Academic journal article Journal of Real Estate Portfolio Management

The Role of Private and Public Real Estate in Pension Plan Portfolio Allocation Choices

Academic journal article Journal of Real Estate Portfolio Management

The Role of Private and Public Real Estate in Pension Plan Portfolio Allocation Choices

Article excerpt

Executive Summary. This article examines the portfolio allocation decision within an asset / liability framework. Here portfolio weights are chosen not just by an asset's return and variance but also by its correlation with pension liabilities. This results in assets that are highly correlated with pension liabilities being weighted higher in the portfolio. Typical mean-variance models estimate allocations to both public and private real estate as high as 40%. In the asset / liability model, allocations to both private and public real estate are lower and closer to what is actually observed in pension plan portfolios.


Over the past twenty years, a large volume of study has been devoted to understanding the contribution of real estate to a mixed-asset portfolio. Foremost was the idea that real estate offered diversification benefits because of its low correlation with other asset classes. Many studies in the 1980s, such as Folger (1984), Hartzell, Heckman and Miles (1986), Webb and Rubens (1987) and Firstenberg, Ross and Zisler (1988), concluded that real estate should comprise 20%-30%, or more of a diversified portfolio. In the 1990s, work by Kallberg, Lui and Greig (1996), Ziering and McIntosh (1997) and Ziobrowski and Ziobrowski (1997) also found that real estate should still be a significant part of an overall asset portfolio. However, actual pension plan allocations to real estate fall far below these findings, averaging between 3% and 4%.

This becomes an even more interesting problem when you consider the institutional changes that occurred in the last few years with regard to pension plans and public real estate. Prior to 1993, pension plans were effectively constrained from investing in real estate investment trusts (REITs) by the "five or fewer" rule. Since the top five shareholders in a REIT could not own more than 50% of the shares outstanding, pensions, who normally take large positions in the stocks they own, would have found it difficult to invest in REITs and not break this rule. However, in 1993, the rule was changed so that pension plans are not considered one investor but instead defined as a conduit for all the beneficiaries of the plan. Pension managers were now free to investigate REITs as a potential new investment class.

A few studies have looked specifically at the addition of public investments in real estate like REITs within an asset allocation decision. Geltner, Rodriguez and O'Connor (1995) and Sanders (1999) both look at investments in both private and public real estate within a mean-variance framework. The results are similar to previous work where allocations to private and public real estate are weighted at levels much heavier than what is seen in practice.

A new body of literature concerning pension plan allocation emerged in the 1990s. These asset/ liability or surplus return models of portfolio diversification take into account not only asset returns and variances but also changes in pension liabilities and their covariance with asset returns. Research beginning with Leibowitz (1987), Sharpe (1990) and Leibowitz, Kogelman and Bader (1994) suggests that pension managers are concerned with maximizing the risk-adjusted surplus value (assets minus liabilities) of the pension. In such an optimization model, asset allocations can differ greatly from the standard mean-variance framework. Peskin (1997) concludes that corporations can reduce the costs and risks of their pension plans by following such a model. Work by Chun, Ciochetti and Shilling (2000) applies the model to pension plan asset allocation decisions involving real estate. They predict allocations to real estate of between 6% and 13%. However, their research considered only private equity real estate. This study adds to the literature by examining for the first time both private and public real estate within the context of an asset/liability model.

The rest of the article is structured as follows. …

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