CFA 2018 level 3 schweser practice exam CFA 2018 level 3 question bank CFA 2018 CFA 2018 r13 managing institutional investor portfolios IFT notes

The advantages and disadvantages of DB and DC pension plans from the perspective of the plan sponsor are summarized below: Advantages  Income from operations can be supplemented by i

Managing Institutional Investor Portfolios

1 Introduction 3

2 Pension Funds 3

2.1 Defined-Benefit Plans: Background and Investment Setting 4

2.2 Defined-Contribution Plans: Background and Investment Setting 9

2.3 Hybrid and Other Plans 9

3 Foundations and Endowments 10

3.1 Foundations: Background and Investment Setting 10

3.2 Endowments: Background and Investment Setting 13

4 The Insurance Industry 14

4.1 Life Insurance Companies: Background and Investment Setting 15

4.2 Non-Life Insurance Companies: Background and Investment Setting 17

5 Banks and Other Financial Institutions 19

5.1 Banks: Background and Investment Setting 19

5.2 Other Institutional Investors 20

Comparison of Institutional Investors 21

Summary 23

Examples from the Curriculum 30

Example 1 Apex Sports Equipment Corporation (1) 30

Example 2 Apex Sports Equipment Corporation (2) 30

Example 3 Apex Sports Equipment Corporation (3) 31

Example 4 Apex Sports Equipment Corporation (4) 32

Example 5 Apex Sports Equipment Corporation (5) 32

Example 6 Taxation and Return Objectives 32

Example 7 Apex Sports Equipment Corporation Defined-Benefit Plan Investment Policy Statement 33 Example 8 Participant Wanting to Make Up for Lost Time 35

Example 9 Participant Early in Career 36

Example 10 Investment Policy Statement for BMSR Company Defined-Contribution Plan 36

Example 11 BMSR Committee Decision 39

Example 12 The Fund for Electoral Integrity 39

Example 13 The City Arts School 40

Example 14 Investment Policy Statement for a Stock Life Insurer 43

Example 15 Investment Policy Statement for a Casualty Insurance Company 46

Example 16 Investment Policy Statement for a Commercial Bank 48

This document should be read in conjunction with the corresponding reading in the 2018 Level III CFA®

Program curriculum Some of the graphs, charts, tables, examples, and figures are copyright

2017, CFA Institute Reproduced and republished with permission from CFA Institute All rights reserved

Required disclaimer: CFA Institute does not endorse, promote, or warrant the accuracy or quality of the

products or services offered by IFT CFA Institute, CFA®, and Chartered Financial Analyst® are

trademarks owned by CFA Institute

This section addresses LO.a:

LO.a: Contrast a defined-benefit plan to a defined-contribution plan and discuss the advantages and

disadvantages of each from the perspectives of the employee and the employer

Pension funds are large pools of assets created by a plan sponsor for the purpose of providing

retirement income for beneficiaries For example, many employers offer pension benefits or health

benefits to its employees

In a defined-benefit (DB) pension plan, employees are promised specific retirement benefits, which the

plan sponsor is typically legally-obligated to provide The sponsor makes contributions to a plan and

bears all investment risk Trustees are appointed with a mandate to ensure that pension assets are

managed in the interests of the plan’s beneficiaries

In a defined-contribution (DC) pension plan, the sponsor’s obligations is limited to only making periodic

contributions Beneficiaries bear all investment risk

Hybrid plans, which have some feature of DB pensions and some features of DC pensions, are discussed

in Section 2.3

The advantages and disadvantages of DB and DC pension plans from the perspective of the plan

sponsor are summarized below:

Advantages

 Income from operations can be supplemented by income generated from pension plan investments

 Pension plan assets can be used to support company stock price

 No liability beyond making contributions

 No investment risk

 No need to administer a plan or comply with laws and regulations governing DB pensions

Disadvantages

 100% of investment risk  Employer must comply with laws

governing DC pensions, such as providing a range of investment options and an IPS

The advantages and disadvantages of DB and DC pension plans from the perspective of plan

beneficiaries are summarized below:

Advantages

 No investment risk

 Income during retirement

 Own all personal contributions and sponsor contributions (after vesting period)

 Assets are easily transferable

 Portfolio to suit individual needs

 Taxable income is reduced

Disadvantages

 Risk of losing job before becoming eligible for benefits

 Vesting period are common

 Restricted withdrawal of funds

 High concentration of risk (both job and pension with employer)

 100% of investment risk

 Must monitor and make necessary reallocation decisions

 Restricted withdrawal of funds

2.1 Defined-Benefit Plans: Background and Investment Setting

DB pension plan assets represent deferred compensation Over the course of their working lives,

beneficiaries accumulate benefits that will be paid out after retirement The sum of all payments due to

beneficiaries is the pension plan’s liability

The curriculum offers three definitions for pension plan liabilities:

 Accumulated benefit obligation (ABO) is the value of all benefits that have been earned as of

today This figure is relatively easy to calculate, but it excludes the value of any obligations that

will be accumulated in the future

 Projected benefit obligation (PBO) includes all the benefits in the ABO and adds the present

value of benefits that are expected to be earned in the future

 Total future liability (TFL) includes all the benefits in the PBO, but makes a more comprehensive

estimate of future benefits that will be accumulated

TFL may be used internally when setting risk and return objectives, but PBO is the most reasonable

liability measure to use for estimating a plan’s funded status, which is the ratio of the market value of a

plan’s assets (AMV) to the present value of its liabilities (PBO)

 If AMV = PBO, the plan is fully-funded and the funded status is 100%

 If AMV > PBO, the plan is in surplus and the funded status is >100%

 If AMV < PBO, the plan is in deficit (or underfunded) and the funded status is <100%

Sections 2.1.1 to 2.1.7 address the following:

LO.b: Discuss investment objectives and constraints for defined-benefit plans

LO.d: Prepare an investment policy statement for a defined-benefit plan

LO.j: Discuss the factors that determine investment policy for… pension funds

2.1.1 Risk Objectives

This section addresses LO.c:

LO.c: Evaluate pension fund risk tolerance when risk is considered from the perspective of the 1)

plan surplus, 2) sponsor financial status and profitability, 3) sponsor and pension fund common risk

exposures, 4) plan features, and 5) workforce characteristics

Risk tolerance factors

Assessing risk tolerance for institutional investors focuses on identifying factors that affect ability to take

risk In contrast to individual investors, willingness to take risk is not typically a relevant concern In this

section, we consider five factors that affect a DB pension plan’s ability to take risk:

1 Plan funded status

2 Sponsor’s financial status and profitability

3 Common risk exposures

4 Plan features

5 Workforce characteristics

Plan funded status

As noted above, a pension plan’s funded status is the ratio of its assets to the present value of its

liabilities, or PBO A higher funded status indicates a higher risk tolerance, as the surplus can absorb a

certain amount of losses before the plan becomes underfunded Whereas, an underfunded plan

indicates a lower risk tolerance

Refer to Example 1 from the curriculum

In Example 1, ASEC pension plan’s funded status is a surplus of $8 million above its projected benefit

obligation While this surplus (8 percent of assets) is described as “small”, any plan with a surplus has a

greater ability to take risk compared to a plan that is in deficit

Sponsor’s financial status and profitability

A plan with a profitable sponsor has a greater ability to take risk than a plan with a less profitable

sponsor A sponsor with a persistent inability to operate profitably will not be able to contribute any

additional funds to its pension plan In Example 1, we are told that ASEC is profitable and its earnings are

rising We are also told that demand for ASEC’s products has been “strong” for the past few years, which

suggests that the company is not simply benefitting from being in a cyclical industry during an attractive

part of the business cycle

Debt can be used as another measure of financial status In Example 1, we are told that the sponsor’s

balance sheet is “strong” due to its low debt All else equal, a plan whose sponsor has less debt has a

greater ability to take risk compared to a plan whose sponsor has more debt

Common risk exposures

A plan’s ability to take risk increases if its portfolio returns have a low correlation with its sponsor’s

earnings and pension assets By contrast, a sponsor will have a reduced ability to contribute to a plan

that has experienced poor returns and possibly even become underfunded if its earnings are depressed

at the same time This issue is discussed further in Section 2.1.8

Plan features

Plans that give beneficiaries the option to access funds sooner (e.g., early retirement or lump sum

payments) have a lower ability to take risk compared to plans that do not offer such features

Workforce characteristics

The younger the workforce and the greater the proportion of active lives (those who are still working) to

retired lives, the greater the duration of plan liabilities and the greater the risk tolerance

In Example 1, ASEC is described as a “relatively young company” and the plan is not currently making

payments to any retired employees The average age of the workforce is 39, which is consistent with a

20-year average duration of pension liabilities All else equal, ASEC’s plan has a greater ability to take

risk than a plan that is obligated to provide benefits to a workforce with an average age of, for example,

55

Summary of risk tolerance factors

Exhibit 1 summarizes the effect that each of the risk tolerance factors mentioned in LO.c has on a

pension plan’s ability to take risk

Lower debt ratios and higher current and expected profitability imply greater risk tolerance

Sponsor and pension

fund common risk

exposures

Correlation of sponsor operating results with pension asset returns

The lower the correlation, the greater risk tolerance, all else equal

Plan features Provision for early

retirement Provision for lump-sum distributions

Such options tend to reduce the duration of plan liabilities, implying lower risk tolerance, all else equal

Workforce

characteristics

Age of workforce Active lives relative to retired lives

The younger the workforce and the greater the proportion of active lives, the greater the duration of plan liabilities and the greater the risk tolerance

Risk objective

The most important risk for DB pension plans is the risk of failing to make the payments that have been

promised to beneficiaries Trustees will therefore want to adopt an asset/liability management (ALM)

perspective and define the plan’s risk objective as minimizing the risk that the market value of assets

drops below the PBO (i.e., the plan becomes underfunded)

Refer to Example 2 from the curriculum

In Example 2, the risk objective for ASCEC is to minimize the probability that the funded status falls

below 100 percent

2.1.2 Return Objectives

DB pension plans are obligated to make payments based on the benefits that participants have already

earned and/or are expected to accumulate Therefore, a pension plan’s return objective will always be

to meet its liability Trustees may establish additional return objectives, but these will be secondary

concerns

To determine a pension plan return requirement, start with the actuarial discount rate that is used to

calculate the present value of these projected obligations Trustees must set a return requirement that is

at least equal to the actuarial discount rate in order to achieve their primary return objective, which is to

meet the liability In Example 1, the ASEC pension plan’s obligations are discounted at a rate of 6 percent

and it would therefore be unacceptable for this plan’s trustees to set a return objective below this rate

Refer to Example 3 from the curriculum

If trustees have established return objectives beyond meeting the liability, the return requirement can

be set above the actuarial discount rate In Example 3, the return requirement for ASEC is set at 7.5

percent – above the actuarial discount rate of 6 percent – in order to pursue the additional return

objectives of minimizing the need for future contributions from the plan sponsor or generating pension

income A higher return requirement is acceptable in this particular case because the ASEC plan has an

above average ability to take risk, but such an adjustment would not be justified for a plan with below

average risk tolerance

Accounting for inflation

It is important to note that the actuarial discount rate has already accounted for expected inflation, so it

is not necessary to set a return requirement that includes an additional inflation component above and

beyond the actuarial discount rate As with any forecast, there is the risk that actual inflation will exceed

expectations, but the best current estimate of future inflation is already included in the actuarial

discount rate

2.1.3 Liquidity Requirements

As with individual investors, liquidity constraints for institutional investors are portfolio withdrawals

required to make payments in the near-term Two important considerations are the share of retired

lives and plan features A plan with a higher ratio of retired lives has a greater liquidity requirement as

more outflows are required to pay benefits Similarly, plan features that allow beneficiaries to receive

payments sooner will also increase a plan’s liquidity requirement

Refer to Example 4 from the curriculum

2.1.4 Time Horizon

As with individual investors, a longer time horizon increases an institutional investor’s ability to take risk

A pension plan’s time horizon will be heavily influenced by the average age of plan participants Plans

that must provide benefits to workers with a higher average age will have shorter time horizons (and

therefore less ability to take risk) than plans that must provide benefits to workforces with a lower

average age Also, the time horizon will be short if the plan is not a going concern and plan termination

is expected in the near future

Refer to Example 5 from the curriculum

2.1.5 Tax Concerns

In many countries, investment income and capital gains for pension plans are exempt from taxation,

which means that tax considerations do not typically factor into asset allocation decisions However,

corporate contributions and distributions do raise tax concerns and require some planning

Refer to Example 6 from the curriculum

2.1.6 Legal and Regulatory Factors

From the perspective of beneficiaries, pension assets represent deferred compensation, so failing to

make pension payments in the future is the equivalent of failing to pay salaries today As a result,

governments tend to enact laws and regulations designed to ensure that plan sponsors deliver on their

obligations and penalties for non-compliance can be severe

2.1.7 Unique Circumstances

Although we cannot generalize unique circumstances, two unique circumstances are discussed in the

curriculum First, smaller plans may lack the resources to invest in alternative asset classes, which

requires extensive due diligence and often refuse to accept investments below a minimum level This

topic will be discussed further in Alternative Investments Portfolio Management Second, pension plans

may have a requirement to follow socially responsible investing (SRI) guidelines The topic of SRI will be

discussed further in Section 5.2 of Equity Portfolio Management

Refer to Example 7 from the curriculum

2.1.8 Corporate Risk Management and the Investment of DB Pension Assets

This section addresses LO.e:

LO.e: Evaluate the risk management considerations in investing pension plan assets

The sponsor of a defined benefit pension plan, will want to avoid having to make significant

contributions to an underfunded plan – particularly at a time when it is experiencing its own financial

difficulties

As was discussed in Section 2.1.1, pension plans should avoid investment risk exposures that are highly

correlated with the sponsor’s operating risk exposures The case discussed in Market Indexes and

Benchmarks, Section 6 provides an example of a pension plan for a US-based technology company that

generates a majority of its sales in Japan The fund manager chooses not to hold any Japanese or

technology sector stocks in order to avoid sharing the same risk exposures as the plan sponsor

A second measure that can be taken to avoid the need for the sponsor to contribute to an underfunded

plan is to practice asset-liability management (ALM) If a plan’s funded status is 100% (i.e., plan asset are

exactly equal to the projected benefit obligation), assets should be managed relative to liabilities As will

be discussed further in Linking Pension Liabilities to Assets, the lowest risk investments from an ALM

perspective are those with returns that are highly correlated with changes in the value of liabilities A

plan with a funded status greater than 100% will want to minimize the variance of the surplus portion of

its portfolio Since liabilities are interest rate sensitive asset allocation is generally weighted towards

bonds

2.2 Defined-Contribution Plans: Background and Investment Setting

This section addresses LO.f:

LO.f: Prepare an investment policy statement for a participant directed defined-contribution plan

Defined contribution plans can be sponsor-directed or participant-directed The curriculum focuses on

participant-directed plans

For participant-directed DC plans, the plan sponsor must have a written investment policy statement A

DC investment policy statement establishes procedures to ensure that a range of individual investor

objectives and constraints can be properly addressed

Typically, DC plan sponsors will be required to provide a minimum number of diverse investment

options and may offer investment education programs It is also recommended that sponsors limit the

amount of their own stock made available to beneficiaries However, as mentioned in Example 8,

sponsors must not provide investment advice to participants, who are responsible for establishing their

own objectives and constraints

Refer to Example 8 from the curriculum

Refer to Example 9 from the curriculum

Refer to Example 10 from the curriculum

Refer to Example 11 from the curriculum

2.3 Hybrid and Other Plans

This section addresses LO.g:

LO.g: Discuss hybrid pension plans (e.g., cash balance plans) and employee stock ownership plans

Cash balance plans often started out as DB plans and have subsequently been amended to adopt some

features of a DC plan Specifically, the sponsor bears the investment risk, although some cash balance

plans transfer a portion of the investment risk to participants While each participant receives an

individual account statement, the actual asset of a cash balance plan are not segregated

Employee stock ownership plans (ESOPs) are essentially DC pension plans in which all of the sponsor’s

contributions are used to purchase the company’s own stock ESOPs can be used as an exit strategy for a

company owner seeking to divest a concentrated single-stock position Employees who participate in

ESOPs take considerable risk by combining their human capital and financial capital in a single company

3 Foundations and Endowments

Foundations are covered in Section 3.1

Endowments are covered in Section 3.2

3.1 Foundations: Background and Investment Setting

This section addresses LO.h:

LO.h: Distinguish among various types of foundations, with respect to their description, purpose,

and source of funds

Foundations are often founded by a wealthy individual or family to fund charitable activities The four

types of foundations discussed in this section are:

1 Independent (private or family) foundations

2 Company-sponsored foundations

3 Operating foundations

4 Community foundations

As shown in Exhibit 2, each of the four types of foundations listed above make grants and/or provide

operating funds to non-profit organizations Furthermore, all foundations have an independent board of

directors or trustees, who have decision-making authority over operational and financial matters

Foundations are typically created by large initial contributions from wealthy families (e.g., the Gates

Foundation) Note that organizations created by wealthy benefactors rarely, if ever, raise funds from the

general public Community foundations, which rely on multiple donors for ongoing support, are more

comparable to charitable organizations

Foundations are typically required to spend a certain percentage of assets each year As noted in Exhibit

2, this figure is 5 percent for independent foundations in the United States, but varies by country

Alternatively, a spending rule may be based on a percentage of investment income For exam purposes,

a relevant spending rate will be provided

Foundation

Type Description Source of Funds

Decision-Making Authority

Annual Spending Requirement

Foundation

Type Description Source of Funds

Decision-Making Authority

Annual Spending Requirement

grant-Generally an individual, family,

or group of individuals

Donor, members

of donor’s family,

or independent trustees

At least 5% of 12-month average asset value, plus expenses associated with generating investment return

Company-sponsored

foundation

A legally independent grant-making

organization with close ties to the corporation providing funds

Endowment and/or annual contributions from a profit- making corporation

Board of trustees, usually controlled

by the sponsoring corporation’s executives

Same as independent foundation

Operating

foundation

Organization that uses its resources to conduct research or provide a direct service (e.g., operate a museum)

Largely the same

as independent foundation

Independent board of directors

Must use 85% of interest and dividend income for active conduct of the institution’s own programs Some are also subject to annual spending requirement equal to 3.33% of assets

Community

foundation

A publicly supported organization that makes grants for social, educational, charitable, or religious purposes A type of public charity

Multiple donors;

the public

Board of directors No spending requirement

The remainder of Section 3.1 addresses LO.j and LO.k as they relate to foundations:

LO.j: Discuss the factors that determine investment policy for… a foundation

LO.k: Prepare an investment policy statement for… a foundation

3.1.1 Risk Objectives

Unlike DB pension plans, foundations do not have contractually-defined liabilities, hence they can take

more risk

3.1.2 Return Objectives

The return objectives of foundations depends on the specific nature of the organization In order to

balance the needs of current and future beneficiaries (“intergenerational neutrality”), many foundations

limit their return objective to maintaining the value of their assets in real terms

The components of a foundation’s required return are:

1 Spending rate

2 Inflation

3 Investment management expenses

Additive vs multiplicative return calculation method

Using a 5 percent mandatory spending rate, 2 percent inflation, and investment management fees of 0.3

percent, the curriculum calculates a required return of 7.3 percent using the additive method and 7.42

percent using the multiplicative method

Foundation constraints include:

3.1.3 Liquidity Requirements

A foundation’s liquidity requirements are anticipated or unanticipated needs for cash in excess of

contributions made to the foundation At a minimum, a foundation’s liquidity requirements will include:

1 The amount determined by the spending rate

2 The amount of investment management fees

Because portfolio returns can be volatile, a smoothing rule is often used to determine the asset value to

which the spending rate is applied This allows for greater predictability when forecasting outgoing

funds Liquidity requirements may also include, for example, a large payment to fund a capital project or

the establishment of a cash reserve

3.1.4 Time Horizon

The default assumption is that foundations have an infinite time horizon However, some foundations

have a limited time horizon during which all funds must be spend In Example 12, the Fund for Electoral

Integrity must “spend itself out of existence within 10 years.” Foundations that have such “spend down”

requirement will have a significantly lower risk tolerance than those with infinite time horizons

3.1.5 Tax Concerns

Taxes are usually not a significant concern for foundations, however the specifics vary by jurisdiction

3.1.6 Legal and Regulatory Factors

In order to continue receiving preferential tax treatment, a foundation must comply with all legal and

regulatory requirements Notably, the minimum spending requirement must be met Additionally,

spending must be directed to legitimate charitable activities

3.1.7 Unique Circumstances

Unique circumstances will vary from foundation to foundation Usually foundations are endowed with

one stock and the donor restricts them from diversifying

Refer to Example 12 from the curriculum

3.2 Endowments: Background and Investment Setting

This section addresses LO.j and LO.k as they relate to endowments:

LO.j: Discuss the factors that determine investment policy for… endowments

LO.k: Prepare an investment policy statement for… an endowment

Endowments are created to provide non-profit institutions with “substantial, stable, and sustainable”

funding The largest and best known endowments are associated with universities and colleges

An endowment’s two dominant objectives are:

1 To maintain the real value of its assets over an indefinite time horizon

2 To provide stable funding, which may be expressed as a percentage of an institution’s operating

budget

In order to achieve these objectives, it is necessary to earn a rate of return that covers both spending

requirements and inflation An endowment’s risk objectives and return objectives must be consistent

with this necessity

Spending

Unlike foundations, endowments are not required to spend a fixed percentage of assets in order to

receive preferential tax treatment While they are free to choose any spending rate, 90 percent of

endowments spending rates in the range of 4 to 6 percent

Some examples of spending rules are:

Simple spending: Equals the spending rate multiplied by the market value of the endowment at the

beginning of the fiscal year

Rolling three-year average spending rule: equals the spending rate multiplied by the average market

value of the last three fiscal year

Geometric spending rule: Equals the weighted average of the prior year’s spending adjusted for inflation

and the product of the spending rate times the market value of the endowment at the beginning of the

prior fiscal year

3.2.1 Risk Objectives

An endowments risk objectives should be considered in conjunction with the spending policy The time

horizon for endowments is typically infinite, which generally translates into an above average ability to

take risk However, if the funded institution relies heavily on the endowment for its operating expenses

or its ability to adapt to a drop in spending is low, then the risk tolerance of the endowment will be low

3.2.2 Return Objectives

Unlike foundations, the return objectives of endowments is not subject to a specific spending

requirement Endowments generally need relatively high long term returns to cover spending rate plus

administrative expenses plus inflation High return is specifically important for academic institutions

where spending rates have increased faster than inflation for general economy Often Monte Carlo

simulations are used to illustrate the effect of investment and spending policies on the fund

3.2.3 Liquidity Requirements

Endowments generally have low liquidity constraints, but they must have cash to make spending

distributions Also, any plan for capital commitments such as building construction should be

considered

3.2.4 Time Horizon

Endowments typically have a single-stage, indefinite time horizon

3.2.5 Tax Concerns

Endowments are generally tax-exempt investors and can therefore disregard tax considerations when

making asset allocation decisions However the specifics vary by jurisdiction

3.2.6 Legal and Regulatory Factors

The legal and regulatory factors vary by jurisdiction In US, most states have adopted the UMIFA as the

governing regulation for endowments

3.2.7 Unique Circumstances

Unique circumstances vary by endowments The examples mentioned in the curriculum are:

 Relatively small endowments may lack the resources required to adequately oversee certain

investments In Example 13, the CAS endowment, with assets of $30 million, “does not have the

resources to identify, evaluate, and monitor the top managers in specialized investment areas.”

With specific respect to alternative investments, which typically require a minimum investment

of $5 million, may need to be avoided entirely in order to prevent an unduly large allocation to

such asset classes

 Another possible unique circumstance is socially responsible investing (SRI), which is an addition

consideration in this category Endowments may include considerations of environmental or

social matters when making investment decisions

Refer to Example 13 from the curriculum

4 The Insurance Industry

For exam purposes, the insurance industry is composed of:

1 Life insurance companies, which are covered in Section 4.1

2 Non-life insurance companies, which are covered in Section 4.2

4.1 Life Insurance Companies: Background and Investment Setting

This section addresses LO.j and LO.k as they relate to life insurance companies:

LO.j: Discuss the factors that determine investment policy for… life insurance companies

LO.k: Prepare an investment policy statement for… an insurance company

As discussed in Lifetime Financial Advice: Human Capital, Asset Allocation, and Insurance, individuals

gain no advantage from bearing mortality risk and should therefore be willing to pay a premium to

hedge it Life insurance, which pays out benefits at the time of a policyholder’s death, is a perfect hedge

against the risk of losing future income (i.e., human capital)

Some of the important concepts about life insurance companies are:

Disintermediation: Disintermediation occurs when policyholders borrow against the accumulated cash

value in insurance products

Credited rates: When interest rates are high, policy holders may surrender their policies, take the

accumulated cash and invest at a high rate To prevent this, insurers offer high rates of interest (called

credited rates) to the policy holder

Traditionally liabilities for life insurance companies had longer duration, but due to disintermediation,

the liabilities are of a much shorter duration now

4.1.1 Risk Objectives

Life insurance companies are considered quasi-trust funds and they have a contractual agreement to

make payments, and funding these liabilities is their primary risk objective In order to achieve this

objective, life insurance portfolios are managed to increase the value of assets relative to liabilities The

difference between the value of assets and liabilities is called the surplus

When assessing a life insurance company’s risk tolerance level, there are four important factors to

consider

Valuation risk

If the duration of portfolio assets does not match the duration of liabilities, their values will respond

differently to changes in interest rates Specifically, when assets have a greater duration than liabilities,

the value of assets will decrease faster in a rising interest rate environment By contrast, falling interest

rates will increase the portfolio’s surplus if assets have a greater duration than liabilities Greater

duration mismatching increases valuation risk

Reinvestment risk

Life insurance company portfolios typically allocate more than 50 percent of assets to fixed income

securities, which means that coupon payments are continually being received and reinvested

Reinvestment income is therefore higher in rising rate environments and lower when interest rates are

falling Reinvestment risk is a particular concern for holders of mortgage-backed securities, who receive

large cash inflows as interest rates fall

Credit risk

Life insurance companies invest heavily in corporate bonds, which creates significant exposure to credit

risk Unexpected widening of spreads over risk-free securities or increases in default rates will reduce

the value of portfolio assets and shrink the surplus

Cash flow volatility risk

Life insurance companies try to manage the volatility of cash flows Portfolios with greater allocations to

mortgage-backed securities will have less predictable cash flows

The bottom line is the life insurance companies need to use ALM to control interest rate risk and

liquidity, and the overall risk tolerance is low

4.1.2 Return Objectives

The return objectives of life insurance companies are twofold:

 Earn a sufficient return to fund all policyholder liabilities and match or exceed the expected

returns factored into the pricing of the company’s various products

 Contribute to the growth of surplus through capital appreciation

Segmentation

As noted in Exhibit 5, US life insurance companies have significantly increased their offerings of

annuities and guaranteed investment contracts (GICs) in recent decades Rather than set a single return

objective, life insurance companies may create segmented portfolios, each with a different return

objective, based on product lines

4.1.3 Liquidity Requirements

Disintermediation

Disintermediation occurs when life insurance policy holders borrow against, or withdraw entirely (i.e.,

surrender), the accumulated value of their policy Policyholders are more likely to take advantage of

these opportunities in rising interest rate environments, thereby increasing a life insurance company’s

liquidity requirement

Asset marketability risk

When the duration of their liabilities was higher, life insurance companies had a greater ability to invest

in less liquid asset classes such as real estate As the duration of their liabilities has decreased in recent

decades, so has their allocation to such asset classes

4.1.4 Time Horizon

In the past, life insurance companies made asset allocation decisions based on a 20 to 40 year time

horizon However, this figure has decreased, particularly as they have offered more annuity products,

which have a lower duration than plain vanilla life insurance policies (see Exhibit 5)

4.1.5 Tax Concerns

The income generated from a life insurance company’s investments falls into two broad categories:

1 Income used to settle policyholder’s claims, which is not taxable

2 Excess income transferred to surplus, which is taxable

Notwithstanding this distinction, life insurance companies are taxable investors who should consider the

tax implications of their investment decisions

4.1.6 Legal and Regulatory Factors

Life insurance companies are relatively highly regulated compared to, for example, endowments

Important concepts include:

Refer to Example 14 from the curriculum

4.2 Non-Life Insurance Companies: Background and Investment Setting

This section addresses LO.j and LO.k as they relate to non-life insurance companies:

LO.j: Discuss the factors that determine investment policy for… non-life insurance companies

LO.k: Prepare an investment policy statement for… an insurance company

Non-life insurance is a broad category which includes - health, property, liability, auto insurance;

investment policy similar across non-life insurance companies

Relative to life insurance, non-life insurance:

 Liability durations are shorter

 Claims processing is longer

 Have lower interest rate risk (some companies may have inflation risk)

 Liabilities are uncertain in time and value

A unique aspect of this industry is a long tail – where a long time may pass between the date of

occurrence and reporting of a claim and the actual payment of a settlement to a policy holder

The industry is also characterized by underwriting (profitability) cycles, which typically result from

adverse claims experience and/or extremely competitive pricing They often coincide with the general

business cycle

4.2.1 Risk Objectives

The primary risk objective for non-life insurance companies is to meet their liability obligations Because

of the unpredictable nature of their liabilities, shorter time horizons, and “erratic” cash flows, non-life

insurance companies have lower risk tolerance than life insurance companies (which have a relatively

low risk tolerance compared to foundations and endowments) Regulators closely monitor the ratio of a

casualty insurance company’s premium income to its total surplus Generally, this ratio is maintained

between 2-to-1 and 3-to-1 Also, many companies have adopted self-imposed limitations restricting

common stocks at market value to ½ or ¾ of the total surplus

4.2.2 Return Objectives

Factor to consider in the return objectives are:

 Competitive pricing

 Profitability

 Growth of the surplus

 After-tax total returns

As stated in Example 15, the return objectives are:

1 Earn sufficient return to fund policyholder liabilities

2 Support competitive pricing of all products

3 Contribute to growth of surplus through capital appreciation

4.2.3 Liquidity Requirements

Due to the high level of uncertainty surrounding both the amount and timing of their liabilities, liquidity

requirement is generally high Hence these companies need a high portion of liquid assets in the

portfolio

4.2.4 Time Horizon

Despite being less predictable, the liabilities of non-life insurance companies are typically shorter

duration than those of life insurance companies However, non-life insurance companies are relatively

more willing to accept a mismatch between the durations of their assets and their liabilities As shown in

Exhibit 7, some non-life insurance company portfolios have higher asset duration than life insurance

company portfolios

4.2.5 Tax Concerns

Tax considerations determine the optimal allocation of taxable and tax-exempt bonds Tax

considerations play a role in realization of gains and losses for bond and stock portfolios

4.2.6 Legal and Regulatory Factors

All investments must qualify under insurance law of the state in which the company is domiciled

4.2.7 Determination of Portfolio Policies

Non-life insurance companies allocate assets with the objectives of meeting liability obligations and

maximizing investment income in order to price premiums more competitively

Refer to Example 15 from the curriculum

5 Banks and Other Financial Institutions

5.1 Banks: Background and Investment Setting

This section addresses LO.j and LO.k as they relate to banks:

LO.j: Discuss the factors that determine investment policy for… banks

LO.k: Prepare an investment policy statement for… a bank

Liabilities of a bank primarily consist of time deposits and demand deposits The financial assets consist

of loan portfolio and investment portfolio A bank’s asset/liability management committee (ALCO) is

generally in charge of overseeing the bank’s security portfolio Refer to Exhibit 8 from the curriculum

which shows the elements of the ALM process used in banks

ALCO monitors the following:

 Net interest margin

 Interest spread

 Leverage adjusted duration gap

 Value at risk

The overall investment objectives of banks are to:

1 Manage interest rate risk

2 Manage liquidity

3 Manage credit risk

4 Produce income

Because their objectives relate primarily to managing risks, banks are very different (and far more risk

averse) investors compared to other institutional investors

Managing the liquidity requirements associated with deposit accounts is critical for banks and results in

an allocation that is heavily tilted toward low-risk, highly-liquid securities

5.1.4 Time Horizon

A bank’s assets (i.e., loans) have a longer duration that its liabilities (i.e., deposits) The duration of

investment portfolio assets is set, in part, with the objective of bridging this mismatch A three-to-seven

year investment time horizon is not uncommon for banks

5.1.5 Tax Concerns

Banks are taxable investors and must factor tax considerations into asset allocation decisions

5.1.6 Legal and Regulatory Factors

Banks are subject to a multitude of laws and regulations, which can include maximum and/or minimum

allocations to certain asset classes Risk-based capital requirements are increasingly common and can

have a significant impact on a bank’s ability to take risk

5.1.7 Unique Considerations

There are no generalizable unique considerations pertaining to banks’ investment practices

Refer to Example 16 from the curriculum

5.2 Other Institutional Investors

This section addresses LO.l:

LO.l: Contrast investment companies, commodity pools, and hedge funds to other types of

institutional investors

Investment companies:

These include open-end mutual funds, closed-end mutual fund, unit trusts and exchange traded funds

They represent pooled investment funds invested in equity and fixed income Each company has its

specific investment objectives and constraints, and seeks funds from investors who are drawn to these

objectives and constraints

Commodity Pools:

Commodity pools are similar to investment companies, however they invest in commodity futures

rather than equity and debt Objectives and constraints vary by fund

Hedge Funds:

Hedge funds differ from investment companies, in that they carter primarily to high net worth

individuals Also, they are subject to fewer regulations Objectives and constraints vary by fund

Comparison of Institutional Investors

LO.i: Compare the investment objectives and constraints of foundations, endowments, insurance

companies, and banks

LO.n: Compare the investment objectives and constraints of institutional investors given relevant

data, such as descriptions of their financial circumstances and attitudes toward risk

Institutional Investor Type Risk Objective

Defined Benefit Plans Depends on plan status, financial status of the company, plan features,

workforce characteristics, and correlation of sponsor operating results with pension asset returns

Foundations Unlike pension plans there is no defined liability; hence, can take more

risk

Endowment Generally high, but low if endowment’s role in operating budget of the

institution is high or if the institution’s ability to adopt to drop in spending is low

Life insurance companies Use ALM to control interest rate risk and liquidity Overall risk

tolerance is low

Non-life insurance companies Overall risk tolerance is low

Institutional Investor Type Return Objective

Defined Benefit Plans Achieve returns that adequately fund the pension liability on an

inflation-adjusted basis

Foundations Preserve real value while allowing spending at appropriate rate

Endowment Generally need relatively high long term returns: spending rate +

admin cost + inflation

Life insurance companies Earn a sufficient return to fund all policyholder liabilities and match or

exceed the expected returns factored into the pricing of the company’s various products Contribute to the growth of surplus through capital appreciation

Non-life insurance companies Earn sufficient return to fund policyholder liabilities Support

competitive pricing of all products Contribute to growth of surplus through capital appreciation

Institutional Investor Type Liquidity Requirements

Defined Benefit Plans Depends on the plan A high portion of retired lives, low corporate

contributions relative to benefit disbursements, early retirement option, lump sum payment option increase liquidity requirements

Foundations Depends on spending rate, minimum 5% in US

Endowment Generally low, but have enough for spending and capital commitments

Life insurance companies Traditionally low, but now is high due to disintermediation

Non-life insurance companies Liquidity requirement is generally high

Institutional Investor Type Time Horizon

Defined Benefit Plans Typically long, but will be short if plan is terminating and average age of

workforce is high

Life insurance companies Traditionally long, but getting shorter Different time horizon for

different products

Non-life insurance companies Short due to the nature of claims

Institutional Investor Type Tax

Defined Benefit Plans Usually tax exempt

Life insurance companies Policy holders share not taxed Corporate share taxed

Non-life insurance companies Tax considerations determine the optimal allocation of taxable and

tax-exempt bonds Tax considerations play a role in realization of gains and losses for bond and stock portfolios

Banks They are taxable, hence need to evaluate investments on an after tax

basis

Institutional Investor Type Legal and Regulatory Factors

Defined – Benefit Plans ERISA

Life insurance companies High

Non-life insurance companies High

Note: Unique circumstances can vary by investor type

Summary

a contrast a defined-benefit plan to a defined-contribution plan and discuss the advantages and

disadvantages of each from the perspectives of the employee and the employer;

Defined Contribution Plan

 No financial liability for plan sponsor

 Plan participants bear investment risk

 Contributions and returns belong legally to participant

 Retirement assets are portable

Defined Benefit Plan

 A pension liability exists for the plan sponsor

 Sponsor bears investment risk

 Participants bear early termination risk

Advantages of a DC plan to company:

 Company does not have the responsibility to set objectives and constraints

 Company does not bear the risk of investment results

 Company's future pension obligations are more stable and predictable

Advantages of a DC plan to employees:

 An employee is able to choose a risk and return objective reflecting his or her own circumstances

 More readily portable

 Defined contribution plans do not have early termination risk

 Employees can rebalance and re-allocate investments

b discuss investment objectives and constraints for defined-benefit plans;

c evaluate pension fund risk tolerance when risk is considered from the perspective of the 1) plan

surplus, 2) sponsor financial status and profitability, 3) sponsor and pension fund common risk

exposures, 4) plan features, and 5) workforce characteristics;

d prepare an investment policy statement for a defined-benefit plan;

Plan status Plan funded status (surplus or

deficit)

Higher pension surplus or higher funded status implies greater risk tolerance

Sponsor financial status and

Sponsor and pension fund

common risk exposures

Correlation of sponsor operating results with pension asset returns

The lower the correlation, the greater risk tolerance, all else equal

Plan features Provision for early retirement

Provision for lump-sum distributions

Such options tend to reduce the duration of plan liabilities, implying lower risk tolerance, all else equal Workforce characteristics Age of workforce

Active lives relative to retired lives

The younger the workforce and the greater the proportion of active lives, the greater the duration of plan liabilities and the greater the risk tolerance

Return Objectives

 Should be consistent with risk objective

 Achieve returns that adequately fund pension liability on an inflation-adjusted basis

• Use discount rate for future obligations as a starting point

• Discount future obligations at long-term government bond rate

 Might have an objective to minimize pension contributions

 Might have an objective related to pension income

Note: If plan is fully funded and objective is to meet future obligations then minimum return objective =

discount rate used for liabilities

Liquidity Requirement

 Net cash outflow: Benefit Payments – Pension Contributions

 Liquidity requirement is higher with:

1 High portion of retired lives

2 Low corporate contributions relative to benefit disbursements

3 Early retirement option

4 Lump-sum payment option

Time Horizon

 Investment time horizon depends on:

1 Whether plan is a going concern or plan termination is expected

2 Average age of workforce and proportion of active lives

 A plan can have multi-stage time horizon:

o For active lives  time horizon = average time to normal retirement age

o For retired lives  time horizon is a function of life expectancy

e evaluate the risk management considerations in investing pension plan assets;

 Coordinate pension investments with pension liabilities (ALM)

1 Consider volatility of pension surplus rather than plan assets

2 Since liabilities are interest rate sensitive, asset allocation weighted towards bonds

 For DB Plan consider shortfall risk of funded status

 Shortfall Risk: portfolio might fall below some threshold level over a given horizon

 Minimize probability that funded status will fall below a certain level

 Manage pension investments in relation to operating investments

f prepare an investment policy statement for a participant directed defined-contribution plan;

An IPS for a participant-directed DC plan documents the following:

 A set of governing principles and rules

 The responsibilities of the plan sponsor, the plan participants, the fund managers, and plan

trustee/record-keeper selected by the plan sponsor

 The procedure of selecting and evaluating a menu of plan options

 The investment strategies and alternatives available to the group of plan participants with

varying risk and return characteristics and with sufficient diversification properties

 Criteria for monitoring and evaluating the performance of investment managers and investment

vehicles relative to appropriate investment benchmarks

 Criteria for selecting, terminating and replacing manager/fund

 Effective communication procedures for the fund managers, the trustee/record keeper, the plan

sponsor, and the plan participants

g discuss hybrid pension plans (e.g., cash balance plans) and employee stock ownership plans;

Hybrid plans have the characteristics of both DB and DC plans

Benefits of DC plans include:

 Portability of assets

 Easy to administer for plan sponsors

 Easy to understand for plan participants

Benefits of DB plans include:

 Guaranteed retirement benefits available to participants

 Benefit payments linked with years of service

 Benefit payments linked to a percentage of salary

Types of Hybrid retirement plans:

1) Cash balance plans: In this plan, a certain percentage of salary of each employee is set aside by the

employer and interest is credited on these contributions

o Investment risk is born by the plan sponsor

o Unlike a DC plan, the account balance is hypothetical

2) Employee stock ownership plan (ESOP): A form of DC plans under which the employees invest all or

majority of plan assets in employer stock Employees who participate in ESOPs take considerable

risk by combining their human capital and financial capital in a single company