Institutional Investor Portfolios Flashcards Preview

CFA Level III > Institutional Investor Portfolios > Flashcards

Flashcards in Institutional Investor Portfolios Deck (29):

DB Plan Vs DC Plan

DB Plan

  • Company makes payments and bears investment risk (company owned)
  • Assets/Liability is put on the balance sheet
  • Company makes investment decisions

DC Plan

  • Company contributes to 401(k) (participant owned)
  • Has portability since participant owns
  • Employee makes investment decision


DB Plan Return Objective

  • Minimum return is the actuarial discount rate (PV of future benfits)
  • Could be higher if not fully funded (1-2%)


Factors Affecting Pension Fund Risk Tolerance

  1. Plan Surplus: positive = higher risk tolerance. They may be willing to take more risk if negative but NOT ok
  2. Financial Status & Profitability: Debt-to-equity and profit margin. Better = high risk tolerance
  3. Profits and Pension: High correlation = less risk tolerance
  4. Liquidity: Liquidity provisions = less risk tolerance. (early retirement/lump-sum withdrawals)
  5. Time Horizon: Longer = higher risk tolerance (low avg worker age, retiree to employee ratio)


DB Plan Liquidity

Liquidity is affected by:

  • # of retired lives (more retired = more benefits paid)
  • amount of contributions
  • Plan features (early retirement/lump-sum)


DB Plan Time Horizon


  • Mostly considered long-term
  • Consider liability duration
  • Sometimes multi-stage (active lives vs retired lives)


DB Plan Taxes, Legal, and Unique


  • Tax-exempt (unless stated which then is a constraint)


  • ERISA regulated
  • Take into consideration laws of current country


  • Small plans have limited staff
  • Restriced asset classes or industries


Cash Balance Plan

  • Company bears investment risk
  • Bascially a small defined-benefit plan that is portable at retirement


Foundations vs Endowments

  • Same for IPS purposes
  • Foundation - funded by gifts
  • Endowments - long-term funds owned by a non-profit organzation


Types of Foundations

  1. Independent: from person or family
    1. Requires 5% spending of assets
  2. Company Sponsored: legally independent from company
    1. Requires 5% spending of assets
  3. Operating: Sole purpose of funding a company (museum, zoo)
    1. Requires 85% spending of dividends and interest
  4. Community: Publicly sponsored
    1. No spending requirements


Foundation Return Objectives

Typically to preserve real value and meet spending requirements


Example for Return (compounded):

Management costs 0.30%, distribution 5%, inflation 2%

Required return = (1.003)(1.05)(1.02) - 1 = 7.42%


Foundation/Endowment Spending Rules

  1. Simple: just a percent of MV
  2. Smoothing:
    1. Rolling 3- year: avg MV of last 3 years
      1. Makes more stable, ↑ risk tolerance


Foundation/Endowment Risk Tolerance

Often high. Increased by:

Lack of obligations/payouts
Inflows of new contributions


Foundation/Endowment Taxes

Mostly tax exempt

  • Look for specified returns that are taxed
  • Look for UBIT


Life Insurance Return Objectives

  • Earn the crediting rate needed to meet obligations
  • Earn additional net interest spread to increase surplus (to pay fees, etc.)
    • Surplus = competitive advantage (can charge less on premiums)
  • May be segmented by line of business


Life Insurance Risk Tolerance

  • Asset Liablity Management (ALM): match asset to liabilties to manage surplus
    • Could expose surplus to interest rate risk
  • Heavy regulated; limits on assets and amounts
  • Must be careful of reinvestment  and credit risk

Increased ability to take risk:

  • Higher surplus



Definition: Allowing policy holders to borrow against the policy value.

Increases when interest rates increase. Surplus would decrease


Life Insurance Taxes

Crediting rate is not taxed

Corporate share is taxed and increases with surplus


Life Insurance: Unique Circumstances

Look for:

  1. Diversity of product offering
  2. Limited company resources
  3. Concentrated risk exposures


Casualty Company Differences

  • Shorter liability duration (uncertain due to timing)
  • Longer processing periods for payouts
    • called long tailed risk (managed by matching with fixed income)
  • Can be highly concentrated (geographically and event risk)
  • Less predictable cash flows


Casualty Underwriting

  1. Tied to business cycle (last 3-5 years)
  2. Losses turn to profits (more strict and increase price, also no profit = no taxes)
  3. Profits attract capital and drive up competition


Casualty Return Objectives

  • Increase profitability (positive spread over crediting rate)
  • Grow the surplus


Bank Details

  • Take deposits (liabilities) and make loans (assets)
  • Reserve requirements must be met
  • Managed portfolio is for funds after loans/reserve


Bank Objectives

  • Manage interest rate risk: short duration to offset loans
  • Manage liquidity: high liquidity to offset loans
  • Generate income
  • Diversify credit risk
  • Return: earn a positive interest spread
  • Risk: ALM (most conservative)


Asset Only and Economic Liability

Asset Only

  • Soley focused on efficient portfolios (higher equities)
  • Ignores the pension liabilities (interest rate risk, inflation, etc)
  • Risk-free portfolio is cash

Economic Liability

  • Mimics liabilities (hard to mimic new entrants, changing demographics)
  • Risk-free portfolio is highly correlated with liabilities



Pension Liability Exposures

Pension Segment        Market/NonMarket       Risk      Liability Mimic

Inactive/ active accrued         Market                 Term        Nominal/Real

Active future wage growth    Market                 Term           Nominal

Active future wage growth    Market                Inflation      Real Return

Active future wage growth    Market           Econ Growth    Equities


Personal Liability Exposure Notes

*Benefits not indexed to inflation --> use nominal bonds
*Benefits indexed to inflation --> real return bonds
*Growth --> equities


Non Life vs Life


Risk Tolerance              Less regulated

Time Horizon                Shorter but with long tail

Liquidity                        Higher and less certain



Inflation Risk for Life & Non-Life

Life Insurance

payouts are nominal, so little inflation risk


insure replacement value and have inflation risk


MVO vs ALM Approach

With defined liabilities, recommend ALM

MVO has instability issues - constantly changes allocation
↑ transactions costs