Reading 33: Portfolio Management for Insto Investors

Question 1

Duration

Answer 1

In a defined benefit plan, the portfolio should be managed to match the duration of liabilities, not the expected final maturity of the last payment. Taxes are not a consideration in a pension plan.

Question 2

DB Plan Objectives

Answer 2

The primary objective is to achieve a target return over a specified long-term horizon while assuming a level of risk that is consistent with meeting its contractual liabilities. A secondary objective could be to minimize (in present value terms) the cash contributions the sponsor will be required to provide.

Question 3

Characteristics of Institutional Investors

Answer 3

Scale: too large can’t invest in small caps or venture capital so they manage them in-house. Smaller may struggle to diversify across asset classes with minimum investment sizes, they may also find it hard to find skilled individual are choose to outsource instead.
Governance framework: more formal composed of board of directors (setting long term SAA), and investment committee (establishing IPS and monitoring).

Question 4

Investment Policy Statement

Answer 4

Should include mission and investment objectives (return and risk tolerance), discussion of investment horizon and liabilities to be paid, external constraints (legal, tax, regulatory, accounting), asset allocation and ranges, rebalancing policy, and reporting requirements.

Question 5

Asset Allocation Approaches

Answer 5

Norway’s SWF (sovereign wealth fund): passively managed with 60/40 allocation; little/no exposure to alternative investments; tight tracking error limits; low cost and fees; easy for board to comprehend; no opportunity for outperformance of markets.
Yale University Endowment: high allocation to alternatives; significant active management; externally managed assets; potential for market outperformance; difficult for small insto’s with alternatives expertise; may be difficult for large managers due to external manager capacity constraints; high fees/costs.
Canada Pension Plan: same as Yale but with internally managed assets; reference portfolio of passive public assets as benchmark (easily communicated); development of internal capabilities; potentially difficult to manage.
Liability driven: focus on maximising expected surplus return and managing surplus volatility; explicitly recognises liabilities; longevity risk to liabilities is hard to hedge.

Question 6

DB vs DC

Answer 6

Recently there has been a move from DB to DC as plan sponsors have less risk with DC and DC’s are also portable when employee moves employer.

Question 7

DB

Answer 7

The funded ratio is the fair value of plan assets / present value of DB obligations. If more people are in ‘retried lives’ the risk tolerance is lower due to shorter investment horizon compared to younger workforce. Higher discount rate gives lower PV of liabilities. Increase in expected investment returns can increase discount rate, potentially lowering liabilities. Higher employee turnover, lowers liability (few employees vesting benefits).

Question 8

DB Risks Considerations

Answer 8

Plan funded status, sponsor financial status, size of plan relative to sponsor, lower correlation of operating earnings and pension assets increases risk tolerance, provision for early retirement or lump sum distribution decreases risk tolerance due to shorter investment horizon, workforce characteristics.

Question 9

DB Liquidity

Answer 9

Are a function of of benefits paid to retired lives and sponsor contributions made to plan. If the plan has higher funded status, less contributions will be made so benefits will be paid from fund, needing liquidity.

Question 10

DB Regulation

Answer 10

Compensation - Retirement Benefits requires that funded status be shown as an asset or liability on the balance sheet. Government Accounting Standards Board rules require assets to be reported at market value and liabilities reported using blended approach where expected return on fund assets is used to discount the funded portion on liabilities and a lower discount rate is used on unfunded portion.

Question 11

DB Objectives

Answer 11

Achieve target return over a specified long term horizon, while assuming risk consistent with meeting contractual liabilities. Secondary objective could be to minimise cash contributions the employer must make (increase funded status). Assets need to grow at a rate of liability growth.

Question 12

DC

Answer 12

Offer life cycle options (target date) where assets are managed in relation to retirement date. Participant switching options auto switch to conservative as they age. Participant/cohort option involves pooling participant with other investors with similar retirement date and fund being managed more conservatively as retirement approaches. Through pooling and increased scale, DC can invest in alternative investments not usually available to individuals. Liquidity is high with older workforce and more ability to switch or withdraw form plan.

Question 13

DC Regulation / Objective

Answer 13

Requirement for plan to educate on savings for retirement and provide default option for disengaged participants, while offering diversified default option. DC is the US are tax deferred. Objective is to prudently grow assets to meet spending needs in retirement, where active management is offered, outperform the benchmark or peer DC funds when people can switch.

Question 14

Sovereign Wealth Funds (SWF) Categories

Answer 14

Investment funds owned by government and include: Budget Stabilisation Fund, set up when heavy correlation of revenue to cyclical industries, need most liquidity, low risk assets (fixed income and cash). Development, funds infrastructure and key industries, long term horizon (infrastructure) and short term (medical research). Savings, benefits future generations using nonrenewable assets revenue, long term with lowest liquidity needs (liquidity increases as natural resources deplete), allocate to equity and alternatives. Reserve funds earn excess return on foreign reserves to reduce negative cost of carry, slightly higher liquidity needs than savings fund (liquid fixed interest). Pension reserve funds, save and invest to meet future pensions (accumulation or decumulation phase).

Question 15

SWF Objectives

Answer 15

Budget stabilisation aims to preserve capital, earn returns above inflation with low probability of loss, avoid correlation with govt revenues. Development aims to support nations economic development and increase long run economic growth, earn real rate of return greater than real GDP growth or productivity growth. Savings aims to maintain purchasing power of assets over time while sustaining govt budgetary needs. Reserve earns rate of return in excess of the yield the govt/central bank pays on bonds it has issued.

Question 16

University Endowments

Answer 16

Typically perpetual, spending rate needs to be adjusted for inflation (subtract expected inflation), it ranges between 4-6% applied to moving average of AUM. Constant growth rule provides fixed annual payout once adjusted for inflation based on Higher Eduction Price Index (HEPI). Market value rule state payouts are pre-specified percentage between 4-6% of three to five year moving average asset value. Hybrid rule is mix between the two. After donations and gifts the spending rate is typically 2-4%. Usually high risk tolerance with majority exposure to alternatives (apart from smaller funds).

Question 17

University Endowments: External Constraints / Objective

Answer 17

Investment gains on a total return basis not just income for example and diversification based on modern portfolio theory (MVO). Usually tex exempt. The objective would be to preserve purchasing power of assets in perpetuity while achieving returns adequate to maintain level of spending. Typical spending is 5% of assets. Secondary objectives of outperforming benchmark or peers could lead to herding however.

Question 18

Private Foundations

Answer 18

Can be private set up by individuals, community, operating (nfp business), or corporate (profits from existing company). Usually perpetual, tax laws in US require minimum annual payouts of 5% of assets plus investment expenses. Unlike endowments, the foundations revenue is usually solely relied on with higher liquidity requirements the risk tolerance is lower than endowments. Total return and diversification are required. Tax exempt depending on spending rules. Objective is to generate real return over CPI of spending rate plus investment expenses with reasonable volatility (10-15%) over three to five year period. Secondary objective of outperforming a policy benchmark. Still high risk tolerance and typically over 50% allocated to alternative investments (smaller have more FI and domestic equity).

Question 19

Banks

Answer 19

Likely to have short term investment assets and are more liquid as liquidity coverage ratios and net stable funding ratios are enforced. Commercial lenders usually use wholesale funding markets. Retail banks use higher level of retail deposits that are more stable than wholesale. Largest banks are regarded as systematically important financial institutions (restrict dividends, increase capital ratios, restrict subordinated debt holders and preferred shareholders to exert claims during bankruptcy, restrict derivative use). Primary objective is to manage liquidity and reduce risk mismatch between non investment assets and liabilities. ALMCo (asset and liability management committee) set IPS, monitor performance and set risk limits.

Question 20

Banks Accountancy Perspective

Answer 20

Standard financial reporting (US GAAP or IFRS) uses accruals and provides smoothest reporting of income. Statutory accounting is utilised by regulators and makes accounts more conservative. True economic accounting uses market value for all assets and liabilities and gives most volatile measure of income.

Question 21

Insurers

Answer 21

Life insurance and fixed annuity insurers run a general account to fund liabilities as insurer bears investment risk. For variable policies and variable annuities the insurer operated a seperate account as the policy holders bear the risk. At times of intense underwriting competition insurers may bear more investment risk to generate returns. At high interest rate policy holders may surrender to invest at higher yields in other investments (increasing net cash outflow of insurer). Same accounting reporting as banks apply, insurers are typically fully taxable. Objective is same as banks to manage liquidity and reduce mismatches between institutions assets and liabilities.

Question 22

Changing Volatility of Equity Capital

Answer 22

Hold diversified and high quality FI that lowers SD of assets and decreases volatility of equity. Maintain similar asset and liability durations and match asset and liability exposure to borrower and claimant options, which increases correlation of A/L and decreases equity volatility. Use derivatives, transparency and collateralisation to protect against unexpected loss. Surrender penalties decreases liability volatility. Prepayment penalties increase correlation of A/L and decreases equity volatility. Variable annuities also does this. Think of the two portfolio variance formula.