CFA Level 3 - Institutional Investors (thank you mtbrennan7)

Two objectives and Five constraints

- Risk and Return -Time Horizon; Taxes; Liquidity; Legal and regulatory factors; Unique circumstances It is helpful to determine the sponsor's risk tolerance before the determination of the return objective

If the performance of the plan assets and firm are highly correlated:

-When pension assets are generating high returns with high operating profits, the probability of the firm having to make a contribution will be low. If a contribution is necessary, the amount will be low. The ability to make contributions is high when the plan is fully funded or overfunded. Therefore, the fund is better able to meet benefit payments, which positively impacts firm valuation due to a lowered negative pension expense. -When pension assets are generating low returns with low operating profits, the probability of the firm having to make a pension contribution is high. The firm's ability to make contributions is low at the same time that the plan is underfunded. An underfunded status means that there is a decreased ability to meet retirement payments, which negatively impacts firm valuation due to increased pension expense

Two Additional Factors that affect Liability Duration for a Life Insurance Company

1. Duration of products sold 2. Policy Surrenders and/or Loans 1. The duration of products sold is a main driving force influencing the overall duration of liabilities. The extent to which a company directs marketing efforts toward short- or long-duration products will tilt overall duration. In this case, the company is placing a heavy emphasis on a two-year guaranteed investment contract product. The duration of this product will be much shorter than that of the overall portfolio. Management indicates that this product is popular, with sales increasing in recent years. This increase, all else being equal, will contribute to a decline in the duration of liabilities. 2. Duration of liabilities is also driven by policy surrender and/or loans, either of which can be triggered by interest rate changes. Surrender rates triggered by interest rate changes are more difficult to predict than mortality rates and have become a critical variable for many life insurance companies. During periods of rising interest rates, policyholder redemptions accelerate as policyholders seek the most competitive rate. Such behavior would be typical in an environment in which "interest rates are rising and are expected to rise another 100 basis points." Accelerating surrenders could also influence an actuary to reduce the assumed duration of a company's liabilities.

Types of Foundations and their characteristics

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). Both are not for profit, serve a social purpose, and generally not taxed if they meet certain conditions, are often perpetual, and unlike pension plans may well and should pursue aggressive objectives.

Assets to be used in Liability-mimicking Portfolio to offset liabilities associated with Active, Retired, and Deferred

Higher proportion of active # of participants against total participants shows higher proportion of equities. Same goes for lower average age of participants. Active and lower average age relates to potential future wage growth (real wage growth)

Life Insurance Segmentation Arguments

If insurance company has multiple products, it is beneficial to segment them against other liabilities with similar characteristics (return/risk, duration, time horizon etc.) Reasons for Segmentation (attached)

Defined Contribution Plan

Plan employer does not establish investment goals and constraints; rather the employee decides own risk and return objectives. Therefore, the employee bears the risk of the investment results. Consequently, the investment policy statement (IPS) for a defined-contribution plan describes the investment alternatives available to the plan participants. This IPS becomes a document of governing principles instead of an IPS for an individual. Some of the issues addressed in the IPS would be: -Making a distinction between the responsibilities of the plan participants, the fund managers, and the plan sponsor -Providing descriptions of the investment alternatives available to the plan participants -Providing criteria for monitoring and evaluation of the performance of the investment choices -Providing criteria for selection, termination, and replacement of investment choices -Establishing effective communication between the fund managers, plan participants, and the plan sponsor

Foundation IPS

Return: Depends on time horizon stated for the foundation Risk Tolerance: Moderate to high, depending on spending rate and time horizon. Usually more aggressive than pension funds Liquidity: Some foundations choose to hold a portion of the annual distribution amount as a cash reserve Time Horizon: Usually infinite Tax Considerations: Not taxable with the exception on investment income from private foundations in the United States (1%) Legal/Regulatory: Few-many states in the US have adopted the Uniform Management Institutional Funds Act as the regulatory framework. Prudent investor rule generally applies

Non-Life Insurance Company IPS

Return: Greater uncertainty regarding claims, but they're not as interest rate sensitive. Fixed-income component should maximize the return for meeting claims. Equity segment should grow the surplus/supplement funds for liability claims. Impacted by competitive pricing policy, profitability, growth of surplus, after-tax returns, and total return Risk Tolerance: Risk must be tempered by the liquidity requirements. Inflation risk is a big concern because of replacement cost policies. Cash flow characteristics are unpredictable. Many companies have self-imposed ceilings on the common stock surplus ratio Liquidity: Relatively high Time Horizon: Short, due to nature of claims Tax Considerations: Taxes play an important role-frequent contact with tax counsel is advised Legal/Regulatory: Considerable leeway in choosing investments. Regulations less onerous than for life insurance companies Unique needs: The financial status of the firm and the management of the investment risk and liquidity requirements influence the IPS

IPS for Defined-Benefit Plan

Return: Minimum return requirement is determined by actuarial rate. If liquidity needs are low and workers young, use a capital gains focus; for high-liquidity needs and older workers, use an income focus (duration matching). Also consider the number of retirees the plan must support Risk tolerance: depends on surplus, age of workforce, time horizon, and company balance sheet. A surplus indicates higher risk tolerance Liquidity: Consider the age of workforce and retired lives population. Income is required to meet payments to retirees, but contributions are available for longer-term investments Time Horizon: Same as for liquidity. In addition, the horizon is long if the plan is a going concern but short if it is a terminating plan. Taxes: Usually tax exempt Legal/regulatory: ERISA and the prudent expert rule apply. The plan must be managed for the sol benefit of plan participants Unique Circumstances: Could include insufficient resources to perform due to diligence on complex investments, special financial concerns related to the sponsor firm or the fund, socially responsible investing requirements.

Banks

Return: The return objective for the bank's securities portfolio is primarily to generate a positive interest rate spread Risk Tolerance: The most important concern is meeting liabilities, and the bank cannot let losses in the securities portfolio interfere with that. Therefore, its tolerance for risk is below average. Liquidity: Because banks require regular liquidity to meet liabilities and new loan requests, the securities must be liquid Time Horizon: Bank liabilities are usually fairly short term, so securities in the portfolio should be of short to intermediate maturity/duration Tax Considerations: Banks are taxable entities Legal/Regulatory: Banks are highly regulated and are required to maintain liquidity, reserve requirements, and pledge against certain deposits Unique circumstances: Some potential unique circumstances include lack of diversification or lack of liquidity in the loan portfolio

Life Insurance Company IPS

Return: Three components (1) minimum required rate of return-statutory rate set by actuarial assumptions, (2) enhanced margin rates of return or "spread management", and (3) surplus rates of return, where surplus equals total assets - total liabilities Risk Tolerance: Specific factors include (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 Liquidity: There are three primary concern to address: disintermediation, asset-liability mismatches, and asset marketability risk 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 Tax Considerations: Taxes are a major consideration. Policyholder's share is not taxed; funds transferred to the surplus are taxed Legal/Regulatory: Heavily regulated at the state level. Regulations relate to eligible investments, prudent person rule, and valuation methods Unique needs: Diversity of product offerings, company size, and level of asset surplus

Endowment IPS

Return: Usually funded for the purpose of permanently funding an activity. Prserve asset base and use income generated for budget needs. No specific spending requirement. Balance the need for high current income with long-term protection of principal. Ensure purchasing power is not eroded by inflation. May use total approach or strive to minimize spending level volatility Risk Tolerance: 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. Infinite life means that over risk tolerance is generally high. Liquidity: Usually low but may be high if large outlays are expected Time Horizon: Usually infinite Tax Considerations: Income is tax exempt Legal/Regulatory: Few-many states in the US have adopted the Uniform Management Institutional Funds Act as the regulatory framework. Prudent investor rule generally applies. (UMIFA) and IRS regulate. Unique Needs: Diverse and endowment specific

Contrast the return requirement of the surplus portfolio to the return requirement of policyholder reserves, in regard to US insurance companies in general

The focus of the return requirement for policyholder reserves is on earning a competitive return on the assets used to fund estimated liabilities. Life insurance companies are considered SPREAD MANAGERS, in that they manage the difference between the return earned on investments and the return credited to policyholders. Spread management can take various forms, such as a yield approach versus a total-return approach, but the objective remains the same. The focus of the return requirement for the surplus is on long-term growth. An expanding surplus is an important indicator of financial stability and the base for building the lines of business. When selecting investments for the surplus portfolio, managers typically seek assets with the potential for capital appreciation, such as common stocks, venture capital, and equity real estate.

Asset Only Approach

a pension fund focuses on selecting efficient portfolios. It does not attempt to explicitly hedge the risk of the liabilities. This approach ignores the fact that a future liability is subject to market related risk. Market risk arises from interest rate risk, inflation risk, or from exposure to economic growth. The risk free investment is the return on cash.

Investment Companies, Commodity Pools, and Hedge Funds

are institutional investors but are just intermediaries that pool and invest money for underlying investors and pass the returns through their investors. Unlike other institutional investors it is not possible to generalize about their policy statements Investment Companies - gather funds from investors and invest in the pooled funds based upon advertised objectives and constraints Commodity Pools - similar to mutual funds but invest in pools of commodity futures and options contracts Hedge Funds - gather funds from institutional and wealthy individual investors and construct various investment strategies aimed at identifying and capitalizing on mispriced securities The primary difference between investment companies, commodity pools, and hedge funds, and the institutional investors is the source and use of their invested funds. Pension plans, insurance companies, endowments, foundations, and banks all invest their own assets to meet various funding requirements, while the latter group collects funds from investors and invests the funds to meet their investors' needs

Sponsor Financial Status and Profitability

can be indicated by the sponsor's balance sheet. Profitability can be indicated by the sponsor's current or pro forma financials. Lower debt ratios and higher current and expected profitability indicate better capability of meeting pension liabilities, and therefore, imply greater ability to take risk. The opposite is also true

Cash Balance Plan

defined-benefit plan that defines the benefit in terms of an account balance, which the beneficiary can take as an annuity at retirement or as a lump sum to roll into another plan. In a typical cash balance plan, a participant's account is credited each year with a pay credit and an interest credit. The pay credit is typically based on the beneficiary's age, salary, and/or length of the employment, and the interest credit is based upon a benchmark such as U.S. Treasuries. Rather than an actual account with a balance, the cash balance is a paper balance only and represents a future liability for the company

Underfunded plans

indicate a liability funding shortfall. Although there may be a willingness to take a greater investment risk, the underfunded status dictates a decreased ability to take risk

Pension Fund

is exposed to market and non market related risks. If the benefits paid are not indexed to inflation, the appropriate liability-mimicking assets are nominal bonds. If the benefits paid are indexed to inflation, the appropriate liability-mimicking assets are inflation-indexed bonds. If the benefits correspond with growth in the firm and economy, the appropriate liability-mimicking assets are equities. Many liabilities are a mixture of these exposures and will require a mix of these assets The retirement payments to inactive participants and the payments to active participants for past service constitute accrued benefits. If the benefits are not indexed to inflation, they will be hedged with nominal bonds A pension's future obligations are those arising due to wages to be earned in the future and new entrants into the plan. The first component is typically hedged with equities, nominal bonds, and real bonds, while the latter component is uncertain and not easily modeled or funded Non-market exposures (liability noise) can be divided into two parts: those that are due to plan demographics and those that are due to model uncertainty. These exposures are not easily hedged

Sponsor and Pension Fund Common Risk exposure

measured by correlation between firm's operating characteristics and pension asset returns. The higher the correlation between firm's operations and pension asset returns, the lower the risk tolerance. The opposite is also true

Plan features

offer participants the option of either retiring early or receiving lump sum payments from their retirement benefits. Plans that offer early retirement or lump sum payments essential decrease the time horizon of the retirement liability and increase the liquidity requirements of the plan. Therefore, the ability to assume risk is decreased

Asset/Liability Management (ALM) For Institution Investors (Pension Funds, Foundations, Endowments, Insurance Companies, Banks)

preferred framework for evaluation portfolios with definable, measurable liabilities. Focusing on asset return and risk is not sufficient. The focus should be on surplus and surplus volatility. At a minimum, asset and liability duration should be matched to stabilize surplus. Depending on risk tolerance, active management through defined deviations in asset and liability duration might be used to exploit expected changes in interest rates. DB Pension plans, insurance companies, and banks are most suited to ALM approach

Workforce characteristics

relate to the age of the workforce and the ratio of active lives to retired lives. In general, the younger the workforce, the greater the ratio of active to retired lives will be. This increases the ability to take risk when managing pension assets. The opposite is also true.

Liability-Relative approach

the portfolio is chosen for its ability to mimic the liability (portfolio will have a high correlation with the liability). If pension liabilities are correctly modeled, this will create the portfolio with the lowest surplus variability. The risk free investment is a portfolio that is highly correlated with and mimics the liability in performance. Likely invested in derivatives. This approach focuses on hedging the pension liabilities and might use derivatives to hedge the pension's market-related risks. This would free up capital to pursue higher expected returns. Advantage over asset only approach: One advantage to the liability-relative approach used by Locke-Berkeley is that it considers the market related risk of the pension liabilities whereas the asset-only approach used by Prometheus Pyro does not. Pension liabilities, representing the present value of deferred wages, are driven by many market related exposures, such as interest rates, inflation and economic growth. Failing to integrate these exposures can result in inefficient investment policies when measured versus liabilities, as they may be exposed to excessive and unrewarded risk relative to liabilities. As a result, the liability-relative approach used by Locke-Berkeley has lower market-related risk because it better matches the risk of the pension assets with the risks of the pension liabilities. How to provide expected return in excess of pension liabilities: Plan managers create an investment benchmark from assets that mimic the specific market related risks associated with the pension liabilities of each demographic group. Then managers use derivatives to hedge the market-related exposures of the liability-mimicking assets making up the investment benchmark. This is more efficient than investing in the low risk portfolio defined by the investment benchmark because the derivatives require far less capital, thus freeing up funds, which can then be used for efficient return generation within asset-only space once the liabilities have been hedged. The funds invested in this asset-only space allow the Locke-Berkeley plan to generate returns in excess of the pension liabilities, thereby decreasing the need for future cash contributions.

Employee stock ownership plan (ESOP)

type of defined-contribution benefit plan that allows employees to purchase the company stock. The purchase can be with before or after-tax dollars and the final balance in the beneficiary's account reflects the increase in the value of the firm's stock as well as contributions during employment.

Traditional asset-only

usually predominantly equities with the remainder in short- and medium-duration nominal bonds. The liability-mimicking portfolio is typically composed of derivatives, long duration bonds, inflation-indexed bonds, and equities, as well as other components dedicated to generating an efficient return. The liability-mimicking, low-risk portfolio is costly and does not provide a return in excess of the liabilities.