As the aged population around the world grows more rapidly than any other age group, issues of saving for the long run, for the most part surrounding retirement, have come to the fore of the investments industry. Traditionally, the advice for the long run could be summa- rized by rules of thumb concerning various rates of gradual, age-determined shifts in asset allocation from risky to safe assets. Implications of “modern” portfolio management, now more than 30 years old, originated from Merton’s lifetime consumption/investment model (ICAPM) suggesting that one consider hedge assets to account for extramarket sources of risk, such as inflation, and needs emanating from uncertain longevity.
In previous sections, we presented the CFA Institute process of devising investment programs for individual investments, as well as for concerns of various institutions. Here we emphasize two important aspects of investment for the long run based on insights from recent research, namely, duration matching and the term structure of volatilities.
Advice from the Mutual Fund Industry
Many employees don’t know the basics of how to invest wisely, despite the wealth of infor- mation on the Internet and countless books and magazines freely available at libraries. The mutual fund industry’s list of basic investing rules includes the following:
• Don’t try to outguess the market by pulling money out or putting it in just because
the market is suddenly up or down. The long-term trend for the market is up (the market risk premium is positive); buying and holding generally pays off.
• Diversify investments to spread risk.
• Put portions of the money into stocks, bonds, and money-market funds. Within
these categories there are additional choices to help further diversify, for example, corporate bonds, government bonds, municipal bonds.
• Avoid keeping 401(k) money in a company’s default investment scheme. It’s
usually a low-risk fund with a correspondingly low rate of return.
• Be wary of investing a large percentage of your 401(k) in your company’s stock.
If your company falters, you could lose your job and your nest egg at once.
As useful as it is, this list neglects some important fundamentals.
Target Investing and the Term Structure of Bonds
Interest rates usually vary by maturity. For example, a person considering investing money in an insured certificate of deposit or a Treasury security will observe that the interest rate she can earn depends on its maturity. Thus, for any given target date there is a different risk-free interest rate. Each investor, with a unique horizon, therefore has his or her own risk-free asset. For Mr. Short it is bills and for Ms. Long it is bonds. Thus, to accommodate investors with different time horizons, there must be a menu of choices that has a term structure of risk-free investments. The principle of duration matching means matching one’s assets to one’s objectives (liabilities) and is equivalent to the immunization strategy for pension funds that we examined in Chapter 16.
In what unit of account should the risk-free term structure be denominated? This is a critical issue because a bond is risk-free only in terms of a specified numeraire (unit of account), such as dollars, yen, and so on. Thus, if a bond promises to pay $100 two years from now, its payoff in terms of yen depends on the dollar price of the yen 2 years from now, and vice versa. Thus even a zero-coupon bond with no default risk can still be very risky if it is denominated in a unit of account (such as a foreign currency) that does not match the investor’s goal. This type of risk is called “basis risk.”
To illustrate, assume the goal is retirement. If the goal is specified as a level of real wealth at the retirement date, then the unit of account should be consumption units.
The risk-free asset in this case would be a bond with a payoff linked to an index of consumer prices, such as the CPI. However, if the index chosen does not truly reflect the specific investor’s future cost of living, there will be some risk. If the goal is to maintain a certain standard of living for the rest of one’s life, then instead of a fixed level of retirement wealth in terms of consumption units, a more appropriate unit of account would be a lifetime flow of real consumption. This can be computed by divid- ing dollar amounts by the market price of a lifetime real annuity that starts paying benefits at the target retirement date. The term structure is then given by the prices of lifetime real annuities with different starting dates. Similarly, education bonds that
are linked to the cost of college education provide the appropriate unit of account for children’s college funds.
Making Simple Investment Choices
A target-date retirement fund (TDRF) is a fund of funds diversified across stocks and bonds with the feature that the proportion invested in stocks is automatically reduced as time passes. 4 TDRFs are often advocated as the simple solution to the complex task of determining the appropriate asset allocation among funds in 401(k) plans, IRAs, and other personal investment accounts. TDRFs are marketed as enabling investors to put their investment plans on autopilot. Once you choose a fund with a target year matching your horizon, the life cycle manager moves some of your money out of stocks and into bonds as your retirement date nears. But this will be optimal only for individuals with “typical”
human capital risk and tolerance for market risk.
An improved design for TDRFs would offer at least one additional fund to each age cohort of life cycle investors: a risk-free investment portfolio with a matching investment horizon.
Individuals could mix the TDRF and the risk-free fund depending on their personal charac- teristics. Under such a portfolio policy, the individual continues to be exposed to equity risk via human capital risk. Directing individuals based on their personal characteristics to either the TDRF and/or the risk-free fund matching their investment horizon would add an addi- tional degree of freedom that generates economically significant individual welfare gains. 5
Inflation Risk and Long-Term Investors
While inflation risk is usually low for short horizons, it is a first-order source of risk for retirement planning, where horizons may be extremely long. An inflation “shock” may last for many years, and impart substantial uncertainty to the purchasing power of any dollar you (or your client) have saved for retirement.
A conventional answer to the problem of inflation risk is to invest in price-indexed bonds such as TIPS (see Chapter 14 for a review). This is a good first step but is not a full answer to inflation risk. A zero-coupon priced-indexed bond with maturity equal to an investor’s horizon would be a riskless investment in terms of purchasing power. This can be achieved with CPI-indexed savings bonds, but the government limits the amount of such bonds one may buy in any year. Unfortunately, market-traded TIPS bonds are not risk-free. As the (real) interest rate changes, the value of those bonds will fluctuate.
Moreover, these bonds pay coupons, so the accumulated (real) value of the portfolio is sub- ject to reinvestment-rate risk. These issues should remind you of our discussion of bond risk in Chapter 16. In this context too, one must balance price risk with reinvestment rate risk by tailoring the duration of the bond portfolio to the investment horizon. But in this case, we need to calculate duration using the real interest rate and focus on real payoffs from our investments.
4 Vanguard describes its TDRFs as follows: “With Target Retirement Funds, you have only one decision to make:
when you plan to retire. Your Target Retirement Fund automatically grows more conservative as your retire- ment date nears. When you are ready to draw income in your retirement, your Target Retirement Fund has a stable, income-oriented mix of assets.” From “Choose a Simple Solution: Vanguard Target Retirement Funds,”
www.vanguard.com/jumppage/retire.
5 The model is detailed in Zvi Bodie and Jonathan Treussard, “Making Investment Choices as Simple as Possible but Not Simpler,” Financial Analysts Journal 63 (May–June 2007).
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1. When the principles of portfolio management are discussed, it is useful to distinguish among seven classes of investors:
a. Individual investors and personal trusts.
b. Mutual funds.
c. Pension funds.
d. Endowment funds.
e. Life insurance companies.
f. Non–life insurance companies.
g. Banks.
In general, these groups have somewhat different investment objectives, constraints, and portfolio policies.
2. To some extent, most institutional investors seek to match the risk-and-return characteristics of their investment portfolios to the characteristics of their liabilities.
3. The process of asset allocation consists of the following steps:
a. Specifying the asset classes to be included.
b. Defining capital market expectations.
c. Finding the efficient portfolio frontier.
d. Determining the optimal mix.
4. People living on money-fixed incomes are vulnerable to inflation risk and may want to hedge against it. The effectiveness of an asset as an inflation hedge is related to its correlation with unanticipated inflation.
5. For investors who must pay taxes on their investment income, the process of asset allocation is complicated by the fact that they pay income taxes only on certain kinds of investment income.
Interest income on munis is exempt from tax, and high-tax-bracket investors will prefer to hold them rather than short- and long-term taxable bonds. However, the really difficult part of the tax effect to deal with is the fact that capital gains are taxable only if realized through the sale of an asset during the holding period. Investment strategies designed to avoid taxes may conflict with the principles of efficient diversification.
6. The life cycle approach to the management of an individual’s investment portfolio views the individual as passing through a series of stages, becoming more risk averse in later years. The rationale underlying this approach is that as we age, we use up our human capital and have less time remaining to recoup possible portfolio losses through increased labor supply.
7. People buy life and disability insurance during their prime earning years to hedge against the risk associated with loss of their human capital, that is, their future earning power.
8. There are three ways to shelter investment income from federal income taxes besides investing in tax-exempt bonds. The first is by investing in assets whose returns take the form of appreciation in value, such as common stocks or real estate. As long as capital gains taxes are not paid until the asset is sold, the tax can be deferred indefinitely.
The second way of tax sheltering is through investing in tax-deferred retirement plans such as IRAs. The general investment rule is to hold the least tax-advantaged assets in the plan and the most tax-advantaged assets outside of it.
The third way of sheltering is to invest in the tax-advantaged products offered by the life insurance industry—tax-deferred annuities and variable and universal life insurance. They com- bine the flexibility of mutual fund investing with the tax advantages of tax deferral.
9. Pension plans are either defined contribution plans or defined benefit plans. Defined contribution plans are in effect retirement funds held in trust for the employee by the employer. The employees in such plans bear all the risk of the plan’s assets and often have some choice in the allocation of those assets. Defined benefit plans give the employees a claim to a money-fixed annuity at r etirement. The annuity level is determined by a formula that takes into account years of service and the employee’s wage or salary history.
SUMMARY
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10. If the only goal guiding corporate pension policy were shareholder wealth maximization, it would be hard to understand why a financially sound pension sponsor would invest in equities at all. A policy of 100% bond investment would both maximize the tax advantage of funding the pension plan and minimize the costs of guaranteeing the defined benefits.
11. If sponsors viewed their pension liabilities as indexed for inflation, then the appropriate way for them to minimize the cost of providing benefit guarantees would be to hedge using securities whose returns are highly correlated with inflation. Common stocks would not be an appropriate hedge because they have a low correlation with inflation.
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risk–return trade-off personal trusts income beneficiaries remaindermen
defined contribution plans defined benefit plans endowment funds
whole-life insurance policy term insurance
variable life universal life liquidity
investment horizon prudent investor rule
tax-deferral option
tax-deferred retirement plans deferred annuities
fixed annuities variable annuities mortality tables immunization
KEY TERMS
1. Your neighbor has heard that you successfully completed a course in investments and has come to seek your advice. She and her husband are both 50 years old. They just finished making their last payments for their condominium and their children’s college education and are planning for retirement. What advice on investing their retirement savings would you give them? If they are very risk averse, what would you advise?
2. What is the least-risky asset for each of the following investors?
a. A person investing for her 3-year-old child’s college tuition.
b. A defined benefit pension fund with benefit obligations that have an average duration of 10 years. The benefits are not inflation-protected.
c. A defined benefit pension fund with benefit obligations that have an average duration of 10 years. The benefits are inflation-protected.
3. George More is a participant in a defined contribution pension plan that offers a fixed-income fund and a common stock fund as investment choices. He is 40 years old and has an accumula- tion of $100,000 in each of the funds. He currently contributes $1,500 per year to each. He plans to retire at age 65, and his life expectancy is age 80.
a. Assuming a 3% per year real earnings rate for the fixed-income fund and 6% per year for common stocks, what will be George’s expected accumulation in each account at age 65?
b. What will be the expected real retirement annuity from each account, assuming these same real earnings rates?
c. If George wanted a retirement annuity of $30,000 per year from the fixed-income fund, by how much would he have to increase his annual contributions?
4. The difference between a Roth IRA and a conventional IRA is that in a Roth IRA taxes are paid on the income that is contributed but the withdrawals at retirement are tax-free. In a conventional IRA, however, the contributions reduce your taxable income, but the withdrawals at retirement are taxable. Try using the Excel spreadsheet introduced in the Appendix to answer these questions.
a. Which of these two types provides higher after-tax benefits?
b. Which provides better protection against tax rate uncertainty?
PROBLEM SETS
i. Basic
ii. Intermediate
1. Angus Walker, CFA, is reviewing the defined benefit pension plan of Acme Industries. Based in London, Acme has operations in North America, Japan, and several European countries. Next month, the retirement age for full benefits under the plan will be lowered from age 60 to age 55.
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The median age of Acme’s workforce is 49 years. Walker is responsible for the pension plan’s investment policy and strategic asset allocation decisions. The goals of the plan include achiev- ing a minimum expected return of 8.4% with expected standard deviation no greater than 16.0%.
Walker is evaluating the current asset allocation ( Table 28A ) and selected financial informa- tion for the company ( Table 28B ). There is an ongoing debate within Acme Industries about the pension plan’s investment policy statement (IPS). Two investment policy statements under consideration are shown in Table 28C .
a. Determine, for each of the following components, whether IPS X or IPS Y (see Table 28C ) has the appropriate language for the pension plan of Acme Industries. Justify each response with one reason.
i. Return requirement ii. Risk tolerance iii. Time horizon iv. Liquidity
Note: Some components of IPS X may be appropriate, while other components of IPS Y may be appropriate.
International Equities (MSCI World, excluding U.K.) 10%
U.K. bonds 42
U.K. small capitalization equities 13
U.K. large capitalization equities 30
Cash 5
Table 28A
Acme pension plan: Current asset allocation Acme Industries total assets £ 16,000 Pension plan data:
Plan assets 6,040
Plan liabilities 9,850
Table 28B
Acme Industries selected financial information (in millions)
IPS X IPS Y
Return requirement Plan’s objective is to outperform the relevant benchmark return by a substantial margin.
Plan’s objective is to match the relevant benchmark return.
Risk tolerance Plan has a high risk tolerance because of the long-term nature of the plan and its liabilities.
Plan has a low risk tolerance because of its limited ability to assume substantial risk.
Time horizon Plan has a very long time horizon because of the plan’s infinite life.
Plan has a shorter time horizon than in the past because of plan demographics.
Liquidity Plan needs moderate level of liquidity to fund monthly benefit payments.
Plan has minimal liquidity needs.
Table 28C
Investment policy statements
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b. To assist Walker, Acme has hired two pension consultants, Lucy Graham and Robert Michael.
Graham believes that the pension fund must be invested to reflect a low risk tolerance, but Michael believes the pension fund must be invested to achieve the highest possible returns.
The fund’s current asset allocation and the allocations recommended by Graham and Michael are shown in Table 28D . Select which of the three asset allocations in Table 28D is most appropriate for Acme’s pension plan. Explain how your selection meets each of the following objectives or constraints for the plan:
i. Return requirement ii. Risk tolerance iii. Liquidity
2. Your client says, “With the unrealized gains in my portfolio, I have almost saved enough money for my daughter to go to college in 8 years, but educational costs keep going up.” On the basis of this statement alone, which one of the following appears to be least important to your client’s investment policy?
a. Time horizon.
b. Purchasing power risk.
c. Liquidity.
d. Taxes.
3. The aspect least likely to be included in the portfolio management process is a. Identifying an investor’s objectives, constraints, and preferences.
b. Organizing the management process itself.
c. Implementing strategies regarding the choice of assets to be used.
d. Monitoring market conditions, relative values, and investor circumstances.
4. Sam Short, CFA, has recently joined the investment management firm of Green, Spence, and Smith (GSS). For several years, GSS has worked for a broad array of clients, including employee benefit plans, wealthy individuals, and charitable organizations. Also, the firm expresses exper- tise in managing stocks, bonds, cash reserves, real estate, venture capital, and international secu- rities. To date, the firm has not utilized a formal asset allocation process but instead has relied on the individual wishes of clients or the particular preferences of its portfolio managers. Short recommends to GSS management that a formal asset allocation process would be beneficial and emphasizes that a large part of a portfolio’s ultimate return depends on asset allocation. He is asked to take his conviction an additional step by making a proposal to executive management.
a. Recommend and justify an approach to asset allocation that could be used by GSS.
b. Apply the approach to a middle-aged, wealthy individual characterized as a fairly conserva- tive investor (sometimes referred to as a “guardian investor”).
5. Jarvis University (JU) is a private, multiprogram U.S. university with a $2 billion endowment fund as of fiscal year-end May 31, 2009. With little government support, JU is heavily d ependent
Current Graham Michael
U.K. large capitalization equities 30 20 40
U.K. small capitalization equities 13 8 20
International equities (MSCI World ex-U.K.) 10 10 18
U.K. bonds 42 52 17
Cash 5 10 5
Total 100 100 100
Expected portfolio return (%) 9.1 8.2 10.6
Expected portfolio volatility (standard deviation in %) 16.1 12.8 21.1
Table 28D
Asset allocations (in %)