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CFA Level III > Institutional Investor Portfolios > Flashcards

Institutional Investor Portfolios Flashcards

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CFA flashcards
1
Q

DB Plan Vs DC Plan

A

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
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2
Q

DB Plan Return Objective

A
  • Minimum return is the actuarial discount rate (PV of future benfits)
  • Could be higher if not fully funded (1-2%)
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3
Q

Factors Affecting Pension Fund Risk Tolerance

A
  1. Plan Surplus: positive = higher risk tolerance. They may be willing to take more risk if negative but NOT ok
  2. Financial Status & Profitability: Debt-to-equity and profit margin. Better = high risk tolerance
  3. Profits and Pension: High correlation = less risk tolerance
  4. Liquidity: Liquidity provisions = less risk tolerance. (early retirement/lump-sum withdrawals)
  5. Time Horizon: Longer = higher risk tolerance (low avg worker age, retiree to employee ratio)
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4
Q

DB Plan Liquidity

A

Liquidity is affected by:

  • # of retired lives (more retired = more benefits paid)
  • amount of contributions
  • Plan features (early retirement/lump-sum)
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5
Q

DB Plan Time Horizon

A
  • Mostly considered long-term
  • Consider liability duration
  • Sometimes multi-stage (active lives vs retired lives)
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6
Q

DB Plan Taxes, Legal, and Unique

A

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
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7
Q

Cash Balance Plan

A
  • Company bears investment risk
  • Bascially a small defined-benefit plan that is portable at retirement
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8
Q

Foundations vs Endowments

A
  • Same for IPS purposes
  • Foundation - funded by gifts
  • Endowments - long-term funds owned by a non-profit organzation
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9
Q

Types of Foundations

A
  1. Independent: from person or family
    1. Requires 5% spending of assets
  2. Company Sponsored: legally independent from company
    1. Requires 5% spending of assets
  3. Operating: Sole purpose of funding a company (museum, zoo)
    1. Requires 85% spending of dividends and interest
  4. Community: Publicly sponsored
    1. No spending requirements
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10
Q

Foundation Return Objectives

A

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%

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11
Q

Foundation/Endowment Spending Rules

A
  1. Simple: just a percent of MV
  2. Smoothing:
    1. Rolling 3- year: avg MV of last 3 years
      1. Makes more stable, ↑ risk tolerance
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12
Q

Foundation/Endowment Risk Tolerance

A

Often high. Increased by:

Lack of obligations/payouts
Inflows of new contributions

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13
Q

Foundation/Endowment Taxes

A

Mostly tax exempt

  • Look for specified returns that are taxed
  • Look for UBIT
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14
Q

Life Insurance Return Objectives

A
  • 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
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15
Q

Life Insurance Risk Tolerance

A
  • 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
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16
Q

Disintermediation

A

Definition: Allowing policy holders to borrow against the policy value.

Increases when interest rates increase. Surplus would decrease

17
Q

Life Insurance Taxes

A

Crediting rate is not taxed

Corporate share is taxed and increases with surplus

18
Q

Life Insurance: Unique Circumstances

A

Look for:

  1. Diversity of product offering
  2. Limited company resources
  3. Concentrated risk exposures
19
Q

Casualty Company Differences

A
  • 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
20
Q

Casualty Underwriting

A
  1. Tied to business cycle (last 3-5 years)
  2. Losses turn to profits (more strict and increase price, also no profit = no taxes)
  3. Profits attract capital and drive up competition
21
Q

Casualty Return Objectives

A
  • Increase profitability (positive spread over crediting rate)
  • Grow the surplus
22
Q

Bank Details

A
  • Take deposits (liabilities) and make loans (assets)
  • Reserve requirements must be met
  • Managed portfolio is for funds after loans/reserve
23
Q

Bank Objectives

A
  • 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)
24
Q

Asset Only and Economic Liability

A

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
25
Q

Pension Liability Exposures

A

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

26
Q

Personal Liability Exposure Notes

A

*Benefits not indexed to inflation –> use nominal bonds
*Benefits indexed to inflation –> real return bonds
*Growth –> equities

27
Q

Non Life vs Life

A

Non-Life

Risk Tolerance Less regulated

Time Horizon Shorter but with long tail

Liquidity Higher and less certain

28
Q

Inflation Risk for Life & Non-Life

A

Life Insurance

payouts are nominal, so little inflation risk

Non-Life

insure replacement value and have inflation risk

29
Q

MVO vs ALM Approach

A

With defined liabilities, recommend ALM

MVO has instability issues - constantly changes allocation
↑ transactions costs

CFA Level III (13 decks)

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