R13 - Managing Institutional Investor Portfolios Flashcards
Defined contribution plan?
employer: makes specified contribution and provides set of investment choices
employee: selects the investment. Investment policy is part of IPS. Employee assets are portable
Defined benefit plan?
employer:
- responsible for future benefit payments.
- bears investment risk
DB plan terminology: Surplus?
Plan assets - PV of liabilities
DB plan terminology: Active-lives?
plan liabilities for participants working and accruing benefits
DB plan terminology: Retired-lives?
plan liabilities for participants drawing benefits
DB plan terminology: Deferred-lives?
plan liabilities for participants no longer working but not yet drawing benefits
DB plan terminology: Frozen plan?
No new entrants allowed or no new benefits accrued
DB plan typical return objectives?
- generate sufficient return to cover liabilities
- Minimum return equal to actuarial discount rate
- absolute return objective
DB plan return objective for active vs retired lives?
active - future benefits less certain
retired - future benefits more certain
Factors that affect DB plan ability to bear risk: Funded status?
negative surplus = underfunded and decreased ability
positive surplus = overfunded and increased ability
Factors that affect DB plan ability to bear risk: Financial status/profitability of plan sponsor?
- weak status/profitability decreases ability
- strong status increases
Factors that affect DB plan ability to bear risk: correlation between plan returns and sponsor business returns?
+ correlation decreases ability
- correlation increases ability
Factors that affect DB plan ability to bear risk: plan features affecting liquidity needs?
- higher liquidity needs decrease ability
- lower liquidity needs increase ability
Factors that affect DB plan ability to bear risk: workforce characteristics affecting liquidity demands or time horizon?
- higher liquidity needs and shorter time horizon decreases ability
- lower liquidity needs and longer time horizon increases ability
DB plan typical risk objectives?
- manage std dev of surplus (or assets)
- achieve 100% funded status
DB plan time horizon?
-functionally determined by plan and current participant characteristics
- duration of plan liabilities
- assets used to fund current participants
- may be split between retired lives and active lives
- may be long term
-for a terminating plan, horizon is termination datae
DB plan taxes?
-generally tax exempt, except for special situations
DB plans legal?
-obligation to manage assets with benefit to participants
DB plan liquidity?
-as required to meet plan payouts
- higher needs indicated by:
- –higher ratio of retired/active lives
- –older workforce
- –higher ratio of plan disbursements/sponsor contributions
- –plan features like early retirement and lump-sum distribution
DB plan unique?
-often none
Hybrid plans: ESOP?
- set up to buy company stock
- may be able to contribute with pre or after-tax funds
Independent foundation: description, purpose, source of funds, spending requirements?
desc - single donor, private or family
purpose - makes grants with aim of contributing to society
source - corporate sponsor
requirements - 5% of avg markt value of assets during preceding year (ex inv management fees)
Operating foundation: desc, purpose, source of funds, spending requirements?
purpose - funding an org
source - can by group, individual, or family
requirements - 85% of dividends plus interest income (maybe also 3.33% of assets)
Community foundation: desc, purpose, source of funds, spending reqs?
desc - publicly sponsored grant-awarding org
purpose - fund social, educational, religious, other
source - general public/large donors
spending reqs - none
Return objective of foundations?
typical obj - preserve real value and meet spending targets
also - maintain intergenerational neutrality so real value maintained
Spending rules of foundations?
simple - x% of beginning market value; but this makes distributions volatile
smoothing rules - purpose of reducing volatility of distributions
example - x% of avg 3yr market value
Risk tolerance of foundations?
ability - perpetual time horizon; flexibility of spending reqs; need to maintain purchasing power; if deemed appropriate by foundation board
reduces ability - recipients depend on distributions; lack of smoothing rules
Liquidity constraints of foundations?
- needs for cash in excess of contributions received
- smoothing helps
- cash equivalent needs usually low
Legal and regulatory constraints of foundation?
- generally less regulated
- varies by country and type
Unique constraints of foundations?
varies and case specific, for example:
- concentrated holdings; restrictions on sale; prohibited investments
- socially responsible investing
- board biases/opinions
- inadequate resources for due diligence on comples investments
Return objectives of endowments?
- maintain principal
- maintain perpetual purchasing power
- distributions sustainable and reliable
- total return should cover spending, inflation, and fees
Endowment spending rules?
simple - x% of beginning market value
rolling avg - x% of last 3yrs
geometric - y% of spending is x% of avg last 3yrs mrkt value, while (1-y%) is past distribution of amount adj for inflation
Endowment risk tolerance?
- normally high due to perpetual time horizon
- reductions of risk tolerance:
- –lack of smoothing rules
- –receivers are heavily dependent on distributions
- –directors focused on short term
liquidity and legal/regulatory constraints on endowments?
liquidity - needs generally limited
legal/reg - varied; normally less regulated
life insurance return objective?
- earn crediting (accumulation rate) necessary to meet promised benefits
- earn net interest spread above crediting rate
life insurance risk tolerance?
-invest using fiduciary principles for quasi-trust funds
- match asset to liability characteristics
- –duration mismatch of A/L exposes surplus to interest rate risk and capital adequacy problems
- –reinvestment risk - reinvesting coupon at rate lower than original purchase yield
- cash flow volatility - anything hindering timely collection of income reduces reinvestment earnings/return
- credit risk - can reduce returns
life insurance liquidity concerns?
- typically predictable
- special considerations - disintermediation/asset marketability
life insurance liquidity issues: disintermediation?
disintermediation increases when int rates increase and asset sold at depressed value
life insurance liquidity issues: asset marketability?
product mix has moved to shorter duration
life insurance time horizon?
- traditionally long duration
- match asset duration to liability
life insurance taxes?
- policyholder share not taxed generally
- corporate share taxed
life insurance legal and regulatory concerns?
heavily regulated:
- eligible investments
- % of types allowed (lists)
- valuation methods
casualty insurance compared to life insurance?
- casualty has shorter liability duration
- longer processing period of payout (long tail on claims)
- uncertain payouts/amounts (life is uncertain in timing, but amount is certain)
issues with casualty insurance?
- business risk can be concentrated geographically
- face an underwriting/profitability cycle
describe underwriting/profitability cycle.
- often tied to economic cycle
- after period of underwriting losses and low profits insurers increase standards and raise premiums
- profits attract capital which increases underwriting capacity
- increased capital/competition in lowers premiums and underwriting standards
- losses come and standards tightened again
casualty insurance company return objective key considerations?
- support competitive pricing
- increase profitability
- grow the surplus
- tax considerations - emphasize taxable bonds when tax rate is zero and profits are negative; tax exempt when opposite is true
- total return focus - regulatory/accounting rules favor active management; realized gains increase surplus
In summary: want to earn positive spread
casualty insurance company return objective differences from life insurance companies?
objectives and results more varied for casualty:
- regulations more relaxed
- product mix and liability durations differ
- companies focus on asset appreciation strategies
- capital adequacy and surplus vary
casualty insurance company risk objective key considerations?
- cash flow needs are large/erratic
- common stock to surplus ratio: equity investing mostly limited to surplus account; risk appetite lower during inflation and bear markets
- few specific regulatory limits vs life insurance companies
casualty insurance company liquidity concerns?
- high liquidity needs
- typically:
- emphasize highly liquid securities
- match assets to known specific needs
- hold high quality government bond portfolio
- if there is surplus, can invest that more aggresively
casualty insurance company time horizon concerns?
- horizon relatively short to match liability duration
- generally accept more interest rate risk than in life companies
- allows for larger mismatch of asset/L duration
- mismatch related to underwriting cycle
Duration swings in US with underwriting cycle:
- when profitable and t>0
- –focus on tax exempt bonds and extend asset duration as tax exempt yield curve tends to be steep
- when unprofitable and t = 0
- –emphasize taxable bonds and reduce asset duration
casualty insurance companies: legal/regulatory/unique concerns?
regulation:
- -permissive vs life companies
- -no asset valuation reserve
unique:
–specific to company or case
For banks, the securities portfolio is a residual after what?
after meeting reserves and loan demand.
Bank security portfolio objectives?
- manage interest rate risk: shorter duration to offset longer loan portfolio duration.
- manage liquidity: high liquid short term gov securities to offset illiquied riskier loans
- generate income for bank
- diversify credit risk
Bank security portfolio return objective?
contribute to earning positive spread over cost of funds (interest paid on deposits)
Bank security portfolio risk objective?
- focus on asset/liability management and protecting surplus
- risk tolerance is below average
Bank security portfolio legal/regulatory concerns?
- extensive
- limits on holding common stock and below investment grade securities
- capital requirements
- some regulations are minimum liquidity levels and max leverage
- leverage adjusted duration gap (LADG) measures interest rate risk
Bank security portfolio liquidity/time horizon concerns?
liquidity: driven by deposits/withdrawals
time horizon: driven by maturity of liabilities
Bank security portfolio taxes and unique concerns?
taxable - incentive to hold losers and sell winners
unique - case specific
For what kinds of companies to use ALM vs Asset Only?
ALM where definable, measurable liabilities:
- DB pension plans
- Insurance companies
- Banks
Asset only where not:
- Foundations
- Endowments
