Learning Center
Plans & pricing Sign in
Sign Out
Your Federal Quarterly Tax Payments are due April 15th Get Help Now >>

Chapter 3 Managing Institutional Investor Portfolios


  • pg 1
									Chapter 3
 Managing Institutional Investor Portfolios

  Major learning outcomes
       Contrast a defined-benefit (DB) plan to a defined-
        contribution (DC) plan, from the perspectives of both the
        employee (plan participant) and employer (plan sponsor)
       Discuss investment objectives and constraints for pension
       Evaluate pension fund risk tolerance from multiple
       Extend analysis to hybrid pension plans, endowment funds,
        foundations, banks, and insurance companies

2/27/2010                                                           1
Specific Learning Outcomes
  Analyze the return objectives, risk tolerance, liquidity
   requirements, time horizon, legal and regulatory
   environment … etc. of these institutional investors
  Compare and contrast the asset/liability management
   needs of these institutional investors

2/27/2010                                                     2
 DB vs DC Plans
    DB plans promise a certain benefit in the future, DC
      plans promise a certain contribution today
         DB: Pension amount based on a formula: function of
          years of service and final earnings
         DC: Pension amount depends on investment returns
    DC plans confer no future liability to the plan sponsor, in
     contrast to DB plans
    Common claim: “DC plan participants bear investment
     risk, DB plan sponsor bears investment risk”
    DB plan participants bear risk of early plan termination
     (e.g., if company is liquidated)
    In a DC plan, participants own their account. Hence,
     more portable if participants change jobs
2/27/2010                                                          3
 DB Plan Objectives and Constraints
    First DB plan – 1928 American Express
    Return objective is to achieve inflation-adjusted returns
     that adequately fund its pension liabilities
    Constraints:
         Liquidity - difference between inflow (annual
            contributions) and outflow (pension payments)
           Time horizon - long if plan is continuing, but age of
            workforce is a consideration
           Taxes - investment returns are tax exempt
           Legal and regulatory - investment policies are governed
            by law
           Others/Unique circumstances - sponsor financial
            condition and specific investment prohibitions
2/27/2010                                                             4
 Evaluating Risk Tolerance for DB Plans

    Risk tolerance governed by multiple factors
            1.   Financial health of plan (e.g., plan surplus)
            2.   Sponsor financial status and profitability
            3.   Sponsor and pension fund common risk exposures
            4.   Plan features, and
            5.   Workforce characteristics

2/27/2010                                                         5
Evaluating Risk Tolerance for DB Plans
 1. Plan surplus (assets in excess of PV of liabilities) – risk
       tolerance could potentially increase with surplus
 2.    Sponsor financial status – A sponsor with less debt and
       higher profits can tolerate more investment risk as shortfalls
       can be made up with additional contributions
 3.    Common risk exposures between sponsor and plan – The
       lower the correlation between sponsor operating results and
       plan returns, the higher the investment risk tolerance
 4.    Plan features – early retirement or lump sum options reduce
       plan duration and reduce risk tolerance
 5.    Workforce characteristics – more risk can be tolerated by
       plans serving relatively young workforce and by plans with a
       higher ratio of active lives to retired lives

2/27/2010                                                               6
Case: Apex Sports Equipment
  $100 million in asset
  $8 million in surplus (relative to PV liabilities)
  Average age of workforce is 39 years
  Duration of liabilities is 20 years
  Demand for company’s product has been strong; balance
    sheet is strong, and low debt ratio

  Assess the risk tolerance of this company’s pension plan:
    below average, average, or above average

2/27/2010                                                      7
 Investing Pension Plan Assets: Risk
   Primary purpose of plan assets is to fund future liabilities
      Measure of financial soundness of a plan: funding ratio
      Fully funded plan: Ratio of asset value to PV of liabilities > =
       100 percent
      Discount rate: yield of high quality investment grade
       corporate bonds
   Asset/Liability management is now a primary concern
      Most plans were asset-focus until the new millenium
      Liability Driven Investment (LDI) – most involve some
       elements of “liability hedging” to reduce inflation and
       interest rate risk, using a portfolio of bonds and swaps
2/27/2010                                                                 8
Investing Pension Plan Assets: Risk
  Plan may set a risk objective relative to the volatility of
   the plan surplus (asset minus PV of liabilities)
  Risk can also be expressed as a shortfall risk relative to a
   specified funding ratio
       e.g., if target funding ratio = 100%, no less than 95% at any

  Side: pension surpluses/deficits are now more
    transparent on corporate balance sheets, courtesy of new
    mark-to-market accounting measures
2/27/2010                                                               9
 Investment Policy Statements for DC Plans
   Main investment issues for sponsor are:
    diversification (via menu of plan options) and limits
    to investments in company stock
   Sponsor’s IPS documents ways to meet fiduciary
    responsibility with regard to plan options and
    procedures to ensure that individual objectives and
    constraints can be met
   Each plan participant is responsible for defining
    his/her own investment objectives and constraints

2/27/2010                                                   10
 Hybrid Pension Plans

  Hybrid plans seek to combine the best aspects of both
   DC plans and DB plans (benefit guarantees, awards for
   length of service, ability to link retirement income to a
   percentage of salary)
  In most hybrid plans, employer bears investment risk
   (e.g., built-in DB plan as a minimum guarantee),
   employee can also benefit from favourable returns from
   pension assets

2/27/2010                                                      11
 Types of Foundations
   Independent (private or family)
        Makes grants to aid social, educational, charitable or
         religious activities
        Funds provided by individual, group or family
        Decision making authority lies with donor, family
         member or independent trustees
        Must spend at least 5% of 12-month average asset
         value, plus expenses

2/27/2010                                                         12
 Types of Foundations
   Company sponsored
        Legally independent, but with close ties to
        Funds provided via endowment or annual
         contributions by a for-profit company
        Decision-making authority lies with board of
         trustees, usually controlled by company executives
        Must spend at least 5% of average assets, plus

2/27/2010                                                     13
 Types of Foundations
   Operating Foundation
      Uses resources to conduct research or provide service
       (such as running a museum or hospital)
      Funds typically provided by individuals, groups or families
      Decisions made by an independent board of trustees
      Must use 85% of investment income in operational
       activity. Some also must spend at least 3.3% of average
       assets per year

2/27/2010                                                            14
 Types of Foundations

   Community Foundation
      Publicly supported organization making grants for social,
       educational, charitable or religious purposes (public
      Funds provided by the public, multiple donors
      Decisions made by Board of Directors
      Not subject to minimum annual spending requirement

2/27/2010                                                          15
 Foundations: Investment Objectives
   Risk objective
        High risk tolerance because maintaining spending level is
            more a desire than a necessity
   Return objective
        Preserve real value of assets while permitting desired
         spending rate
        Intergenerational equity arises when spending rate can be
         sustained in real terms in perpetuity (i.e. mandated 5%
         spending rate + investment expenses + inflation rate =
         required return to assure intergenerational equity)

2/27/2010                                                            16
Foundations: Investment Constraints
  Constraints
           Liquidity needed to provide for spending levels
           Time horizon = perpetuity
           Tax concerns are minimal
           Legal and Regulatory – must comply with UMIFA or non-US
               Uniform Management of Institutional Funds Act: law governing how
                much of an endowment a charity can spend, for what purpose, and how
                the charity should invest the endowment funds.
       Other factors/unique circumstances – many foundations
            have large holdings in a single company

2/27/2010                                                                             17
Endowments: Investment Objectives and
 • Risk objective
       • Must be consistent with goal of stable, real income over time
         (intergenerational equity)
       • Can be higher if institution can adapt to fluctuations by altering
       • If smoothing mechanisms are used, periods of high return can
         increase risk tolerance in subsequent periods
 • Return objectives
       • High return needed to maximize sustainable real income
 • Constraints
       •    Liquidity – sufficient to cover short-term spending needs
       •    Time horizon is long-term, with short term spending considerations
       •    Tax considerations are minimal
       •    Legal and Regulatory – UMIFA or equivalent, tax exempt status, etc.
       •    Unique circumstances – vary by endowment

2/27/2010                                                                         18
 Banks: Investment Objectives and Constraints
     Risk objective
           Constrained by asset/liability management (ALM) – short-
            term deposits are used to finance long-term loans
           Characterized by below average risk tolerance
     Return objective
           Positive spread over rate paid to depositors
     Constraints
           Liquidity – significant need to cover deposit outflows and
           Time horizon – intermediate, balancing the needs of return
            and managing interest rate risk
           Tax concerns – fully taxable portfolios
           Legal and regulatory – restrictions on stock and sub-
            investment grade bond investing
2/27/2010                                                              19

To top