Institutional Investor Flashcards
Defined-Benefit (DB) vs Defined-Contribution (DC) Pension Plan
Defined-Benefit:
. Sponsor obligated to ensure benefit (promises for the retirement stage). Creates a pension liability.
. Sponsor bears inv risk
Defined-Contribution:
. Current contributions are promised (current stage promises). No financial liability.
. Participants bear the inv risk. Any over return is owed to the participant. 2 types - sponsor-directed and participant-directed
. Portable (transferrable to another employer)
Defined Benefit Pension Plan (DB)
Factors affecting Risk Objectives
PS: on common risk exposures, you want high correlation between assets and liabilities, but low correlation b/w pension assets and operating assets
Asset-Liability Management (ALM)
“ALM minimizes the volatility of the surplus (MVAssets > PVLiabilities” through high correlation b/w assets & liabilities
Different fro Strategic asset allocation (SAA), where you ignore pension liability when selecting pension assets, ALM mimics the structure of pension liabilities with pension assets, using predominantly fixed income assets
Shortfall Risk
Risk that a portfolio will fall below a minimum acceptable level over an investment horizon, stated as a probability.
If (Expressed return <= Portfolio E(R) - 2σ), then ok!
—– / —–
Factors that increase shortfall risk:
- ALM mismatch
- Greater allocation of equities (than fixed income)
- Smaller pension surplus
Liquidity in a DB pension plan
(Net cash outflow and Liquidity %)
Net cash outflow $ = benefit payment - pension contribution
Liquidity % = annual benefit pmt / asset base
Foundation vs Endowment
Return, Risk, Liquidity, Time Horizon, and Tax Concerns
Foundation
. Usually single donor
. No fund-raising campaigns
. Payout requirement (5% annually of MVAssets)
. Return: Preserve real value of assets while allowing for spending at the desired rate. Maintain “intergenerational equity”
. Risk: Asset only (AO) allocation. More aggressive than DB plans
. Liquidity: annual spending (% rate x portfolio value) + inv mgt fees - contributions
Endowment
. Frequent individual small gifts to provide Substantial, Stable, Sustainable distributions to nonprofit operating institutions
. Frequent fund-raising campaigns
. 2 types: True endowments that have spending restrictions, to preserve principal into perpetuity and Funds Functioning as Endowments with voluntary savings and no spending restrictions.
. Return: Spending rate < expected return (same rate may lead to a low probability of survival, due to volatility w/ path dependency)
. Risk: Dependent on spending policies (smoothing allow higher ability for risk). Usually high tolerance, but higher spending rate, higher budget reliance (from beneficiary), heavy reliance on donations, short-term pressure, and others may impair endowment’s ability to bear risk.
. Liquidity: limited need (except cash for spending dist)
Endowment: 3 Spending Rules
(1) Simple Rule: Spendingt = Spending rate * End MVt-1
Very simple application
(2) Rolling 3-yr average: Spendingt = Spending rate * (1/3) * [End MVt-1 + End MVt-2 + End MVt-3]
The problem is that it places equal weight on MV of 3 years, even if the mkt sunked in the last year
(3) Geometric smoothing rule: Spendingt = Smoothing rate * [Spendingt-1 * (1 + inflationt-1)] + (1 - Smoothing rate) * (Spending rate * Beg MVt-1)
Solves the last problem, using a weighted averag
Life Insurance
Disintermediation Risk
When policyholders surrender or borrow at lower rates (defined in the insurance contract at inception) accumulated cash values from whole life policies & deposit in higher yielding securities during high-interest rate periods
eg.: Borrow at 9% and invest at Bank CDs at 14%
This led to shorter duration of liabilities, in a moment that assets (bonds) were marked at a low price
Life Insurance
Return, Risk, Liquidity, Time Horizon, and Tax Concerns
Return:
Primary objective is to fund future benefits (at least at actuarial rate), and growth of surplus (for shareholders and to provide a competitive advantage). Total return approach does not work well when asset side (bonds) face market volatility. Port may be segmented.
Risk:
Interest rate risk is the largest risk factor. Maintain an Asset Valuation Reserve (AVR) to absorb losses from surplus account and must also maintain sufficient risk-based capital (Basileia).
ALM Mgt:
1. Valuation concerns: mismatch b/w asset & liability durations (DA > DL) during periods of interest rate volatility
2. Reinvestment risk: risk of reinvesting coupon income at a rate less than the original coupon rate (major concern for annuities)
Risk-based capital:
3. Credit risk: default may be really hurtful for an insurance company. Even though credit analysis is considered one of the industry’s strengths, insurance companies must diversify and exercise careful analysis
4. Cash flow volatility: loss or delay in reinvesting income reduces compounding
Liquidity
Minimal needs if firm is growing volume, but companies disintermediation and asset marketability risk may increase liquidity needs
Time Horizon
Long-term, ALM always in mind, portfolio segmentation contributes to a closer match b/w A&L
Tax Concerns
Tax paying entities should max. after-tax returns
Legal & Regulatory
Most heavily regulated institution. Face limits of eligible investments (ICSD 1.5x, etc). Prudent investor rule (replacing “laundry list”). Uniform valuation methods
Non-Life Insurance
Return, Risk, Liquidity, Time Horizon, Tax, and Legal
Uncertain liability amount & timing, exposed to inflation risk, claim processing has long-tail settlement, shorter duration than life insurance
Risk:
- Erratic cash flow: collection of premiums (slow and steady) vs. claim payments (abrupt large pmts) - lower the tolerance for loss of principal.
- Common stock / total surplus ratio
Return:
- “**Underwriting* cycle influences the return objective”
1. Competitive pricing - companies who earn more in returns, are able to be more aggressive in pricing
2. Profitability - maximize ROE
3. Growth of surplus - Helps expand insurance underwriting volume
4. Tax considerations - maximize after-tax returns with a mix of tax-exempt (profitable cycle) and taxable bonds (loss cycle)
5. Total return - much more flexible in the portfolio of assets, not limited to bond strategies based on yield only
Liquidity:
Erratic cash flows require more attention to liquidity needs and constitution of a buffer. The mix change b/w taxable and tax-exempt bonds also contribute for a higher liquidity need. Important to notice that this liquidity constraint also limits the risk tolerance of this kind of company.
Time Horizon:
To optimize the yield advantage offered by tax-exempt securities, maturities of non-life companies is usually higher than life companies (that do not have to worry about taxes). Duration, on the other hand, is usually shorter, matching liabilities and risk characteristics of each business.
Tax Concerns:
Tax paying entity, aims to max. after-tax returns. Tax-exempt income is taxable.
Legal
More permissive asset classes (but still some restrictions), no AVR, risk base capital mandates
Banks
Portfolio, Return, Liquidity, Time Horizon, Tax, and Legal
Banks take money (deposits with interest cost) and lend money (interest revenue)
Portfolio: Highly liquid to easily manage the B/S interest rate risk. Assume low credit risk in securities portfolio to diversify from existing exposure in liabilities
Return: Positive ROIC, Positive spread
Liquidity: Cover outflows and loan demand
Time Horizon: Short (usually 3-7 yrs)
Tax Concerns: Fully taxable. Accounting rules may encourage holding losses to avoid reducing net income.
Legal & Regulatory: Restrictions on weights, Risk-based capital requirements (Basel I, Basel II and Basel III)
Banks
Leverage adjusted duration gap (LADG)
LADG = DA - kD<strong>L</strong>
Bank duration measure capturing the extent of duration mismatch in bank B/S. The wider in absolute terms, the more a bank is exposed to rate changes
where:
k = MV Deposits Liabilities / MV Loans Assets
DA = Assets Duration
DL = Liabilities Duration
Scenarios:
↑ interest rates, ↓ asset duration, ↑ liabilities duration, MV net worth ↓ if LADG is positive, instead a negative LADG would be beneficial
