Institutional Investor Flashcards
14.a: Contrast a defined-benefit plan to a defined-contribution plan and discuss the advantages and disadvantages of each from the perspectives of the
employee and the employer.
14.b: Discuss investment objectives and constraints for defined-benefit plans.
14.c: Evaluate pension fund risk tolerance when risk is considered
from the perspective of the
1) plan surplus -The greater the plan surplus, the greater the ability of the fund to withstand poor/negative investment results without increases in funding.
2) sponsor financial status and profitability -Indicators such as debt to equity and profit margins indicate the financial strength and profitability of the sponsor.
3) sponsor and pension fund common risk exposures -The higher the correlation between firm profitability and the value of plan assets, the less the plan’s risk tolerance.
4) plan features -Provisions for early retirement or for lump-sum withdrawals decrease the duration of the plan liabilities and, other things equal, decrease the plan’s risk
tolerance.
5) workforce characteristics. The lower the average age of the workforce, the longer
the time horizon and, other things equal, this increases the plan’s risk tolerance.
14.d: Prepare an investment policy statement for a defined-benefit plan.
Under ALM,
risk is measured by the variability (standard deviation) of plan surplus.
At a minimum the return objective is the discount rate
used to compute the present value of the future benefits.
14.g: Discuss hybrid pension plans (e.g., cash balance plans) and
employee stock ownership plans.
In a typical cash balance plan, a participant’s
account is credited each year with a pay credit and an interest credit.
14.h: Distinguish among various types of foundations, with respect to
their description, purpose, and source of funds.
foundations are grant-making entities funded by gifts
and an investment portfolio.
Endowments are long-term funds owned by a non-profit
institution (and supporting that institution).
Foundations: - 1) Independent - Private or Family
2) Company sponsored - Closely tied to sponsoring corporation
3) Operating - Established for the sole purpose of
4) COmmunity
Foundation Objectives
Foundation Constraints
a minimum return equal to the required payout plus expected
inflation and fund expenses.
Time horizon - most foundations have infinite time horizons
Liquidity.- spending requirement is termed its spending rate. annual rate or smothing rule
Tax considerations.- 1% tax in United states - but generally not taxable.
Endowments: -
1) Simple spending rule
2) Rolling 3 year average
3) Geometric spending rule
spendingt = (R)(spendingt_1)(1 + It_1) + (1 - R)(S)(market valuet_1)
where:
R = smoothing rate
I = rate of inflation
S = spending rate
Risk tolerance for an endowment is affected by the institution’s dependence on funding from the endowment portfolio to meet its annual operating budget
Return. Attention to preserving the real purchasing power of the asset base is paramount.
Taxes: Endowments are tax exepmt. unrelated business income be taxed.
Legal and regulatory considerations: the Uniform Management Institutional Fund Act (UMIFA) of 1972 as the governing regulation for endowments. ( limited )
Unique circumstances: The long-term nature
of endowments and many foundations have lead to significant use of alternative investments. The cost and complexity of these assets should be considered. They
generally require active management expertise.
INSURANCE COMPANIES
Whole life or ordinary life-The cash value builds up over the life of the policy at a crediting rate.
disintermediation risk occurs during periods of high interest rates ( They withdrawn cash )
Risk
Valuation risk and ALM will figure prominently in any discussion of risk, and interest rate risk
(NAIC) directs life insurance companies to maintain an asset valuation reserve (AVR)
Return
More desirable is to earn a net interest spread, a return higher than the actuarial assumption.
The investments are heavily fixed-income oriented with an exception. The surplus may pursue more
aggressive objectives such as stock, real estate, and private equity.
Time horizon. Traditionally long at 20-40 years, it has become shorter for all the reasons discussed previously.
Tax considerations. Life insurance companies are taxable entities. often the return up to the actuarial assumed rate is tax free and above that is taxed.
Ultimately after-tax return is the objective.
Legal and regulatory constraints: Heavily regulated at state level
Unique circumstances. Concentration of product offerings, company size, and level of surplus are some of the most common factors impacting each company.
Non Life Insureance Companies
The risks insured by casualty companies are less
predictable.
The cash flow characteristics of non-life companies are often erratic and unpredictable. Hence, risk tolerance, as it pertains to loss of principal and declining investment income, is quite low.
Liquidity needs are high given the uncertain business profitability and cash flow needs.
The company typically 1) holds significant money market securities such as T-bills and commercial paper, 2) holds a laddered portfolio of highly liquid government bonds, and
3) matches assets against known cash flow needs.
Tax considerations. Non-life insurance companies are taxable entities.
Legal and regulatory constraints. Regulatory considerations are less onerous for non-life insurance companies than for life insurance companies.
An asset valuation reserve (AVR)
is not required, but risk-based capital (RBC) requirements have been established.
Unique circumstances. There are no generalizations to make.
Time horizon : It is generally short due to the short duration of the liabilities.
Banks
Banks usually have a below-average risk tolerance because
they cannot let losses in the security portfolio interfere with their ability to meet their
liabilities.
Return. The return objective for the bank securities portfolio is to earn a positive interest spread.
Liquidity. A bank’s liquidity needs are driven by deposit withdrawals and demand for loans as well as regulation. The resulting portfolio is generally short and liquid.
Time horizon. The time horizon is short and linked to the duration of the liabilities.
Taxes. Banks are taxable entities. After-tax return is the objective.
Legal and regulatory. Banks in industrialized nations are highly regulated. Risk-based capital (RBC) guidelines require banks to establish RBC reserves against assets; the
riskier the asset, the higher the required capital. This tilts the portfolio towards highquality, short-term, liquid assets.
Unique. There are no particular general issues.
14.e: Evaluate the risk management considerations in investing pension
plan assets.
Pension investment returns in relation to the operating returns of the company.
Coordinating pension investments with pension liabilities.
14.m: Compare the asset/liability management needs of pension funds,
foundations, endowments, insurance companies, and banks.
Focusing on asset return and risk is not sufficient. The focus should be on surplus and surplus volatility.
At a minimum, asset and liability duration should be
matched to stabilize surplus.
14.l: Contrast investment companies, commodity pools, and hedge funds
to other types of institutional investors.
