2.1 Defined-Benefit Plans: Background and Investment Setting Pension plan’s performance should be judged relative to the adequacy of its assets with respect to funding pension liabiliti
Trang 1“ MANAGING, INSTITUTIONAL INVESTOR PORTFOLIOS ”
FS = Funded Status
DB = Defined Benefit
DC = Defined Contribution
PBO = Projected Benefit Obligation ABO = Accumulated Benefit Obligation
IR = Interest Rates
FI = Fixed Income ALM = Asset Liability Management
2 PENSION FUNDS
Plan sponsor’s obligation in terms of the
benefit to plan participants
Investment risk is borne by plan sponsor
Early termination risk
Types of Pension Plans
Sponsor’s obligation is to contribute to the pension fund
Participants bear the investment risk
Can be sponsor directed or participant directed
Cash balance plan ⇒ DB plan whose benefits are displayed in individual record keeping accounts
2.1 Defined-Benefit Plans: Background and Investment Setting
Pension plan’s performance should be judged relative to the adequacy of its assets with respect to funding pension liabilities
If plan’s assets are >< PV of plan’s liabilities, the plan is over (under)funded
Three basic liability concepts:
Total future liability ⇒ PV of accumulated & projected future service benefits
the no of retired lives, the pension fund’s liquidity requirements
the % of retirees, shorter the duration of pension liabilities
2.1.1 Risk Objectives
Direct relationship b/w FS & sponsor’s investment risk
correlation b/w the sponsor’s operating results & pension asset returns, ability to tolerate risk
Older the workforce, the risk tolerance
ALM approach is more suitable for DB pension plan
Surplus volatility & shortfall risk are important considerations
2.1.2 Return Objectives
Return requirement begins with the discount rate used to calculate the PV of plan liabilities
A realistic return objective is to minimize the amount of future pension contributions
A well funded plan can be in a position to generate pension income
2.1.3 Liquidity Requirement
the retirees, the liquidity requirement
Inverse relationship with contributions
Younger the workforce, the liquidity requirement
Trang 22.1.4 Time Horizon
Investment time horizon for a DB plan depends on:
The proportion of active & the age of workforce
Whether the plan is a going concern or plan termination is expected
2.1.5 Tax Concerns
DB pension plans are usually tax-exempt
2.1.6 Legal and Regulatory Factors
Pension plans are governed by laws & regulations
ERISA act 1974 governs U.S pension plans
2.1.7 Unique Circumstances
Smaller plans may face human & financial resources constraints
Self imposed constraints against investing in certain industries
2.1.8 Corporate Risk Management and the Investment of DB Pension Assets
Two important concerns:
the correlation b/w sponsor operating results & pension asset returns (lower risk tolerance)
Coordinating pension investments with pension liabilities
2.2 Defined-Contribution Plans: Background and Investment Setting
Principal issues for participant-directed DC plans are:
Diversification (sponsor must offer a list of investment options)
Company stocks holdings
2.2.1 The Objectives and Constraints Framework
Participants are responsible for choosing a risk & return objective
IPS describes the strategies & alternatives available to the participants
2.3 Hybrid and Other Plans
DB plan where the employer bears the investment risk
Personalized statement with account balance
DC plans that invest all or the majority of plan assets in employer stock
diversification
Trang 33 FOUNDATIONS AND ENDOWMENTS
Grant-making institutions funded by gifts & investment assets
Long term funds generally owned by operating non-profit institutions
3.1 Foundations: Background and Investment Setting
Types of foundations are:
Independent foundations
Company sponsored foundations
Operating foundations
Community foundations
Foundations can vary widely in time horizons & their investment goals
Private foundations are subject to payout requirement
3.1.1 Risk Objectives
Foundations can be more aggressive because of no contractual liability as
in pension fund
Return > than needed to maintain purchasing power is acceptable
3.1.2 Return Objectives
Foundations vary in their return objectives because:
Some are short term while others are long term in their nature
Minimum return requirement should cover the spending needs, inflation & management expenses
Anticipated or unanticipated cash needed in excess of contributions made
to the foundation
Smoothing rule is used to avoid large fluctuations in operating budget
Anticipated needs are captured by the spending rate
Cash reserve for contingencies by some private foundations
3.1.4 Time Horizon
Usually longer time horizon
Greater ability to bear risk
3.1.5 Tax Concerns
Not-for-charitable purposes income is taxed at regular corporate tax rates
Private foundation pays a 2% tax on its net investment (may reduced to 1%)
Trang 43.1.6 Legal and Regulatory Factors
Variety of legal & regulatory constraints (vary by country & sometimes by type of foundation)
3.1.7 Unique Circumstances
Single stock position restricted by the donor from diversifying
3.2 Endowments: Background and Investment Setting
Fund established to provide budgetary support for universities, colleges, hospitals etc
Not subject to legally required spending level
Spending Rule
⁄ [ ௧ିଵ+ ௧ିଶ+ ௧ିଷ]
Geometric Smoothing Rule
௧ିଵ
Place more emphasis on recent MV & less on past values
3.2.1 Risk Objectives
Depends on the endowment’s role in the operating budget & institution’s ability to in spending:
Lower the need for endowment contribution, the risk tolerance
the correlation b/w donor’s base & endowment, the risk tolerance
Large fixed expenditures can reduce risk tolerance
3.2.2 Return Objectives
Sum of spending rate, the expected inflation rate & management fee can serve as starting points for appropriate return objective
The relevant inflation rate may differ from that of the general economy
Long-term average spending rate must be < than the long term expected real return to preserve purchasing power
Trang 53.2.3 Liquidity Requirements
Perpetual nature & measured spending of true endowments limit their need for liquidity
Cash needs (to make spending distributions, to meet capital commitments &
to facilitate portfolio rebalancing transactions)
3.2.4 Time Horizon
Long term & multistage (in some cases)
3.2.5 Tax Concerns
Not a major concern (usually tax exempt)
3.2.6 Legal and & regulatory Factors
UMIFA is the primary governing legislation for endowments in U.S
3.2.7 Unique Circumstances
Socially responsible investing may become constraints (e.g child labor, gambling etc.)
4 THE INSURANCE INDUSTRY
Insurance industry has two broad categories:
Life insurance
Casualty insurance
Insurance companies are established either stock companies or mutual
Duration management is a major concern in investment setting
Risk of disintermediation becomes acute when IR are high:
One type of disintermediation occurs when policyholders borrow against cash value in insurance at below market policy loan rates
reinvest at higher rates
Some new insurance products are:
Universal life ⇒ provides premium flexibility & adjustable death benefits
Type of ordinary life insurance
Death benefits & cash values are linked to investment performance
Trang 64.1.1 Risk Objectives
claims
Insurance regulators have been moving towards risk-based capital to ensure adequate surplus
ALM approach is useful to control IR risk & liquidity for a life insurance company
Aspects of IR risk
Valuation concerns
Reinvestment risk
Credit risk & CF volatility are other risk objectives
4.1.2 Return Objectives
Specified primarily by the rates that actuaries use to determine policyholder reserves (minimum return requirement)
Desired net interest spread ⇒ diff b/w interest earned & interest credited
to policyholders
Surplus growth is another return objective
Segmentation has promoted sub-portfolio return objectives
4.1.3 Liquidity Requirements
A major concern in periods of sharply rising IR
In assessing liquidity needs, insurers must address the following
Disintermediation
Asset marketability risk
4.1.4 Time Horizon
Traditionally, life insurance companies were considered long term investors
ALM has tended to shorten the time horizon
4.1.5 Tax Concerns
Insurance companies are taxable investors so focus should be on after tax returns
Income can be viewed into two parts for tax purposes:
Portion related to the rate necessary to fund reserve is not taxed
Surplus is taxed
4.1.6 Legal and Regulatory Factors
Important concepts related to regulatory concerns include:
Eligible investments
Prudent investor rule
Valuation methods
4.1.7 Unique Circumstances
Company’s size & the sufficiency of its surplus position are among the considerations influencing portfolio policy
Trang 74.2 Non-Life Insurance Companies: Background and Investment Setting
These include health, property, liability, marine, surety insurance
Investment policies differ significantly from life insurance
Characteristics of non-life insurance industry:
Cyclical in nature
Long tail nature of liabilities
Underwriting cycle
Business cycle
4.2.1 Risk Objectives
Ability to meet policyholder’s claims is a dominant consideration
Inflation must be considered due to replacement cost or current cost coverage
The ratio of premium income to total surplus should be maintained b/w +2 to 1 to 3 to 1
Volatile stock market conditions lower the % of surplus invested in equities
4.2.2 Return Objectives
Factors influencing return objective include:
return objectives
primary determinants
volume of insurance
Tax considerations ⇒ flexibility to shift b/w taxable & tax exempt bonds
Total return management
4.2.3 Liquidity Requirements
Important consideration due to uncertainty of the CF
Casualty Company needs to manage the marketability schedule
4.2.4 Time Horizon
Duration of causality liabilities are typically than life insurance liabilities
Under writing cycle affect the mix of taxable & tax exempt bond holdings
Long-term equity investor status has been modified due to turnover in stocks portfolio
4.2.5 Tax Concerns
Tax is an important consideration:
Asset allocation b/w taxable& tax exempt bonds
Subject to tax code modification
Trang 84.2.6 Legal and Regulatory Factors
No asset valuation reserve requirement
Subject to risk-based capital requirement
Eligible asset classes & quality standard for each class are subject to regulations
4.2.7 Determination of Portfolio Policies
In determining investment policy, limited investment risk tolerance & difficulty in forecasting
CF are important considerations
5.1 Banks: Background and Investment Setting
=
Play a key role in managing bank’s risk & liquidity positions
Profitability measures:
Interest spread ⇒ interest yield –interest cost of liabilities
Risk measures:
Leverage-adjusted duration gap ⇒ − ×
where
= duration of assets
= duration of liabilities
For a +ve (-ve) IR shock: the MV of net worth () for a bank with +ve (-ve) gap
given level of probability
5 BANKS AND OTHERINSTITUTIONAL INVESTORS
Securities Portfolio’s Objectives
Adjustment mechanism for IR risk
To assure adequate liquidity
To produce income
To modify & diversify overall credit risk
To meet other needs e.g pledging requirement
Portfolio’s Objectives
ALM considerations
Below-avg risk tolerance
+ve return on invested capital
Positive spread over the cost of funds
Trang 9Portfolio’s Constraints
Determined by:
Net outflow of deposits
Demand for loans
Liability structure reflects an overall shorter maturity than its loan portfolio
Time horizon is usually intermediate term
common shares & below investment grade bonds
Risk based capital regulations
Factors such as loan concentration & community needs are important considerations
5.2 Other Institutional Investors: Investment Intermediaries
Investment companies serve as financial intermediate
Pooled investor funds usually invested in equity & F.I markets
individuals & subject to fewer regulations