seller must then go back to the market and restart the sale process. All of this, of course, comes with an implied cost associated with this approval process. Clearly, no seller will agree to take a property off of the market without some premium being paid for this risk. Trustees need to understand this implicit fact, that their acquisition cost may be higher, when electing to choose to operate in a non-discretionary format. The key for non-discretionary accounts is to set up a timely and efficient review and approval process to minimize the additional time requirements, and therefore, the amount of the premium that may be required to lock in purchase opportunities.

In addition to the increased time and cost for the seller’s risk premium, there is a further argument that non-discretionary accounts result in limiting the pool of potential acquisitions. The investment manager typically will only be able to work with a limited pool of sellers, since sellers want the certainty that the buyer of the asset is going to be able to close — without some third party, e.g., the trustees, vetoing the transaction. Many sellers of real estate assets will not work with an investment manager unless the funds are fully discretionary. The reputation of the investment manager in closing non-discretionary acquisitions can help overcome this concern in some instances, but it is an issue that must be addressed by trustees. Clearly, in a strong real estate market similar to that which we are in now, sellers have the ability to pick and choose potential buyers, and buyers who have discretionary capital are going to be more capable of being the successful bidder for a transaction. This same concern also exists with the asset management and disposition decisions, whereby certain tenants and/or buyers will not deal with owners who have the obligation to obtain approvals because of the increased time and complexity, and the lack of certainty, associated with getting board of trustee approval for the transaction.

Although creating a non-discretionary account may allow the trustees to exert control over the real estate investment and over the investment manager, it may increase the cost of the investment program and, therefore, negatively impact the investment return. On the other hand, it is also possible that the insight of the trustees can positively impact the investment results.

Of greater significance to the trustees is that trustees of pension plans which are governed by the Employee Retirement Income Security Act of 1974, as amended, ("ERISA"), who elect to operate under a non-discretionary account, in investment decisions, are not absolved from liability under ERISA as a fiduciary, because they have not delegated their management responsibilities to the investment manager necessary to obtain the liability shield. Thus, trustees will be considered fiduciaries and liable for their actions when they elect to participate in the investment decisions via a non-discretionary account. This is not the case with discretionary accounts and is an extremely important issue that trustees of pension plans must understand in evaluating the creation of their real estate investment strategies. In a non-discretionary account, pension plan trustees have liability for the acts of the investment manager because the trustees have retained the decision-making authority.

Should trustees of Taft-Hartley pension plans, after reading this article, still elect to create a non-discretionary account with a real estate investment manager, they should put into place the following:

Work only with real estate investment managers who have had prior non-discretionary account experience. This type of an account requires skill, agility, a knowledge of the sensitivities of trustees and staff, and the ability to balance the needs of all parties in the transaction, including third parties. The investment manager’s reputation and relationships with third parties is critical to the success of the account;
Create clear, concise and articulate investment guidelines which specifically outline the type of properties, age, tenant mix, building characteristics, etc., which are allowed to be acquired by the investment manager, so that the investment manager can clearly focus on bringing appropriate transactions to the pension plan. (The prior experience of the investment manager and the real estate consultant with non-discretionary accounts will be invaluable in formulating workable investment guidelines);
Develop clear guidelines at the beginning of the relationship as to what authority the investment manager has to enter into leases, make capital expenditures, or engage third parties, e.g., lawyers, accountants, so that the investment manager can act decisively and quickly;
Develop a streamlined review process with time lines for submission of investment summaries that are tied to staff review requirements and dates of board meetings. For example, if board meetings are only held once a month, appropriate procedures should be created between the staff and the investment manager to ensure that the reviews of the proposed investments submitted to the board are made quickly and promptly;
Create an investment submission and analysis approval report that includes all of the information which the staff and the board of trustees agree is essential to the review process and important for decision-making, so that the review process is reduced to the shortest possible time frame; and
Most importantly, the staff, the real estate consultant, and the investment manager must make all reasonable attempts to resolve any disagreements or differing views prior to the presentation of the potential investment to the trustees, since disagreement at this late stage creates further delays to the decision process.

Discretionary Account

Fully discretionary accounts are much more typical than non-discretionary accounts in pension plan real estate investment management relationships today. In a discretionary account, the trustees establish certain investment guidelines, but delegate responsibility for making all investment decisions to the investment manager. This insulates the trustees from liabilities attributable to the investment manager’s decisions, although trustees of pension plans always have liability for the manner in which they hire the investment manager.

Trustees of pension plans who operate under this format must establish strong and prudent controls in setting up the investment program and performing the appropriate due diligence with respect to hiring the investment manager. Additionally, trustees must monitor the investment managers on a regular basis in order to ensure that the investments are performing properly. This is an important part of the responsibilities of the trustees.

Within the defined investment guidelines, all investment decisions are made by the investment manager. The trustees of the pension fund monitor the results of those investment decisions as part of their normal fiduciary duties. The discretionary account allows the investment manager to make all decisions with respect to the acquisition, disposition, and operation of the property, including leasing, capital budgets, expenditures, and development of the investment plan, provided that it is consistent with the investment guidelines of the pension plan.

This type of an account clearly eliminates many of the inherent costs and time delays associated with the non-discretionary account. It is probably the most proactive and viable type of real estate account that can be created by a pension plan, because the trustees need only verify that performance is consistent with guidelines that are agreed to by all parties.

The trustees still have adequate control over a discretionary account, because they establish the investment guidelines, and if they are unhappy with the performance of the manager, they have the ability to terminate the investment manager. Most trustees and investment managers believe that the right of termination by the pension plan is the most powerful tool of all, and is a significant determinant in the behavior of the investment manager in the investment management process.

The benefits of the fully discretionary account are:

The trustees are absolved of liability for making investment decisions and are not deemed to be fiduciaries under ERISA with respect to the investment decisions made by a discretionary investment manager;
The investment manager can operate freely within established investment guidelines and investment strategies which can be reviewed by the pension plan before the investments are made, and monitored annually thereafter;
The potential delays associated with seeking approval in a non-discretionary account are reduced;
There is some time and cost savings by the pension plan staff and trustees;
The trustees are not making complex investment decisions that they may not be qualified to make;
Investment decisions are made by real estate professionals, just as decisions on securities investments are made by securities professionals; and
The trustees of the pension plans can always terminate the investment manager should performance not be up to par.
The discretionary account is clearly more appropriate for those pension plans who understand the significance of trustee responsibility and culpability as a fiduciary, who want to create a real estate program without the need to regularly and actively control and oversee the investment process, who want investment decisions made by real estate professionals, and for trustees who may not be fully qualified to make real estate investment decisions. The key, however, to a successful, discretionary account is to ensure the appropriate investment guidelines are created and that the board of trustees hires the appropriate investment manager and real estate consultant who can and will implement the portfolio strategies without a great deal of oversight.

Quasi-Discretionary Account

For those pension plans that want to blend the investment decision-making responsibilities, the quasi-discretionary account is another option that has been effectively used by some pension plans.

The quasi-discretionary account or "discretion in a box", recognizes that many decisions can be made by the investment manager in accordance with a predetermined investment plan agreed to by the pension plan and the investment manager. However, the major investment decisions are subject to the board of trustee approval, such as the acquisition or disposition of an asset, the undertaking of a major capital expenditure, or a change in the investment strategy and investment plan.

The major distinction between the quasi-discretionary account and the non-discretionary account is that under the quasi-discretionary account fewer decisions are subject to review and approval by the board of trustees.

The quasi-discretionary account has been used in the following context:

The pension plan elects to acquire various real estate assets within an investment plan and wants to review each asset that is going to be acquired prior to acquisition. In this case, the investment manager sources the transaction, performs the necessary due diligence to allow the board to make a decision, and, ultimately, submits it to the investment board of the pension plan for review and final approval.
The investment decisions that are made during the holding period are reviewed within the context of an annual budget, investment strategy and asset plan, which are approved by the pension plan with the understanding that no expenditures or investment decisions can be made outside of the pre-approved budget, business plan, and investment strategy.
Disposition decisions are approved by the board of trustees, after the investment manager presents the recommendation rationale for the disposition decision.
Unfortunately, the quasi-discretionary account is still subject to the inherent time delays associated with a non-discretionary account, and it does not necessarily relieve the trustees of any greater fiduciary liability than a non-discretionary account. Under this set of circumstances, the trustees retain full ERISA liability for making or participating in the investment decisions and are deemed to be an ERISA fiduciary for these investment decisions. It is important to understand that the trustee does not have any less liability associated with the transaction by creating the quasi-discretionary account.

While under this set of circumstances the trustees may feel more comfortable with respect to the decision-making process because of their involvement, they still run the risks associated with non-discretionary management. This includes time delays due to obtaining prior approval, delaying their decision-making, losing transactions, and sellers resistance.

When creating a quasi-discretionary account, the trustees should keep in mind the six guidelines outlined previously in the formation of a non-discretionary account.

Conclusion

Trustees who elect to utilize a non-discretionary account or a quasi-discretionary account need to be mindful of the consequences, including increased liability under ERISA, and realize that this type of a relationship is not typically used with their investment managers in the stock and bond sector. Non-discretionary or quasi-discretionary accounts are unique to the real estate sector. It is safe to say that trustees who recognize their obligations under ERISA and understand how real estate investment decisions are made will generally be willing to grant full discretion to their investment managers. This will typically maximize the overall return to the pension plan of their real estate investments, and control can be maintained by ensuring compliance with investment guidelines. Trustees need to understand that there will be constant changes in real estate cycles, and that in the creation of the investment program they need to ensure that they have granted the investment manager the necessary flexibility to effectively implement the investment process both in a proactive and reactive context.

Even after reading this article, some trustees may still not want to consider the use of a discretionary account, because they need the additional controls on the investment process provided by a non-discretionary account. In that case, the trustees should try to implement the guidelines outlined in this article to ensure that a non-discretionary account works as effectively and efficiently as possible. In addition, the pension plan may want to consider utilizing a real estate consultant to help them with the review process, which may further insulate the trustees from fiduciary liability, as well as hire an investment manager who has the ability and experience to operate with this type of account.

A discretionary account provides the trustees with the same level of control as they typically enjoy with the manager of other investments. Trustees need to be mindful that, ultimately, they have the ability to terminate the manager if the manager does not perform. While that does not necessarily resolve the problem if an investment has already been made, it nonetheless creates a lever that can be effectively utilized to ensure that future investments are in compliance with the goals and objectives of the trustees. This control has always been considered sufficient for non-real estate investment managers.

In the end, trustees need to be aware of their fiduciary responsibilities and the necessity to focus their energies and efforts on those areas where they can maximize the overall value of the pension plan, and not in micromanaging the investment, the investment manager, and the investment process.


Stanley L. Iezman, Esq. is the President and Chief Executive Officer of American Realty Advisors, a registered investment advisor with the Securities and Exchange Commission providing real estate investment management services to domestic pension plans, and an adjunct professor of real estate asset management at the University of Southern California’s School of Policy, Planning, and Development Lusk Center for Real Estate Development.

 

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