Institutional Investor Portfolios Flashcards
DB Plan Vs DC Plan
DB Plan
- Company makes payments and bears investment risk (company owned)
- Assets/Liability is put on the balance sheet
- Company makes investment decisions
DC Plan
- Company contributes to 401(k) (participant owned)
- Has portability since participant owns
- Employee makes investment decision
DB Plan Return Objective
- Minimum return is the actuarial discount rate (PV of future benfits)
- Could be higher if not fully funded (1-2%)
Factors Affecting Pension Fund Risk Tolerance
- Plan Surplus: positive = higher risk tolerance. They may be willing to take more risk if negative but NOT ok
- Financial Status & Profitability: Debt-to-equity and profit margin. Better = high risk tolerance
- Profits and Pension: High correlation = less risk tolerance
- Liquidity: Liquidity provisions = less risk tolerance. (early retirement/lump-sum withdrawals)
- Time Horizon: Longer = higher risk tolerance (low avg worker age, retiree to employee ratio)
DB Plan Liquidity
Liquidity is affected by:
- # of retired lives (more retired = more benefits paid)
- amount of contributions
- Plan features (early retirement/lump-sum)
DB Plan Time Horizon
- Mostly considered long-term
- Consider liability duration
- Sometimes multi-stage (active lives vs retired lives)
DB Plan Taxes, Legal, and Unique
Taxes
- Tax-exempt (unless stated which then is a constraint)
Legal
- ERISA regulated
- Take into consideration laws of current country
Unique
- Small plans have limited staff
- Restriced asset classes or industries
Cash Balance Plan
- Company bears investment risk
- Bascially a small defined-benefit plan that is portable at retirement
Foundations vs Endowments
- Same for IPS purposes
- Foundation - funded by gifts
- Endowments - long-term funds owned by a non-profit organzation
Types of Foundations
-
Independent: from person or family
- Requires 5% spending of assets
-
Company Sponsored: legally independent from company
- Requires 5% spending of assets
-
Operating: Sole purpose of funding a company (museum, zoo)
- Requires 85% spending of dividends and interest
-
Community: Publicly sponsored
- No spending requirements
Foundation Return Objectives
Typically to preserve real value and meet spending requirements
Example for Return (compounded):
Management costs 0.30%, distribution 5%, inflation 2%
Required return = (1.003)(1.05)(1.02) - 1 = 7.42%
Foundation/Endowment Spending Rules
- Simple: just a percent of MV
-
Smoothing:
- Rolling 3- year: avg MV of last 3 years
- Makes more stable, ↑ risk tolerance
- Rolling 3- year: avg MV of last 3 years
Foundation/Endowment Risk Tolerance
Often high. Increased by:
Lack of obligations/payouts
Inflows of new contributions
Foundation/Endowment Taxes
Mostly tax exempt
- Look for specified returns that are taxed
- Look for UBIT
Life Insurance Return Objectives
- Earn the crediting rate needed to meet obligations
- Earn additional net interest spread to increase surplus (to pay fees, etc.)
- Surplus = competitive advantage (can charge less on premiums)
- May be segmented by line of business
Life Insurance Risk Tolerance
- Asset Liablity Management (ALM): match asset to liabilties to manage surplus
- Could expose surplus to interest rate risk
- Heavy regulated; limits on assets and amounts
- Must be careful of reinvestment and credit risk
Increased ability to take risk:
- Higher surplus
Disintermediation
Definition: Allowing policy holders to borrow against the policy value.
Increases when interest rates increase. Surplus would decrease
Life Insurance Taxes
Crediting rate is not taxed
Corporate share is taxed and increases with surplus
Life Insurance: Unique Circumstances
Look for:
- Diversity of product offering
- Limited company resources
- Concentrated risk exposures
Casualty Company Differences
- Shorter liability duration (uncertain due to timing)
- Longer processing periods for payouts
- called long tailed risk (managed by matching with fixed income)
- Can be highly concentrated (geographically and event risk)
- Less predictable cash flows
Casualty Underwriting
- Tied to business cycle (last 3-5 years)
- Losses turn to profits (more strict and increase price, also no profit = no taxes)
- Profits attract capital and drive up competition
Casualty Return Objectives
- Increase profitability (positive spread over crediting rate)
- Grow the surplus
Bank Details
- Take deposits (liabilities) and make loans (assets)
- Reserve requirements must be met
- Managed portfolio is for funds after loans/reserve
Bank Objectives
- Manage interest rate risk: short duration to offset loans
- Manage liquidity: high liquidity to offset loans
- Generate income
- Diversify credit risk
- Return: earn a positive interest spread
- Risk: ALM (most conservative)
Asset Only and Economic Liability
Asset Only
- Soley focused on efficient portfolios (higher equities)
- Ignores the pension liabilities (interest rate risk, inflation, etc)
- Risk-free portfolio is cash
Economic Liability
- Mimics liabilities (hard to mimic new entrants, changing demographics)
- Risk-free portfolio is highly correlated with liabilities
Pension Liability Exposures
Pension Segment Market/NonMarket Risk Liability Mimic
Inactive/ active accrued Market Term Nominal/Real
Active future wage growth Market TermNominal
Active future wage growth Market InflationReal Return
Active future wage growth Market Econ GrowthEquities
Personal Liability Exposure Notes
*Benefits not indexed to inflation –> use nominal bonds
*Benefits indexed to inflation –> real return bonds
*Growth –> equities
Non Life vs Life
Non-Life
Risk Tolerance Less regulated
Time Horizon Shorter but with long tail
Liquidity Higher and less certain
Inflation Risk for Life & Non-Life
Life Insurance
payouts are nominal, so little inflation risk
Non-Life
insure replacement value and have inflation risk
MVO vs ALM Approach
With defined liabilities, recommend ALM
MVO has instability issues - constantly changes allocation
↑ transactions costs
