How Funding Ratios Affect Pension Plan Portfolio Allocations

Abstract

Executive Summary. This article examines how a pension plan's funding ratio can affect the portfolio allocation decision. Specifically, an asset / liability model of pension plan decision-making is developed. Typical mean-variance models estimate allocations to both public and private real estate as high as 50%. In the asset / liability model, predicted allocations to both private and public real estate are much lower and closer to what is actually observed. In addition, the results show that as a pension plan becomes more underfunded, the allocation to private real estate falls while the allocation to public real estate stays about the same. As a plan becomes more overfunded, allocations to both private and public real estate increase but still by less than what is predicted in mean-variance models.