Module 10: Implementing the Defined Benefit Pension Plan Investment Policy Flashcards
Depict and label the investment cycle for a DB pension plan.
- Set investment objectives and constraints
- Determine long-term investment strategy
- Determine investment manager structure and roles
- Select Investment Managers
- Monitor investment results against objectives
Describe the main purpose of each step in the investment cycle for a DB pension plan and what occurs after the completion of the cycle.
Step 1. Set investment objectives and constraints. This step identifies how the investment decision makers intend to deliver on the benefit objective (or “pension promise”). A key investment objective is the rate-of-return objective, while investment constraints include such things as the portion, if any, of certain types of investments that will be allowed.
Step 2. Determine long-term investment strategy. This step determines the asset classes that will be authorized by the plan’s SIPP and the strategy to allocate funds among those asset classes. This strategy is commonly referred to as the pension plan’s “target asset mix.”
Step 3. Determine investment manager structure and roles. This step involves determining the types and numbers of investment managers that best suit the plan’s objectives and that can be retained to implement the investment policy.
Step 4. Select investment managers. The step involves the selection of managers that correspond with the chosen investment management strategy, that have exhibited skill in the management of the asset classes selected for the plan and that are able to fulfill the roles determined under Step 3 of the investment cycle.
Step 5. Monitor investment results against objectives. This step has the objective of providing plan fiduciaries with accurate, comprehensive measurements that provide a basis for decision making and allow more effective discharge of plan governance responsibilities.
Once the cycle has been completed for the first time, the statement of investment policies and procedures (SIPP) is reviewed. The review process includes consideration and review of the decisions made in Steps 1 through 3, and the monitoring process of Step 5 may, in turn, lead to reconsideration of the manager structure initially established in Step 4. In effect, with each review, the plan sponsor/trustees and/or pension committee returns to Step 1 and starts the process over again—or at least confirms that the policy decisions and actions taken in the early steps are still applicable.
Describe how the “investment return assumption” relates to the ultimate cost of a defined benefit pension plan.
While the rate-of-return objective impacts the investment policy for a defined benefit pension plan, it does not impact the ultimate plan cost borne by the plan sponsor. The ultimate cost of a defined benefit plan depends upon the key factors of plan design (i.e., the “richness” of the pension and other benefits provided), the demographics of the plan membership, and the plan’s “experience” throughout its existence. Net investment growth (i.e., growth after allowing for investment-related expenses) is a critical component of the plan’s experience.
Identify the first step for investment decision makers when developing the target asset mix and describe the areas of difference between the various asset classes.
The first step for a plan’s investment decision makers when developing the target asset mix for the pension plan is to understand the characteristics of each asset class. The various asset classes differ from each other in a number of ways, including:
(a) Degree of marketability
(b) Stability of principal
(c) Liquidity
(d) Preservation of purchasing power
(e) Growth in value
(f) Current income from interest payments, dividends, etc.
(g) Regulatory limitations.
Outline plan-specific factors considered by investment decision makers when determining the pension plan’s asset-allocation strategy.
Target asset mix is the dominant factor in a plan’s expected return-and-risk level—Significantly more return volatility is explained by asset mix than by manager selection.
When determining the asset classes to include in the plan’s portfolio and how much of each asset class to include, investment decision makers typically consider the following plan-specific factors:
(a) The pension plan’s need for liquidity to satisfy payment of benefits and expenses
(b) The pension plan’s funding objectives and obligations, given its liabilities
(c) The acceptable trade-off between risk and reward, that is, the investment return level that corresponds with the plan sponsor’s level of acceptable investment risk
(d) Any intention to establish an investment strategy that includes liability matching to mitigate the impact of interest rate movements upon the plan’s funded status
(e) Type of benefits offered
(f) Amount of capital to invest
(g) Outlook of investment decision makers or their delegated advisors on interest rates, inflation, economic growth, etc.
Explain the application of the prudent person rule to derivative investments included in a pension fund as outlined in the Ontario pension regulator’s publication Investment Guidance Notes IGN-002, Prudent Investment Practices for Derivatives.
Derivatives can be used as a hedge in pension funds to reduce certain risks. However, the specific nature and complexity of derivatives can also substantially increase risks such as market risk, basis risk, liquidity risk, counterparty credit risk, and operations and systems risk, depending on how they are used.
It is the pension plan administrator’s duty to ensure that all investments, including derivatives, comply with the prudent person rule—the use of derivatives judged primarily in terms of the overall context of the plan and its investment portfolio. Prudence includes making decisions based on the consideration of sufficient and relevant information and documenting the decisions, the reasons for them and the factors considered. It also includes minimizing the risk of large losses to a pension fund associated with a sizable exposure to a single counterparty, asset or class of assets and considering the risks of using derivatives compared to other investments with the same potential benefits.
Describe the Ontario pension regulator’s expectations for risk mitigation activities relating to pension plan investment in derivatives as outlined in Investment Guidance Notes IGN-002, Prudent Investment Practices for Derivatives.
This guidance from the Ontario pension regulator outlines expectations of investment decision makers for risk mitigation activities when a pension plan invests in derivatives, including:
(a) Sources independent from counterparties perform the valuation of non-exchange traded derivatives. A contract with a third party for valuation measurement should specify valuation procedures and the need for independent price sources.
(b) Appropriate legal documentation, including appropriate collateral requirements, is put in place between the pension fund and counterparties of nonstandard over-the-counter derivative trades and repurchase agreements (repos).
(c) The investment decision makers obtain appropriate legal advice and complete appropriate legal due diligence in respect of the derivative investments, including consideration of the ability to contain potential losses through various mechanisms (e.g., stop-loss provisions or the ability to terminate a contract).
(d) Appropriate mechanisms are put in place to permit the administrator to contain potential losses.
(e) Original documents are stored safely in accordance with FSCO’s document retention policy.
(f) Specific and unambiguous soft and hard limits to derivatives exposures are set by the administrator, and exposures are measured using widely accepted methodologies.
(g) Compensation policies relating to derivative investments are set so as to discourage excessive risk taking.
These best practices apply regardless of whether the investment is made directly by the administrator or through delegation to an external investment manager.
Define “responsible investment” and provide examples of issues that may be considered in responsible investing as outlined in SHARE, Putting Responsible Investment Into Practice.
“Responsible investment” is most commonly defined as the integration of environmental, social and governance (ESG) considerations into the investment management process. It is based on an active ownership approach and on the belief that these factors can have an impact on the financial performance of investments.
Some common examples of ESG issues are climate change, human rights and executive compensation.
Outline requirements to qualify as a responsible investment strategy under the United Nations-supported Principles for Responsible Investing (U.N. PRI) and identify examples of issues relating to ESG Incorporation.
To qualify as a responsible investment strategy under U.N. PRI, the investment strategy must in some way incorporate the “review and use of environmental, social and governance (ESG) information in the investment decision making process.” This is referred to as “ESG Incorporation” and reflects the following definitions of the ESG criteria:
(a) Environmental. Issues relating to the quality and function of the natural environment and natural systems. These include biodiversity loss; greenhouse gas emissions; climate change; renewable energy; energy efficiency; air, water or resource depletion/pollution; waste management; stratospheric ozone depletion; changes in land use; ocean acidification; and changes to the nitrogen and phosphorus cycles.
(b) Social. Issues relating to the rights, well-being and interests of people and communities. These include human rights; labour standards in the supply chain; child, slave and bonded labour; workplace health and safety; freedom of association and freedom of expression; human capital management and employee relations; diversity; relations with local communities; activities in conflict zones; health and access to medicine; HIV/AIDS; consumer protection; and controversial weapons
(c) Governance. Issues relating to the governance of companies and other investee entities. In the context of listed market equities, these include board structure, size, diversity, skills and independence, executive pay, shareholder rights, business ethics, bribery and corruption, internal controls and risk management and, in general, issues dealing with the relationship between a company’s management, its board, its shareholders and its other stakeholders. This may include matters of business strategy that encompass both the implications for business strategy for environmental and social issues and how the strategy is to be implemented. With respect to unlisted assets, governance issues also include matters of fund governance such as advisory committee powers, valuation issues, fee structures, etc.
Describe the “universal owner hypothesis” in the context of incorporating ESG factors into a pension plan investment policy.
The “universal owner hypothesis” suggests that large institutional investors inevitably bear some of a firm’s externalities because institutional investors own shares in other firms that suffer the consequences of the externalities. Emission of pollutants into the water system is an “externality.” Externalities represent potentially significant costs shifted from a single corporation to the general community.
Assume an investor owns stock of Firms A, B and C in its portfolio. The cost of emission of pollutants into a water system by Firm A may be borne by individuals (or their families) who become ill, the corporations that employ those individuals and provide them with health insurance, and governments that sponsor health care systems and pay for pollution cleanup. If Firm A emits pollution that imposes costs on Firms B and C, then Firm A has an economic advantage because it has shifted costs to Firms B and C. But the universal owner, with ownership interests in Firms B and C, has to pay the cost one way or other.
The “universal investor hypothesis” urges institutional investors to take steps to control externalities at the corporate level to protect the interests of their portfolios as a whole. A difficulty with the universal owner hypothesis is that while large institutional investors such as pension plans may have portfolio-driven interests that are separate and distinct from the interests of any one of their investee companies, the structure of governance at the individual company level reflects the corporation’s interest, not the institutional owner’s portfolio interests.
Outline the premise of the “public fiduciary hypothesis” in the context of incorporating ESG factors into an investment policy.
Like the universal investor hypothesis, the “public fiduciary hypothesis” presumes that the overall financial returns generated by financial markets are the most important determinant of a pension fund’s financial success; that is, most funds’ returns come from general exposure to the market rather than seeking market benchmark outperformance.
Institutional investors are seen as part of a network of fiduciaries. Each investor performs specialized and complex functions in an interdependent marketplace. Because of their scale and structure, it is argued that courts should impose obligations of trust on institutional fiduciaries, not only toward their beneficiaries but also toward the public at large. According to the public fiduciary hypothesis, pension fiduciaries are obligated to pay close attention to reputational and sustainability concerns and to engage in collective and collaborative actions with other public fiduciaries to address broader ESG issues.
Explain the “shareholder value case” and “values-based case” rationales for incorporating responsible investment practices in asset management structures as outlined in SHARE, Putting Responsible Investment Into Practice.
The “shareholder value case” is based on the premise that following responsible investment practices can help institutional investors avoid potential risks that ESG issues pose to investment performance—risks that are not often captured through standard financial analyses. At the same time, incorporating ESG considerations into investment analyses helps pension funds identify valuable investment opportunities such as investing in companies with strong environmental records or in growing sectors of the economy such as green technology and renewable energy.
The “values-based case” is based on the premise that the move to responsible investment has been driven by the expectations of pension plan members and beneficiaries, foundation donors and stakeholders as well as general society. The expectation is that companies behave in a manner that is consistent with broader, positive societal values, including environmental protection, sustainability, good corporate governance and social justice.
Describe how ESG considerations can drive fiduciary actions regarding pension plan investment decisions as outlined in SHARE, Putting Responsible Investment Into Practice.
According to SHARE:
(a) If the ESG consideration can be reasonably expected to have a material impact on the financial performance of the investment, the consideration must be considered by the plan fiduciaries (together with all other relevant considerations).
(b) If the ESG consideration can be reasonably believed to be the subject of a clear consensus among beneficiaries, the consideration must be considered by the plan fiduciaries (together with all other relevant considerations).
(c) If the ESG consideration provides a point of differentiation between equally attractive alternatives, the consideration may be considered by plan fiduciaries (together with all other relevant considerations).
Responsible investment practices such as proxy voting, shareholder engagement, economically targeted investments (ETIs) and screening are all permitted investment strategies, provided they are authorized in a fund’s investment policy and carried out in a prudent and impartial manner in the best interest of pension plan members or endowment beneficiaries.
Describe how fiduciary obligations of pension fund administrators are impacted by the ESG criteria.
Increasingly, ESG criteria are recognized as relevant to the long-term risk-and-return characteristics of securities and the underlying enterprises. Fiduciary obligations direct pension fund administrators to seek the best investment returns available at a level of risk acceptable to the institutional investor considering its liability profile.
However, there is an increased social expectation that pension plans will behave as responsible investors and play a constructive role in the general economy as they grow in size and potential influence while benefiting from generous tax incentives. The important and difficult balance between economic and pension funding objectives on one hand and social responsibility on the other hand will continue to challenge pension administrators and stakeholders.
Outline provisions that a plan sponsor should include in its SIPP if intending to follow responsible investment practices as outlined in SHARE, Putting Responsible Investment Into Practice.
If the plan sponsor intends to follow responsible investment practices as outlined in the SHARE publication, its SIPP should include the following:
(a) An acknowledgement of the fiduciary duty requirements within which the fund is bound to operate
(b) An allowance for the consideration of extra-financial criteria
(c) For mission-based investors, an indication of whether or not rate of return is the paramount consideration
(d) An allowance for appropriate diversification levels in accordance with legal requirements
(e) Consideration of the structure of the fund’s liabilities or perpetuity requirements
(f) Indications of which responsible investment strategies are permissible, including proxy voting, shareholder engagement, ETIs and screening
(g) Indications of whether investments will be managed in-house or externally
(h) Indications of permitted categories of investments
(i) A description of how proxy voting rights will be exercised
(j) A description of how policy implementation will be monitored, including fund performance.
Describe proxy voting and how it can be used by a pension fund that follows a responsible investment policy, as outlined in SHARE, Putting Responsible Investment Into Practice.
Attached to the voting share of every public company is a proxy that legally permits shareholders to have a say in how the company is run. A pension fund or endowment’s investment policy typically outlines how these proxies get voted, ideally in accordance with formal proxy voting guidelines established by the fund or endowment. Except for very large pension funds, the actual casting of proxies is typically carried out by an investment manager or a dedicated proxy voting service provider.
Responsible investors use proxy voting as a tool for encouraging companies to improve their transparency and accountability to shareholders and to improve companies’ management of ESG issues.
Explain how pension plans can influence proxy voting in a pooled fund as outlined in SHARE, Putting Responsible Investment Into Practice.
Pension plans invested in pooled funds generally cannot direct the voting of proxies. However, the plan can try to negotiate an arrangement to permit the voting of a proportionate number of the pooled fund’s proxies according to individual fund guidelines. At minimum, plans in this situation advise investment managers of their voting preferences and request a voting report on how the pooled fund’s shares are voted.
Describe the steps that the SHARE publication Putting Responsible Investment Into Practice recommends be considered by a pension fund when implementing a shareholder engagement strategy to address ESG issues.
Steps in implementing a shareholder engagement strategy to address ESG issues include:
(a) Consult key stakeholders to determine the specific issues of importance (e.g., survey key stakeholders to identify common values or areas of concern).
(b) Determine what ESG criteria will provide the framework for engagement activities (e.g., will the focus be on one specific issue or a broader set of ESG issues or in an area of high investment exposure).
(c) Decide what engagement strategies will be initially employed (e.g., write letters, seek meetings with corporate management, file shareholder resolutions).
(d) Finalize how, and by whom, the engagement activities will be coordinated (i.e., who will be responsible for approving specific engagement activities, whether the pension fund will cooperate with other investors on engagement activities, who will represent the fund in discussions with companies).
(e) Seek professional advice (e.g., use current fund managers to implement engagement strategy or use additional or alternative service providers to develop specialized engagement services that adhere to the fund’s responsible investment policy).
(f) Establish a monitoring provision to assess the long-term costs and benefits associated with carrying out a shareholder engagement strategy.
Describe Economically Targeted Investments (ETIs) and provide examples as outlined in SHARE, Putting Responsible Investment Into Practice.
ETIs, also known as “community investments,” are investments that seek to generate a market rate of financial return along with providing specific social, economic and environmental benefits. Generally, investing in ETIs is prudent and permissible as long as the investment return is commensurate with similar types of investments having similar risk profiles.
Examples of ETIs include investments designed to increase the availability of affordable housing, provide capital to small- and medium-sized enterprises, revitalize inner cities or support nontraditional industries such as renewable energy.
Explain why plan sponsors choose ETIs as a responsible investment strategy as outlined in SHARE, Putting Responsible Investment Into Practice.
According to SHARE, investors choose ETIs as a responsible investment strategy to:
(a) Support social or economic development or environmental protection within a specific geographical region
(b) Advance technological developments in a targeted industry
(c) Cultivate job creation and business development in a specific sector or for disadvantaged groups, such as women or minorities.
Explain steps recommended by SHARE in its publication Putting Responsible Investment Into Practice for pension funds to consider if implementing an ETI strategy.
According to SHARE, steps that should be considered by pension funds when implementing an ETI strategy are:
(a) Determine the types of collateral social, economic and/or environmental returns the pension fund seeks to achieve through an ETI strategy. The fund may want to consult key stakeholders directly to determine the types of benefits that are most important.
(b) Determine the types of investment vehicles that are viable for ETIs (e.g., venture capital, private placements, mortgages, debt financing and real estate)
(c) Identify the percentage of assets to allocate to ETIs and the pension fund’s overall risk-return profile
(d) Evaluate each investment decision for an ETI on a case-by-case basis
(e) Collaborate with other investors interested in ETIs. Pooling assets and expertise can help build a viable investment vehicle for ETIs. Potential collaborators include pension funds, foundations and the public sector, along with financial intermediaries.
Identify the types of investment screening defined by the U. N. Principles for Responsible Investments (U.N. PRI) and explain uses of screening as described by SHARE in its publication Putting Responsible Investing Into Practice.
The U.N. PRI identifies the following three types of investment screening:
(1) Negative/exclusionary screening. Excluding from a fund or portfolio certain sectors, companies or practices based on specific ESG criteria
(2) Positive/best-in-class screening. Investing in sectors, companies or projects based on positive ESG performance relative to industry peers
(3) Norms-based screening. Vetting against minimum standards of business practice based on international norms.
Historically, screening was carried out using a negative screen. Negative screening is a useful tool for addressing ethical and reputational risks, particularly for mission- or value-based investors. Positive screening is also now being used. Positive screens incorporate normal investment risk analysis along with the consideration of ESG criteria to assess which companies perform best when measured against similar companies in an investment universe.
Identify reasons for screening in the context of responsible investment as outlined in SHARE, Putting Responsible Investment Into Practice.
According to SHARE, investors choose screening to:
(a) Eliminate specific risks from their portfolio
(b) Protect the fund’s reputation as an investor supporting companies that are committed to responsible business practices
(c) Respond to key stakeholders’ expectations around ethical standards.
Describe the guidance offered for the incorporation of ESG factors into investment policies and procedures by the Ontario pension regulator in Investment Guidance Note IGN-004, Environmental, Social and Governance (ESG) Factors.
Approaches to incorporating ESG factors into investment policies and practices differ among investors. Guidance offered by the Ontario pension regulator offers the following approaches for the incorporation of ESG factors into investment policies and procedures:
(1) Integrate ESG factors into fundamental investment analysis to the extent they are relevant to investment performance. This approach is driven by the belief that effective research, analysis and management of ESG factors can play a part in assessing the valuation and future performance of an investment over the short, medium and long term. It involves assessing a wider range of risks and opportunities that may influence the investment performance of a pension fund by looking at factors beyond those included in traditional financial analysis. It also recognizes the longterm nature of ESG factors and the impact they may have on the sustainability and profitability of individual entities or of an industry sector in which the pension fund may invest. This approach sees ESG factors as among the many factors that may impact the investment performance of an asset, asset class or the entire portfolio. While all such factors should be considered as part of an administrator’s duty to invest prudently, it is up to the administrator as fiduciary to evaluate which factors are relevant and how to account for them.
(2) Integrate ESG factors from an ethical or moral perspective instead of from a financial perspective. For example, an investor may screen investments on social and environmental factors, employing ethical screens targeting certain industries. An administrator should be cautious to ensure that its approach to incorporating ESG factors does not conflict with its fiduciary duties. The best interests of plan beneficiaries have traditionally been defined by the courts in terms of the beneficiaries’ financial interests, with the result that there is a potential conflict with investing with other goals in mind, such as ethical and moral considerations.
Identify the information that the Ontario pension regulator expects to be disclosed in a statement of investment policy and procedures for a pension plan that has elected to incorporate ESG factors in the plan’s investment policy.
The Ontario pension regulator expects the following information to be disclosed once a plan administrator has decided to incorporate ESG factors in its investment policies and procedures:
(a) Either a broad statement that the administrator incorporates all ESG factors or a list of ESG factors that are incorporated, such as a particular ESG category(ies) (i.e., environmental, social or governance) and/or specific factors with those categories (e.g., labour relations, shareholder rights) that form the focus of the administrator’s approach to incorporating ESG factors
(b) A brief explanation of the approach taken by the plan to incorporate ESG factors
(c) A description of the scope of the application of ESG factors. The disclosure should indicate whether ESG factors are considered across the entire pension fund or only certain portions of the pension fund (e.g., certain asset classes or internally managed assets rather than externally managed assets).
Identify the factors to be considered by pension plan investment decision makers when determining the type of manager structure to implement.
Factors that investment decision makers will consider when determining the type of manager structure to implement are:
(a) The size of the pension fund
(b) Availability of qualified internal staff to dedicate to investment activities
(c) Cost and time constraints related to fulfilment of investment activities by internal staff
(d) Availability of investment products given the size of the pension fund and the authorized investment classes.
For small to medium-sized pension funds, factors (b) and (c) above require careful consideration in the context of following a prudent investment approach. When the organization does not employ staff with the necessary skills to undertake the necessary investment activities relating to the pension fund, delegation of those activities to outside organizations is the prudent approach. This may limit the available choices of investment manager structure for those plans.
Describe two basic approaches to the fund manager structure.
(a) Balanced approach. This can be done by using one manager whose expertise includes the supervision of portfolios containing a variety of asset classes (e.g., bonds, stocks and cash reserves) and who constructs a portfolio that invests all assets in accordance with the asset allocation policy for the pension plan. Another way to do this is to retain a number of managers of balanced funds, with each managing a portion of the pension fund and effectively competing against each other.
Each fund manager:
- Follows the asset allocation policy as directed by the investment decision makers for the pension plan. This usually includes performing rebalancing activities to maintain the long-term asset mix policy.
- Makes all decisions relating to security selection (i.e., the specific securities to be included in each asset class).
(b) Specialist approach. A number of specialist managers can be engaged for each broad asset class (e.g., one for bonds and one for equities) or for narrow asset classes (e.g., a specialist for Canadian large cap growth equities). This approach focuses on identifying and utilizing the particular strengths of the available managers.
Under this approach, the investment decision makers direct plan assets to each manager in accordance with the asset mix policy and oversee the level of assets held by each manager (i.e., in order to maintain the asset mix policy). Typically, each specialty manager must stay fully invested (i.e., no cash) in their assigned asset class at all times.
Each specialty manager:
- Makes all decisions relating to security selection for the asset class under their mandate.
Explain the role of a swing manager.
Sometimes, to achieve changes in asset mix when specialists are used, a swing manager is hired. Swing managers are usually market timers who move assets in and out of the market or switch between asset classes, using predictive methods such as technical indicators or economic data. Their allowable range of asset mix is quite broad. The actual changes in the asset mix of the entire pension fund are achieved by varying the asset mix in the swing manager’s fund.
Describe investment style and identify the determinants of style for stock portfolios.
Investment style refers to the investment characteristics sought by a fund manager when selecting securities for an investment portfolio.
For stock portfolios, style is determined by:
(a) The market capitalization of the company issuing the stock (large cap, mid cap and small cap)
(b) The value/growth characteristics of the company whose stock is being considered.
Describe the determining qualities of value and growth characteristics of stocks and the focus of activities of fund managers that follow those styles.
The determining qualities of value and growth characteristics of stocks are:
(a) Value stocks are those that are selling for less in the market than managers believe they are worth based on a valuation model such as the price/earnings (P/E) ratio. These are often “out of favour” companies.
Value-style managers search out stocks that fit the valuation model and place less emphasis on expected revenue/earnings growth.
(b) Growth stocks are those whose prices managers believe will increase at a rate significantly above the average growth for the market due to above average growth in revenues. These stocks may have relatively high P/E ratios and typically don’t pay dividends. It’s possible that there are no earnings at the moment but earnings are expected in the future.
Growth-style managers search out stocks that fit this valuation model in the belief that they have the potential to provide greater returns than the market as a whole. Growth-style stocks carry greater risk because of volatile prices; thus, growth managers are viewed as more aggressive than value managers.
Identify the most common styles of active management and describe their characteristics.
The most common styles of active management are a top-down (returns-based analysis) approach, a bottom-up (holdings-based analysis) approach or some combination of the two (e.g., a top-down approach for industry sector allocation and a bottom-up approach for security selection).
(a) Top-down. A top-down approach starts with a broad international or national economic outlook, forecasting factors such as gross domestic product (GDP) growth, government and central bank policies, inflation and interest rates. The manager then compares the relative attractiveness of markets (e.g., allowed asset classes), reviews the growth prospects of various industries at the current stage of the business cycle and, finally, buys/sells securities within the identified areas or sectors. The cash content of the portfolio is a specific choice under this approach.
(b) Bottom-up. At the other extreme, the bottom-up approach starts with an analysis of fundamentals (e.g., dividend yield, P/E ratio, earnings growth, etc.) of each stock/company or bond under consideration and then places values on the securities within the current economic/market/industry outlook. The preferred securities (i.e., the ones whose current values are below the manager’s assessment of their value) are then organized into a portfolio, subject to diversification constraints. The cash content in this approach tends to be a result of the relative attractiveness and/or availability of investments, not a specific investment decision.
Describe what investment management fees are and explain how they are determined.
Investment management fees are the fees payable to an investment management firm for the ongoing management of a portfolio. Investment management fees can be asset-based (a percentage of assets held in the portfolio), performance-based (based on the portfolio’s performance relative to a benchmark) or a combination of the two but may take different forms as well. Fees for active investment management of a DB pension plan’s assets typically scale down with the asset-level ranges (e.g., size of the investment). A fee schedule that starts out at 100 basis points on the first dollar of assets may be as low as 15 basis points on each dollar of assets over $100,000,000.
Describe two different approaches for the handling of administration fees and provide examples of two different types of bundled fees.
Administrative fees include all fees other than the trading expenses and the investment management fee. Administrative fees include custody fees, accounting fees, consulting fees, legal fees or other related fees. Custody fees include fees payable to the custodian for the safekeeping of the plan’s assets. Custody fees typically contain an asset-based portion and a transaction-based portion of the fee. The total custody fee may also include charges for additional services, including accounting, securities lending or performance measurement.
Administrative fees are typically outside the control of the investment management firm and are not included in either the gross-of-fees return or the net-of-fees return. However, there are some financial markets and investment vehicles where administrative fees are controlled by the investment manager. These are termed “bundled fees.” A bundled fee combines multiple fees into one bundle. Bundled fees can include any combination of management, transaction, custody and other administrative fees. Two specific examples of bundled fees are all-in fees and wrap fees.
(1) All-in fees. These fees are specific to a particular client. All-in fees can include any combination of investment management, trading expenses, custody and other administrative fees.
(2) Wrap fees. These fees are specific to a particular investment product called either a “wrap fee account” or, more commonly, a “separately managed account” or SMA. Wrap fees can be all-inclusive, asset-based fees (may include any combination of management, transaction, custody and other administrative fees).
