MIP CH 3: Managing Institutional Investor Portfolios

Question 1

Describe institutional investors

Answer 1

• Institutional investors are legal entities that ultimately serve as intermediaries between individuals and investment markets
• Examples include:
  
  • DB/DC plans
  • Foundations and Endowments
  • Life and Non-Life Insurance Companies
  • Banks

Question 2

State some of the key differences between DB and DC pension plans.

Answer 2

1. A DC plan has no financial liability; a DB plan does
2. DC plan participants bear the investment risk; the plan sponsor bears this risk for DB plans
3. The contributions and investment returns legally belong to the DC plan participant
4. DC retirement assets are more portable (subject to vesting and tax penalties)

Question 3

Describe foundations vs. endowments.

Answer 3

• Foundations are grant-making institutions funded by gifts and investment income
• Foundations are usually funded by a single donor
• Endowments are long-term funds owned by nonprofit institutions like universities and hospitals
• Endowments are usually funded by many people over time

Question 4

State the objectives in managing securities portfolios

Answer 4

1. Manage overall risk of the balance sheet
2. Manage liquidity
3. Produce income
4. Manage credit risk (substantial credit risk is already in the loan portfolio)
5. To meet other needs (e.g. regulatory constraints)

Question 5

How is net interest margin calculated?

Answer 5

• Net interest margin equals interest income minus interest expense, divided by average earning assets
• Or, equivalently, net interest margin is the ratio of net interest income to invested assets

Question 6

How is the leverage-adjusted duration gap calculated?

Answer 6

D_A - kD_L
k = L/A

Question 7

Describe the impact from interest rate changes for a company with a positive
leverage-adjusted duration gap

Answer 7

If interest rates fall, the company will have a gain (assets increase more than liabilities)

Question 8

What are the principal investment issues for DC plans?

Answer 8

1. Diversification
   
   • ERISA requires at least three options and granting the participant rights to move between the options at least quarterly
2. Company stock
   
   • Should be limited to ensure diversification

Question 9

Describe cash balance pension plans.

Answer 9

• Sponsor bears the investment risk
• Looks like a DC plan to the participant (account balance, contribution credit, earnings credit)
• Contribution credit is percentage of pay based on age
• Earnings credit tied to long-term interest rates
• Usually from converted DB plans; the conversion often hurts older workers with many years of service

Question 10

Describe Employee Stock Ownership Plan (ESOP) pension plans.

Answer 10

• Much of the plan assets are invested in employee stock
• The contribution is usually a percentage of the employee pay
• Some sell the stock at a discount
• Some allow employee contribution, while others prohibit it
• A problem occurs if the company fails because the participant may lose their job and much of their retirement savings at the same time

Question 11

State the four main types of foundations.

Answer 11

1. Independent (funded by individual donor and usually requiring payouts of at least 5% annually; this is the dominant type of foundation)
2. Company sponsored (usually short-term focus)
3. Operating (income to support specific programs)
4. Community (fund a variety of grants)