Pension Plan Allocation to Real Estate when Plan Trustees have

Reputational Utility

Kiat-Ying Seah and James D. ShillingNational University of Singapore

DePaul University, ChicagoERES 2010Milan, Italy

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

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.

Pension Trustee’s Objective function Measure reputation by an entropy function

Objective of each plan trustee: maximize reputation subject to a shortfall constraint

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.

Given beliefs, solve for portfolio

1. Power utility form, risk aversion is endogenous2. What matters?

• Target returns, W0Z• Surplus returns ST

Initial Funding Ratio matters

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

Summary Statistics

Portfolio Simulations

1. SRMP looks at total portfolio variance2. Entropic cares about the entire distribution

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)

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.