R15 Managing Institutional Investor Portfolios

Question 1

R15

DB Pension Fund General

Answer 1

• Accumulated benefit obligation (ABO). - The present value of pension benefits, assuming the pension plan terminated immediately such that it had to provide retirement income to all beneficiaries for their years of service up to that date.
• Projected benefit obligation (PBO) - A measure of a pension plan’s liability that reflects accumulated service in the same manner as the ABO but also projects future variables, such as compensation increases.
• Total future liability - With respect to defined-benefit pension plans, the present value of accumulated and projected future service benefits, including the effects of projected future compensation increases.

Question 2

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DB Pension Fund RISK

Answer 2

• Higher pension surplus or higher funded status implies greater risk tolerance.
• Lower debt ratios and higher current and expected profitability imply greater risk tolerance.
• Correlation of sponsor operating results with pension asset returns. The lower the correlation, the greater risk tolerance, all else equal.
• Provision for early retirement and provision for lump-sum distributions. Such options tend to reduce the duration of plan liabilities, implying lower risk tolerance, all else equal.
• The younger the workforce and the greater the proportion of active lives, the greater the duration of plan liabilities and the greater the risk tolerance.

Question 3

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DB Pension Fund RETURN

Answer 3

• Fund its pension liabilities on an inflation-adjusted basis.
• If pension assets equal the present value of pension liabilities and if the rate of return earned on the assets equals the discount rate used to calculate the present value of the liabilities, then pension assets should be exactly sufficient to pay for the liabilities as they mature. Therefore, for a fully funded pension plan, the portfolio manager should determine the return requirement beginning with the discount rate used to calculate the present value of plan liabilities.
• Return desire may be higher than its return requirement
• If the plan has a young and growing workforce, the sponsor may set a more aggressive return objective than it would for a plan that is currently closed to new participants and facing heavy liquidity requirements.
• May manage investments for the active-lives portion of pension liabilities according to risk and return objectives that are distinct from those they specify for the retired-lives portion.

Question 4

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DB Pension Fund LIQUIDITY

Answer 4

• The net cash outflow (benefit payments minus pension contributions) constitutes the pension’s plan liquidity requirement.
• 3 Main issues affecting liquidity:

1. The greater the number of retired lives, the greater the liquidity requirement, all else equal.
2. The smaller the corporate contributions in relation to benefit disbursements, the greater the liquidity requirement. The need to make contributions depends on the funded status of the plan. For plan sponsors that need to make regular contributions, young, growing workforces generally mean smaller liquidity requirements than older, declining workforces.
3. Plan features such as the option to take early retirement and/or the option of retirees to take lump-sum payments create potentially higher liquidity needs.

• When a pension fund has substantial liquidity requirements, it may hold a buffer of cash or money market instruments to meet such needs.

Question 5

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DB Pension Fund TIME HORIZON

Answer 5

• Overall time horizon for many going-concern DB plans is long.
• Depends on:

1. whether the plan is a going concern or plan termination is expected
2. the age of the workforce and the proportion of active lives. When the workforce is young and active lives predominate, and when the DB plan is open to new entrants, the plan’s time horizon is longer.

Question 6

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DB Pension Fund TAX

Answer 6

• Investment income and realized capital gains within private defined-benefit pension plans are usually exempt from taxation

Question 7

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DB Pension Fund LEGAL REGULATORY

Answer 7

• All retirement plans are governed by laws and regulations that affect investment policy.
• United States, corporate plans and multi-employer plans are governed by the Employee Retirement Income Security Act of 1974 (ERISA)
• The institutional practitioner to understand and apply the law and regulations of the entity having jurisdiction when developing investment polic

Question 8

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DB Pension Fund UNIQUE

Answer 8

• Investment in alternative investments often requires complex due diligence
• Self-imposed constraint against investing in certain industries viewed as having negative ethical or welfare connotations, or in shares of companies operating in countries with regimes against which some ethical objection has been raised.

Question 9

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DC Pensions

Answer 9

• participant-directed v sponsor-directed plan [similar to DB]
• The principal investment issues for DC plans are as follows:

1. Diversification - sponsor must offer a menu of investment options that allows participants to construct suitable portfolios.
2. Company Stock -oldings of sponsor-company stock should be limited to allow participants’ wealth to be adequately diversified.

• An IPS for a participant-directed DC plan is the governing document that describes the investment strategies and alternatives available to the group of plan participants characterized by diverse objectives and constraints.

Question 10

R15

Hybrid Pensions

Answer 10

• 2 main types - cash balance and ESOP
• Cash Balance:

1. employer bears the investment risk
2. To employee it looks like a DC plan because they are provided a personalized statement showing their account balance, an annual contribution credit, and an earnings credit
3. Traditional DB plans that have been converted in order to gain some of the features of a DC plan.
4. Unfair to older workers - “grandfather” clause

• ESOP:

1. DC plans that invest all or the majority of plan assets in employer stock.
2. Have been used by companies to liquidate a large block of company stock held by an individual or small group of people, avoid a public offering of stock, or discourage an unfriendly takeover by placing a large holding of stock in the hands of employees via the ESOP trust.
3. An important concern for ESOP participants is that their overall investments (both financial and human capital) reflect adequate diversification.

Question 11

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Independent foundation (private or family)

Answer 11

• Independent foundation (private or family)
• Independent grant-making organization established to aid social, educational, charitable, or religious activities.
• Generally an individual, family, or group of individuals are source of funds
• Donor, members of donor’s family, or independent trustees make decisions
• At least 5% of 12-month average asset value, plus expenses associated with generating investment return.

Question 12

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Company-sponsored foundation

Answer 12

• Company-sponsored foundation
• A legally independent grant-making organization with close ties to the corporation providing funds.
• Endowment and/or annual contributions from a profit-making corporation are source of funds
• Board of trustees, usually controlled by the sponsoring corporation’s executives make decisions
• Same as independent foundation.

Question 13

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Operating foundation

Answer 13

• Organization that uses its resources to conduct research or provide a direct service (e.g., operate a museum).
• Largely the same as independent foundation. Source of funds from profit making corporation
• Independent board of directors make decisions
• Must use 85% of interest and dividend income for active conduct of the institution’s own programs. Some are also subject to annual spending requirement equal to 3.33% of assets.

Question 14

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Community foundation

Answer 14

• A publicly supported organization that makes grants for social, educational, charitable, or religious purposes. A type of public charity.
• Multiple donors; the public provide funds
• Board of directors make decisions
• No spending requirement.

Question 15

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Foundations: RISK

Answer 15

• Foundations can have a higher risk tolerance.
• Pension funds have a contractually defined liability stream in contrast, foundations have no such defined liability
• It is also acceptable, if risky, for foundations to try to earn a higher rate of return than is needed to maintain the purchasing power of assets

Question 16

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Foundations: RETURN

Answer 16

• Some foundations are meant to be short lived; others are intended to operate in perpetuity.
• For those foundations with an indefinitely long horizon, the long-term return objective is to preserve the real (inflation-adjusted) value of the investment assets while allowing spending at an appropriate (either statutory or decided-upon) rate
• Intergenerational equity or neutrality - an equitable balance between the interests of current and future beneficiaries of the foundation’s support.

Question 17

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Foundations: LIQUIDITY

Answer 17

• Anticipated or unanticipated needs for cash in excess of contributions made to the foundation.
• Smoothing rule - With respect to spending rates, a rule that averages asset values over a period of time in order to dampen the spending rate’s response to asset value fluctuation.
• It is prudent for any organization to keep some assets in cash as a reserve for contingencies, but private and family foundations need a cash reserve for a special reason: They are subject to the unusual requirement that spending in a given fiscal year be 5 percent or more of the 12-month average of asset values in that year.

Question 18

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Foundations: TIME HORIZON

Answer 18

• The majority of foundation wealth resides in private and other foundations established or managed with the intent of lasting into perpetuity.
• Some institutions, however, are created to be “spent down” over a predefined period of time; therefore, they pursue a different strategy, exhibiting an increasing level of conservatism as time passes.

Question 19

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Foundations: TAX CONCERNS

Answer 19

• unrelated business income will be subject to regular corporate tax rates
• Income from real estate is taxable as unrelated business income if the property is debt financed, but only in proportion to the fraction of the property’s cost financed with debt.

Question 20

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Foundations: LEGAL REGULATORY

Answer 20

• Foundations may be subject to a variety of legal and regulatory constraints.
• In the United States, many states have adopted the Uniform Management of Institutional Funds Act (UMIFA) as the primary legislation governing any entity organized and operated exclusively for educational, religious, or charitable purposes.

Question 21

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Foundations: UNIQUE

Answer 21

• A special challenge faces foundations that are endowed with the stock of one particular company and that are then restricted by the donor from diversifying.
• With the permission of the donor, some institutions have entered into swap agreements or other derivative transactions to achieve the payoffs of a more diversified portfolio.

Question 22

R15

Endowments: General

Answer 22

• Provide a significant amount of budgetary support for universities, colleges, private schools, hospitals, museums, and religious organizations.
• Legally and formally, however, the term “endowment” refers to a permanent fund established by a donor with the condition that the fund principal be maintained over time. In contrast to private foundations, endowments are not subject to a specific legally required spending level.
• Generally are exempt from taxation on investment income derived from interest, dividends, capital gains, rents, and royalties.

Question 23

R15

Endowments: Spending Rules

Answer 23

• Spending is typically calculated as a percentage, usually between 4 percent and 6 percent of endowment market value (endowments are not subject to minimum spending rates as are private foundations in the United States).
• Frequently use an average of trailing market values rather than the current market value to provide greater stability in the amount of money distributed annually
• One problem with this rule is that it places as much significance on market values three years ago as it does on more recent outcomes
• A more refined rule might use a geometrically declining average of trailing endowment values adjusted for inflation, placing more emphasis on recent market values and less on past values.
• 3 possible spending rules:

1. Simple spending rule. Spending equals the spending rate multiplied by the market value of the endowment at the beginning of the fiscal year.
2. Rolling three-year average spending rule. Spending equals the spending rate multiplied by the average market value of the last three fiscal year-ends.
3. Geometric smoothing rule. Spending equals the weighted average of the prior year’s spending adjusted for inflation and the product of the spending rate times the market value of the endowment at the beginning of the prior fiscal year. The smoothing rate is typically between 60 and 80 percent.

Question 24

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Endowments: RISK

Answer 24

• Spending policies with smoothing or averaging rules can dampen the transmission of portfolio volatility to spending distributions.
• If the same market forces affect both its donor base and its endowment, an institution that relies heavily on donations for current income may see donations drop at the same time as endowment income
• On a short-term basis, an endowment’s risk tolerance can be greater if the endowment has experienced strong recent returns and the smoothed spending rate is below the long-term average or target rate.
• On the other hand, endowment funds with poor recent returns and a smoothed spending rate above the long-term average run the risk of a severe loss in purchasing power.

Question 25

R15

Endowments: RETURN

Answer 25

• Endowment funds should maintain their long-term purchasing power after inflation.
• An endowment’s returns need to exceed the spending rate to protect against a long-term loss of purchasing power.
• Endowments are not subject to specific payout requirements.
• Can use a smoothing rule, to dampen the effects of portfolio volatility on spending distributions.
• Monte Carlo simulations illustrate the effect of investment and spending policies on the likelihood that an endowment will provide a stable and sustainable flow of operating funds for an institution.

Question 26

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Endowments: LIQUIDITY

Answer 26

• The perpetual nature and measured spending of true endowments limit their need for liquidity.
• In general, endowments are well suited to invest in illiquid, non-marketable securities given their limited need for liquidit

Question 27

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Endowments: TIME HORIZON

Answer 27

• Endowment time horizons are extremely long term because of the objective of maintaining purchasing power in perpetuity.
• Annual draws for spending, however, may present important short-term considerations

Question 28

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Endowments: TAX

Answer 28

• Taxes are not a major consideration for endowments
• Unrelated business taxable income (UBTI) from operating businesses or from assets with acquisition indebtedness may be subject to tax.
• A portion of dividends from non-US securities may be subject to withholding taxes that cannot be reclaimed or credited against US taxes.

Question 29

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Endowments: LEGAL REGULATORY

Answer 29

• UMIFA
• To achieve and maintain tax-exempt status under Section 501(c)(3) of the US Internal Revenue Code, an institution must ensure that no part of its net earnings inure or accrue to the benefit of any private individual

Question 30

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Endowments: UNIQUE

Answer 30

• Vary widely in their size, governance, and staff resources, and thus in the investment strategies that they can intelligently and practically pursue
• Endowments should have significant resources and expertise before investing in nontraditional asset classes.
• Some endowed institutions develop ethical investment policies that become constraints to help ensure that portfolio investment activity is consistent with the organization’s goals and mores.

Question 31

R15

Life Insurance: General

Answer 31

• Risk of disintermediation, which often becomes acute when interest rates are high
• Exposure to interest-rate-related risk is one major characteristic of life insurers’ investment setting.
• When interest rates are high there is the risk that policyholders will surrender their cash value life insurance policies for their accumulated cash values, in order to reinvest the proceeds at a higher interest rate

Question 32

R15

Life Insurance: RISK

Answer 32

• Conservative fiduciary principles limit the risk tolerance of an insurance company investment portfolio.
• Valuation concerns. In a period of changing interest rates, a mismatch between the duration of an insurance company’s assets and that of its liabilities can lead to erosion of surplus
• Reinvestment risk
• Credit risk
• Cash flow volatility. Loss of income or delays in collecting and reinvesting cash flow from investments is another key aspect of risk for which life insurance companies have low tolerance.

Question 33

R15

Life Insurance: RETURN

Answer 33

• minimum return requirement.
• The insurer desires to earn a positive net interest spread, and return objectives may include a desired net interest spread
• Consistently above-average investment returns should and do provide an insurance company with some competitive advantage in setting premiums
• Segmentation of insurance company portfolios has promoted the establishment of sub-portfolio return objectives to promote competitive crediting rates for groups of contracts.

Question 34

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Life Insurance: LIQUIDITY

Answer 34

• insurers may be forced to sell bonds at a loss to meet surrenders of insurance policies in periods of sharply rising interest rates.
• Disintermediation - In a period of rising interest rates, a mismatch between the duration of an insurance company’s assets and its liabilities can create a net loss if the assets’ duration exceeds that of the liabilities. If disintermediation occurs concurrently, the insurer may need to sell assets at a realized loss to meet liquidity needs. Thus, an asset/liability mismatch can exacerbate the effects of disintermediation.
• Asset marketability risk - The marketability of investments is important to insure ample liquidity.

Question 35

R15

Life Insurance: TIME HORIZON

Answer 35

• Life insurance companies have long been considered the classic long-term investor.
• One reason that life insurance companies have traditionally segmented their portfolios is the recognition that particular product lines or lines of business have unique time horizons and return objectives.

Question 36

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Life Insurance: TAX

Answer 36

• Subject to income, capital gains, and other types of taxes in the countries where they operate
• Life insurance companies’ investment income can be divided into two parts for tax purposes: the policyholders’ share (that portion relating to the actuarially assumed rate necessary to fund reserves) and the corporate share (the balance that is transferred to surplus). Under present US law, only the latter portion is taxed.

Question 37

R15

Life Insurance: LEGAL REGULATORY

Answer 37

• Insurance is a heavily regulated industry
• Eligible investments. Insurance laws determine the classes of assets eligible for investment and may specify the quality standards for each asset class.
• Prudent investor rule. Replacing traditional “laundry lists” of approved investments with prudent investor logic simplifies the regulatory process and allows life insurance companies much needed flexibility to keep up with the ever-changing array of investment alternatives.
• Valuation methods. In the European Union, International Accounting Standards specify a set of valuation procedures. In the United States, uniform valuation methods are established and administered by the NAIC.

Question 38

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Life Insurance: UNIQUE

Answer 38

• Each insurance company, whether life or non-life, may have unique circumstances attributable to factors other than the insurance products it provides.

Question 39

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NON-Life Insurance: General

Answer 39

• Non-life liability durations tend to be shorter, and claim processing and payments periods are longer, than for life companies;
• Some (but not all) non-life liabilities are exposed to inflation risk, although liabilities are not directly exposed to interest rate risk as those of life insurance companies
• A life insurance company’s liabilities are relatively certain in value but uncertain in timing, while a non-life insurance company’s liabilities are relatively uncertain in both value and timing, with the result that non-life insurance companies are exposed to more volatility in their operating results.
• One of the primary factors that limits the duration of a non-life company’s assets is the so-called underwriting (profitability) cycle, generally averaging three to five years.

Question 40

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NON-Life Insurance: RISK

Answer 40

• Cash flow characteristics. Not surprisingly, cash flows from casualty insurance operations can be quite erratic. Have low tolerance for loss of principal or diminishing investment income. Investment maturities and investment income must be predictable in order to directly offset the unpredictability of operating trends.
• Common stock to surplus ratio. Many casualty companies have adopted self-imposed limitations restricting common stocks at market value to some significant but limited portion (frequently one-half to three-quarters) of total surplus

Question 41

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NON-Life Insurance: RETURN

Answer 41

• Competitive policy pricing. Low insurance policy premium rates, due to competition, provide an incentive for insurance companies to set high desired investment return objectives. The flip side is that high investment returns may induce insurance companies to lower their policy rates, even though a high level of returns cannot be sustained. I
• Profitability. Casualty insurance portfolios are managed to maximize return on capital and surplus to the extent that prudent asset/liability management, surplus adequacy considerations, and management preferences will allow.
• Growth of surplus. An important function of a casualty company’s investment operation is to provide growth of surplus, which in turn provides the opportunity to expand the volume of insurance the company can write.
• Tax considerations. Over the years, non-life insurance companies’ investment results have been very sensitive to the after-tax return on the bond portfolio and to the tax benefits of certain kinds of investment returns.
• Total return management. Active bond portfolio management strategies designed to achieve total return, rather than yield or investment income goals only, have gained popularity among casualty insurance companies, especially large ones

Question 42

R15

NON-Life Insurance: LIQUIDITY

Answer 42

• Liquidity has always been a paramount consideration for non-life companies.
• Quite often it maintains a portfolio of short-term securities, such as commercial paper or Treasury bills, as an immediate liquidity reserve.
• may also hold a portfolio of readily marketable government bonds of various maturities

Question 43

R15

NON-Life Insurance: TIME HORIZON

Answer 43

• Durations of casualty liabilities are typically shorter than those of life insurance liabilities.
• Casualty companies find that they must invest in longer maturities (15 to 30 years) than the typical life company to optimize the yield advantage offered by tax-exempt securities
• In terms of common stock investments, casualty companies historically have been long-term investors

Question 44

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NON-Life Insurance: TAX

Answer 44

• A very important factor in determining casualty insurance companies’ investment policy
• A computer model is generally needed to determine the appropriate asset allocation, if any, between tax-exempt and taxable securities for both new purchases and existing holdings

Question 45

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NON-Life Insurance: LEGAL REGULATORY

Answer 45

• Casualty company investment regulation is relatively permissive
• A casualty company is not required to maintain an asset valuation reserve.

Question 45

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NON-Life Insurance: UNIQUE

Answer 45

• Casualty insurance companies develop a significant portfolio of stocks and bonds and generate a high level of income to supplement or offset insurance underwriting gains and losses.
• Casualty companies seek some degree of safety from the assets offsetting insurance reserves

Question 46

R15

NON-Life Insurance: Variation in returns between companies

Answer 46

1. the latitude permitted by insurance regulations;
2. differences in product mix, and thus in the duration of liabilities;
3. a particular company’s tax position;
4. the emphasis placed on capital appreciation versus the income component of investment return; and
5. the strength of the company’s capital and surplus positions.

Question 47

R15

Banks: General

Answer 47

• Banks’ liabilities consist chiefly of time and demand deposits but also include purchased funds and sometimes publicly traded debt
• Measures ALCO monitor:

1. net interest margin -With respect to banks, net interest income (interest income minus interest expense) divided by average earning assets.
2. interest spread - With respect to banks, the average yield on earning assets minus the average percent cost of interest-bearing liabilities.
3. leverage-adjusted duration gap - A leverage-adjusted measure of the difference between the durations of assets and liabilities which measures a bank’s overall interest rate exposure.
4. Value at Risk (VaR)

Question 48

R15

Banks: Role of bank’s securities portfolio

Answer 48

1. To manage overall interest rate risk of the balance sheet. Bank-held securities are negotiable instruments trading in generally liquid markets that can be bought and sold quickly. Therefore, securities are the natural adjustment mechanism for interest rate risk
2. To manage liquidity. Banks use their securities portfolios to assure adequate cash is available to them.
3. To produce income. Banks’ securities portfolios frequently account for a quarter or more of total revenue.
4. To manage credit risk. The securities portfolio is used to modify and diversify the overall credit risk exposure to a desired level

• Bank’s security portfolios consist almost exclusively of fixed-income securities.

Question 49

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Banks: RISK

Answer 49

• Dominated by ALM considerations that focus on funding liabilities. Therefore, risk relative to liabilities, rather than absolute risk, is of primary concern

Question 50

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Banks: RETURN

Answer 50

• A bank’s return objectives for its securities portfolio are driven by the need to earn a positive return on invested capital. For the interest-income part of return, the portfolio manager pursues this objective by attempting to earn a positive spread over the cost of funds.

Question 51

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Banks: LIQUIDITY

Answer 51

• A bank’s liquidity position is a key management and regulatory concern. Liquidity requirements are determined by net outflows of deposits, if any, as well as demand for loans.

Question 52

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Banks: TIME HORIZON

Answer 52

• A bank’s time horizon for its securities portfolio reflects its need to manage interest rate risk while earning a positive return on invested capital. A bank’s liability structure typically reflects an overall shorter maturity than its loan portfolio, placing a risk management constraint on the time horizon length for its securities portfolio. This time horizon generally falls in the three- to seven-year range (intermediate term).

Question 53

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Banks: TAX

Answer 53

• Banks’ securities portfolios are fully taxable.
• Realized securities losses decrease reported operating income, while securities gains increase reported operating income. According to some observers, this accounting treatment creates an incentive not to sell securities showing unrealized losses, providing a mechanism by which earnings can be managed.

Question 54

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Banks: LEGAL REGULATORY

Answer 54

• Regulations place restrictions on banks’ holdings of common shares and below-investment-grade risk fixed-income securities.
• Risk-based capital (RBC) regulations are a major regulatory development worldwide affecting banks’ risk-taking incentives.- BASAL.

Question 55

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Banks: UNIQUE

Answer 55

• There are no common unique circumstances to highlight relative to banks’ securities investment activities. That situation stands in contrast to banks’ lending activities, in which banks may consider factors such as historical banking relationships and community needs, which may be viewed as unique circumstances.