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Flashcards in S5 Deck (95):

Accumulated benefit obligation (ABO)

PV of pension liabilities to date, ignoring future salary increases.

A measure of liabilities for a terminated plan.


Projected benefit obligation (PBO)

ABO + the PV of the additional liability from future salary increases.

Used in calculating funded status for ongoing plans.


Total foture liability

PBO + PV of tliabilities from future years of service.

Some plans may consider it as supplemental information in setting objectives.


Funded status

PV of pension assets - PV of pension liabilities


DB Pension plan - risk tolerance factors

Plan surplus
Financial status and profitability
Sponsor and pension fund common risks exposures
Plan features (lump sum withdrawals, early retirement)
Workforce characteristics (avg. age, active/retired lives age)


Under ALM, risk is measured

by the variability (standard deviation) of plan surplus.


shortfall risk (pensions)

the probability that the plan asset value will be below some specific level or have returns below some specific level)


DB plan. Return.

Achieve a total return sufficient to fund its liabilities on an inflation-adjusted basis.

Actuarial rate.


Foundations. Return

Private foundations must generate 5% + management expenses + inflation.

Total return approach.

Depends on time horizon stated for the foundation.


Life insurance. Return.

Fixed-income segment: spread management and actuarial assumptions (minimum required rate of return).

Surplus segment: achieve higher returns through portfolio growth.


Nonlife insurance. Return.

Fixed income: max1m1ze the return for meeting claims.

Equity segment: grow the surplus/ supplement funds for liability claims.


Commercial banks. Return.

Return is determined by the COSt of funds.

Primarily concerned with earning a positive interest rate spread.


DB plan. Risk.. Factors

Depends on
.age of workforce,
.company balance sheet,
.time horizon.


Foundations. Risk

Moderate to high, depending on spending rate and time horizon.


Endownment. Risk Tolerance and 2 factors.

Due to infinite life - Moderate to high.

Linked to relative importance of the fund in the sponsor's overall budget picture.

Inversely related to dependence on current income.

Exposure to market fluctuation is a major concern.


Life insurance. Risk. Factors

Fixed-income segment: conservative. Surplus segment: aggressive.

Risk factors:
(1) how market volatility adversely impacts asset valuation,
(2) a low tolerance of any loss of income or delays in collecting income,
(3) reinvestment risk is a major concern, and
(4) credit quality is associated with timely payment of income and principal.


Nonlife insurance. Risk.

Fixed-income segment: conservative.
Surplus segment: aggressive.

Many companies have self-imposed ceilings on the common stock to surplus ratio.


Commercial banks. Risk

Banks are primarily concerned with meeting their liabilities and other liquidity needs and cannot suffer losses in the securities portfolio.

Tend to have below-average risk tolerance.


DB plan. Liquidity. Factors and formula

Depends on age of workforce and retired lives proportion.

= payments to beneficiaries - sponsor contributions


Foundations. Liquidity

Some hold a % of annual distribution amount as a cash reserve.

may be high if large outlays are expected.


Endowment. Liquidity

Some hold a percentage of annual distribution amount as a cash reserve.


Life insurance. Liquidity

Fixed-income portion: relatively high.

Surplus segment: nil.

There are three primary concerns to address: disintermediation, asset-liability mismatches, and asset marketability risk.


Nonlife insurance liquidity

Fixed-income portion: relatively high.

Surplus segment: nil.


Com banks. Liquidity

Liquidity is also relative to liabilities.

Banks need conrinuing liquidity for liabilities and new loans.


DB plans. Time horizon

Long if going concern.
Short if terminating plan.


Fundations. Time horizon

Long, usually infinite.


Endownment. Time horizon.

Long, usually infinite.


Life insurance. Time horizon

Traditionally 20-40 years but progressively shorter as the duration of liabilities has decreased due to:

- increased interest rate volatility and
- competitive market factors.


Nonlife insurance. Time horizon.

Short due to the nature of claims.


Banks. Time horizon.

Time horizon tends to be short to inrermediate because of mostly short-term liabilities.


DB plan. Legal

ERISA, prudent expert rule.


Foundation. Legal.

Few. Prudent investor rule applies.
UMIFA applies.


Endowment. Legal.

Low. Prudent investor rule typically applies.
UMIFA applies.


Life insurance. Legal.

High = (complex and extensive), especially on the state level

prudent investor rule.

May have eligible valuation methods.

Stricter regulation on admissible investments vs nonlife.


Nonlife insurance. Legal.

Moderate, but increasing. (complex and extensive)

prudent investor rule.

Less stricter regulation on admissible investments vs life.


Bank. Legal

Must meet regulatory requirements for liquidity, reserves, and pledging.

Usually with short-term treasuries.


DB plan. taxes



Foundations. Taxes



Endowments. Taxes.



Life insurance. Taxes


Taxes are a major consideration.
- Policyholder's share is not taxed;
- funds transferred to the surplus are taxed.


Nonlife insurance. Taxes.



Banks. Taxes.

Banks are taxable entities, so taxes must be considered.


DB plans. Unique circumstances

Surplus, age of workfo rce, time horizon, and company balance sheet affect policy.


Foundations. Unique corcumstances.

Foundation specific.
Moral/ ethical concerns may restrict certain securities.


Endowments. Unique circumstances.

Restrictions on certain securities/ asset classes common due to nature of funds.


Life insurance. Unique circumstances

Must distinguish between strategies for the fixed- mcome segment and the surplus segment.


Non-life insurance. Unique circumstances.

The financial status of the firm; the management of investmenr risk and liquidity requiremenrs influence IPS.


Banks. Unique circumstances.

Varies from bank to bank.

May need to use securities portfolio as diversification tool and/or to provide liquidity.


Prudent investor rule.

Prudent investor rule requires a fiduciary to "prudently" invest trust assets as if they were his own based on the knowledge the fiduciary has at the time and considering only the needs of the trust's beneficiaries.


Prudent expert rule

prudent expert rule requires that the fiduciary manage the portfolio with the care, skill, prudence, and diligence, under the circumstances then prevailing, that a prudent investor would use.

It extends the prudent investor rule beyond prudence by suggesting a higher level of expertise.


DB plan. Benefits for employee and employer

Employee - No investment risk. Stable retirement mcome.

Employer - Possible pension income. Ability to support stock with some investment in company stock.


DB plan. Disadvantage to employee

Early termination risk.
Usually a vesting period.
Restricted withdrawal of funds.
Adverse affect on diversification because both job and pension are linked to health of employer.


DB plan. Disadvantage to employer.

Investment risk.
Regular funding obligation.
Early retirement and other options can increase liquidity requirements.
Highly regulated by governments.
Extra resources needed to fulfill due diligence.


DC plan. Advantages to employee

Own all personal contributions.
Once vested, own all sponsor contributions.
Assets easily transferred to another plan.
Can diversify portfolio to suit needs.
Lowers taxable income.


DC plan. Advantages to employer

No financial liability other than matching provisions.
No investment risk.
Lower liquidity requirements.
Fewer resources required.
Fewer regulations.


DC plan. Disadvantages to employee

Investment risk.
Must monitor and make necessary reallocation decisions.
Restricted withdrawal of funds.


DC plan. Disadvantage to employers

Usually legally required to have an IPS that addresses how the plan will help participants meet their objectives and constraints (e.g., types and number of investment alternatives, advice).


Foundations. Annual spending requirement.

Independent - 5% of assets
Company sponsored - 5% of assets
Operating - At least 85% of dividend and interest income for operations (sometimes 3.33% of assets)
Community - none


Cash balance plan' account is credited each year with

- pay credit - based upon the beneficiary's age, salary, and/or length of employment,
- interest credit - based upon a benchmark such as U.S. Treasuries.


Cash balance pension plan

a type of DB plan that defines the benefit in terms of an account balance.

cash balance plan is a DB plan whose benefits are displayed in individual recordkeeping accounts.

These accounts show the participant the current value of his or her accrued benefit and FACILITATE PORTABILITY to a new plan.


Foundations are

grant-making entities funded by gifts and an investment portfolio


Endowments are

long-term funds owned by a non-profit institution (and supporting that institution)


Operating foundations are established

for the sole purpose of funding an organization (e.g., a museum, zoo, public library) or some ongoing research/medical initiative


Sending rules - endowments and foundations

Simple. Scurrent = S% * MVlast
Rolling 3yr average = S% * MV avg for pst 3 yrs
Geometric. Scurrent = R * Slast * (1 + inflation) + (1 - R)*
S% * MVlast, where R is smoothing rate of 0.6-0.8


Product mix and duration. Life non-life insurance companies.

Nonlife - more diverse product mix, shorter duration.


Payouts and inflation exposure. Life nonlife insurance companies

Life - amount predictable, timing uncertain.
Nonlife - both amount and timing unpredictable.
Nonlife exposed to inflation - replacement parts value.


Which insurance companies exposed to cyclicality and geographical concentration?

Non-life insurance companies.


bank uses its security portfolio to manage

Duration, credit risk, diversification, liquidity of its assets.

Lastly, portfolio may be used as source of income.


Banks, leverage adjusted duration gap

Duration of Assets - Debt/Assets*Duration of liabilities


Investors with definable, measurable liabilities should have among portfolio objectives

Maximization of surplus
Minimization of surplus volatility


Pension plan, allocation to equities should be

Diversified thru exposure to domestic, developed and emerging markets.


Return objective for underfunded DV pension plan

At least the discount rate used in calculation of PV of liabilities in order to at least maintain the current (underfunded status).

Company should seek ways to increase contributions to reach the fully funded status.


DC plan committee / board functions

See that participants have sufficient EDUCATIONAL opportunities to facilitate investment decisions.
Provide DESCRIPTIONS of all investment opportunities.
Select and periodically evaluate fund MANAGERS.
Generally OVERSEE the plan and its participants.


Return requirement formula. endowments

(1 + spending rate) (1 + inflation)(1 + % fees) - 1


Requirements for DC plans

1. Diversification.
The sponsor must offer a menu of investment options
... 1) at least three investment choices diversified versus each other and
... 2) provision for the participant to move freely among the options.
... 3) make available to participants sophisticated retirement planning tools such as Monte Carlo simulation to aid in decision-making.

2. Company Stock.
Holdings of sponsor-company stock should be limited to allow participants’ wealth to be adequately diversified.


2 inactive categories in pension plans



Inactive and active-accrued - risk, risk exposure and liability mimicking

1 Market exposure
2 Term structure
3a Nominal bonds for benefits not linked to inflation
3b Real return bonds for benefits linked to inflation


Active future wage growth - risk, risk exposure and liability mimiking

Term structure - nominal bonds
Inflation - real return bonds
Economic growth - stocks


Asset only approach ignores

Market related risks of pension liabilities.


A pension's future obligations are those arising due to

wages to be earned in the future - is typically hedged with equities, nominal bonds, and real bonds

new entrants into the plan - is uncertain and not easily modeled or funded.


Non-market exposures (liability noise) can be divided into two parts:

1 - those that are due to plan demographics

2 - that are due to model uncertainty

These exposures are not easily hedged.


Correlation ... asset only vs liability mimicking approach in pensions

asset-only approach ... investments chosen with a low correlation with firm assets.

liability-relative approach ... hedging the pension liabilities... investments chosen with have a high correlation with the liabilities.


6 pension components

Active accrued (past service)
Future wage inflation
Future real wage growth
Future service


The larger the pension plan population

The closer will be model to the actual pan experience.


The larger the share of inactive lives, the smaller is

The model uncertainty = liability noise


By using derivatives in liability mimicking approach, the manager

. hedges the market-related exposures
. frees up funds as the derivatives require far less capital
. allows efficient return generation within asset-only space once the liabilities have been hedged.


The younger, larger is the active participants in pension, the higher is the portion of liabilities related to

future wage growth


Allocation to equity securities in the plan's assets vs risk of plan assets and firms equity beta.

. increases the risk of the plan assets, which in turn increases the firm's equity beta.
. The firm's equity beta and total asset beta are positively related.


Correlation of risk of the pension plan assets and:
. firm's operating asset beta.
. firm's WACC.

Positive correlation.


In order to protect stockholders against an increase in the risk of its pension assets, management must

increase the proportion of owners' equity, thus decreasing the firm's D/E ratio.

(Total asset beta stays the same, but higher equity means less beta per unit of equity.)


WACC using OPERATING Asset (not EQUITY) Beta

WACC = RFR + beta of oper assets * Market risk premium


Do not mess CORRELATION of pension assets vs
. operating ASSETS

First - increases risk tolerance,
second - decreases.


Total asset beta =

Equity x equity beta / (equity + debt + pension liabilities)


Operating asset beta=

Pension equities * its beta + companies operating asset * its beta = Total asset beta * total assets.


Operating asset beta% = ($beta of company - $beta of pension equities) / operating assets.


DB plan, 2 possible return focuses

- capital gains focus when the fund has low liquidity needs and younger workers

- income focus (duration matching) when there are high liquidity needs and older workers.