Academic journal article Real Estate Economics

Pension-Plan Real Estate Investment in an Asset-Liability Framework

Academic journal article Real Estate Economics

Pension-Plan Real Estate Investment in an Asset-Liability Framework

Article excerpt

Gregory H. Chun [*]

Brian A. Ciochetti [**]

James D. Shilling [***]

This study explores the role of pension-plan real estate investment in an asset- liability framework. By assuming that the pension-plan manager wishes to have assets of at least equal value to the liabilities at all points in time, an asset selection process is derived which depends on both the asset's covariance with other assets and its covariance with the liability stream. We generally find real estate not to be highly correlated with pension-plan liabilities. This finding is of general interest, since it helps to explain why pension-plan real estate investment is extremely limited and much smaller than one would expect if pension-plan investors cared only about the mean and variance of the real return to their invested wealth.

Two approaches have typically been used to analyze pension-plan investment. One approach posits that pension funds care about only the mean and variance of portfolio returns. The other approach assumes that pension plans allocate their assets in an asset-liability framework. In the former, the pension fund chooses from all portfolios with the same level of risk that portfolio with the greatest expected utility. In the latter, the pension fund allocates its assets to maximize its risk-adjusted future surplus value (equal to assets minus liabilities). Work by Sharpe (1990) suggests that the maximization of risk-adjusted future surplus value can cause optimal investment positions for pension plans to deviate significantly from mean-variance efficiency.

Many studies of pension-plan real estate investment in a mean-variance framework exist, such as those by Firstenberg, Ross and Zisler (1988), Fogler (1984), Hartzell, Hekman and Miles (1986), Ibbotson and Siegel (1984), Miles and McCue (1984), and most recently Brown and Schuck (1996), Hudson-Wilson and Elbaum (1995), Kallberg, Lui and Greig (1996) and Ziobrowski and Ziobrowski (1997). There are several recent studies of pension-plan investment in an assetuliability framework, including Leibowitz, Kogelman and Bader (1994) and Peskin (1997). Of these, none has made an attempt to analyze real estate allocation in an assetuliability framework. This paper represents an attempt to bridge this gap in the literature. Specifically, our paper brings evidence to bear on the role of real estate ownership in an assetuliability framework. Knowledge about this relationship is important to both researchers and pension-fund portfolio managers in debates over the optimum amount of pension-plan real estate investment. [1]

While this paper is intended as a contribution to the theoretical analysis of risk taking and pension-plan investment, it is also, we think, a contribution to the empirical literature on the subject. We formulate a portfolio allocation model in an assetuliability framework that is both simple and appealing. We then proceed to show that real estate's main role in this type of framework is on the liability side of the balance sheet as a hedge against inflationadjusted pension liabilities. This is in stark contrast to real estate's role in a meanuvariance framework, which is on the asset side of the balance sheet as a diversifier of a large stock portfolio. Our model appears to be capable of explaining why pension-plan investment in real estate is extremely limited and much smaller than one would expect based on most meanuvariance portfolio models.

The remainder of the paper is organized as follows. In the next section, we construct optimal meanuvariance-efficient portfolios from retums and variances of stocks, bonds and real estate. Five different portfolios are constructed, corresponding to five different risk assumptions. A description of the pension liability index used in the paper is given in the following section, and the section after that reports the benefits of real estate diversification in an assetuliability framework. …

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