17 - Setting an investment strategy Flashcards
What are the primary objectives of setting an investment strategy for health insurers, medical schemes, and retirement funds?
The primary objectives involve assessing the importance of different stakeholders and ensuring that the chosen strategy affects the security and level of benefits offered to policyholders and members. This includes ensuring guaranteed benefits are met and that returns meet expectations.
Name the main parties typically involved in the process of implementing an investment strategy.
The main parties include the following:
* Board of trustees or directors
* Beneficial owner
* Custodian
* Investment manager
* Broker
* Investment consultant
Outline the key steps an entity needs to consider when determining and implementing an investment strategy.
Key steps include:
* Choosing a baseline strategic asset allocation.
* Choosing the legal form for holding assets.
* Determining the investment style for each investment.
* Determining the responsible investment managers.
* Defining the freedom of managers to deviate from targets.
* Selecting custodians, brokers, and consultants as needed.
Explain the concept of Liability-Driven Investment (LDI) strategies and why they have gained popularity in retirement funds.
LDI strategies use the liabilities as a benchmark for the investment strategy. Their popularity in DB retirement funds increased due to changes in accounting rules making deficits more transparent. LDI typically involves matching the asset portfolio with liabilities using bonds and derivatives.
Compare and contrast active and passive investment management styles, highlighting their core philosophies and typical fee structures.
Active management aims to outperform benchmarks by identifying mispriced securities or asset classes, often involving higher fees. Styles include growth, value, income, and momentum investing.
Passive management seeks to replicate benchmark performance, typically through index-linked funds or ETFs, with lower management fees. It operates on the argument that consistent outperformance by active managers is rare.
Define fiduciary management in the context of investment strategy and explain the extent of responsibility it entails for the consultant.
Fiduciary management is an implemented consulting approach where the retirement fund delegates significant investment-related decisions and responsibilities to the consultant. A fiduciary takes on particular responsibilities related to the application or discretion in respect of retirement fund assets.
Describe the Total Expense Ratio (TER), Total Investment Charge (TIC), and Reduction in Yield (RIY) as measures of investment management fees, noting their key differences.
Total Expense Ratio (TER)
Measures investment management fees for mutual funds/collective schemes, excluding fund asset costs.
Total Investment Charge (TIC)
A standardized disclosure measure including TER plus all transaction costs, taxes, brokerage, etc..
Reduction in Yield (RIY)
A prospective measure indicating how much charges reduce the projected investment yield.
What are the fundamental differences in setting investment strategies for DB and DC retirement funds?
In DB funds, the sponsor generally bears the investment risk, and benefits are defined based on factors like salary and service.
In DC funds, members bear the investment risk, and the final benefit depends on contributions and investment returns.
The link between investments and individual member outcomes is direct in DC but indirect in DB.
Identify several key issues for consideration when establishing an investment strategy specifically for a Defined Benefit (DB) fund.
Key considerations for DB funds include:
* The fund’s liability profile (nature and term of liabilities).
* The funding position (surplus or deficit).
* The size of the fund (larger funds have more options).
* Expected cashflow and liability requirements.
* The attitude of involved parties towards risk.
* The nature and financial strength of the sponsor.
How might the investment strategy of a DB fund differ based on its life cycle stage, such as a new fund versus a mature fund closed to new entrants?
New fund with no past service
May have a longer-term horizon and higher risk tolerance due to a smaller liability base.
Mature fund with new entrants
Liability term may be shorter depending on surplus allocation.
Mature fund closed to new entrants
Likely has a negative cashflow, necessitating a focus on matching assets to liabilities to meet payouts.
What are the two primary perspectives from which the risks inherent in a DB fund can be considered?
The risks can be viewed from the perspective of the DB fund as a stand-alone entity, focusing on its ability to meet liabilities independently, or by considering the presence of a corporate sponsor and the impact of the fund’s performance on the sponsor’s financial position.
Explain the rationale behind “matching assets to liabilities” in a DB fund and discuss potential trade-offs associated with this strategy.
Matching aims to align asset cash flows with liability cash flows to reduce the risk of a deficit. However, a strict matching strategy, often involving low-yielding fixed-income assets, may reduce the potential for higher returns and surplus generation.
Describe the implications for a corporate sponsor when a DB fund is held on its balance sheet, particularly concerning investment risk.
When the fund is on the sponsor’s balance sheet, changes in asset and liability values directly impact the sponsor’s financial position. Investing in mismatched assets can be seen as the firm taking on more leverage, increasing its overall financial risk.
Identify several factors that have increased the risk for corporate sponsors of DB pension plans in recent times.
Increased risks include:
* Shorter lifespans of modern companies compared to DB plan liabilities.
* The ability of a company’s debtholders to force liquidation, potentially impacting the pension fund.
* Retirement funds having a claim for underfunding in case of company debt default.
What is a fundamental characteristic that distinguishes investment strategy for DC funds compared to DB funds?
A key feature of DC funds is that members bear the investment risks. This necessitates trustees considering the diverse needs and risk appetites of individual members rather than focusing solely on aggregate asset-liability management.
What are some common reasons for the introduction of member investment choice within DC pension schemes?
Reasons include:
* Advancements in administration systems making choice feasible.
* Improved member communication and financial sophistication.
* Trustees’ discomfort in making investment decisions for members bearing the risk.
Describe some examples of suboptimal investment behaviours that members with investment choice in DC funds might exhibit.
Suboptimal behaviours can include:
* Blindly applying heuristic rules.
* Herding behaviour (following popular trends).
* Chasing winners (investing in recent high-performing assets).
* Choosing more expensive investment options.
* Inappropriately switching to low-risk assets like cash at a young age.
Outline the characteristics of some common default investment strategies used in DC pension schemes.
Common default strategies include:
* A single investment strategy for all members.
* A strategy that becomes more conservative as retirement approaches (growth bias during accumulation, lower growth near retirement).
* Lifestage models that gradually reduce exposure to riskier assets based on the member’s age.
Explain the concept and typical mechanism of a “lifestage model” as a default investment strategy within a DC pension plan.
A lifestage investment model automatically adjusts a member’s asset allocation over time, typically shifting from higher-growth, higher-risk assets (like equities) to more conservative, lower-risk assets (like bonds) as the member gets closer to retirement, usually over a period of 5 to 10 years before NRA.
What are “customised defaults” in the context of DC investment strategies, and what are some typical factors used to personalise these defaults?
Customised defaults are tailored investment strategies for individual DC members based on verifiable characteristics. Personalisation often relies on simple variables such as lifestage or age to adjust the asset allocation.
Identify several key portfolio theory tools or considerations that are commonly employed when formulating an overall investment strategy.
Important considerations include:
* The level of accumulated savings.
* Current and expected future contribution rates.
* The expected term to retirement.
* How accumulated funds will be converted into retirement income.
* Other sources of retirement income or support.
* Member risk tolerance and investment knowledge.
* Minimum desired consumption levels in retirement.
State some key principles that should generally guide the selection and design of investment strategies for pension funds.
Strategies should be:
* Simple to communicate to stakeholders.
* Provide good value.
* Comply with fiduciary responsibilities.
* Goal-directed (aligned with objectives).
* Account properly for model risk (uncertainty in assumptions).
Explain the purpose and general methodology of using a “model office approach” to determine an investment strategy.
A model office approach involves simulating future financial outcomes under different investment strategies to assess their impact on the entity’s ability to meet its obligations and achieve its goals. This typically involves projecting assets and liabilities under various scenarios.
Summarise the core steps involved in a model office approach for evaluating and selecting an investment strategy.
The steps generally include:
* Allocating free assets to support reserves.
* Performing Asset-Liability Management (ALM) projections.
* Checking solvency capital requirements (SCR).
* Calculating aggregate profitability measures.
* Repeating the above for different risk levels to achieve a target insolvency probability.
* Identifying the most profitable strategy at the target risk level.
What are the fundamental decisions that need to be made in essence when undertaking a model office approach to setting an investment strategy?
The key decisions revolve around:
* The riskiness of the investment strategy.
* The level of free assets to deploy.
* The acceptable probability of insolvency.
Briefly discuss the role and importance of investment manager selection in the overall process of setting an investment strategy for a fund.
Selecting competent investment managers is crucial for executing the chosen investment strategy effectively. Careful monitoring is particularly important for external managers due to potentially less control and access to performance data.
Define liquidity risk in the context of investment strategy for financial institutions like health insurers or pension funds.
Liquidity risk is the risk that the institution cannot meet its financial obligations as they fall due, or can only do so by incurring significant unexpected costs. Maintaining sufficient liquid assets is essential for meeting short-term payment obligations.
Explain credit risk as it pertains to various types of investments commonly held by pension funds and insurers.
Credit risk is the risk of loss arising from the failure of a counterparty (e.g., bond issuer, deposit-taking institution) to meet its financial obligations, such as the payment of interest or principal. This is particularly relevant for investments like corporate bonds and deposits.
Highlight some key aspects of the regulatory framework that must be considered when establishing an investment strategy for retirement funds.
Regulatory considerations include:
* Restrictions on permissible asset types.
* Requirements for a stated and regularly reviewed investment policy.
* Increasing focus on Environmental, Social, and Governance (ESG) factors.
Briefly describe some common types of regulatory controls that might be imposed on the investment activities of insurance companies and similar financial institutions.
Regulatory controls can include:
* Restrictions on asset types.
* Limits on the amount invested in particular assets for solvency purposes.
* Maximum exposure limits to single counterparties or countries.
* Requirements for matching assets and liabilities by currency.
* The need to hold mismatching reserves.
* Restrictions on valuation methods.
