Reading 15 Flashcards
Managing Institutional Investor Portfolios
Contrast a defined-benefit plan to a defined-contribution plan and discuss the advantages and disadvantages of each from the perspectives of the employee and the employer
DB plans: sponsor promises a future benefit. This creates a pension liability and the sponsor bears the investment risk (i.e. defined future benefits are promised)
DC plans: the sponsor promises a current contribution and the employees bear the investment risk (i.e. no specific future benefit is promised)
DB plans create early termination risk that the plan will be terminated or the employee will leave before vesting (owning the promised benefit)
For DC plans, the employee generally owns the contribution and subsequent return as soon as they occur. The benefits are generally portable
DC plans can be sponsor directed where the sponsor makes the investment decision on behalf of the participants or participant directed where participants select from a set of investment alternatives offered by the sponsor
Evaluate pension fund risk tolerance when risk is considered from the perspective of the
1) Plan surplus
2) sponsor financial status and profitability
3) sponsor and pension fund common risk exposures
4) plan features
5) workforce characteristics
Pension fund risk tolerance is increased (decreased) by:
- Positive (negative) surplus
- Stronger (weaker) financial status and profitability of the plan sponsor
- Lower (higher) correlation of plan asset returns and the sponsor’s business
- Plan features and workforce characteristics that increase (decrease) time horizon and lower (increase) liquidity needs
Prepare an investment policy statement for a defined-benefit plan
RETURN: the actuarial discount rate or somewhat higher
RISK: Determined by the plan and sponsor characteristics. Factors reducing risk tolerance include shorter time horizon, higher liquidity needs, weak sponsor, and positive correlation of sponsor results with plan asset returns
TIME HORIZON: Linked to liability duration
TAXES: Generally untaxed
LEGAL/REGULATORY: A prudent expert managing the assets for the benefit of plan participants
LIQUIDITY: Linked to needs for plan payouts
UNIQUE: Watch for small plans with inadequate resources to complete proper due diligence
Evaluate the risk management considerations in investing pension plan assets
1) Correlation
2) ALM
High (positive) correlation of plan asset returns to sponsor operating results reduces risk tolerance because when asset returns are poor and additional contributions may be required, the sponsor is least able to make those contributions and meet the pension liabilities
ALM is superior to asset only management because it explicitly manages the expected return and volatility of the surplus. It is the size of the surplus that directly affects the future burden of the plan on the sponsor and the sponsor’s ability to meet the pension liabilities.
Prepare an investment policy statement for a participant directed defined-contribution plan
In a defined-contribution plan, the plan employer does not establish the investment goals and constraints; rather, the employee decides her own risk and return objectives.
Therefore, the employee bears the risk of the investment results
Consequently, the IPS for a DC plan describes the investment alternatives available to the plan participants. This IPS becomes a document of governing principles instead of an IPS for an individual.
Some issues addressed in the IPS:
- Making a distinction between the responsibilities of the plan participants, the fund managers, and the plan sponsor
- Providing descriptions of the investment alternatives available to the plan participants
- Providing criteria for monitoring and evaluation of the performance of the investment choices
- Providing criteria for selection, termination and replacement of investment choices
- Establishing effective communication between the fund managers, plan participants, and the plan sponsor
Discuss hybrid pension plans (e.g., cash balance plans) and employee stock ownership plans
CASH BALANCE
- DB plan
- Benefit defined in terms of an account balance, which the beneficiary can take as an annuity at retirement or as a lump sum to roll into another plan
- Participant’s account is credited each year with a pay credit and an interest credit
- Rather than an actual account with a balance, the cash balance is a paper balance only and represents a future liability for the company
ESOP
- Employee Stock Ownership Plan
- DC plan
- Allows the employees to purchase the company stock
- Purchase can be with before- or after-tax dollars and the final balance in the beneficiary’s account reflects the increase in the value of the firm’s stock as well as contributions during employment
IPS for a Defined Benefit Plan
RETURN: The actuarial discount rate or somewhat higher
RISK: Determined by plan and sponsor characteristics. Factors reducing risk tolerance include shorter time horizon, higher liquidity needs, weak sponsor, and positive correlation of sponsor results with plan asset returns
TIME HORIZON: Linked to liability duration
TAXES: Generally untaxed
LEGAL/REGULATORY: A prudent expert managing the assets for the benefit of plan participants
LIQUIDITY: Linked to needs for plan payouts
UNIQUE: Watch for small plans with inadequate resources to complete proper due diligence
IPS for Foundations and Endowments
RETURN: Geometric link of distribution, relevant inflation, and expense rates
RISK: Often higher, may be diminished if the beneficiary is heavily dependent on the distributions
TIME HORIZON: Often perpetual
TAXES: Generally untaxed, but watch out for specifically taxed income sources
LEGAL/REGULATORY: Relatively unregulated
LIQUIDITY: Situation specific
UNIQUE: Watch for concentrated positions, restrictions on sale, and social issues (e.g. defence)
IPS for Insurance
RETURN: At minimum the return assumed by the actuaries, may be set by line of business
RISK: Generally conservative though the surplus may be invested more aggressively
TIME HORIZON: Related to duration of the liabilities, non-life tends to be shorter but with a long tail related to claims litigation
TAXES: Generally taxable
LEGAL/REGULATORY: Heavily regulated at multiple levels. Non-life is generally less regulated
LIQUIDITY: Situation specific. Life is generally more predictable than non-life. Some life policies introduce disintermediation risk. Non-life may also insure replacement value making liquidity needs dependent on inflation
UNIQUE: None in particular
IPS for Banks
RETURN: Contribute to interest earnings, but the securities portfolio is primarily a residual used to manage overall asset duration and provide liquidity
RISK: Heavily regulated and conservative
TIME HORIZON: Related to duration of the liabilities, generally shorter
TAXES: Generally taxable
LEGAL/REGULATORY: Heavily regulated at multiple levels. Subject to numerous asset and capital limits.
LIQUIDITY: Emphasis on highly liquid securities, mainly government securities
UNIQUE: None in particular
Compare the asset/liability management needs of pension funds, foundations, endowments, insurance companies, and banks
ALM (management of surplus) is more appropriate than asset-only management when there are definable future liabilities.
Thus, ALM is more appropriate for DB plans, insurance companies and banks, but not for foundations and endowments
Total return management (as opposed to specifying sources of return: income, realised and unrealised) is appropriate for all portfolios unless otherwise specified
Contrast investment companies, commodity pools, and hedge funds to other types of institutional investors
All are intermediaries which gather and invest funds.
Funds are invested according to the specific rules of the portfolio making generalisations about investment characteristics impossible
