•Under DC plans, the pension fund belongs to the employee beneficiary, such that, he/she does not lose the benefit upon changing jobs; the participants are entitled to receive the value
Trang 1Reading 13 Managing Institutional Investor Portfolios
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Institutional investors refer to corporations or other legal
entities that serve as financial intermediaries between
individuals and investment markets These include
pension plans, foundations, endowments, life insurance
companies, non-life insurance companies, and commercial banks These entities have diverse investment objectives and constraints
Pension funds are used to support a promise of
retirement income made by an organization, called
plan sponsor
Types of Pension Funds:
Defined-benefit (DB) plans: The defined-benefit plans are
plans under which the plan sponsor (i.e employer)
promises to pay plan participants (i.e retirees) a
pre-defined amount (commonly a % of salary) each month
during retirement
•These benefit payment promises represent “pension
liability” of sponsor because the risk associated with
funding the benefit obligation is borne by the
employer/plan sponsor
•The pension liability in DB plans is based on various
assumptions (e.g number of years of service and
final earnings) and thus it is uncertain and difficult to
estimate
Defined-contribution (DC) plans: The
defined-contribution plans are plans under which the employer
(i.e plan sponsor) is only required to contribute a
specific amount to the employee’s retirement fund each
year
•Under DC plans, the pension fund belongs to the
employee (beneficiary), such that, he/she does not
lose the benefit upon changing jobs; the
participants are entitled to receive the value of the
pension account as either a lump-sum or a series of
payments upon withdrawal from the plan or upon
retirement However, employees are subject to
vesting requirements of 3-5 years i.e they cannot
withdraw their employer contributions until after they
have been employed with the sponsor for a
specified period of time
o This portability feature allows participants to
diversify retirement portfolio to suit their needs
•Any risk (benefit) associated with pension plan assets
is born by the employee
•In addition, the DC pension plans are tax-deferred
and thus lower taxable income of participants
•DC pension plans are attractive for employers as
they involve lower liquidity requirements, require
fewer resources to meet contributions and are
subject to fewer regulations
There are two arrangements in DC plans:
i Pension plans in which the plan sponsor only promises the contribution, not the benefit;
ii Profit-sharing plans in which contributions are based
on profits of the plan sponsor
Types of DC plans:
Sponsor directed: In a sponsor directed DC plan, the investments are chosen by the sponsor (like in DB plan)
However, it is less complex than DB plans
Participant directed: In a participant directed DC plan, the participants determine their own personalized investment policy by choosing investments from a menu
of diversified investment options provided by plan sponsor Most DC plans are participant directed
Hybrid plans: Hybrid plans have the characteristics of
both DB and DC plans It is discussed in detail in section 2.3
The key differences between DC and DB plans
1 A specific future benefit is promised which has generated pension liability for the plan sponsor; no specific present obligation
Only present contribution is promised; not future benefit
2 Promise is made for the retirement stage
Promise is made for the current stage
3 Investment risk is borne by plan sponsor/employer
Investment risk is borne by plan participants
4 Plan participants are exposed to risk of early plan termination (e.g if a company is liquidated)
Plan participants are NOT exposed to early termination risk because the pension account legally belongs to the plan participants
5 DB plans are NOT portable DC plans are
portable to plan participants upon changing jobs
However, they are subject to certain
Trang 2DB plans DC plans
rules, vesting schedules, and possible tax penalties and payments
2.1 Defined-Benefit Plans: Background and
Investment Setting Three basic liability measures for determining pension
liability are as follows:
1)Accumulated benefit obligation (ABO): The ABO
represents the present value of pension benefits that
are owed to an employee to date(i.e associated
with accumulated service), whether vested or not
ABO does not include any future benefits to be
earned by employees
•It is the most appropriate estimate of total pension
liability for a terminated plan
2)Projected benefit obligation (PBO): The PBO
represents the present value of all benefits that
employees are expected to earn during employment
The PBO measure incorporates the impact of
expected future compensation increases
•It is the most appropriate estimate of total future
pension liability for a going concern companies
Commonly, the funded status is computed using
PBO
3)Total future liability: It represents the present value of
accumulated and projected future service benefits
and takes into account the impact of expected
future compensation increases as well as changes in
the workforce and benefit changes associated with
inflation It is the most comprehensive but also the
most uncertain pension liability measure
The primary objective of plan assets is to fund future
pension liabilities The ability of a pension fund to meet its
future liabilities is measured by the funded status of a
plan
Funded Status of Pension Plan = Market value of Pension
plan assets – Present value of pension plan liabilities
Where,
Present value of pension liabilities is found by discounting
the value of pension liabilities at some discount rate,
typically, the yield of high quality, long-term, investment
grade corporate bonds)
The lower (higher) the discount rate, the greater
(smaller) the present value of pension liabilities
•When value of plan’s assets > present value of plan
liabilities plan is over-funded i.e plan’s funded
status is > 100%
• When value of plan’s assets < present value of plan liabilities plan is under-funded i.e plan’s funded status is < 100%
• When value of plan’s assets = present value of plan liabilities plan is fully-funded i.e plan’s funded status is = 100%
Important to Note: Maintaining funded status of a plan
requires increase in contributions to the plan by the plan sponsor
2.1.1) Risk Objectives The ability of a DB pension plan to tolerate investment risk is governed by several factors, such as:
• In addition, over-funded pension plan implies lower costs for the sponsor in terms of lower contributions
When pension plan is underfunded (i.e negative funded status), the plan sponsor has lower ability to tolerate risk
(all else equal),implying under-funded plan has average risk tolerance
below-• It is important to understand that when pension plan
is underfunded, then the plan sponsor may have higher willingness to take risk in order to generate higher returns so that the plan can be made fully-funded
• An under-funded plan status increases costs of the sponsor in the form of requirement of greater contributions to the plan
B Sponsor’s financial status and profitability: Sponsor’s financial status is determined using debt-to-assets ratio, and profitability is judged through current and expected profitability of a company
• When the sponsoring company is financially strong (i.e has low debt ratios/low financial leverage) and has higher current and expected profitability (i.e profitable despite operating in a cyclical industry), it has greater ability to take risk, implying an above-average risk tolerance (all else equal)
Reason: A financially strong and profitable
sponsoring company has greater ability to fund shortfalls attributed to negative returns by making additional contributions to the plan
• When the sponsor is financially weak, (i.e has high
Trang 3debt ratios/high financial leverage) and has lower
current and expected profitability, it has lower ability
to take risk, implying below-average risk tolerance
(all else equal)
C.Common risk exposures between sponsor and
pension fund: From asset/liability management
perspective, the pension plan assets should be highly
correlated with pension plan liabilities BUT minimally
correlated with sponsoring company’s operating
assets
• When operating results of a sponsoring company are
highly correlated with pension asset returns, higher
operating risk tends to limit the amount of investment
risk assumed by the plan, implying lower risk
tolerance, all else equal
Reason: High correlation implies that when the
sponsor’s operating results are weak, the pension
asset returns will also be poor; but, due to weak
operating results, the sponsor will be unable to make
additional contributions to support payment of
benefit obligations
• In contrast when sponsor operational risk is unrelated
with the investment risk, then if a pension portfolio
faces negative returns, the sponsor will be able to
increase contributions to support payment of benefit
obligations
D.Plan features: A pension plan which has specific plan
features i.e., early retirement options or option to
receive a lump-sum distributions has lower risk
tolerance (all else equal) because such options tend
to shorten the time horizon of pension plan by
reducing the duration of plan liabilities
E Workforce characteristics: It includes two things i.e
a)Age of workforce: A pension plan with younger or
growing workforce has greater risk tolerance
because the younger the workforce, the greater
the duration of plan liabilities, the lower the liquidity
requirements and the longer the time horizon
b)Proportion of active lives versus proportion of
retired lives: A pension plan with high ratio of
active lives to retired lives has greater risk tolerance
because the greater the proportion of retired lives,
the greater the pension fund’s liquidity
requirements (i.e greater cash outflows each
month to retirees), the smaller the duration of plan
liabilities and thus the shorter the time horizon
Summary:
Pension plan has above-average risk tolerance
Pension plan has below-average risk tolerance Funded
Weak balance sheet with high financial leverage
Pension plan has above-average risk tolerance
Pension plan has below-average risk tolerance Profitability Profitability is not
adversely affected by business cycles
Profitability is adversely affected
by business cycles
Age of workforce
Younger or growing workforce, implying longer duration of pension liabilities
Older workforce or currently closed to new participants, implying shorter duration of pension liabilities
% of active lives relative to retired lives
High % of active lives relative to retired lives, implying low immediate liquidity needs
High % of retired lives relative to active lives, implying high immediate liquidity needs Plan
features
No early retirement or lump-sum payment option
Early retirement or lump-sum payment option
Stating a risk objective of DB pension plans: The risk objective of DB plans can be manifold, such as:
A.Shortfall risk relative to specified funded status: For example,
• Pension plan wants a funded status of 100% or > 100% or above some regulatory threshold level
• Pension plan wants to minimize the probability that funded status falls below 100%; or
• Pension plan wants to minimize the probability that funded status falls below 100% to be ≤ 10%
B Pension surplus volatility (i.e standard deviation): For example,
• Pension plan wants the volatility of pension surplus to
C.Risk related to contributions: For example, Practice: Example 1,
Volume 2, Reading 13
Trang 4• Pension plan wants to minimize the year-to-year
volatility of future contribution payments
• If currently the plan is over-funded and thus no
contributions are being made by the sponsor, the
pension plan may want to minimize the probability
of making any future contributions
D.Absolute risk: For example, a pension plan may want
to minimize the risk of large losses within any one asset
class, investment type, industry or sector distributions,
maturity date, or geographic location
2.1.2) Return Objectives Like risk objectives, the return objectives of a DB pension
plan can be manifold
Primary return objective is “To earn sufficient,
inflation-adjusted returns that adequately meet expected
pension liabilities”
In addition to the primary return objectives, the DB plans
may have the following objectives
Return objectives related to both funding of benefit
payments and future pension contributions: To earn
sufficient, inflation-adjusted returns that adequately
meet pension benefit payments and to minimize the
probability of making future contributions to the plan or
to minimize the amount of sponsor’s future contributions
to the plan so that the company can use its cash for
other productive uses
• Stretch target: A stretch target refers to the objective
of DB plans to make future pension contributions
equal to zero
Return objectives for a fully funded or over-funded plan:
A fully-funded or over-funded pension plan may have
an objective to maintain the plan’s funded status
(pension surplus) relative to plan liabilities
Return objectives for an underfunded pension plan: An
underfunded pension plan may have an objective to
earn return equal to the benchmark return i.e the return
sufficient to meet pension benefit payments
A comprehensive return objective may be stated as: To
earn sufficient, inflation-adjusted returns that adequately
meet pension benefit payments, minimize the probability
of making future contributions to the plan and generate
pension income (negative pension expense), resulting in
increase in the sponsor’s reported earnings
• A well-funded pension plan with pension income
may have the objective of maintaining or increasing
pension income in order to boost profitability
Return objective in numerical terms can be stated as follows:
Minimum Required return for a fully-funded pension plan
= Discount rate used to calculate the PV of plan liabilities Desired return for a fully-funded pension plan = Discount rate used to calculate the PV of plan liabilities + Excess Target return
• The stated return of DB plans may be higher than the minimum required return in an attempt to minimize the probability of making future contributions by the plan sponsor and/or to decrease pension expense (or increase pension income); however, the high return requirement must be consistent with plan’s ability to tolerate risk
IMPORTANT TO NOTE:
The greater (lower) the risk tolerance ability of a pension plan, the more (less) aggressive risk and return objectives can be adopted
2.1.3) Liquidity Requirement Pension plan’s liquidity requirement i.e its Net cash outflow can be estimated as:
Net cash outflow = Benefit payments – Pension
contributions – Investment income Example:
Suppose a pension fund has obligation to pay pension benefits of $100 million per month It has an asset base of
$10 billion and receives no pension contributions Annual liquidity requirement = ($100 million × 12) / 10 billion = 12%
This implies that in order to meet pension benefit obligations without eroding capital base, the asset base needs to grow to 10 billion (1.12) = $11.2 billion
Pension plan’s liquidity requirement depends on various factors, including:
Proportion of retired lives relative to active lives: The greater the number of retired lives relative to active lives, the greater the liquidity requirement, all else equal; e.g
a pension plan of a company operating in a declining industry will have greater proportion of retired lives Size of annual Sponsor’s contributions to the plan relative
to annual benefit payments: The smaller the sponsor’s contributions relative to benefits payments, the greater the liquidity requirement, all else equal
Practice: Example 3, Volume 2, Reading 13
Practice: Example 2,
Volume 2, Reading 13
Trang 5Age of workforce served by the plan: A plan with young,
growing (older, declining) workforce tends to have
smaller (greater) liquidity requirements
Early retirement options and/or the option of retirees to
take lump-sum payments: A pension plan with such
options provided to participants tends to have greater
liquidity requirements
Funded status of a plan: A fully-funded or overfunded
(under-funded) pension plan tends to have low (high)
liquidity needs, all else equal
Managing high liquidity needs: Higher liquidity needs of
pension fund can be met by:
• Holding a cash reserve or investments in money
market instruments;
• Taking a long position in stock index futures contracts
to gain equity market exposure;
• Taking a long position in bond futures contracts to
gain bond market exposure;
2.1.4) Time Horizon The time horizon of a DB plan is governed by the
following factors:
Going-concern DB plans versus terminated DB plans: A
going-concern DB plan has a long time horizon, all else
equal By contrast, a DB plan that is expected to
terminate has a short time horizon
Age of workforce and proportion of active lives: A DB
pension plan with younger workforce and greater
proportion of active lives has a longer time horizon, all
else equal
Plan open to new entrants: A DB plan that is open to new
entrants tends to have a long time horizon, all else
equal
The time horizon can be single-stage or multi-stage For
example, going-concern DB plans have multi-stage time
horizons related to active lives and retired lives portions
of plan participants
Time horizon for active-lives portion = Average time to
the normal retirement age
Time horizon for retired-lives portion = Average life
expectancy of retired plan beneficiaries
2.1.5) Tax Concerns Pension funds are either tax-exempt or are taxed at very favorable tax rates Hence, there is little or no need for tax-sheltered income and the investor can focus on total return In addition, tax-exempt bonds are not
appropriate investment vehicles for pension plans
Investment income and realized capital gains are typically exempt for taxation However, corporate contribution and plan termination does involve the tax issues
2.1.6) Legal and Regulatory Factors All retirement plans are governed by laws and regulations that attempt to ensure protection for beneficiaries by specifying standards of care that must
be met by plan sponsors
• For example, in the U.S., corporate plans and employer plans are governed by the Employee Retirement Income Security Act of 1974 (ERISA) whereas the state and local government plans are governed by state law and regulations
multi-• ERISA imposes a higher standard of due diligence on the investment selection process and also legally obligates that DB plan must be operated for the sole interests of beneficiaries (plan participants), not the sponsor
2.1.7) Unique Circumstances This section of the IPS documents any circumstances unique to the DB pension plan and/or any details that are not covered elsewhere in the IPS For example,
• A preference for socially responsible funds;
• Investing in companies with high environmental standards;
• Self-imposed restrictions on investing in certain sector/industry/companies or certain asset classes e.g company with poor labor practices, company with poor environmental standards, high-risk assets like equities etc
• Size of the pension plan e.g smaller pension plans have lack of human and financial resources available to manage plan assets and to perform complex due diligence needed to investigate the investment characteristics of alternative investments (e.g private equity, hedge funds, and natural resources)
• Other specific considerations may include:
o Considerably high average employee age relative
Practice: Example 5,
Volume 2, Reading 13
Practice: Example 4,
Volume 2, Reading 13
Trang 6Investment policy statement (IPS) of a DB plan and
strategic asset allocation:
• The IPS must be reviewed annually or more
frequently as required by significant changes in:
o Laws or regulations;
o Funded status of the plan;
o Capital market conditions;
• The plan’s strategic asset allocation depends on the
following factors:
o Plan’s time horizon;
o Funded status of the plan;
o Company’s financial strength;
• The level of risk assumed by the plan is largely
determined by the plan’s strategic asset allocation
IMPORTANT TO NOTE:
The investment objectives of all the institutional investors
are set by its investment committee
2.1.8) Corporate Risk Management and the Investment
of DB Pension Assets From asset/liability management perspective, pension
investments should be managed relative to pension
liabilities as well as operating investments rather than
any external index benchmarks
For example, since pension plan liabilities are interest
rate sensitive, ALM approach involves a substantial use
of interest rate sensitive securities (particularly bonds)
2.2 Defined-Contribution Plans: Background and
Investment Setting NOTE:
In the following section, the investment policy statement
of participant-directed plans is discussed
2.2.1) The Objectives and Constraints Framework
Roles and Responsibilities of a Plan Sponsor in a DC
retirement plan:
• The plan sponsor is responsible to ensure adequate
diversification by offering a menu of plan investment
options, by limiting holdings in the sponsor’s
company stock and by monitoring the fund
objectives to facilitate participants to invest
according to their varying investment needs
• The plan sponsor is responsible to provide sufficient
investment information to participants on a regular
basis, basic principles of investing as well as
educational resources (e.g., sophisticated retirement
planning tools like Monte Carlo simulation
techniques) to plan participants to help them in
investment decision-making
• The plan sponsor is required to monitor the investment performance (including fees) of funds made available to plan participants
o Each fund’s performance is evaluated by the plan sponsor by comparing its time-weighted returns
and volatility of returns over at least past five years
or longer than that of appropriate market indexes and to peer group universes
• Terminating and replacing funds, selecting, monitoring and recommending the replacement of the Trustee/Recordkeeper of the plan when
judicious and appropriateness is also the responsibility of plan sponsor
• The plan sponsor must allow plan participants to
transfer funds between investment choices at least once every 90 days
• The plan sponsor has a legal obligation to establish a written IPS which helps the members of the plan in effectively establishing, monitoring, evaluating, and revising the investment program established for the
DC plan
An IPS for a participant-directed DC plan documents the following:
o A set of governing principles and rules
o The responsibilities of the plan sponsor, the plan participants, the fund managers, and plan trustee/record-keeper selected by the plan sponsor
o The procedure of selecting and evaluating a menu of plan options for meeting the fiduciary responsibility of ensuring diversification and ensuring that individual objectives and constraints can be met
o The investment strategies and alternatives available to the group of plan participants with varying risk and return characteristics and with sufficient diversification properties
o Criteria for monitoring and evaluating the performance of investment managers and investment vehicles relative to appropriate investment benchmarks
o Criteria for selecting, terminating and replacing manager/fund
o Effective communication procedures for the fund managers, the trustee/recordkeeper, the plan sponsor, and the plan participants
• It is important to note that Plan sponsor of a DC
pension plan complies with ERISA Section 404 (c)
circumstances, goals, and risk tolerance
• In a participant-directed DC plan, the plan sponsor is not required to counsel or advise the participants with regard to selecting and periodically evaluating investments; rather, it is the responsibility of plan participants (like individual investors) to decide asset allocation among investment alternatives, to Practice: Example 7,
Volume 2, Reading 13
Trang 7establish their savings and investment strategies and
to reallocate assets among funds as needed,
depending on significant changes in personal
circumstances
Hybrid plans have the characteristics of both DB and DC
plans and thus, provide the combined benefits of
traditional defined benefit and defined contribution
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: It is the most common type of
hybrid plan In a cash balance plan, a certain
percentage of salary of each employee is set aside
by the employer and interest is credited on these
contributions
• Like DB plans, the investment risk in cash balance
plans is borne by the plan sponsor In some cash
balance plans, the participants are allowed to
select among fixed-income and equity-based
options that generates investment risk for the
participants
• Like DC plans, the employees (participants) receive
a personalized statement outlining their individual
ownership, account balance, an annual
contribution credit, and an earnings credit that
facilitates portability to a new plan
• However, unlike a DC plan, the account balance is
hypothetical because the employee does not have
a separate account
Contribution credit = % of pay based on age, salary and/or length of employment
Earnings credit = % increase in the account balance
• At retirement, the participant has the option to either receive a lump-sum distribution which can be rolled into another qualified plan or receive a lifetime annuity
• Grandfather clause: Under a “Grandfather” clause, older workers are allowed to choose between joining a new cash balance plan and continuing with an existing traditional DB plan
2)Employee stock ownership plan (ESOP): It is a form of
DC plans under which the employees invest all or majority of plan assets in employer’s stock ESOPs encourage employee ownership in a company
• Like DC plans, the contribution credit in ESOPs is determined as a % of pay
• The final value of the plan for the employees depends on the vesting schedule, the level of contributions, and the change in the per-share value
of the stock
• These plans are subject to different regulations that vary among countries E.g some ESOPs require employee contributions, some ESOPs prohibit employee contributions, some ESOPs are allowed to sell stock to employees at a discount to market prices, while others may not, some ESOPs are required to rely on contributions and are not permitted to borrow to purchase large amounts of employer stock
• The plan participants in ESOPs must pay special attention to the overall diversification of their investments because the employees have both human (by working in a sponsoring company) and financial capital (by sponsoring company’s stock holdings) at stake in the company
Objectives of ESOPs:
• To encourage employee ownership in a company;
• To facilitate liquidation of a large block of company stock held by an individual or small group of people;
• To avoid a public offering of stock;
• To discourage an unfriendly takeover by increasing employee ownership in a company;
3)Pension equity plans 4)Target benefit plans 5)Floor plans
Practice: Example 8, 9 & 11,
Volume 2, Reading 13
Trang 83 FOUNDATIONS AND ENDOWMENTS
3.1 Foundations: Background and Investment Setting
Foundations are grant-making institutions funded by gifts
and investment assets
Four types of foundations:
1)Independent foundations or private/family
foundations: These are independent grant-making
institutions that are established to support social,
educational, charitable, or religious activities
•Sources of Funds: Independent foundations are
funded by an individual donor, family or group of
individuals to fund philanthropic goals Most of
private foundations do not receive additional assets
into their funds
•Decision-making Authority: Donor, members of
donor’s family, or independent trustees
•Annual Spending Requirement: The minimum
amount that private foundations are required to
spend for charitable purposes is known as “annual
spending requirement” In a given fiscal year, a
private foundation is required to spend 5% or more
of the average market value of its total asset values
in that year plus expenses associated with
generating investment return i.e
Minimum annual spending requirement = 5% of the
average market value of its total assets
•These foundations do not engage in fund-raising
campaigns, may not receive any new contributions
from the donor and do not receive any government
support As a result, most private foundations must
generate their entire grant-making and operating
budget from their investment portfolio
2)Company-sponsored foundations: It is a private
foundation whose grant-making funds are derived
primarily from the contributions of a corporation
(profit-making companies)
•Source of Funds: Endowment and/or annual
contributions from a profit-making corporation
•Decision-making Authority: Board of trustees, usually
controlled by the sponsoring corporation’s
executives
•Annual Spending Requirement: A
company-sponsored foundation is required to spend annually ≥
5% of 12-month average market value of its total
assets plus expenses associated with generating
investment return
Minimum annual spending requirement = 5% of the
average market value of its total assets
•Investment focus: Short-term, to fund philanthropic
activities
•It is subject to the same rules and regulations as
other private foundations
3)Operating foundations: Operating foundations are private foundations that use their income to support their own charitable activities rather than supporting other charitable organizations e.g a museum
• Sources of Funds: Funded by an individual donor, family or group of individuals They do not depend
on grants from third parties
• Decision-making Authority: Independent board of directors
• Annual Spending Requirement: An operating foundation is required to spend 85% of interest and dividend income to support an institution’s own programs In addition, it must spend at least 3.33% of the average market value of its total assets
• They are similar to public charities or educational endowments with respect to distributional requirements and tax treatment for donors
4)Community foundations: Community foundations area type of public charity that makes grants for social, educations, charitable, or religious purposes in
a specific geographic area, community, or region
• Sources of Funds: Multiple donors as they are funded
by the public
• Decision-making Authority: Board of directors
• Annual Spending Requirement: No spending requirement
3.1.1) Risk Objectives Unlike pension funds who have contractually defined pension liability (i.e benefit payments), foundations have undefined liabilities As a result, they can have moderate to higher risk tolerance and may accept higher year-to-year volatility, depending on spending rate and time horizon The above-average risk tolerance
is also implied by their long time horizon reflected by their aim to exist in perpetuity
aggressive risk and return objectives and adopt aggressive asset allocation by focusing more on equities, illiquid assets, and alternative assets
• Foundations with shorter time horizon (e.g due to being “spent down” over a predefined period of time and due to constant spending of funds on charitable programs) tend to have below-average risk tolerance Foundations with short time horizon follows conservative investment policy e.g with S.D
of annual returns between 5-7% (intermediate-term bonds typically fall in this range)
Risk objective may be stated as: “To minimize large fluctuations/volatility in spending to avoid disruption of the institution’s budget and finances and to provide a stable flow of funds”
Trang 93.1.2) Return Objectives
funding, then the primary objective of its investment
portfolio will be to provide a stable, reliable flow of
organization
perpetuity (i.e have infinitely long time horizon), their
long-term return objective is to preserve the real
(inflation-adjusted) value of the investment assets
while maintaining the minimum spending rate
requirement for providing a stable, reliable flow of
funds
intergenerational equity or neutrality (i.e equally
treating the interests of current beneficiaries and
future beneficiaries of the foundation’s support) by
both maintaining year-to-year budget stability and
protecting future purchasing power of the fund
against the impact of inflation
Return objective can be stated as:
“To earn rate of return that is sufficient to meet annual
spending needs, to pay expenses associated with
generating investment returns (e.g fees of managers,
consultants, custodians etc.) and to keep pace with
inflation”
In numerical terms, the required rate of return can be
stated as follows:
Minimum return requirement = Minimum annual
spending rate + Investment management expenses (i.e
cost of generating investment returns) + Expected
inflation rate
Or Minimum return requirement = [(1 + Minimum annual
spending rate) × (1 + Investment management expenses
(i.e cost of generating investment returns)) × (1 +
Expected inflation rate)] -1
rate for foundations
objective to earn a rate of return greater than the
return needed to maintain the purchasing power of
assets in an attempt to increase its grant-making
ability over time
urgent need (i.e with limited/short time horizon), it
may have the objective to earn a higher return
consistent with its risk tolerance ability
The performance of investment portfolio of a foundation
is evaluated (at least annually) by comparing the value
of foundation’s investment assets against the spending
rate + expenses + inflation
NOTE:
When a foundation is established to fund independent programs for only at most few years and it is not the primary source of funding available to those programs,
portfolio volatility while seeking high long-term investment returns
* It includes Minimum annual spending rate (including
“overhead” expenses e.g salaries) + Investment management expenses
Spending rules (i.e averaging or smoothing rules) can
be used by Foundations to:
values on spending distributions;
In addition, the tax authorities in the U.S allow forwards(which facilitate foundations to avoid penalties
carry-for under-spending in one year by spending more in a
subsequent year) and carry-backs (which allow
foundations to under-spend in a subsequent year in case of over-spending in prior years)
These carry-forwards and carry-backs facilitate implementation of smoothing rules as well as enable foundations to increase grant-making in a single year without jeopardizing the long-term sustainability of its investment program
Cash Reserve: Since the average of total asset values or the dollar value of its spending for a given fiscal year is not known to a foundation until the end of that year, a foundation needs to keep a cash reserve (e.g 10% or 20% of its annual grant-making and spending budget) This cash reserve is used to avoid spending all of the budgeted money before the year is ended and the 12-month average of asset values is known with greater certainty
Uses of Cash Reserve: Keeping cash reserve allows foundations to increase grants at the year-end during
“up” market years and avoid overspending in flat or
“down” market years
3.1.4) Time Horizon
• Most foundations are intended to operate in perpetuity which implies that they have infinitely
Trang 10long time horizon and consequently higher risk
tolerance, all else equal
perpetuity and may intend to spend down the
principal over a predefined period of time As a
result, as time passes, their time horizon shortens,
resulting in decrease in risk tolerance over time
3.1.5) Tax Concerns The foundation is tax-exempt under present U.S law as
long as it meets its minimum (5%) spending requirement
But, foundation’s unrelated business income is subject to
regular corporate tax rate An unrelated business
income is the income that is not related to charitable
purposes of a foundation For example, if the real estate
property is debt financed then income from real estate is
taxed as unrelated business income (however, in
proportion to the fraction of the property’s cost financed
with debt)
• A private foundation must pay a 2% excise tax
annually on its net investment income However, if
the charitable distribution for the year ≥ both 5% and
(Average of the previous 5 years’ payout + 1% of the
net investment income), then excise tax can be
reduced to 1% This favorable tax treatment is
basically provided to encourage spending on
charitable activities
NOTE:
Net investment income = (Dividends + Interest income +
Capital gains) –Foundation’s Expenses directly
associated with generation of investment income
(investment management & brokerage fees)
3.1.6) Legal and Regulatory Factors
Foundations may be subject to different legal and
regulatory constraints which vary among countries and
types of foundations In the U.S., foundations are
governed by Uniform Management of Institutional Funds
Act (UMIFA) and IRS (internal revenue service)
regulations In addition, all foundations must adhere to
prudent investor rule which means that all investments
must be evaluated from a portfolio perspective rather
than on a stand-alone basis This implies that a
foundation can invest in high risk investments that have
low correlations with portfolio assets
3.1.7) Unique Circumstances
This section of the IPS documents any circumstances
unique to the endowment or foundation and/or any
details that are not covered elsewhere in the IPS For
example,
• A preference for socially responsible funds;
• Investing in companies with high environmental
standards;
• Restrictions on investing in certain companies or
asset classes e.g gambling or tobacco;
• Investment manager-level constraints i.e limiting the
% of portfolio that may be invested in any given security
• Concentrated stock holdings and selling restrictions imposed by donor for the purpose of retaining voting rights Such selling restrictions impede an institution’s ability to diversify the risk associated with a
concentrated position
o Some foundations are allowed to use swap contracts or other derivative contracts to achieve diversification and to avoid fluctuations in the asset value associated with concentrated stock holdings
of a single company
3.2 Endowments: Background and Investment Setting
Endowments are long-term, permanent funds established to provide income for continued support of
a not-for-profit organization i.e universities and colleges, museums, hospitals, and other organizations
• Endowments are funded by individual gifts over time Some endowments may expect additional contributions from donor in the future
• Endowments are not subject to minimum spending requirements
Types of Endowments:
A.True Endowments: A true endowment refers to funds (i.e gifts) received from external donors with
permanent restriction that the principal (gift amount)
must be invested and maintained in perpetuity and cannot be spent; only the spending distributions can
be spent to support programs
B Quasi-endowments or Funds functioning as endowment (FFE): FFE refer to endowments established by the institution rather than by an external source with no restrictions on the use of principal They are treated as long-term financial capital They may be subject to self-imposed restrictions by the board; however, in extraordinary
self-imposed restriction and spend the FFE because
Restricted versus Unrestricted Endowment Funds:
Restricted Endowment funds: Restricted Endowment Funds are funds in which the spending is restricted by the donor to specified purposes e.g just to support a
Trang 11An endowment fund has two conflicting goals i.e
•Short-term goal is to provide a substantial, stable
and sustainable flow of income without frequent,
large fluctuations to support current operations of
the beneficiary institution; and
•Long-term goal is to preserve purchasing power of
endowment assets (i.e by protecting the real value
of the Endowment over time)
Trade-off between short-term and long-term objectives:
Too much current spending will erode the principal value
of the endowment fund, reducing its ability to support
operations in the future; too little current spending will
benefit future beneficiaries of the endowment fund at
the expense of current beneficiaries
•Similarly, investing in higher-yielding assets allows the
fund to increase spending distributions but ruins
endowment’s principal value by decreasing its
ability to generate adequate inflation-adjusted
long-term returns
•In addition, large fluctuations in year-to-year
spending can disrupt the endowed institution’s
operating budget, finances and staffing
To efficiently manage the trade-off between these two
competing objectives, an endowment needs to adopt a
spending rule that strikes a reasonable balance
between current spending distributions and reinvestment
of the remainder to protect the real value of the
Endowment over time
Spending Rules: In general,
Annual amount of Spending = % of an endowment’s
current market value
Or
Annual amount of Spending = % of an endowment’s
average trailing market value
•Spending rule based on average trailing market
value is preferred to use as it provides greater
stability in the annual amount of spending
Uses of Spending Rule:
•Helps in preserving the long-term objectives of the
endowment;
•Ensures smooth and predictable spending
distributions;
•Protects endowment assets against inflation;
•Dampens the adverse effect of volatility in asset
values on spending distributions and consequently
allowing the endowed institution to accept
short-term portfolio volatility while seeking high long-short-term
investment returns necessary to fund programs and
to maintain purchasing power
Examples of Spending Rules:
1)Simple spending rule:
Spending t = Spending rate × Endowment’s Ending
market value t-1NOTE:
Ending market value t-1 = Beginning market value t
2)Rolling three-year average spending rule:
Spending t = Spending rate × Endowment’s Average
market value of the last three fiscal year-ends
Spending t = Spending rate × (1/3) [Endowment’s Ending market value t-1+ Endowment’s Ending market value t-2 + Endowment’s Ending market value t-3] Advantage: This spending rule provides greater stability
in the annual amount of spending
Drawbacks: It places equal emphasis on market values three years ago and recent market values As a result, highly volatile returns three years ago may cause a dramatic change in spending in the current year despite stable returns in the last two years
3)Geometric smoothing rule: In this rule, annual spending amount is estimated as % of geometrically declining average of trailing endowment values adjusted for inflation i.e
Spendingt = Weighted average of the prior year’s spending adjusted for inflation + Spending rate ×
Beginning market value of the prior fiscal year
Spending t = Smoothing rate × [Spending t-1 × (1 + Inflation t-1)] + (1 – Smoothing rate) × (Spending rate × Beginning market value t-1 of the endowment)
It is considered as a more appropriate spending rule because:
• It places more emphasis on recent market values and less on past values
• By incorporating previous year’s beginning spending rather than ending endowment market value, this spending rule eliminates large fluctuations in year-to-year spending and aids the beneficiary institution to plan in advance for its operating budget needs
Trang 12•By adjusting spending levels towards the long-term
target spending level and for the changes in
endowment market value, this spending rule
provides stability in long-term purchasing power
NOTE:
Interpretation of a 75/25 smoothing rule: 75% of last
year’s spending and 25% of 5% of last year’s endowment
market value
3.2.1) Risk Objectives The Risk objectives of an endowment fund can be stated
in the following ways:
•To minimize the risk of dramatic decline in
endowment purchasing power (real value) over a
certain time horizon; or
•To minimize the risk of volatile short-term declines in
asset values or annual spending flows;
•To minimize the risk of substantial decline in support
for the operating budget
It is important to understand that taking low investment
risk does not necessarily imply low risk of purchasing
power impairment or low risk of not meeting endowment
objectives because low risk investments provide low
expected returns which decrease an endowment’s
ability to provide stable and sustainable flow of funds
In general, endowments have high risk tolerance (but
lower than that of foundations due to short-term
budgetary needs of beneficiary institution) and thus
higher ability to accept higher volatility in the short-term
to maximize long-term total returns as implied by the
following reasons:
•Long time horizon
•Predictable cash flows relative to spending
requirements
Risk Tolerance of Endowments is governed by the
following factors:
a)Smoothing rule: Endowments that use a smoothing
spending rule tend to have high tolerance for
assuming term portfolio risk (i.e volatile
short-term declines in asset values or annual spending
flows)which increases the endowment’s ability to take
on risk while striving for higher long-term returns
compared to endowments with no spending rule, all
else equal
b)Relative importance of the Endowment in the
operating budget of the beneficiary institution and
institution’s ability to adapt to drops in spending:
When an endowment’s contributions constitute a
substantial (minimal) portion of the beneficiary
institution’s annual budget, the endowment fund may
have below-average (above-average) risk tolerance
because poor investment returns may have serious
(little) impact on the endowed institution, all else
equal
c)Level of debt/ financial leverage and operating leverage in the Endowed Institution: All else being equal, when an endowed institution is debt-free and/or has low operating leverage, it has above-average risk tolerance In contrast, when an endowed institution has high financial leverage and/or high operating leverage, it has below-average risk tolerance, all else equal
d)Common risk exposures between donor and endowment fund: When both donor and its endowment fund are affected by same market forces then during poor market conditions donations and endowment income will fall at the same time, which implies below-average risk tolerance for the endowment fund
e)Short-term performance of endowment fund: An endowment with strong (poor) recent performance tends to have above-average (below-average) risk tolerance on short-term basis
• Despite long-term investment objective of endowment fund, it is important to have high tolerance for short-term volatility and strong short-term performance for several reasons i.e
o Poor recent investment returns may cause a decline in the level of endowment spending
o Investment staff and trustees are evaluated on relatively short-term frames
o The performance of endowment funds are often evaluated on an annual basis
f) Smoothed spending rate relative to target spending rate: When the smoothed spending rate is less (greater) than the long-term average or target rate then, on short-term basis, an endowment’s risk tolerance can be greater (lower) due to low (high) risk of a severe loss in purchasing power
g)Amount and Source of external funding: Endowments with a more stable or reliable external funding source (e.g public donations) tend to have higher risk tolerance, all else equal Similarly, the greater the external funding (donations), the lower the % of invested assets is required to meet current spending needs and consequently, the higher the risk
tolerance
NOTE:
It must be stressed that a high required return objective and an objective to meet relatively high spending needs imply a high willingness (not high ability) to accept risk For example, increase in expected inflation rate may make endowment to demand a higher real return to offset perceived increase in risk, reflecting higher risk tolerance in the form of higher willingness to take risk
3.2.2) Return Objectives
The primary objective of endowments is “to maintain or grow the value (i.e purchasing power after inflation) of endowment’s assets in perpetuity” and the secondary objective is “to achieve investment returns sufficient to provide substantial, stable, and sustainable flow of income needed to support ongoing operations”