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RPIRM - EDGE Flashcards

1
Q

Duties of the Trustee (9)

A
  1. Duty of loyalty
  2. Duty of care
  3. Duty to diversify plan assets
  4. Duty of impartiality
  5. Duty to delegate
  6. Duty to follow statutory constraints
  7. Duty to make the property productive
  8. Duty regarding co-trustees
  9. Duty to act in accordance with the trust agreement
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2
Q

US Safe Harbor for Shifting Responsibility for Investment Decisions to Plan Members (3)

A
  1. Have at least 3 diversified investment options covering a broad range of investment options
  2. Can transfer fund at least quarterly
  3. Sufficient information upon which to make an informed decision (investment managers, description of funds, etc.)
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3
Q

Disclosures that must be made upon the participants request (5)

A
  1. Description of plan expenses
  2. Prospectuses, financial statements and reports
  3. List of asset and their value within the investment
  4. Value of shares or units available to participants and past investment performance
  5. Information concerning the value of shares or units in investment alternatives held by the beneficiary
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4
Q

Points regarding 404(c) Protection (Responsibilities of the Fiduciary) (5)

A
  1. Fiduciary remains liable for the prudent selection and management funds to be offered
  2. Fiduciary remains liable for prudent investment and diversification of plan assets if plan does not offer member choices
  3. Multi-fund plan fiduciary not complying with 404(c) responsible for the prudent investment of plan funds
  4. Fiduciary responsible for prudent asset mix if changes allowed less often than quarterly
  5. It is transactional
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5
Q

Requirements for 404(c) Protection for Default Fund used with Automatic Enrollment (7)

A
  1. Must be QDIA (Plan sponsor fiduciary responsible for selecting and monitoring QDIA)
  2. Participant had opportunity to direct investments but did not do so
  3. Must notify participants at least 30 days before initial investment and each subsequent plan year
  4. Provide ERISA 404(c) fee and expense disclosures
  5. Can transfer assets at least quarterly
  6. QDIA fees same for everyone
  7. Must offer at least 3 broad range investments
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6
Q

QDIA Requirements (4)

A
  1. Can’t be employer stock unless part of a mutual fund
  2. Can transfer out within 90 days
  3. Must be professionally managed by regulated firm or named fiduciary
  4. Must be one of the following
    - TDF or Target life expectancy fund
    - Balanced fund
    - Actively managed account similar to 2 above
    - Preserve capital (120 days only)
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7
Q

Role of the plan administrator includes: (3)

A
  1. Managing the plan assets (following prudent principles)
  2. Drafting an investment policy
  3. Ensuring assets are managed according to the investment policy and legislation
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8
Q

Fiduciaries must: (3)

A
  1. Act in prudent manner
  2. Manage/make decisions in the best interest of plan members
  3. Exercise due diligence
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9
Q

Due diligence means making decisions based on: (2)

A
  1. Adequate information

2. Documenting decisions, motives and circumstances

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10
Q

Steps that demonstrate a prudent investment strategy (4)

A
  1. Developed
  2. Adopted
  3. Implemented
  4. Monitored
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11
Q

Prudent investment practices take into account (4)

A
  1. Nature of plan liabilities
  2. Timing of payments
  3. Expected future experience
  4. Demographics of plan members
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12
Q

Prudent investment principles (5)

A
  1. Prudent person rule
  2. Prudent delegation
  3. Define investment objectives
  4. Develop an investment policy
  5. Proper monitoring
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13
Q

When delegating functions, plan administrator… (2)

A
  1. Must do so prudently

2. Remains responsible for delegated activities (should review and monitor the delegates)

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14
Q

Clearly defined investment objectives allows the risks associated with the objectives (2)

A
  1. To be understood

2. To be actively managed

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15
Q

Investment objectives should be consistent with the plan’s (4)

A
  1. Retirement income objectives
  2. Liabilities
  3. Demographics
  4. Ability to accommodate investment volatility
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16
Q

Investment objectives should reflect (2)

A
  1. Relevant legal provisions

2. Relevant investment principles regarding asset allocation, diversification and liquidity

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17
Q

Investment policy/ SIP&P should (6)

A
  1. Reflect plan’s investment objectives
  2. Specify investment principles, strategic asset allocation, performance objectives, etc.
  3. Life investment restrictions
  4. Identify the asset allocation
  5. Identify the plan’s expected returns
  6. Address the nature and extent of anticipated risk
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18
Q

When monitoring, administrator should (5)

A
  1. Review investment objectives and risk tolerances
  2. Ensure adequate investment procedures are in place
  3. Review key investment decisions
  4. Ensure service providers are monitored and measured
  5. Review plan’s investment performance
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19
Q

Purpose of pension governance (3)

A
  1. Structure / process for effective administration
  2. Ensure fiduciary compliance
  3. Ensure participants receive benefits according to plan terms and understand their rights/responsibilities
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20
Q

An effective pension governance system incorporates (3)

A
  1. Framework for defining duties
  2. All pension aspects (management, communication, funding)
  3. Oversight to protect plan members
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21
Q

Advantages of good governance (6)

A
  1. Meet fiduciary requirements
  2. Minimize risks and inefficiencies
  3. Promote accurate and timely delivery of benefits
  4. Consistent benefits administration
  5. Provides control mechanisms to facilitate decision making, efficient practices, accountability and review
  6. Facilitates positive plan performance
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22
Q

Fiduciary must (5)

A
  1. Treat members impartially
  2. Act with care, skill and diligence of a prudent person
  3. Interpret plan terms fairly
  4. Prevent personal conflict of interest
  5. Ensure members receive benefits
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23
Q

Risk management governance framework should (6)

A
  1. Identify risks
  2. Assess / prioritize risks
  3. Responsibilities for managing risk
  4. Define acceptable risks
  5. Design response to mitigate
  6. Monitor
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24
Q

Participant Communications Should (3)

A
  1. Outline process for asking and raising questions
  2. Communicate how important decisions are made
  3. Information about plan’s risks, benefits, options and participants responsibilities
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25
Q

Investment Behavior DC Sponsors are Likely to See Among the Norm (4)

A
  1. Correlated equity allocation decisions
  2. High utilization in hybrid allocations
  3. Static asset allocations
  4. Tax inefficiencies
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26
Q

Investment Behavior DC Sponsors are Likely to See among the Minority (4)

A
  1. Trade too much
  2. Invest too much in company stock
  3. Insufficiently diversified
  4. Invest too much or not enough in equities
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27
Q

Likely to see among the Norm Higher Equity Allocations Correlated with (12)

A
  1. Positive stock market performance
  2. Younger age
  3. Higher education
  4. Higher income
  5. Longer investment horizons
  6. Higher risk tolerance
  7. Higher number of investment choices
  8. Not participating in a DC plan
  9. Good health
  10. Married
  11. Non-union
  12. Male
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28
Q

Theory to understand causes of irrational investment behavior is called

A

Prospect Theory (argues investors follow an investment process)

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29
Q

Prospect Theory Investment Process

A

Phase 1 (Framing and Editing): Decision affected by the way the problem is presented and the investors habits and expectations

Phase 2 (Evaluation): Decision affected by investor’s risk aversion

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30
Q

Party Responsible for Oversight of DC Plan Investments

A
  • For DC, if ee has no control over how assets are invested, er has full responsibility
  • For DC, if ee has choices, er bears responsibility of selecting investment funds and making sure find line-up is diverse and competitive (can reduce fiduciary liability through 404(c))
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31
Q

Items DC Sponsors should Provide Participants (3)

A
  1. An investment framework
  2. Guidance
  3. A range of investment options
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32
Q

To Increase Tax Inefficiency, DC Sponsors should Recommend Participants to… (2)

A
  1. Invest bonds in pre-tax fund

2. Invest equities in after-tax fund

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33
Q

Reasons why DC Governance is more complicated than DB Governance (3)

A
  1. DC plans are participant-directed
  2. Participants have unique financial circumstances
  3. Participants have different investment abilities
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34
Q

DC Sponsors should Facilitate Best-Practice (3)

A
  1. Skills
  2. Resources
  3. Processes
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35
Q

Items DC Sponsors should Review (5)

A
  1. Investment performance
  2. Program’s effectiveness reaching HR goals
  3. Program’s likelihood of reaching targeted replacement ratios
  4. Asset allocations selected by participants
  5. Program’s legal compliance
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36
Q

DC Governance should Address 3 common DC Structural flaws

A
  1. Participant lack of investment skills
  2. Providing a sub-optimal investment line-up
  3. Not offering annuities
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37
Q

Due to 3 common flaws, DC Fiduciaries should consider the following principles (4)

A
  1. Participants’ needs and circumstances
  2. Correct framing on retirement adequacy
  3. Protect participants from themselves
  4. Provide simple but not simplistic solutions
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38
Q

Items designed to address structural flaws 1 and 2 (5)

A
  1. Fewer and lower cost investment options
  2. Automatic enrollment
  3. Auto-escalation contribution rates
  4. Professionally managed target-date funds
  5. Advice and financial education
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39
Q

Key Attributes to a Successful DC Plan (9)

A
  1. Empowerment within the scope of ability
  2. Design-making support
  3. Comprehensive risk profiling
  4. Efficient investment building blocks
  5. Offer options with protection
  6. Right amount of fund choice
  7. Cost controlled
  8. Easy-to-understand reporting against objectives
  9. Well-defined governance aligned with participant needs
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40
Q

Building blocks DC Plan investment structure (3)

A

Tier 1 funds (Asset allocation funds): Professionally managed TDF and lifestyle funds

Tier 2 funds (Core funds): Participant managed funds

Tier 3 funds (Specialty funds): Participant managed

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41
Q

Advantage of offering Tier 1 funds

A

Asset allocation decision is outsourced

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42
Q

Disadvantage of offering Tier 1 funds

A

May not reflect participant’s unique risk profile

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43
Q

Advantages of offering Tier 2 funds (2)

A
  1. Exposed to major asset classes

2. Can develop desired risk / return profile

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44
Q

Should only offer actively managed Tier 2 funds if (2)

A
  1. Believe markets are inefficient

2. Sponsor can select managers with skill

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45
Q

Advantage of offering Tier 3 funds

A

Attractive to highly compensated and sophisticated participants

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46
Q

Items fiduciaries should consider when offering / evaluating TDF (5)

A
  1. Potential impact on decisions / strategy
  2. Capacity constraints
  3. Manager invested in fund?
  4. Fund’s principle strategies / objectives and risks
  5. Fees
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47
Q

Target-Date Glide Path Characteristics affecting Risk / Reward (4)

A
  1. Initial and ultimate asset allocations
  2. Slope (market-timing risk)
  3. To vs. Through
  4. Sub-asset classes (type, weight, active/passive)
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48
Q

Glide Path Balances the Following Risks (2)

A
  1. Longevity (higher equity allocation)

2. Market (higher fixed income allocation)

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49
Q

Comparing TDF performance (2)

A
  1. Differentiate based on risk exposures

2. Apply goals-based framework

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50
Q

ERISA DC Fiduciaries responsible for (related to services)

A

Ensuring services DC plan receives are charged reasonable fees and that services are necessary

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51
Q

Best-practice Considerations for ERISA DC Fiduciaries (4)

A
  1. Develop inventory of fees paid by the plan
  2. Benchmark fees
  3. Review service agreements and contracts for appropriate scope and transparency
  4. Assess record keeper services compared to other vendors
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52
Q

Plan Fiduciary Responsibilities (2)

A
  1. Act in best interest of participants (Prudence + Care)

2. Monitor Delegates

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53
Q

Services used to help with plan investments (2)

A
  1. Investment management

2. Investment consulting

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54
Q

Role of an independent investment consultant (5)

A
  1. Establish overall investment policies
  2. Write investment policy statements
  3. Benchmark investment results
  4. Ensure all appropriate asset classes are represented
  5. Ensure plan fiduciaries are discharging duties appropriately
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55
Q

The investment management process (3 steps)

A
  1. Develop SIPP
  2. Implement
  3. Monitor
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56
Q

DB SIPP should address (6)

A
  1. Investment objectives
  2. Investment specifics
  3. Manager selection/termination
  4. Performance measurement (expected return, monitoring)
  5. Risks (tolerance, management, measurement)
  6. Governance
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57
Q

Required Considerations when Setting the DB Investment Policy (3)

A
  1. Liabilities
  2. Funded Status
  3. Factors affecting funding and solvency
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58
Q

Member-Directed DC Plan’s SIPP should Include / Address (7)

A
  1. Investment Philosophy
  2. Permitted asset classes
  3. Default Investment options
  4. Monitoring process
  5. Manager selection / termination
  6. Fees / expenses
  7. Investment communications to participants
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59
Q

Types of Risks Addressed in SIPP (3)

A
  1. Asset based
  2. Liability based
  3. Asset-Liability-based
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60
Q

Example of Liability-Based Risk

A

Longevity

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61
Q

Example of Asset-Liability Risk

A

Solvency

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62
Q

Example of Assets Risks (17)

A
  1. Active management
  2. Alternative asset
  3. Asset concentration
  4. Compliance
  5. Counterparty
  6. Country
  7. Currency
  8. Derivative
  9. Index-tracking
  10. Inflation
  11. Interest rate
  12. Investment style
  13. Leverage
  14. Liquidity
  15. Market
  16. Operational
  17. Securities lending
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63
Q

Examples of outcomes investment categories (4)

A
  1. Absolute return
  2. Yield-generating assets
  3. Low volatility
  4. Low correlation with rest of fund
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64
Q

Examples of traditional investment categories (2)

A
  1. Style

2. Geography

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65
Q

Sponsor’s Fiduciary Responsibility: Ensure Investment Decisions Process (3)

A
  1. Sound
  2. Systematic
  3. Informed
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66
Q

Recommended first step in managers selection process is to consider (5)

A
  1. Number of managers
  2. Type (Specialty / Balanced)
  3. Style
  4. Primary approach (Fundamental / Quantitative)
  5. Active / Passive management
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67
Q

Factors affecting the manager selection (7)

A
  1. Cost
  2. Oversight resources
  3. Diversification
  4. Benchmark volatility
  5. Varying expertise between managers
  6. Ability to add value by switching asset classes
  7. Market efficiency of different asset classes
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68
Q

Desired attributes of the manager (8)

A
  1. Expertise in a specific asset class
  2. An established investment team
  3. Minimum level of assets under management
  4. No significant issues involving the overall organization
  5. Low portfolio turnover
  6. Above median performance over the past 5 years
  7. Below median performance volatility over the past 5 years
  8. Reasonable fees
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69
Q

Plan size affects the following items (4)

A
  1. Risk distribution
  2. Manager selection
  3. How funds will be invested (asset classes, type of account)
  4. Economies of scale
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70
Q

Plan size and its impact on risk (2 small, 2 large)

A

Small plans:

  1. Less asset class diversification
  2. Use of separate accounts leads toward active management concentration risk

Large plans:

  1. Lack of high-quality managers for needed asset classes
  2. Balancing active management risk and avoiding low-quality managers
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71
Q

Plan size and use of separate and commingled fund

A

Large plans: Separate accounts

Small plans: Commingled accounts

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72
Q

Disadvantages of active management concentration (2)

A
  1. Potentially lower returns

2. Diverge from peer groups

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73
Q

Advantages of separate accounts (5)

A
  1. Access and fee scale to sophisticated managers
  2. Can customize plan
  3. Can customize tracking error targets
  4. Specify risk parameters
  5. Can develop performance statistics
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74
Q

Disadvantages of customized accounts (2)

A
  1. Require significant oversight

2. Implementation risks

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75
Q

Advantages of commingled accounts (5)

A
  1. Many exist
  2. Provide investment solutions
  3. Can develop performance statistics
  4. Facilitates cost-effective allocations
  5. Access to high-quality managers
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76
Q

Disadvantages of commingled accounts (2)

A
  1. Active management risk if only one manager

2. Must monitor the manager’s performance, risk and style consistency

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77
Q

Typical investment cost (4)

A
  1. Investment management
  2. Custodial
  3. Transaction costs
  4. Administration
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78
Q

Small Plans and Costs

A

Need economies of scale through commingling

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79
Q

Performance measurement should be carried out in the context of (3)

A
  1. Plan’s current value
  2. Current and expected contribution levels
  3. Anticipated liabilities or expenditure requirements
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80
Q

Advantages of performance evaluation (3)

A
  1. Enhances the effectiveness of a fund’s investment policy
  2. Identifies the program’s strengths and weaknesses
  3. Provides trustees evidence program is being conducted appropriately
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81
Q

Types of Performance Evaluations (2)

A
  1. Comparative performance

2. Benchmark-based

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82
Q

Properties of a valid benchmark (7)

A
  1. Unambiguous
  2. Investable
  3. Measurable
  4. Appropriate
  5. Reflective of current investment options
  6. Specified in advance
  7. Owned
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83
Q

Types of benchmark (7)

A
  1. Absolute
  2. Manager universe (median manager or fund)
  3. Broad market indexes (TSX, S&P500)
  4. Style indexes (small cap, large cap)
  5. Factor-model-based benchmark
  6. Returns-based benchmarks
  7. Custom security-based benchmark
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84
Q

Median of Manager Universe as Benchmark not Valid Because (4)

A
  1. Can’t be specified in advance
  2. Not investable
  3. Typically Ambiguous
  4. Subject to survivor bias
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85
Q

Steps to building custom security-based benchmarks (5)

A
  1. Identify aspects of the manager’s investment process
  2. Select securities consistent with that process
  3. Devise a weighting scheme for the benchmark securities, including cash position
  4. Review preliminary benchmark and make modifications
  5. Rebalance benchmark on a predetermined schedule
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86
Q

Criteria used to test whether a benchmark is good or bad (6)

A
  1. Should be minimal systematic biases relative to the account over time
  2. Tracking error should be minimal
  3. Account’s exposure to systematic sources of risk should be similar to benchmark over time
  4. Manager’s account should have high coverage relative to benchmark
  5. The benchmark’s turnover should not be excessive
  6. The manager should not be expected to hold largely positive active positions for actively managed long-only accounts
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87
Q

Methods of measuring investment returns (3)

A
  1. Money-weighted rate of return (IRR)
  2. Time-weighted rate of return
  3. Linked internal rate of return
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88
Q

Advantage of IRR

A

Account only valued at the beginning and end of the evaluation period

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89
Q

Disadvantages of IRR (2)

A
  1. R can’t be solved directly

2. Sensitive to the size and timing of external cash flows while TWR is not

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90
Q

Advantages of TWR (2)

A
  1. Not sensitive to the size and timing of external cash flows
  2. Accurately reflects how an investor would have fared over the period
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91
Q

Disadvantage of TWR

A

Account valued every time an external cash flow occurs (more expensive and more error prone)

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92
Q

TWR vs. MWR

A

MWR more appropriate if manager maintains control over the timing and amount of cash flows

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93
Q

Stock’s risk (definition)

A

Return variance and covariance with other stock returns in the portfolio

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94
Q

Tracking error (definition)

A

Standard deviation of the difference between the portfolio’s return and the benchmark

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95
Q

Information ratio (definition)

A

Portfolio’s average active return divided by its tracking error

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96
Q

Sharpe ratio

A

Excess return of the portfolio divided by its volatility

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97
Q

Efficient portfolio (definition)

A

Portfolio with the highest expected return for a target level of risk. Highest information ratio possible given the risk budget. All risks are compensated

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98
Q

Active management in an EPM context

A

Overweighting attractive stocks and underweighting unattractive stocks relative to benchmark weights

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99
Q

Four major steps in the EPM investment process

A
  1. Forecasting returns, risks and transaction costs
  2. Constructing efficient portfolios
  3. Trading stocks efficiently
  4. Evaluating results and updating the process
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100
Q

Characteristics of a well-structured investment process (6)

A
  1. Sound economic logic
  2. Diverse information sources
  3. Careful empirical analysis
  4. Reliable forecasts
  5. Effective implantation
  6. Easy to explain
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101
Q

EPM Approaches (2)

A
  1. Traditional

2. Quantitative

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102
Q

Traditional Approach

A

Construct an in-depth stock-specific analysis (talk to senior management, study financial statements, conduct competitive analysis)

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103
Q

Advantages of the traditional approach

A

More in depth knowledge than quantitative approach:

  • Cope with data errors
  • Cope with company’s structural changes
  • Understand data sources
  • Incorporate qualitative factors
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104
Q

Disadvantages of the traditional approach (5)

A
  1. Relies heavily on analyst judgement
  2. Costly
  3. Difficult to evaluate
  4. Typically relies on only the most distinctive factors
  5. Fewer and larger bets taken
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105
Q

Quantitative approach

A

Use statistical models to forecast each stock’s return, risk and cost of trading

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106
Q

Advantages of the quantitative approach (8)

A
  1. Transparent
  2. Minimizes subjective bias
  3. Cost effective
  4. Model can be tested historically
  5. Can uncover opportunities more quickly and efficiently than traditional approach
  6. Spreads risk over many companies
  7. Every specified factor considered before reaching a conclusion
  8. Model is stochastic
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107
Q

Disadvantages of the quantitative approach (3)

A
  1. Subject to specification errors
  2. Overfitting
  3. Model can be misleading
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108
Q

Process for forecasting returns (quantitative approach) (4 steps)

A
  1. Identify signals
  2. Test the effectiveness of each signal
  3. Determine signal weights
  4. Blend output with market equilibrium
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109
Q

Forecasting risk

A
  • Consider the frequency of data to use
  • The more observations the better
  • Consider giving more weight to recent observations
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110
Q

Methods of forecasting transaction costs (2)

A
  1. Examine the complete record

2. Use own trades to develop a model

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111
Q

Transaction costs have two components (2)

A
  1. Implicit costs

2. Explicit costs

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112
Q

Approach to constructing an efficient portfolio (2)

A
  1. Rule-based system

2. Portfolio optimization

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113
Q

Rule-based system

A
  • Rank stocks based on a few key risk factors

- Invests heavily in the highest-ranked stocks while keeping the portfolio’s total weight close to the benchmark

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114
Q

Advantage of rule-based system

A

Portfolio is neutral with respect to identified risk factors while overweighting attractive stocks and underweighting unattractive stocks

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115
Q

Disadvantages of rule-based system (2)

A
  1. Not very efficient

2. Can’t explicitly consider trading costs

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116
Q

Advantages of the portfolio optimization approach (3)

A
  1. Expected returns and risk/cost/constraints better balanced
  2. Facilitates portfolio customization
  3. Only requires use of forecasts
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117
Q

Portfolio optimization caveat

A

Need to make sure model’s inputs are reliable

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118
Q

Evaluating results and updating the process

A
  • Compare actual results against expected

- Determine sources of under and over performance

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119
Q

Advantages of Alternative Investments (Private Equity or Hedge Fund) (3)

A
  1. Lower volatility
  2. Higher absolute and risk-adjusted returns
  3. Varied correlations
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120
Q

Risks Particularly Unique to Alternative Investments (9)

A
  1. Market
  2. Illiquidity
  3. Valuation
  4. Operational
  5. Regulatory Obligations (Lack of)
  6. Strategy Risk
  7. Counterparty Risk
  8. Sub-Advisor Risk
  9. Unstable / Unreliable Vendor
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121
Q

Common Characteristics of Illiquid Investments (Private Equity) (5)

A
  1. Return Premium (3%+)
  2. High dispersion of returns
  3. Long time horizon before profits (10+ years)
  4. Upfront commitment
  5. Potential good fit for pensions
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122
Q

Hedge Funds designed to look for (2)

A
  1. Arbitrage opportunities

2. Pricing Inefficiencies

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123
Q

Characteristics of hedge funds (8)

A
  1. Purest form of active management
  2. Loosely Regulated
  3. Lack of Transparency
  4. Performance fees paid
  5. Short lived
  6. Illiquid
  7. May experience capacity constraints
  8. Unconstrained with regard to short selling, leverage, instruments, strategies
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124
Q

Typical fund fee structure of hedge funds

A

Fixed management fee + Performance fee subject to high water mark

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125
Q

Main advantage of hedge funds

A

Provide opportunity to both enhance expected returns and reduce risk

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126
Q

Short selling (definition)

A
  • Borrow then sell asset and repurchase it later

- Sell high and buy low (hedge against another asset, exploit relative price movements)

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127
Q

Hedge fund strategies (4)

A
  1. Relative value
  2. Event driven
  3. Equity long/short
  4. Tactical trading
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128
Q

Private Equity Investment (definition)

A

Any ownership interest not publicly traded, except for real estate

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129
Q

Advantages of private equity (5)

A
  1. Efficient market hypothesis does not apply (high returns)
  2. Illiquid market may reduce purchase price
  3. Long-term focus
  4. Have more company control
  5. Can decide when to exit investment
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130
Q

Disadvantages of private equity (2)

A
  1. Lack of transparency makes analysis difficult

2. Market illiquid/difficult to sell

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131
Q

Private equity investment strategies include (4)

A
  1. Buying start-ups
  2. Restructuring large company
  3. Repositioning large company
  4. Innovation
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132
Q

Investment Characteristics of Infrastructure (4)

A
  1. Defensive - less risk (higher barrier to entry, monopoly-like, less sensitive to business cycle, inflation protection)
  2. Long operational life
  3. High operating margins
  4. Reliable long term cash flow
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133
Q

Potential advantages of Infrastructure as a pension investment (3)

A
  1. Enhanced diversification
  2. Match liability profile with cash flows
  3. Higher risk/return optimization
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134
Q

Infrastructure’s similarities/differences with other asset classes

A

Fixed income (Long-term predictable cashflow/Inflation hedge, low interest rate risk

Real estate (Physical Asset/Barrier to entry, predictable cash flow)

Private Equity (Management control/Longer time horizon)

Equities (Equity ownership/Fewer securitization)

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135
Q

Infrastructure risks (6)

A
  1. Patronage / Demand
  2. Regulatory
  3. Contractual / Credit
  4. Operational / Constrution
  5. Financing / Inflation
  6. Liquidity
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136
Q

Essential Traits Needed for an Infrastructure Investment Team (6)

A
  1. In-depth sector knowledge
  2. Transaction capabilities
  3. Operational experience
  4. Access to Quality deal flow
  5. Ability to select best opportunities
  6. Apply strict governance
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137
Q

Risks with emerging market investments (8)

A
  1. Lack of reliable information
  2. Currency risk
  3. Poor legal infrastructure (may permit insider trading)
  4. Political instability
  5. Different accounting systems
  6. Transaction costs
  7. Shareholder rights
  8. Ability to recover investment
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138
Q

Major sources of fixed income risk (10)

A
  1. Interest rate risk
  2. Yield curve risk
  3. Sector risk
  4. Credit risk
  5. Volatility risk
  6. Prepayment risk
  7. Currency risk
  8. Security-Specific risk
  9. Reinvestment risk
  10. Liquidity risk
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139
Q

Measurement typically used to measure interest rate risk exposure

A

Duration

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140
Q

Ways to construct portfolios with the same duration but different exposures to yield curve risk (3)

A
  1. Bulleted
  2. Barbelled
  3. Laddered
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141
Q

Measurement typically used to measure yield curve risk exposure

A

Key-Rate Duration (Portfolio’s duration that comes from cash flows in each part of the yield curve)

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142
Q

Measurement typically used to measure sector risk exposure

A

Contribution to duration (MV weighted average duration of sector holdings x MV weight holdings in sector)

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143
Q

Credit risk usually defined by…

A

Nationally recognized rating organization

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144
Q

Volatility risk

A

Risk bond value impacted by how much interest rates move in either direction

Arises when instrument has asymmetric payoffs

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145
Q

Types of risk exposures that arise when investing in embedded options

A
  1. Gamma exposure

2. Vega risk

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146
Q

Gamma exposure

A
  • Market value impact from experiencing a change in interest rates
  • If you are long volatility then you gain from market movement
  • Convexity used to quantify gamma exposure
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147
Q

Vega risk

A
  • Risk due to a change in the market’s expectation of future volatility of interest rates
  • Volatility duration is used to quantify vega risk
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148
Q

Volatility duration

A

Percentage change in bond price due to a 1% change in expected future (or implied) volatility

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149
Q

Prepayment risk

A
  • Defined as the return volatility arising from the over or underestimation of actual prepayment rates
  • Prepayment duration used to quantify prepayment risk
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150
Q

Prepayment duration

A

-Percentage change in price due to a 10% increase in projected prepayment rates

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151
Q

Currency risk

A

Can mitigate/eliminate risk using currency hedging techniques such as currency forward contracts

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152
Q

Active management strategies…

A

Change the risk exposure of the portfolio to maximize return given a level of risk or minimize risk given a level of return

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153
Q

Most widely used active management fixed income strategies (6)

A
  1. Duration timing
  2. Yield Curve positioning
  3. Sector allocation
  4. Security selection
  5. Country allocation
  6. Currency allocation
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154
Q

Combining active strategies using risk budgeting…

A

Need to allocate risk efficiently across investment idea and strategies

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155
Q

Risk budgeting process/steps used to maximize return per budgeted level of risk (7)

A
  1. Determine benchmark
  2. Determine investment constraints
  3. Determine permissible active strategies
  4. Determine maximum tracking error allowed
  5. Estimate information ratio
  6. Determine the target excess return or tracking error
  7. Determine the optimal amount of risk to each strategy
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156
Q

Ready to determine appropriate allocation once you determine… (5)

A
  1. What strategies can be used
  2. How much could be allocated to each strategy
  3. How good you are at generating returns in each strategy
  4. How you expect them to move together
  5. How much risk or return looking to achieve
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157
Q

Successful investing (5)

A
  1. Reposition risk to create return
  2. Maximize return per unit of risk
  3. Diversify
  4. Avoid concentrated risks
  5. Understand sources of risk
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158
Q

Central them of MPT

A

Look at the expected return of each investment in relation to the impact that it has on the risk of the overall portfolio

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159
Q

Risk and return estimates (characteristics)

A
  1. Estimating expected returns problematic

2. Estimating volatility is more complex but more easily quantified

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160
Q

Implied views (other name)

A

Hurdle Rates

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161
Q

Repositioning risk allocations…

A
  1. Improves the portfolio’s expected return

2. Assets that reduce risk are less expensive on budget

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162
Q

Traditional portfolio immunization strategy

A

Requires prior specification of expected excess return for all of the assets

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163
Q

Alternative technique based on MPT to optimize a portfolio’s return to risk ratio

A
  • Analyse the risk margins to decide whether to sell/purchase asset
  • Portfolio optimal when expected excess return per marginal contribution is the same for all assets in the portfolio
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164
Q

Advantages of the alternative technique (2)

A
  1. Can calculate excess return on one asset and back out the implied views on all of the others
  2. Analysis based on more risk statistics than expected return statistics
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165
Q

Active vs management decision

A

Directed by belief about the EMH

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166
Q

EMH

A
  • Active manager can’t outperform index
  • No arbitrage opportunities
  • Market reflects all information
  • Stock price movement is random
  • Stock prices unpredictable apart from a long-term trend
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167
Q

EMH supported historically by (2)

A
  1. Net of expenses, most active funds do not outperform index
  2. Data does not support strong performance persistence
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168
Q

Advantages of passive investing (4)

A
  1. Low management fees
  2. No active management risk
  3. Low transaction costs
  4. Returns close to benchmark
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169
Q

Disadvantages of passive investing (3)

A
  1. Most require high dollar minimums
  2. No opportunity to reduce risk relative to benchmark
  3. Return typically less than benchmark by the amount of management fees
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170
Q

ERM steps of evaluating a pension plan’s risk (5)

A
  1. Identify the stakeholders
  2. Identify risk
  3. Quantify risk
  4. Separate risk
  5. Manage risk
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171
Q

Things to consider when managing pension assets relative to the firm’s economic strength (4)

A
  1. Corporate risk in addition to pension risk must be considered
  2. Must coordinate pension assets with corporate strength to minimize business interference
  3. Must reflect liabilities to address surplus volatility
  4. Must coordinate pension assets, liabilities and corporate strength to maximize firms expected life
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172
Q

Risks to participant and shareholder by funding strategies (3 strategies)

A
  1. Pay as you go:
    - P: Will company be around to pay benefit
    - S: Future shareholder must pay benefits
  2. Balanced asset allocation:
    - P: Will the company be able to make up any future shortfall
    - S: Shortfall/Surplus addressed bu future shareholder
  3. ALM asset allocation:
    - P: Risk is very small
    - S: Large up-front contribution and minimal possibility of surplus
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173
Q

General framework to follow when determining an asset allocation (4 steps)

A
  1. Identify stakeholders and their needs
  2. Identify risks
  3. Quantify risk
  4. Separate and manage risk
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174
Q

Three dimensions to risk management

A
  1. Panning
  2. Budgeting
  3. Monitoring
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175
Q

Risk management wants to (3)

A
  1. Identify risk exposure
  2. Measure risk exposures
  3. Report risk exposures to senior management
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176
Q

Measures of risk (2)

A
  1. VaR

2. Tracking error

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177
Q

Risk plan should include/address the following items (6)

A
  1. Set expected return and volatility goals
  2. Define points of success and failure
  3. Determine how risk capital will be used to meet objectives
  4. Determine events that are disappointing vs life threatening
  5. Identify critical dependencies
  6. Involve senior leadership in the planning process
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178
Q

Advantages of involving senior leadership in the risk plan (3)

A
  1. Risk and return issues are addressed, understood and communicated
  2. Can better describe context for risk and financial capital allocations
  3. Better understand risks needed to generate profits
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179
Q

Risk budget

A
  • Amount of risk allocated toward a targeted tracking error
  • Budget carried out through the asset allocation
  • Each risk allocation should have a corresponding return expectation
180
Q

Ideal amount of risk

A

Within risk tolerance

181
Q

Advantages of risk monitoring (2)

A
  1. Ensures transactions are authorized and within risk tolerance
  2. Can distinguish material deviations from target that need to be addressed
182
Q

Recommended approach to managing risk

A

Create an independent risk management unit (RMU)

183
Q

Objectives of RMU (9)

A
  1. Enable stakeholders to better understand and control risk
  2. Develop a process to identify and address risks
  3. Set and implement the risk agenda and initiatives
  4. Identify/report unusual events to management
  5. Start comprehensive risk-related discussions
  6. Be a focal point where risk topics are identified and discussed
  7. Ensure transactions are within risk tolerance
  8. Develop risk measurement and performance attribution tools
  9. Develop an inventory of risk data
184
Q

Objectives of performance management tools (4)

A
  1. Compare manager against benchmark
  2. Compare manager against peer group
  3. Confirm whether returns compensate enough for the risk taken
  4. Create process to identify superior managers
185
Q

Commonly used performance tools (5)

A
  1. The Green zone approach
  2. Attribution of returns
  3. Sharpe and Information ratios
  4. Alpha vs. Benchmark
  5. Alpha vs. peer group
186
Q

Green zone tool

A
  1. Identify excess returns statistically different from targeted excess returns
  2. Compare actual tracking error against targeted tracking
  3. Form policies for 1 and 2
  4. Compile report with the results (Green is within defined expectation, yellow, red)
187
Q

Attribution of returns tool

A
  • Measures the quality of returns

- Determines the sources of the return

188
Q

Sharpe ratio

A
  • Portfolio’s excess return / portfolio’s standard deviation
189
Q

Information ratio

A
  • Portfolio’s excess return / Portfolio’s tracking error
190
Q

Advantages of the Sharpe and Information ratio (3)

A
  1. Can compare investment managers within the same peer group
  2. Can test whether return compensated enough for risk taken
  3. Can use at the portfolio level and individual sector/country level
191
Q

Disadvantages of the Sharpe and Information ratio (2)

A
  1. May require data that is not available

2. Results may not be relevant if use actual vs. forecasted risk

192
Q

Alpha vs. the Benchmark tool

A
  • Regress portfolio’s excess return against the benchmark’s excess return
  • Tool’s outputs (intercept + slope)
  • Apply confidence tests to regression outputs (to test if alpha is statistically significant)
193
Q

Advantages of the alpha vs. benchmark tool (4)

A
  1. Can test whether excess return is skill or chance
  2. Can distinguish between excess returns due to leverage vs. skill
  3. Easy to calculate
  4. Beta shows whether manager used underweighting or overweighting
194
Q

Disadvantages of the alpha vs. benchmark tool (1)

A
  1. May not have enough data points to determine alpha’s statistical significance
195
Q

Alpha vs. peer group tool

A
  • Regress portfolio’s excess return against the excess return of the manager’s peer group
196
Q

Advantages and disadvantages of the alpha vs. peer group tool (4+3)

A
  1. Can test whether excess return is skill or chance
  2. Can distinguish between excess returns due to leverage vs. skill
  3. Easy to calculate
  4. Beta shows whether manager used underweighting or overweighting
  5. May not have enough data points to determine alpha’s statistical significance
  6. Peer group subject to survivorship bias
  7. Easier for peer group managers with small portfolios to produce excess returns
197
Q

Recommended framework: Three tenets

A
  1. Objective analysis
  2. Unbiased guidance
  3. Well understood outcome
198
Q

Framework is applied in 5 key work steps

A
  1. Define the objective
  2. Define universe of alternative strategies
  3. Analyze the alternatives
  4. Implement
  5. Monitor
199
Q

Advantages of having an established strategy/being proactive (3)

A
  1. Can act on favorable market conditions
  2. Implementation lead time
  3. Increasing challenges
200
Q

Common De-risking strategies (4 types)

A
  1. Plan design (Close, Freeze, Reduce benefits)
  2. Financial (Addl contrib., lump sum, Borrow-to-fund)
  3. Investment (LDI, Dynamic Asset allocation)
  4. Insurance (Buy-in, Buy-out, Longevity insurance)
201
Q

Advantages of de-risking (5)

A
  1. Minimized pension volatility (Balance-sheet + Contrib)
  2. Secures benefits for participants
  3. Increase financial flexbility
  4. Increases shareholder value
  5. Can focus on core business
202
Q

Risk defined from an asset-liability perspective can be defined as (3)

A
  1. Contribution volatility
  2. Funding surplus volatility
  3. Probability of avoidance of a large decrease in funded status
203
Q

Problem with Asset Only Perspective

A

If plan assets outperformed policy benchmark al was well, even if funded status deteriorated

204
Q

LDI

A
  • Maximize return while reducing interest rate risk
  • Strategy tailored to specific plan needs
  • Principal measure is the plan’s funded status
  • Investment framework not restricted to just bonds
205
Q

Three key concepts of LDI management (3)

A
  1. Liability duration must be hedged or partially hedged by the assets
  2. Asset duration can come from either securities
  3. Excess return comes at the cost of increased liability tracking
206
Q

LDI elements

A
  • Marked-to-market liabilities are focus of investing
  • Appropriate benchmark is plan liabilities
  • Strategy coordinates assets and liabilities
  • Strategies are tailored to specific plan needs including interest rate sensitivity, plan design features, etc.
  • LDI seeks alpha and risk mitigation strategies custom tailored to the sponsor’s objectives
207
Q

LDI Checklist (8)

A
  1. Determine objectives
  2. Determine pan liability duration
  3. Determine desired fixed income allocation
  4. Determine portfolio duration
  5. Determine additional duration needed
  6. Determined degree of comfort with derivatives
  7. Determine appetite for active management
  8. Monitor LDI strategy against liability benchmark
208
Q

Succesful LDI considerations (4)

A
  1. What risks should be hedged
  2. Degree of deviation from immunization
  3. Portfolio’s expected outcome
  4. How will fiduciaries handle costs, leverage, monitoring, etc.
209
Q

Limitations of liability-driven investing (2)

A
  1. Higher expected long-term return is sacrificed for lower risk
  2. Availability of certain types of investments may be limited
210
Q

Myths About Liability-Driven Investing (10)

A
  1. LDI always means reducing risk
  2. IRR is uncompensated risk so reduce as much as possible
  3. LDI can completely eliminate interest rate risk
  4. Implement LDI if believe IR will rise
  5. LDI reduces equity exposure which increases plan costs
  6. Reducing equity exposure will reduce EROA so shouldn’t reduce equity exposure
  7. Getting a free LDI strategy from a fixed income manager is wise
  8. IRR can be hedged by matching the timing of future benefit cash flows and fixed income exposure
  9. A good fixed income manager means a good fixed income manager for a LDI strategy just by adding swaps
  10. LDI isn’t worth the trouble
211
Q

Should consider the following when determining risk tolerance (3)

A
  1. Relative size of company’s worldwide pensions to sponsor’s size
  2. Credit rating/strength of sponsor
  3. Plan’s funded status
212
Q

Process for developing an optimal portfolio in an asset-liability context (5)

A
  1. Define risk tolerance/preferences
  2. Create financial inputs
  3. Generate stochastic scenarios
  4. Analyze multiple asset allocations
  5. Choose portfolio within risk tolerance with highest expected return
213
Q

Two ways to mitigate funded status volatility

A
  1. Asset diversification

2. Duration management

214
Q

Types of ALM strategies (2)

A
  1. Dedication

2. Immunization

215
Q

Ways to increase matching if liability duration longer than asset duration (4)

A
  1. Add long-term bonds
  2. Replace short-term bonds with long-term bonds
  3. Increase inflation-linked assets
  4. Use fixed income derivatives (Futures, Forwards, Swaps)
216
Q

Derivatives meet the needs of three groups of people

A
  1. Those who wish to discover information
  2. Those who wish to speculate
  3. Those who wish to hedge
217
Q

Advantage of derivatives

A

Don’t have to sell existing equity or bond positions to achieve desired duration

218
Q

Disadvantage of derivatives (2)

A
  1. Need sufficient liquidity to fund initial and variation margin requirements
  2. Introduces new sources of risk (counterparty, liquidity, valuation, etc.)
219
Q

Types of fixed income options include (3)

A
  1. Call
  2. Convertible bonds
  3. Swaps
220
Q

Interest rate swap

A
  • Periodic exchange of cash flows
  • Have a fixed leg and a floating leg
  • Settlement = Annual rate difference x Notional Principal x Fraction of the year
  • Swap duration = difference of duration of fixed rate bond and the duration of the floating-rate bond
  • Swap duration for fixed-rate receiver is positive
  • The same swap has a negative duration for the counterparty
221
Q

Swaption

A
  • Have a right but not the obligation to enter an underlying swap
  • Pay an upfront premium
  • Can set the exercise date to be plan’s next measurement date
  • A purchased receiver swaption provides provides protection against yield below strike level
222
Q

Choices swaption receiver has on exercise date

A
  1. Out of the money : Let option expire

2. In the money: Take delivery and become receiver of an above market swap OR close out swap and collect FV

223
Q

Swaption collar

A
  • Plan buys one swaption and sells another (buy a fixed rate receiver, sell a floating rate payer)
  • Reduces or eliminates up-front expense
  • Receiver option increases in value if rates drop below strike level
  • Payer option decreases in value if rates increases above strike level
224
Q

Disadvantage of large fixed income allocation

A

Lower expected returns

225
Q

Advantage of swaps and swaptions (2)

A
  1. Minimizes volatility without changing the asset allocation
  2. May have higher return than large fixed income strategy
226
Q

Caveats regarding a risk management strategy involving interest rate derivatives (3)

A
  1. Significant learning curve
  2. Should consider underhedge vs. overhedge
  3. Model risk
227
Q

Duration

A
  • Modified duration if the first derivative of the bond with respect to a change in interest rate
  • Second derivative is convexity
228
Q

What drives the price component of a bond ?

A

Change in price = Change in yield X Duration X -1

229
Q

Convexity typically thought of as a percentage measure

A

Price gain from convexity = 0.5 X Convexity X Changei n DR

230
Q

Key Rate Duration

A

Duration at key points on yield curve

231
Q

Advantages of Key Rate Duration over Effective Duration (2)

A
  1. Parallel shifts are rare

2. Effective duration doesn’t properly capture risk exposure

232
Q

Additional risk management tools (2)

A
  1. Buy-out

2. Buy-in

233
Q

Advantages of buy-out (2)

A
  1. Exports all risks for covered obligation

2. Reduces expense volatility

234
Q

Disadvantages of buy-out (2)

A
  1. May be more expensive than immunization

2. Triggers settlement accounting

235
Q

Advantages of buy-in (4)

A
  1. Avoids settlement accounting
  2. Exports most of the covered obligation’s risks
  3. Have buy-out option at no additional cost
  4. Reduces expense volatility
236
Q

Disadvantages of buy-in (2)

A
  1. May be more expensive than immunization

2. Sponsor responsible for making payments

237
Q

Long position

A

Owning the asset

238
Q

Short position

A

Owing the asset

239
Q

When to take the long position

A

Expect asset value to increase

240
Q

When to take the short position

A

Expect asset value to decrease

241
Q

When to use put option vs. short strategy

A

Put: Unsure whether security will decrease
Short: Confident security will decrease

242
Q

Advantage of Forwards

A

Customized

243
Q

Disadvantages of Forward (2)

A
  1. Lack of liquidity

2. Counterparty risk

244
Q

Advantages of Futures (3)

A
  1. Liquid
  2. Minimal counterparty risk
  3. Can be used to increase/decrease duration
245
Q

Approaches used to preserve capital (3)

A
  1. Cash equivalents
  2. Sell index future
  3. Put option
246
Q

Asset/strategies negatively correlated with equities (3)

A
  1. Commodities
  2. Short sales
  3. Selling index futures
247
Q

Types of derivatives (2)

A
  1. Exchange traded derivatives

2. Non-standard over-the-counter derivatives

248
Q

Fiduciary prudence regarding investment derivative management

A
  • Good documentation (reason for decisions, factors considered)
  • Minimize risk of large losses
249
Q

Derivative SIP&P/IPS documentation expectations (2)

A
  1. Authorized derivative users

2. List allowable categories, proportion of assets invested in derivatives, asset amount used for collateral

250
Q

Types of derivative risks (5)

A
  1. Market
  2. Liquidity
  3. Basis
  4. Counterparty
  5. Operations and system
251
Q

Derivative risk management practices document expectations (9)

A
  1. Uses and strategies
  2. Investment objectives
  3. Funds risk tolerance
  4. Nature of plan’s liabilities
  5. Sponsor’s funding policy
  6. Plan’s funded status
  7. Sponsor’s ability to fund the plan
  8. List independent controls
  9. Risk management considerations
252
Q

Non-standard OTC risk mitigation best practices (4)

A
  1. Price via independent professional
  2. Netting agreements
  3. Initial and on-going credit rating
  4. Start with standardized documentation
253
Q

Risk mitigation best practices expectations applicable for all derivatives types (9)

A
  1. Quantify potential risks
  2. Value derivative
  3. Attain legal review
  4. Require collateral
  5. Have system to monitor and contain risks
  6. Limit derivative exposure
  7. Limit counterparty exposure
  8. Limit derivative activities
  9. Compensation policies that reduce risk-taking
254
Q

One approach for setting the plan’s asset allocation

A

Dynamic investment policy

  • Liability-responsive approach
  • Glide path
255
Q

Glide path

A
  1. Shifts asset allocation (risk-seeking to risk-protection, shifts when hit trigger)
  2. Sponsor’s risk tolerance affects the number of trigger points and the degree of shifting
256
Q

Most common approaches to increasing a plan’s interest rate hedge ratio (2)

A
  1. Increase fixed income duration

2. Increase fixed income allocation

257
Q

Most common reason sponsors avoid long-duration fixed income allocations

A
  • Expect rates will rise

- Glide path provides a balanced approach

258
Q

Reasons to establish a target asset duration policy ahead of time (4)

A
  1. Lack of ability to support risk
  2. Economic cost vs regret risk
  3. Asymmetric risk/reward trade-off
  4. Opportunity cost
259
Q

Advantages of a glide path (3)

A
  1. Balanced approach (long-term objectives vs. short term concerns)
  2. Predefined triggers
  3. Avoids inaction
260
Q

Key Glide Path Design Considerations (4)

A
  1. Clear end state
  2. Appropriate trigger points
  3. Appropriate monitor frequency
  4. Formalized governance framework
261
Q

Most common glide path triggers (5)

A
  1. Interest rate levels
  2. Interest rate spreads
  3. Funded status
  4. Plan maturity
  5. Time
262
Q

Items to consider when developing a dynamic asset allocation (4)

A
  1. Evaluate risk/return trade-offs
  2. Factors affecting risk/return trade-off
  3. Account for risks within hedging strategies
  4. One-way or two-way street
263
Q

Factors affecting risk/return trade-off (3)

A
  1. Low funded status
  2. Large benefit accruals
  3. Frozen or low accrual plan with surplus
264
Q

Method of developing a dynamic asset allocation (5 steps)

A
  1. Determine the current asset allocation policy as normal
  2. Determine high-water mark
  3. Define high-water mark allocation
  4. Fill in the intermediate allocation
  5. Define low-water mark
265
Q

Practical considerations regarding a dynamic asset allocation approach (8)

A
  1. Will funded status estimates be readily available
  2. Consider month-end shifts after trigger met
  3. Integrate contributions with dynamic strategy
  4. Consider special allowances regarding rebalancing policy
  5. Size of trigger-point frequency and shifting
  6. Governance process more complex than static approach
  7. Define reporting procedures
  8. Conduct formal reviews regularly
266
Q

Longevity risk

A
  1. Can’t be addressed by LDI alone

2. Increases plan’s liability and duration

267
Q

Demographic factors that affect longevity risk (6)

A
  1. Number of participants
  2. Age
  3. Gender
  4. Socio economic profile
  5. Health profile
  6. LS take-up rate
268
Q

Benefit factors that affect longevity risk (2)

A
  1. COLAs

2. LS option

269
Q

Significance of longevity risk measured in two stages:

A
  1. Estimate likelihood and size of longevity increase

2. Estimate item 1’s impact on the pension liability

270
Q

Methods to manage longevity risk (7)

A
  1. Buy-out
  2. Buy-in
  3. Lump sum
  4. Longevity swap
  5. Q-forward
  6. Synthetic buy-in
  7. Out-of-the-money longevity swap
271
Q

Characteristics of a q-forward

A
  • Forward q’s index, date set-up front and dollar amount set up-front
  • Plan pays dollar amount x forward q
  • Plan receives dollar amount x fixed q
272
Q

Characteristics of a synthetic buy-in

A

-Longevity swap combined with other hedges

273
Q

Ideal plan characteristics for a longevity swap (5)

A
  1. Large plan
  2. Large fixed income allocation
  3. Strong funded status
  4. Want to retain some risk
  5. Preference to pay de-risking over time
274
Q

Types of longevity swaps (2)

A
  1. Indemnity-based

2. Index-based

275
Q

Longevity risk transfer

A
  • Converts unknown payment stream into fixed payments
  • Indemnity-based: Actual experience reimbursed
  • Index-based: Reimbursement based on a change in mortality index
276
Q

Longevity contract risks (4)

A
  1. Counterparty
  2. Rollover
  3. Basis
  4. Legal
277
Q

Ways to reduce default risk (5)

A
  1. Net approach
  2. Collateral
  3. Good documentation
  4. Review regulatory regime/capital requirements
  5. Review financial strength
278
Q

Best practice longevity contract considerations (7)

A
  1. Quantify longevity risk exposure
  2. Confirm contract is permitted by SIP&P and permitted by law
  3. Minimal administrative complexity
  4. Consider contract’s duration
  5. Lack of liquidity
  6. Review risk exposures
  7. Actuarial valuation implications
279
Q

Characteristics of an out-of-the-money longevity swap

A

Longevity swap with a threshold trigger and cap

280
Q

Advantage of buy-outs

A

Risk irrevocably transferred

281
Q

Disadvantages of buy-outs (3)

A
  1. May trigger settlement accounting
  2. Partial buy-out may reduce funded status for remaining population
  3. Must fully fund obligation
282
Q

Buy-in best practices (3)

A
  1. Confirm contract is permitted by SIP&P and permitted by law
  2. Review default risk
  3. Review contract terms
283
Q

Buy-in best practice review /considerations when contract issued by a foreign insurer (5)

A
  1. Regulatory regime
  2. Insurer’s capital/solvency requirements
  3. Coverage/guarantees if default
  4. Contract’s enforceability
  5. Exchange rate risk
284
Q

Buy-in actuarial valuation considerations (4)

A
  1. Value of contract = value of covered benefits
  2. Calculate value under different scenarios (ongoing, solvency)
  3. Reflect costs under different scenarios
  4. Do not smooth value if AVA smoothed
285
Q

Advantages of Buy-Ins (3)

A
  1. No settlement accounting
  2. Funded status unaffected (other than cost of contract)
  3. Contract can be converted to a buy-out
286
Q

Disadvantages of Buy-ins (2)

A
  1. PBGC premiums still due

2. Counterparty risk

287
Q

Advantages of Longevity Swaps/Insurance (6)

A
  1. Can retain investment risk
  2. Don’t need to alter asset allocation
  3. Fully funded plan not required
  4. Pays de-risking over time / not all up-front
  5. Divest unrewarded risk
  6. Easier to manage LDI strategy
288
Q

Borrow-to-fund Strategy (5)

A
  1. Facilitates immediate de-risking
  2. Low borrowing rates
  3. Interest cost offset by PBGC savings
  4. Volatile deficit converted to fixed debt
  5. Accelerates tax deductions
289
Q

Evaluating the cost of a risk transfer (3 steps)

A
  1. Compare economic liability to insurer premium
  2. Economic liability = accounting liability adjusted to reflect PBGC premium, expenses, etc.
  3. Consider in-kind asset transfers
290
Q

Risk defined from an asset-only perspective

A

Volatility of the asset return

291
Q

Investment plan components (3)

A
  1. Asset allocation
  2. Risk budget
  3. Update and monitor investment plan
292
Q

Asset allocation

A
  • Determines overall risk level and long-run expected return
  • Determine bond/equity split
  • Determine allocation to alternative asset classes
293
Q

Other types of risk management investment strategies (2)

A
  1. Alternative investments (Private equity, hedge funds, etc)
  2. Alpha-only portfolio
294
Q

Risk management examples of alternative investment strategies (3)

A
  1. Infrastructure assets and private equity match long-term liability characteristics
  2. Can hedge inflationary benefit increases with commodities and many infrastructure assets
  3. Alternative assets have a low correlation with stock and bonds
295
Q

Potential pitfalls and challenges of alternative investments (5)

A
  1. Valuation and performance measurements difficult
  2. Leveraging used
  3. Short histories and a lack of robust data
  4. High costs
  5. Less control
296
Q

Risk management examples of alpha-only portfolios (2)

A
  1. Can hire a skilled manager that invests in a market deemed to be too risky
  2. Return correlation can be measured against other alpha and beta portfolios
297
Q

Change in asset allocation risk (4)

A
  1. Drift
  2. Undeployed cash
  3. Currency deviations
  4. Manager or benchmark transitions
298
Q

Ways to minimize allocation risk (2)

A
  1. Rebalancing

2. Completion manager

299
Q

Effectiveness of ALM strategy can be reduced by (2)

A
  1. Payment amount uncertainty

2. Timing of payment uncertainty

300
Q

Events that cause change in duration and method for keeping duration on track

A
  1. Change in yield curve or passage of time

2. Rebalancing required

301
Q

Pension put theory suggests investing in … is optimal

A

Equities. Equities increase value of put.

302
Q

Tax arbitrage theory suggests investing in… is optimal

A

Matching bonds

303
Q

Labor-relations theory suggests investing in… is optimal

A

Equities (high return, used to fund or increase benefits)

304
Q

Accounting theory suggests investing in… is optimal

A

Equities. Reduces expense

305
Q

Pension Liability theory suggests investing in… is optimal

A

Depends on whether tying to hedge interest rate risk and /or future salary

306
Q

Pension put’s value increases with (5)

A
  1. Duration
  2. Reduction in sponsor’s credit rating
  3. Asset liability mismatch
  4. Reduced funded status
  5. Plan contributions
307
Q

Plan contributions increase pension put because (3)

A
  1. Pension assets are risky
  2. Pension has long maturity
  3. Plan members are passive
308
Q

Labor-relations explanations for typical high equity allocation (2)

A
  1. Fiduciary concerns

2. Surplus sharing/entitlement

309
Q

Pension liability theory

A
  1. ABO is metric of interest (Matching bonds optimal)

2. PBO is metric of interest (Include equities to provide long-term hedges)

310
Q

Inputs for ALM (3)

A
  1. Asset assumptions
  2. Liability assumptions
  3. Financial assumptions
311
Q

Setting ALM assumptions (4)

A
  1. Start with a historical analysis and combine with current economic conditions
  2. Bond expected return needs to reflect capital appreciation due to change in rates
  3. Equity risk premium approach typically used to set expected return for equities
  4. Determine correlations matrix
312
Q

Efficient frontier

A

Portfolio’s best risk/reward combination (highest yield for a given risk or lowest risk for a given yield)

313
Q

Risk and reward measures may consist of any variable including (Asset perspective (3), Asset-Liability perspective (6))

A

Asset perspective

  1. Portfolio return
  2. Real return
  3. Wealth

Asset-Liability perspective

  1. Surplus
  2. Funded ratio
  3. Contributions
  4. Expense
  5. Benefits paid
  6. Charges to balance sheet
314
Q

Efficient frontier methodology (2)

A
  1. Single period

2. Non-linear programming

315
Q

Reasons for using constraints in efficient frontiers include (4)

A
  1. Liquidity issues
  2. Fiduciary issues
  3. Accuracy of estimates
  4. Investment policy issues
316
Q

ALM- Monitoring the follow-up

A
  • Every 3 to 5 years
  • Accelerates if changes in :
  • Plan benefit structure
  • Funded level
  • Risk tolerance
  • Economic conditions
  • Plan demographics
  • Results
317
Q

Traditional asset allocation vs ALM: Investment objective

A

Maximize return per unit of volatility vs Minimize cost per unit of volatility

318
Q

Traditional asset allocation vs ALM: Equity exposure

A

Subject to risk tolerance of trustees vs Virtually dictated by liabilities and funded status

319
Q

Traditional asset allocation vs ALM: Bond duration

A

Intermediate duration provides higher return per unit of volatility vs Long duration provides lowest cose per unit of volatility cost

320
Q

Traditional asset allocation vs ALM: Funding policy

A

Set through regulations and negotiated assumptions vs Integrated with investment policy to minimize risk adjusted PV of future contributions

321
Q

Traditional asset allocation vs ALM: Benefit policy

A

Maximize benefit per unit of cost on deterministic actuarial basis vs Maximize benefit per unit of risk adjusted cost

322
Q

Sources of public pension savings (ways to save taxpayers money) (7)

A
  1. Better asset/liability matching
  2. Extend the dollar duration of the fixed income portfolio
  3. Amount of equity exposure
  4. Rebalancing rules
  5. Funding policy
  6. Using a stochastic integrated approach
  7. ALM enforces investment discipline
323
Q

Suggested reasons against shifting equities in public funds to bonds (5)

A
  1. Government has no shareholders
  2. Government pays no taxes
  3. GASB not rushing toward a transparent economic accounting model
  4. Taxpayers can move to avoid troubled pension fund whereas shareholders must find buyers
  5. Indefinite lifetime of government plans
324
Q

Disadvantages of investing public pension plans in equities (5)

A
  1. Subject to market risk
  2. Lowers contribution for current tax payer but passes risk onto future generation
  3. Current taxpayers subject to under-pricing risk
  4. Surplus may not go back to taxpayer but used to enhance benefits
  5. Higher governmental borrowing cost
325
Q

Obstacles to investing public plans exclusively in bonds (2)

A
  1. Politicians prefer lower taxes now and passing risk to future generation
  2. Lack of accounting transparency hides amount of risk being passed on
326
Q

How do public plans differ from private plans (5)

A
  1. Less oversight
  2. Diffuse governance
  3. Budgeting process and accounting standards
  4. Design issues
  5. Higher public transparency
327
Q

Problem with government accounting

A

Liability uses EROA vs. market discount rate

328
Q

Public plans need to balance… (3)

A
  1. Fulfilling promises to retirees
  2. Maintaining reasonable pay and benefits for employees
  3. Reasonable tax assessment
329
Q

Actions increasing stress on public plans (3)

A
  1. Insufficient funding
  2. Excessive benefit levels
  3. Inappropriate benefit design
330
Q

Four common contributors of stress

A
  1. Slippery slope of skipping contributions
  2. Managing surplus
  3. Asset-liability mismatch
  4. Competing objectives of controlling authorities
331
Q

Three main financial levers can be used to control risk

A
  1. Benefit levels
  2. Contributions paid by employees and employers
  3. Investment policy
332
Q

The risk management system should establish policies and mechanisms to support… (4)

A
  1. Continuous funding
  2. Education of administration and employees
  3. Avoiding misaligned/mispriced plan provisions
  4. Identifying stakeholder objectives that clash with system objectives
333
Q

Risk management framework (5 steps)

A
  1. Identify participants/stakeholders
  2. Define the objectives of the risk system
  3. Define the sponsor’s risk budget
  4. Evaluate range of risk mitigation approaches
  5. Maintain a feedback process
334
Q

When identifying participants/stakeholders, document… (2)

A
  1. Where they conflict with each other

2. Misalignment of principal and agent interests

335
Q

Public pension stakeholders (6)

A
  1. Society/Taxpayers
  2. Public employees
  3. Unions
  4. Public sector employers
  5. Retirement system governing body
  6. Elected officials
336
Q

Defining objectives of the system

A

May be difficult due to competing interests

337
Q

Considerations when defining system’s objectives and risks to be managed (5)

A
  1. Sustainability
  2. Equitable costs for taxpayers
  3. Appropriate funding
  4. Benefit design
  5. Governance that mitigates the competing objectives of stakeholders
338
Q

Risk budget steps (4)

A
  1. Define the risk budget
  2. Scenarios in which the budget might be exceeded
  3. Risk mitigation strategies that can be used
  4. Process and time horizon to implement strategy
339
Q

Example of systematic risk

A

Longevity risk affecting pool as a whole

340
Q

Example of tail risk

A

Lower tax revenue when contributions increase

341
Q

Risk mitigation techniques (5)

A
  1. System discipline
  2. Pricing discipline
  3. Budgetary discipline
  4. Traditional risk mitigation
  5. Depending on regulatory backstop structure
342
Q

System discipline examples (2)

A
  1. Tight control over surplus uses

2. Risk-sharing plan provisions

343
Q

Pricing discipline examples (4)

A
  1. Using market values
  2. Stochastic measurements
  3. Stress and specific scenario testing
  4. Analyzing trade-offs if changes made
344
Q

Budget discipline examples (2)

A
  1. Align revenue with costs

2. Ensure cost variability can be supported by taxpayers

345
Q

Regulatory backstop if system fails

A

Increases taxes

346
Q

Items that distort the pension plan feedback loop (4)

A
  1. Long time horizon
  2. Dysfunctional control structure
  3. Lack of effective regulatory standard
  4. Economic and demographic cycles
347
Q

Funding dysfunction occurs when (4)

A
  1. Employer not required to make needed contributions
  2. Non-actuarial method used to determine contributions
  3. Benefits not adjusted if contributions are insufficient
  4. There are no surplus restrictions
348
Q

Approach taxpayers should consider implementing to manage risk (6)

A
  1. Report liability on a market basis
  2. Freeze future DB accruals
  3. Invest existing DB assets in matching treasuries
  4. Address remaining deficit
  5. Provide DC accruals prospectively
  6. Allow employees to participate in Social Security prospectively
349
Q

Federal government could incent reforms (2)

A
  1. Encourage state-local govt to issue bonds to finance deficit
  2. Provide subsidies with conditions (Freeze DB accruals, reduce ancillary benefits, require asset liability matching, etc.)
350
Q

Purpose of funding policy

A

Ensure benefits can be paid on on-going basis and on solvency basis

351
Q

Advantages of developing a funding policy (6)

A
  1. Improves understanding and management of risks
  2. More robust governance
  3. Increased funding discipline
  4. Increased transparency
  5. Provide guidance to the actuary (selection of assumptions and cost methods)
  6. Documents sponsor’s objectives and how will meet them
352
Q

Factors that should be taken into account when developing a funding policy (9)

A
  1. Benefit security
  2. Stable and affordable contributions
  3. Sponsor’s financial situation and needs
  4. Plan population demographics
  5. Legal minimum funding requirements
  6. Plan’s funded status
  7. Agreement between sponsor and participants
  8. ITA maximum limits
  9. Use of surplus requirements
353
Q

Best practice issues that should be considered when developing a funding policy (11)

A
  1. Plan overview
  2. Funding objectives
  3. Key risks faced by the plan
  4. Funding volatility factors and management of risk
  5. Funding target ranges
  6. Cost sharing mechanism
  7. Utilization of funding excess
  8. Actuarial methods and assumptions
  9. Frequency of valuations
  10. Monitoring
  11. Communication policy
354
Q

Funding target ranges should describe desired (3)

A
  1. Funding target
  2. Contribution levels
  3. Cost sharing
355
Q

Funding policy should be aligned with the (4)

A
  1. Decision making process
  2. Sponsor’s objectives
  3. Plan objectives
  4. Investment policy
356
Q

Key risks that can affect benefit security and funding volatility (2)

A
  1. Asset liability mismatch

2. Plan population specifics

357
Q

Multi-employer pension plans funding policy should describe (5)

A
  1. Approach used to set the benefit levels
  2. Risks related to fixed contributions
  3. Decision making roles of trustees, employers and union
  4. How intergenerational equity will be addressed
  5. Policy regarding benefit reductions (when adjusted, what is adjusted, etc.)
358
Q

Actuarial violation of corporate finance principles (4)

A
  1. Intergenerational inequity
  2. Underpricing pensions in compensation decisions
  3. US GAAP biases investment decisions
  4. Smoothing conceals risk
359
Q

How do financial economists and actuaries believe pensions should be valued?

A

Actuaries

  • Reflect equity risk premium
  • Use EROA
  • Smooth gains and losses
  • Level contributions

Financial economists

  • Do not reflect equity risk premium (reflect gain when earned)
  • Risk-adjusted discount rate (matching bond portfolio)
  • Report ABO not PBO
  • Focus is market-based vs. level contributions
360
Q

Financial economists: reporting of pension surplus

A

Only report if invested in matching bonds

361
Q

Pension finance utilizes the following liability calculations (3)

A
  1. Market liability
  2. Solvency liability
  3. Budget liability
362
Q

Differences between pension finance liability calculations explains the following

A
  • Market liability - Solvency liability = Default risk

- Market liability - Budget liability = Expected equity risk premium

363
Q

Financial economics preference for corporate reporting (5)

A
  1. Balance sheet = deficit
  2. Expense = change in deficit
  3. Charge against operating income = SC
  4. Finance charge = IC - actual return on assets
  5. OCI adjustment (demographics g/l, assumption changes, amendments)
364
Q

Additional arguments of financial economists (3)

A
  1. Asset liability mismatch passes risk to someone other than sponsor
  2. Budgeting model inadequate (does not ensure security when poorly funded
  3. Cost of pension fund is independent of the way it is funded
365
Q

Additional arguments by actuaries regarding valuation models (2)

A
  1. Financial economics limitations (no matching assets)

2. Cash flow matching may not be optimal

366
Q

Two methods of calculating the market value of the liability per actuary’s understanding of financial economics

A
  1. Project the salary with the expected salary growth and discount the benefit with the expected return on the matching assets
  2. Project the salary with the risk-adjusted salary growth and discount the benefit at the risk-free rate
367
Q

Ways of calculating risk-adjusted salary growth (2)

A
  1. Calculated the expected value of salary growth using risk neutral probabilities
  2. Use the following formula : k* = k+ pj(r-i)/s
368
Q

Law of one price

A
  • Marked-to-market accounting based on the law of one price
  • Two financial instruments that generate identical cash flows and are both tradable in an efficient market must have the same price
369
Q

Typical approaches to managing pension (3)

A
  1. Silo approach (not integrated into ERM)
  2. Decisions focus on shareholder value
  3. Key measures (improve operating earnings, reduce earnings volatility)
370
Q

Recommended approaches for corporations

A

Incorporate holistic balance sheet approach into risk management, strategic planning, decision making and financial metrics

371
Q

Empirical evidence of pension effects

A
  1. Large plan size relative to business = greater stock price volatility/beta, greater cost of capital
  2. Pension debt viewed as riskier than other debt
  3. Plan freeze/close neutral on stock price
  4. Credit rating impact : Buy-out = neutral, ALM = positive
  5. Credit spreads impact (asymmetric effect, ALM de-risking not significant)
372
Q

Principles from financial economics regarding pensions (7)

A
  1. Should not destroy shareholder value
  2. Invest in matching bonds (tax arbitrage)
  3. Use economic pension liability
  4. Transparent accounting (no EROA/smoothing
  5. Pension deficits are corporate debt
  6. Surplus/deficit impacts are asymmetric on credit rating and stock value
  7. Allocate/manage pension risks efficiently
373
Q

Economic pension liability reflects (4)

A
  1. ABO
  2. PBGC costs
  3. Termination rate
  4. Embedded options
374
Q

Pension deficits vs other corporate debt (2)

A
  1. Borrowed from employees

2. Not efficient (volatile, greater impact on credit rating, subject to PBGC premium)

375
Q

Observations of the holistic balance sheet (4)

A
  1. Uses economic pension liability
  2. Net pension obligation approach lacks transparency
  3. Buyout removes assets and liabilities
  4. Remove assets/liabilities for hedged pension liability
376
Q

Holistic balance sheet considers all sources of funding (3)

A
  1. Plan assets
  2. Sponsor support
  3. Value of PBGC insurance
377
Q

Pensions can materially impact the following decisions (2)

A
  1. Raise equity or debt capital (affected by size of deficit relative to company)
  2. Issue fixed or floating rate debt (affected by plan’s interest rate risk)
378
Q

Key corporate finance metrics affected by pensions (3)

A
  1. Corporate leverage (debt to equity ratio)
  2. Income/ cash flow adjustments made by rating agencies
  3. WACC
379
Q

Corporate leverage ratios include (3)

A
  1. Debt to equity ratio
  2. Long term debt to equity ratio
  3. Total assets to equity ratio
380
Q

Moody’s credit rating adjustment (2)

A
  1. Only SC included in pretax income
  2. If the plan is underfunded
    - Implied interest =deficit x marginal borrowing rate
    - Implied interest subtracted from pretax income
    - Contributions in excess of SC reclassified
381
Q

Standard and Poor’s credit rating adjustment

A

Items offset against core earnings:

  • SC
  • Interest cost not covered by the actual return
382
Q

Risk budgeting

A

Amount spent to mitigate risk

383
Q

Questions managers should ask (2)

A
  1. How does pension risk reward the corporation?

2. Which risks should be hedged / retained / transferred?

384
Q

Key goals of ERM

A

Determine how much risk should be taken and how

385
Q

ERM

A
  1. Analyze the trade-off between risk and capital

2. Allocate shareholder capital to different risks

386
Q

Risk budgeting approaches (5)

A
  1. VaR
  2. TVaR
  3. Ruin probability
  4. Sensitivity analysis
  5. Maintain equity and debt betas
387
Q

Equity Capital (reserve)

A
  1. Complete a risk budgeting approach

2. Set aside reserve based on quantified risk

388
Q

Key concepts regarding capital

A
  1. Uses
    - Grow income
    - Mitigate risk
  2. Ways to raise capital
    - Debt
    - Issue shares
389
Q

Outside considerations that may explain corporate preference for equities (12)

A
  1. Cost reduction
  2. Professional advice
  3. Legal issues (PPR)
  4. Wider interests of shareholders
  5. Signaling
  6. Inertia
  7. Strong historical equity growth disguises risk
  8. Accounting methods reward equity allocation
  9. Failure by analysts and investors to see through opaque accounting
  10. Asset allocation risk not reflected in insurance premiums
  11. Competitive reasons
  12. Short-term risks are self-corrected in the actuarial process
390
Q

Inside considerations that may explain corporate preference for equities (5)

A
  1. The role of corporate managers (incentive to increase their own wealth)
  2. Direct interest of management in pension scheme (generating surplus)
  3. Preference for rewarded risk
  4. Scope for creative accounting
  5. Better correlated with salaries
391
Q

Reasons why subjective judgments should be avoided (selecting discount rate that results in a lower liability than its economic value) (4)

A
  1. People tend to overrate their ability to forecast asset prices and returns
  2. Stakeholder may further their own interests at the expense of other stakeholders
  3. Actuaries susceptible to client pressures
  4. More open to criticism
392
Q

Financial economists : Reasons to shift asset allocation from equities to 100% duration matched bonds from the shareholders view (9)

A
  1. Investor can invest equities in own portfolio
  2. Benefit security
  3. Reduce investment management fees
  4. Reduce sponsor’s financial risk
  5. Tax arbitrage
  6. Cost of pension fund independent of way it is funded
  7. Reduces asymmetry risk
  8. Reduces underpricing risk
  9. Surplus asymmetric reward/risk
393
Q

Effect of financial economic assumptions on arbitrage amount (4)

A
  1. Equity return assumption does not impact after-tax income
  2. Arbitrage is proportional to bond return assumption
  3. Arbitrage is proportional to individual tax rate spread
  4. Arbitrage is proportional to (1-corporate tax rate)
394
Q

Arbitrage amount formula

A

Plan assets x Tax spread x bond return x (1 - corporate tax rate)

395
Q

What are advantages about borrowing money and then purchasing duration matched bonds if have a pension deficit? (6)

A
  1. Leaves net liabilities unchanged and borrowing capacity undiminished
  2. Can take tax deduction on principal immediately vs deferred on loan used to fund plan
  3. Accelerate deductions on interest on loan vs. funding plan’s interest cost later
  4. Does not compete with borrowing to fund capital investment
  5. Employees happier
  6. Shareholders happier because full funding can create tax arbitrage
396
Q

Advantages of VBO accounting over PBO accounting (9)

A
  1. Immunizes employees so don’t bear brunt of plan design changes
  2. Clarifies employment contract
  3. Reduces dependency on ambiguous implicit contracts
  4. Minimizes opportunities for gaming
  5. Reduces the threat and cost of regulation
  6. Provides transparency to investors
  7. Gives management more plan design flexibility
  8. Would illuminate total cost of plan amendments immediately to shareholders
  9. Avoids moral hazards
397
Q

Types of contract risks faced by employees (3)

A
  1. Demographics risk
  2. Firm-specific risk
  3. Moral hazard
398
Q

Principles behind contracts (2)

A
  1. Increasing employment contract risk may be efficient up to a limit
  2. Exposing employees to moral hazard is generally inefficient
399
Q

DB plan contract design from an employer and employee perspective (4)

A
  1. Compensation is withheld
  2. Trains employees to enhance future productivity
  3. Motivates them to perform under the risk of losing value withheld
  4. Rewards them at retirement
400
Q

What is one way to identify a frail plan design?

A

ABO significantly larger than VBO (Put’s employees compensation at risk/creates a moral hazard) Employees will demand a higher pay in this situation

401
Q

Frail design features (5)

A
  1. Subsidized early retirement with cliff eligibility
  2. Revocable benefit promises
  3. Past service benefits
  4. Plan shutdown benefits
  5. Cash balance conversions
402
Q

Benefit design features that reduce post-employment frailty (3)

A
  1. Fund individual accounts
  2. Modest class-year vesting
  3. Full vesting at an age when retention is no longer a goal
403
Q

Moral hazard provides opportunity for exploitation which if acted on can… (4)

A
  1. Diminish employee morale
  2. Increase turnover
  3. Cause recruiting difficulties
  4. Lead to lawsuits
404
Q

Typical funding regulations for determining minimum contributions (3)

A
  1. Formula based on funded status
  2. Determined on plan-specific basis
  3. Based pension asset’s risk profile
405
Q

Current funding regulations are procyclical which have the following effects (3)

A
  1. Contribution requirements inversely correlated with economic conditions
  2. Affect investment strategies
  3. Benefit changes correlated with economic conditions
406
Q

Disadvantages of procyclical funding regulations (3)

A
  1. Increased pressure on sponsors when economic conditions are bad
  2. Unstable contributions
  3. DB plans discontinued
407
Q

Goals of counter-cyclical pension plan funding (3)

A
  1. Long-term viability
  2. Stability
  3. Benefit security for participants
408
Q

Counter-cyclical approach : Funding regulations that want to achieve long-term viability, stability and security should (3)

A
  1. Encourage additional contributions when sponsor’ finances are strong (deficit reduction contributions, surplus build-up)
  2. Maintain predictable costs and dampen volatility
  3. Give sponsors more control over managing risks and costs
409
Q

Counter-cyclical approach : What type of funding regulations is better aligned with goals of funding regulations

A

Counter-cyclical

410
Q

Counter-cyclical funding policies should incorporate the following principles (8)

A
  1. Avoid excessive reliance on market values
  2. Funding targets that provide benefit security
  3. Allow overfunding in good economic times
  4. Limit contribution holidays and sponsor’s access to surplus
  5. Actuarial methods producing stable contribution patterns
  6. Flexible rules that reflect funding volatility
  7. Avoid over-regulation
  8. Maintain stable regulatory environment
411
Q

Smoothing techniques as an alternative to market techniques include (3)

A
  1. Average interest rate
  2. Smoothed value of assets
  3. Average funded ratio
412
Q

Caveats with smoothing (2)

A
  1. Use consistent techniques for assets and liabilities

2. Can mask plan that is in serious financial trouble

413
Q

Ways to develop funding targets that promote benefit security (2)

A
  1. Increase funding target if exposed to asset liability mismatch
  2. Target should reflect insurance schemes (conservative target if benefits not insured)
414
Q

Methods to allow overfunding in good economic times (3)

A
  1. Maximum limit based multi-year period
  2. Increase maximum surplus level before suspending contributions
  3. Max based smoothing metric
415
Q

Ways to limit access to surplus (3)

A
  1. Require additional benefits
  2. Allow partial withdrawal above specified
  3. Excise tax
416
Q

Ways to incorporate flexible rules that reflect funding volatility (3)

A
  1. Allow longer amortizations if use market techniques
  2. Allow letter of credit to secure deficits
  3. Allow trustee to set prudent recovery period
417
Q

PBGC is designed to be self-financing through (4)

A
  1. Premiums (fixed and variable)
  2. Assets acquired by terminating plans
  3. Investment returns
  4. Bankruptcy recoveries
418
Q

Filing a claim with the PBGC (4 conditions)

A
  1. Member guarantee is limited
  2. Must be in severe financial distress
  3. Plan must be underfunded
  4. PBGC may terminate plan without employer consent
419
Q

Flaws in the pension insurance system (6)

A
  1. Premiums set by congress
  2. Premiums not properly priced
  3. Funding requirements inadequate
  4. Funded status not transparent
  5. Subject to systematic risk
  6. Low-risk sponsors subsidizing high-risk sponsors
420
Q

Reforms needed that… (6)

A
  1. Implement risk-adjusted premiums
  2. Tighten funding rules
  3. Restrict investment policies
  4. Allow PBGC to purchase reinsurance
  5. Require regular and timely disclosures
  6. Given pensions seniority over other creditors
421
Q

Should charge risk-adjusted premiums reflecting (3)

A
  1. Probability firm will experience distress
  2. Full extent of underfunding
  3. Asset-liability mismatch
422
Q

Factors contributing to inadequate funding requirements (3)

A
  1. Asset and liability smoothing
  2. Extended amortization of plan amendments
  3. Credit balances
423
Q

Approaches to reform (2)

A
  1. Implement market incentives to existing system

2. Mandate firms purchase insurance through private market

424
Q

Potential criticisms of privatization (3)

A
  1. PBGC should be viewed as a social insurance program
  2. Difficult to insure systematic risk in private market
  3. Transition difficult for poorly funded plan
425
Q

DB funding regulations should aim for (3)

A
  1. Benefit security
  2. Acceptable costs to sponsors
  3. Encouraging DB plans
426
Q

Purpose of pension regulations is to enhance (3)

A
  1. Equity
  2. Adequacy
  3. Benefit security
427
Q

Three types of market risks pension regulations should address (3)

A
  1. Information asymmetry
  2. Externality
  3. Monopoly
428
Q

Caveats of excessive regulations (2)

A
  1. Discourage participation

2. Reduce competitiveness

429
Q

Societal issues regarding trend from DB to DC (4)

A
  1. Not saving enough
  2. Poor investment choices
  3. High management costs
  4. Increasing cost of annuity purchase rates
430
Q

Examples of regulatory features that discourage DB plans (4)

A
  1. Minimum benefit requirements
  2. Investment guarantees
  3. Mandatory indexation
  4. Surplus restrictions
431
Q

Ways to regulate risky investments (2)

A
  1. QAR

2. PPR

432
Q

Current regulatory needs (2)

A
  1. Address longevity risk

2. Require counter cyclical funding

433
Q

Advantages of PPR vs QAR (2)

A
  1. Can invest on the efficient frontier

2. Does not restrict free market

434
Q

Disadvantages of QAR (3)

A
  1. Not needed for diversification since PPR requires diversification
  2. Restricts investment liquidity vs. investor’s liquidity position
  3. Plan’s specific liability duration not reflected
435
Q

Regulatory enforcement of QAR vs PPR

A

QAR: confirm rues not broken
PPR: assess validity of the investment approach

436
Q

Risk-based regulations to address funded status risk / asset-liability risk in DB plans (4)

A
  1. VaR
  2. Stress testing
  3. Scenario testing
  4. Score card
437
Q

Examples of risk-based funding regulations (2)

A
  1. Adjust funding target

2. Require stress tests

438
Q

Risk-based funding regulations should reflect (5)

A
  1. Nature of plan risks
  2. Extent benefits can be modified
  3. Extent contributions can be raised
  4. Sponsor’s creditworthiness
  5. Whether benefits are insured
439
Q

Stress test caveats (2)

A
  1. Valid model outcomes needed for success

2. Can lead to complacent risk management

440
Q

Risk scoring process (5 steps)

A
  1. Complete detailed profile of fund
  2. Identify management units
  3. Assess risks
  4. Assign a score
  5. Score drives frequency of on-site inspections
441
Q

Caveats with an insurance-based regulatory approach (4)

A
  1. Guarantor may default
  2. Moral hazard
  3. Conflicting regulations
  4. May discourage participation
442
Q

Caveats with risk-based regulations (3)

A
  1. Encourages short-term investment policies
  2. Model risk / assumption risk
  3. Herd outcomes
443
Q

Ways to regulate DC costs (3)

A
  1. Direct
  2. Central agency
  3. Transparency
444
Q

Ways to regulate DC Risks / Outcomes includes restricting investments via (4)

A
  1. QAR
  2. Stress testing
  3. Daily VaR ceilings
  4. Risk scoring
445
Q

Caveats with DC investment regulations (3)

A
  1. Greater low risk allocations can harm retirement outcome
  2. Sell equities during market downturn
  3. Subject to modeling error
446
Q

Ways to regulate longevity risk for DC Participants (4)

A
  1. Require annuitization
  2. Subsidize / fix price of annuities
  3. Regulate broker commissions
  4. Electronic quotation system
447
Q

Ways to regulate transparency and financial education for DC participants (5)

A
  1. Auditor report
  2. Benefit statements
  3. Benefit risk simulators
  4. Fee disclosure
  5. Require financial education

RPIRM 2 (1 decks)

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