CAIA L2 - 4.3 - Pension Fund Portfolio Management Flashcards
List
Motivations
for Using Pension Plans
4.3 - Pension Fund Portfolio Management
- Hiring and retention of key talent
- decrease the need for the employees to directly save themselves
- Tax deferral until retirement
- Lower marginal tax rate during retirement than during their accumulation years
- Pooled funds benefits = enhance risk premium (illiquidity + time horizon) + access + reduced fees
- Mitigation of longevity risk
4.3 - Pension Fund Portfolio Management
Define
Cash balance plan
4.3 - Pension Fund Portfolio Management
hybrid DB plan
that maintains individual account records for plan participants,
showing their current value of accrued benefits.
ability to transfer the benefit to a new plan
if the employee changes employers
4.3 - Pension Fund Portfolio Management
Describe
Three approaches
to managing assets
in defined benefit plans
4.3 - Pension Fund Portfolio Management
- Asset focused. Considers only the volatility of the rate of return on the plan’s assets. Within the context of the plan sponsor’s investment constraints and risk tolerance, a plan manager will determine an allocation to risk-free assets (cash and cash equivalents) and risky assets that will maximize expected return.
- Asset liability. Along with its assets, a plan has liabilities, which are its promised benefits payable. The plan’s funded status is the difference between its assets and liabilities. A positive difference is called a pension surplus (overfunded) , while a negative difference is called a shortfall / deficit (underfunded) . Using the asset-liability perspective, the risk of DB plan assets = volatility of its surplus. In general, the higher (lower) the correlation between assets and liabilities, the lower (higher) the risk. For example, an asset that has low volatility (on a stand-alone basis) but is negatively correlated with plan liabilities would have higher risk. In that regard, cash will not always be a low-risk asset.
-
Integrated asset liability. The approach considers the plan’s funded status + plan sponsor’s operating profits simultaneously. Because a funding shortfall will necessitate higher cash inflows from the sponsor, it is better that such a shortfall occurs when the sponsor is more profitable.
Ideally = negative correlation of funded status and the plan sponsor’s operating profits. Therefore, an asset with low correlation to plan liabilities might not be considered as risky if it is negatively correlated with the plan sponsor’s operating profits.
4.3 - Pension Fund Portfolio Management
Formula
Equity value
(in terms of plan’s funded status)
4.3 - Pension Fund Portfolio Management
E’t’ = Operating Equity + funded status
E’t’ = OA’t’ – OL’t’ + (A’t’ – L’t’)
E’t’ = Equity
OA’t’ = operating assets
OL’t’ = operating liabilities
A’t’ – L’t’ = funded status of the DB plan
Ideally = negative correl of oper profits and funded status
4.3 - Pension Fund Portfolio Management
Identify
Four factors
that drive the impact of liabilities
on a plan’s risk
4.3 - Pension Fund Portfolio Management
- Interest rate changes. Biggest concern (probably) - impact the discount rate used to compute the projected benefit obligation. A fall in interest rates will result in a rise in future liabilities.
- Inflation. Important because it is assumed that future benefits are linked to inflation (e.g., computed based on salary and include cost-of-living adjustments). If inflation increases, then so would future benefit payments.
- Retirement cycle. Considers the trend of when participants retire and become benefit recipients. Given the large sample size, it is often reasonably predictable, although the potential for disability or early retirement due to business cycle declines (among many possible factors) may present some uncertainty.
- Mortality rate. Due to the large sample size, the mortality rate is reasonably predictable in the short term. The longer-term concern may be declining mortality, which means increasing longevity and longer pension payouts.
4.3 - Pension Fund Portfolio Management
Identify
Five major factors
that affect the risk tolerance
of a plan’s sponsor.
4.3 - Pension Fund Portfolio Management
- Participant demographics. If the pool of participants is a younger (older) group of individuals, the sponsor has a higher (lower) risk tolerance. The idea here is that for younger (older) employees, the plan has a longer (shorter) amount of time to overcome a funding shortfall. As well, with older employees, the increased liquidity requirements will reduce risk tolerance.
- Funded status of the plan - In general, an underfunded (overfunded) plan means that the sponsor has a lower (higher) risk tolerance. However, an underfunded (overfunded) plan may mean that the sponsor must take somewhat more (less) risk to improve (maintain) its funded status.
- Sponsor’s assets vs plan’s liabilities - Fund size - The smaller (larger) the plan’s liabilities compared to the sponsor’s assets, the higher (lower) the sponsor’s risk tolerance.
- Sponsor’s cash flow vs Contributions - Expected future contributions relative to the sponsor’s expected cash flows. Assuming stable future contributions, if the sponsor’s future free cash flow is expected to be high (low), then the plan sponsor can tolerate more (less) risk.
- Sponsor’s general financial position as measured by expected future free cash flows and the debt-to-equity (D/E) ratio, for example. Sponsors with a high (low) D/E ratio will have a lower (higher) risk tolerance.
4.3 - Pension Fund Portfolio Management
Explain
Two buckets of
Strategic Asset Allocation (SAA)
for a DB Plan
4.3 - Pension Fund Portfolio Management
Hedging bucket
* Goal = track plan’s liabilities / minimize volatility of the fund’s surplus
* Include = long-duration bonds, inflation-indexed bonds, or longevity derivatives
* + correlated to 1) inflation, 2) population longevity
* - correlated to interest rate
3 approaches of hedging:
* duration matching of the hedging bucket with the liabilities, to address interest rate risk. Requires constant monitoring and rebalancing.
- cash flow matching - future cash inflows of plan assets with outflows of the plan liabilities. Is more challenging - hard to find exact timing.
- overlay - use derivatives to hedge. Interest rate swaps could be used => no need to sell assets (from growth bucket), but may result in increasing the plan’s leverage.
Growth bucket
- Goal = outperform the growth rate in plan liabilities / reduce the need for future contributions
- Include = riskier investments
- How? +growth bucket with same risk // +risk with =growth bucket
4.3 - Pension Fund Portfolio Management
Define
surplus risk
4.3 - Pension Fund Portfolio Management
Risk that arises from changes in the value of the
plan’s assets and the
PV of its liabilities
4.3 - Pension Fund Portfolio Management
Recognize
Why defined benefit plans
are withering?
4.3 - Pension Fund Portfolio Management
-
High cost
. US regulation: funded status in BP and disclosed to employees
. underfunded plans must make it fully funded in 7 years - DB plans less attractive to younger laborforce
4.3 - Pension Fund Portfolio Management
Explain
Liability-driven investing (LDI)
in a Defined Benefit Plan (DB plan)
4.3 - Pension Fund Portfolio Management
Lower surplus risk by
portfolio of assets highly correlated with plan liabilities
4.3 - Pension Fund Portfolio Management
Define
Cost-of-living adjustment (COLA)
in a Defined Benefit Plan (DB plan)
4.3 - Pension Fund Portfolio Management
annual inflation-indexed increase
in benefits
during retirement
Inflation-protected bonds = least effective to protect
Although inflation-protected bonds earn a set coupon and the principal increases with inflation, their overall returns have historically been low. Therefore, real assets (including commodities, real estate, timber, and farmland) are now serving as suitable long-term inflation hedges because of their higher returns.
4.3 - Pension Fund Portfolio Management
Compare
Governmental Social Security Plans
and
Defined Benefit Plan (DB plan)
4.3 - Pension Fund Portfolio Management
Governmental Social Security Plans
- have progressive system (higher-salary employees receive benefits that are a smaller percentage of their salary compared to lower-salary employees). DB = income levels are positively correlated with benefits size
- portability for employee + provide benefits to dependents
4.3 - Pension Fund Portfolio Management
Define
target-date fund
4.3 - Pension Fund Portfolio Management
Fund that follows a glide path.
Invests in
- risky assets when further away from retirement
- conservative assets when the retirement date gests closer
4.3 - Pension Fund Portfolio Management
Formula
Expected economic life (EL)
(of an annuity)
4.3 - Pension Fund Portfolio Management
EL = – [1/ln(1+R) ] × ln[ (payment – R×assets) / payment]
R = expected after-fee investment return after inflation (i.e., the real return after fees)
payment = annual spending in the first year of retirement (expected to increase at the rate of inflation)
assets = value of the portfolio
4.3 - Pension Fund Portfolio Management
Formula
present value of a growth (growing) annuity
or “cost of a annuity”
4.3 - Pension Fund Portfolio Management
PV’ordinary annuity’ = [initial payment/(r-g)] × {1–[(1+g)/(1+r)]^n}
payment = fixed annual annuity payment
r= discount rate
g= growth rate of annuity
n= number of periods involved
4.3 - Pension Fund Portfolio Management
