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Pension Plan Allocation to Real Estate when Plan Trustees have Reputational Utility

Pension Plan Allocation to Real Estate when Plan Trustees have Reputational Utility. Kiat-Ying Seah and James D. Shilling National University of Singapore DePaul University, Chicago ERES 2010 Milan, Italy. Objectives. Tries to explain why institutions invest very little in real estate.

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Pension Plan Allocation to Real Estate when Plan Trustees have Reputational Utility

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  1. Pension Plan Allocation to Real Estate when Plan Trustees have Reputational Utility Kiat-Ying Seah and James D. Shilling National University of Singapore DePaul University, Chicago ERES 2010 Milan, Italy

  2. Objectives • Tries to explain why institutions invest very little in real estate. • An entropy model where institutions care about what their target returns are • Conformity matters • Persistent portfolio allocation • Implication: allocation is based on a power utility not on a mean-variance variety

  3. Motivation • Reality: institutions invest 2.5% to 4% of total assets in real estate • Normative studies: • 15-20% (Fogler, 1984) • 43% (Webb and Rubens, 1987) • 19-28% (Giliberto, 1993) • Modelling idea: - Pension plans are fiduciaries and care about how others assess their performance: include “Reputation” in utility function.

  4. Pension Trustee’s Objective function • Measure reputation by an entropy function • Objective of each plan trustee: maximize reputation subject to a shortfall constraint

  5. Allocation is a function of belief-choice • Optimal belief choice: multinomial logit probabilistic choice function • Trustees will skew their portfolio toward assets with higher returns. • Prob of choosing a target that deviates from group mean is low – conforming behavior.

  6. Given beliefs, solve for portfolio • Power utility form, risk aversion is endogenous • What matters? • Target returns, W0Z • Surplus returns ST Initial Funding Ratio matters

  7. Data and Results • Data are obtained from CRSP/COMPUSTAT • 1990-2004. • Summary Statistics:

  8. Summary Statistics

  9. Portfolio Simulations • SRMP looks at total portfolio variance • Entropic cares about the entire distribution

  10. Empirical Evidence • Use Sharpe’s (1992) “style” methodology: • Regress pension surplus returns on six benchmark returns. • Collect R-square statistic for each pension plan. • Because R-square varies from 0 to 1, transform this variable using the logistic transformation = “STYLE” variable • Run the following regression: Style = F (Target surplus return, Conformity, Initial Funding Ratio)

  11. Conclusion • Empirical results are the same when we include firm fixed effects. • Reputational utility causes institutions to • Skew portfolio away from real estate to achieve minimum target rate of return. • Achieving minimum target rate of return requires that pension trustees be conformists. • Explains herding behavior.

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