Level 3 SS5

Defined benefit:

-sponsor company agrees to make payments to employees after retirement based on criteria (avg salary, # yrs worked) ○ As future benefits are accrued by employees, the employer accrues a liability equal to the present value of the expected future payments. ○ This liability is offset by plan assets which are the plan assets funded by the employer's contributions over time. ○ A plan with assets greater (less) than liabilities is termed overfunded (underfunded). ○ The employer bears the investment risk and must increase funding to the plan when the investment results are poor.

LOS 15.a: Contrast a defined-benefit plan to a defined-contribution plan and discuss the advantages and disadvantages of each from the perspectives of the employee and the employer.

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LOS 15.c: Evaluate pension fund risk tolerance when risk is considered from the perspective of the 1) plan surplus, 2) sponsor financial status and profitability, 3) sponsor and pension fund common risk exposures, 4) plan features and 5) workforce characteristics

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LOS 15.e: Evaluate the risk management considerations in investing pension plan assets

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LOS 15.i: Compare the investment objectives and constraints of foundations, endowments, insurance companies, and banks.

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LOS 15.j: Prepare an investment policy statement for a foundation, an endowment, an insurance company, and a bank.

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SEE PAGE 30 AND 31 OF BOOK 2 FOR FACTORS AFFECTING INVESMENT POLICIES OF INSTITUITONAL INVESTORS.

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DB Plan risk on the sponsor. The company needs to consider two factors:

1. Pension investment returns in relation to the operating returns of the company a. This is the issue of correlation of sponsor business and plan assets considered earlier, now viewed from the company's perspective. b. Company should also favor low correlation to minimize the need for increasing contributions during periods of poor performance. c. The plan should avoid investing in the sponsor company (often illegal) and in securities in the same industry or otherwise highly correlated with the company. 2. Coordinating pension investments with pension liabilities a. This is an ALM issue b. By focusing on managing the surplus and stability of surplus, the company minimizes the probability of unexpected increases in required contributions.

What are the five things that affect the risk tolerance (ability and willingness to take risk) for a defined benefit plan?

1. Plan surplus: the greater the plan surplus, the greater the ability of the fund to withstand poor/negative investment results without increases in funding. a. Thus allows higher risk tolerance b. Negative surplus might increase the sponsors desire for risk taking in hope of higher returns would reduce need to make contributions. BAD, don't allow. c. DB plans will range from low to moderately above avg risk tolerance. 2. Financial status and profitability: debt to equity and profit margins indicate the financial strength and profitability of th e sponsor. a. The greater the strength, the greater the plan's risk tolerance. b. Both lower debt and higher profitability indicate an ability to increase plan contributions if investment results are poor. 3. Sponsor and pension fund common risk exposures a. The higher correlation between firm profitability and the value of plan assets, the less the plan's risk tolerance. 4. Plan features: provisions for early retirement or for lump-sum withdrawals decrease the duration of the plan liabilities and, other things equal, decrease the plan's risk tolerance. a. Any provisions that increase liquidity needs or reduce time horizon reduce risk tolerance. 5. Workforce characteristics: the lower the average age of the workforce, the longer the time horizon and, other things equal, this increases the plan's risk tolerance. a. The higher the ratio of retirees drawing benefits to currently working plan participants, the greater the liquidity requirements and the lower the fund's risk tolerance. b. When the ratio of active lives to retired lives is higher the plan's risk tolerance is higher.

Key considerations of non life risk

1. The cash flow characteristics of non life companies are often erratic and unpredictable. Hence, risk tolerance as it pertains to loss of principal and declining investment income, is quite low. 2. The common stock-to-surplus ratio has been changing. Traditionally the surplus might have invested in stock. Poor stock market returns in the 197 0s and regulator concerns lead to reduced stock holdings. Bull markets in the 1990s only partially reversed this trend.

Endowment constraints

1. Time horizon: perpetual 2. Liquidity requirements: low. Only emergency needs and current spending require liquidity. However large outlays may require higher levels of liquidity. 3. Tax considerations: endowments are generally tax exempt. In us, sometimes. Unrelated business income tax may have to be paid. If a case does include details on taxation note this as tax constraint and consider the after tax return of tht asset. 4. Legal and regulatory considerations: regulation is limited. a. In us, tax regulations require earnings from tax-exempt entities not be used for private individuals. b. Most states have adopted the uniform management institutional fund act (UMIFA) of 1972 as the governing regultion for endowments. If no specific legal considerations are stated in the case, for us entities, state umifa applies. Other countries may have other laws. 5. Unique: diverse so may have unique. a. Social issues b. Long term, so often alternative investments. The cots and complexity of these assets should be considered. c. Generally require active management expertise.

What is shortfall risk?

Another way to set a risk objective for DB plan is to focus on shortfall risk ○ It is the probability that the plan asset value will be below some specific level of have returns below some specific level) over a given time horizon. ○ May be estimated for a status at some future date of fully funded (relative to the PBO) Funded with respect to the total future liability Funded status that would avoid reporting a liability (negative surplus position) on the firms balance sheet Funded status that would require additional contribution requirements of regulators or additional premium payments to a pensi on fund guarantor

Non life ins. Unique circumstances

No generalizations to make

Non life conclusion

Portfolio is first structured for liquidity needs. A portfolio of bonds and Stocks is used to increase return. The management of the portfolio must be coordinated with the company's business needs.

Funded status

Refers to the difference between the present values of the pension plan's assets and liabilities

Non lice insurance company constraints (legal and regulatory)

Regulatory considerations are less onerous for non life insurance companies than for life insurance companies. An asset valua tion reserve (AVR) is not required, but risk based capital ((RBC) requirements have been established. Non life companies are given considerable leeway in choosing investments compared to life insurance companies.

Non-life insurance company objectives risk

Risk: quasi fiduciary requirement ad must be invested to meet policy claims. The payoffs on claims are less predictable. Inflation risk if the payout is based on replacement cost of the insured item

Defined contribution (DC) plan:

company agrees to make contributions of a certain amount as they are earned by employees (e.g. 10% of salary each month) into a retirement account owned by the participant. ○ Still may be vesting rules, generally an employee legally owns his account assets and can move the funds if he leaves prior to retirement. Plan has portability. ○ At retirement, the employee can access the funds but there is no guarantee of the amount. ○ In a participant directed DC plan, the employee makes the investment decisions and in a sponsor directed DC plan, the sponsor chooses the investments. ○ Either case, the employee bears the investment risk and the amount available at retirement is uncertain in a DC plan. Firm has no future liability.

Plan surplus

is calculated as the value of plan assets minus the value of plan liabilities. When plan surplus is positive the plan is over funded and when negative, it is underfunded

Total future liability

is more comprehensive and is the PBO plus the present value of the expected increase in the benefit due current employees in the future from their service to the company between now and retirement. Could include such items as possible future changes in the benefit formula that are not part of the PBO. Some plans may consider it as in the benefit formula that are not part of the PBO. Some plans may consider it as supplemental information in setting objectives.

Projected benefit obligations

is the ABO plus the present value of the additional liability from projected future status for ongoing (not terminating) plans.

Accumulated benefit obligation (ABO)

is the total present value of pension liabilities to date, assuming no further accumulation of benefits. It is the relevant m easure of liabilities for a terminated plan.

Fully Funded:

refers to a plan where the values of plan assets and liabilities are approximately equal.

Active lives

the number of currently employed plan participants who are not currently receiving pension benefits.

Retired lives:

the number of plan participants currently receiving benefits from the plan (retirees)

Cash Balance Plan:

type of DB plan in which individual account balances (Accrued benefit) are recorded so they can be portable. ○ A profit sharing plan is a type of DC plan where the employer contribution is based on the profits of the company. ○ A variety of plans funded by an individual for his own benefit, grow tax deferred, and can be withdrawn at retirement ((e.g. individual retirement accounts or IRAs) are also considered defined contribution accounnts.

Non-Life insurance companies

• ALM is still crucial. Differs from life insurance in several areas: ○ While the product mix is more diverse, the liability durations are shorter. Typically covers 1 yr insurance. Often long tail- claim filed and take years to process before payout. ○ Inflation risk: company may insure replacement value of the insured item creating less certain and higher payoffs on claims. In contrast, life insurance policies are typically for a stated face value. ○ Non life is hard to predict in both amount and timing. ○ Non life insurers have an underwriting or profitability cycle. Vary over 3-5 year cycle and portfolio may be liquidated to supplement cash flow. ○ Non-life business risk can be very concentrated geographically or with regard to specific events ○ Thus.... Operating results for non life insurance companies are more volatile than for life insurance companies, duration is shorter, liquidity needs are both larger and less predictable.

LOS 15.m: compare the asset/liability management needs of pension funds, foundations, endowments, insurance companies, and banks

• ALM is the preferred framework for evaluation portfolios with definable, measurable liabilities. • Focusing on asset return and risk is not sufficient. 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 assets and liability duration might be used to exploit expected changed in interest rates. • DB pension plans, insurance companies, and banks are the most suited to the ALM approach.

Employee Stock ownership plans (ESOP)

• An ESOP is a type of defined contribution benefit palm that allows employees to purchase the company stock, sometimes at a di scount from market price. • Purchase can be before or after tax dollars • Final balance in the beneficiary account reflects the increase in the value of the firm's stock as well as contributions duri ng employment. ESOPs receive varying amounts of regulation in different countries. • ESOP is an exception to the general version to holding the sponsors securities in a retirement plan. • It does expose the participant to a high correlation between plan return and future job income.

Leverage adjusted duration gap

• Another regulatory tool. It is defined as the duration of the barks assets less the leveraged duration of the banks liabilities

LOS 16.a: contrast the assumptions concerning pension liability risk in asset-only and liability relative approaches to asset allocation.

• Asset only approach: pension fund focuses on selecting efficient portfolios. Does not attempt to explicitly hedge the risk of the liabilities. Ignores fact that a future liability is subject to market related risk. Market risk arises form interest rate risk, inflation risk, or from an exposure to economic growth. If firm does well due to economy, its wages paid may go up and future liability will increase. Failure to recognize the risk in the liabilities could lead to a portfolio that does not adequately satisfy the liabilities. ○ Risk free investment is the return on cash • Liability relative approach: more appropriate asset allocation approach would recognize economic liability. This approach recognizes the various exposures and components of the pension liability, as an ability to mimic the liability. (portf. Will have high correlation with the liability) ○ The risk free investment is a portfolio that is highly correlated with and mimics the liability in performance. Have to decom pose the liability into its various exposures. Can be used for non pension obligations like meeting insurance liabilities too.

Bank risk measures

• Both assets and liabilities are sensitive to changing interest rates. • Must continually monitor their interest rate risk • Value at risk (VAR) is a commonly used tool. Regulators often define and specify calculation methodology set minimum target l evels, and impose restrictions if targets are not met.

Obligations to active participants:

• Can be separated into that owed for past service and that owed for future service. Past service are analyzed like those for inactive prticipants and matched with real rate and nominal bonds based on whether or not the pat service benefits are linked to inflation. The retirement payments owed to inactive part icipants and the payments for PST service to active constitute ACCRUED BENEFITS.

LOS 15.g: Discuss hybrid pension plans (e.g. cash balance plans) and employee stock ownership plans.

• Cash balance plans are a type of defined-benefit plan that defines the benefit in terms of an account balance. ○ A participant's account is credited each year with a pay credit and an interest credit. Pay credit is based upon the beneficiary age, salary, and or length of employment, while the interest credit is based upon a benchmark such as U.S. treasuries. These features are similar to DC plans. Who bears the risk in a cash balance plan? • The sponsor bears all the investment risk because increase and decrease in the value of the plan's investments do not affect t he benefit amounts promised to participants. At retirement can take lump sum or roll into another plan or receive lifetime annuity.

Other life insurance risks

• Cash flow volatility: life insurance companies have a low tolerance for any loss of income or delays in collating income from investment activities. ○ Reinvesting interest on cash flow coming in is a major component of return over long periods. ○ Most companies seek investments that offer minimum cash flow volatility. • Credit risk: credit quality is associated with the ability of the issuers of debt to pay interest nd principal when due. ○ IMPORTANT TO MAINTAIN

Life insurance companies

• Common to separate the investment portfolio by type of policy (line of business) and invest to match the needs of that product. • Whole life or ordinary life: requires level payment of premiums over multiple years to the company and provides a fixed payoff amount at the death. Include a cash value allowing the policyholder to terminate the policy and receive that cash value. Can also borrow it. Cash value builds up over the life of t he policy at a crediting rate. Can Create. Need for higher return on the portfolio. ○ Disintermediation risk: periods of high interest rates when policyholders are more likely to withdraw cash value causing increased demand for liquidity from the portfolio. High rates are also likely to be associate with depressed market values in the portfolio. ○ Duration of whole life is usually long, the combination of policy features and volatile entered rates makes the duration and time horizon of the liabilities more difficult to predict. ○ Overall, competitive market factors and volatile interest rates have led to shortening the time horizon and duration of the investment portfolio. • Term life provides insurance coverage on a year by year basis leading to very short duration assets to fund the short duratio n liability. • Variable life, universal life, and variable universal life include a cash value build up and insurance, but the cash value buildup is linked to investment returns. ○ Features are less likely to trigger early cash withdrawals but increase the need to earn competitive returns on the portfolio to retain and attract new customers.

Complicating factors impacting non-life insurance company return objectives that do notaries for life insurance companies include:

• Competitive pricing policy: high return objectives allow the company to charge lower policy premiums and attract more business, but when high returns are eared the companies tend to cut premiums. (underwriting cycle) • Profitability: investment income and return on investment portfolio are primary determinants of company profitability. They a lso provide stability to offset the less table underwriting cycle of swings in policy pricing. The company seeks to maximize return on the capital and surplus consistent with appropriate ALM. • Growth of surplus: higher returns increase the company's surplus. This allows the company to expand the amount of insurance it can issue. Alternative investments, common stocks, and convertibles have been used to seek surplus growth. • After tax returns: non life insurance companies are taxable entities nd seek after tax return. At one time differential taxation rules in the united states led to advantages in holding tax exempt bonds and dividend paying stocks. Changes in regulation have reduced this. • Total return: active portfolio management and total return re the general focus for at least some of the portfolio.Returns across companies are varied. Reflects wider latitude by non life regulators, a more varied product mix, varying tax situations, varying emphasis in managing for total return or for income, a nd differing financial strength of the companies.

Banks for the exam

• Driven by fundamentals of the banking business. • O&C dependent upon place in the overall asset liability structure of the bank • Make money on the spread between interest earned on assets less paid on liabilities. • Potential problem: liabilities are mostly in the form of short-term deposits, while assets (loans) can be fairly long term in nature and illiquid. Loans generally offer returns higher than can be earned on the securities in which banks invest and are riskier. This leads to a significant mismatch in asset -liability durations, liquidity and quality. • Banks security portfolio is a residual use of funds (i.e. excess funds that have not been loaned out or required to be held a s reserves against deposits). • Primary purpose of the securities portfolio is to address the mismatch of liabilities (deposits) and the primary assets (loan s).

Banks: Duration, credit risk, income, and liquidity

• Easier and timelier to adjust characteristics of the investment portfolio than to adjust the characteristics of the liabiliti es or the other assets (loans) • Investment portfolio manager adjust the bank investment portfolio duration such that overall asset duration is kept in the de sired relationship to liability duration. • If forecast increasing interest rates, can decrease the duration of the portfolio to set the overall duration below the liability duration. If correct, the assets will decline by less than the liabilities for an economic gain. This is risky. Not done a lot. Bank leverage is very high with very low equity capital to a ssets. Thus, the primary goal is to adjust the duration of the portfolio such that overall duration of assets matches liability duration.

Endowments and Spending rules

• Endowments are legal entities that have been funded for the expressed purpose of permanently funding the endowments institutional sponsor (a not for profit that will receive the benefits of the portfolio. • Goal Is to preserve asset principal value in perpetuity and to use the income generated for budgetary support of specific activities. • Most have speeding rules- in US, foundations have a minimum required spending rule but endowments can decide their spending rate, change it, or just fail to meet it.

The future benefits for inactive participants could be:

• Fixed, not increasing with inflation, making nominal bonds the optimal benchmark • Fully indexed to inflation making real rate (real return) bonds such as treasury inflation protected securities (TIPS) the op timal benchmark • Or partially indexed, making a combination of real rate and nominal bonds appropriate.

LOS. 15.h: distinguish among various types of foundations, with respect to their description, purpose, source of funds, and annual spending requirements

• Foundations are grant making entities funded by gifts and an investment portfolio. • Endowments: long term funds owned by a non-profit institution (and supporting that institution) • Both are not for profit, serve a social purpose, generally are not taxed if they meet certain condition, are often perpetual, and unlike pension plans may well and should pursue aggressive objectives.

MARKET EXPOsures due to future benefits

• Future benefits are those from wages to be earned in the future by existing and new entrants. Do not affect short term risk but their effect on the plan's funded status and the ability to hedge these liabilities must be considered. ○ Wages: if you know the growth rate in wages then calculate the expected amount of future benefits. Future wage liability... add that to accrued benefits represents the projected benefit obligation under international standards. Inflation plus any real growth over and above inflation. The liability that will increase with inflation will require real return bonds as a benchmark; however, the future benefits a ssociated with those wages may or may not be inflation indexed so some nominal bonds may also be needed for the benchmark. Wage growth from real growth is due to increases in labor productivity. This productivity will be reflected in GDP growth, wh ich is strongly correlated with the stock market. The liability associated with wage increase over and above inflation can be best mimicked with stocks.

DB Plan objectives may include:

• Future pension contributions: return levels can be calculated to eliminate the need for contributions to plan assets. • Pension income: accounting principles require pension expenses be reflected on sponsor's income statements. Negative expenses , or pension income, can also be recognized. This also leads the sponsor to desire higher returns, which will reduce contributions and pension expense.

LOS 16.c: compare pension portfolios built from a traditional asset-only perspective to portfolios designed relative to liabilities and discuss why corporations may choose not to implement fully the liability mimicking portfolio.

• In terms of satisfying their future liability over the time, the best portfolio for a pension will be a liability mimicking p ortfolio consisting of nominal bonds, real return bonds, and stocks. ○ The weights are determined by the proportion of future obligations relative to accrued, inflation indexing of the benefits, and the plan status (whether it is frozen or growing) If workforce younger, more to equities. If a lot indexed to inflation, inflation indexed bonds are used more then nominal bonds. If plan is frozen, there are no future obligations and nominal bonds would dominate the portfolio. ○ Low risk. Will not proved a return in excess of the liabilities. ○ For pension plans, the best use of the low risk portfolio is as a benchmark. Outperforming the benchmark will ensure that the majority of the pensions obligations are met. The optimum is to outperform the benchmark, while minimizing the risk of not being able to meet obligation ○ In traditional asset only approach: the portfolio is usually composed of 60 -70% equities with the rest in short and medium duration nominal bonds. In liability relative Approach, derivatives can be used to hedge the market related exposure of the pension. Term structure risk is typically the largest plan exposure and can be hedged with bond futures contracts. Derivatives are relatively inexpensive and free up capital for use in a higher expected return portfolio component. Thus, the liability mimicking portfolio is typically composed of derivatives, long duration bonds, inflation indexed bonds and equities as well a other components dedicated to generating an efficient return.

DB Plan Constraints: (Legal and regulatory factors)

• In the US, employee retirement income security act (ERISA) regulates the implementation of defined-benefit plans. • Requirements of ERISA are consistent with the CFA program and modern portfolio theory in regard to placing the plan participants first and viewing the overall portfolio after considering diversification effects. • Key point to remember is that when formulating an IPS for a pension plan, the adviser must incorporate the regulatory framework existing within the jurisdiction where the plan operates ○ Consultation with appropriate legal expertise is required if complex issues arise. ○ A pension plan trustee is a fiduciary and as such must act in the best interests of the plan participants. A manager hired to manage assets for the plan takes on that responsibility as well.

LOS 15.k: contrast investment companies, commodity pools, and hedge funds to other types of institutional investors.

• Institutional investors up to now have managed money for a particular entity. Categorizing by group offers useful insights. A ll DB have similarities in their objectives and share common issues of analysis. Investment companies, commodity pools and hedge funds are institutional investors that are just intermedi aries that pool nd invest money for groups of investors and pass the returns through to those investors. ○ Investment companies are mutual funds and invest in accord with their prospectus. There are mutual funds to fit jut about any equity or fixed income investment style, from small cap growth funds to large cap value funds that invest exclusively in one of a variety of sectors or industries. ○ Commodity pools invest in commodity-related futures, options contracts, and related instruments. ○ Hedge funds are highly diverse. Grouping all hedge fund types under the same general heading explains virtually nothing about what each fund does. Hedge funds gather money from institutional and wealthy individual investors and construct various investment strategies aimed at identifying and capitalizing on mispriced securities. ○ All three of above pool money and pursue the stated objective of the portfolio.

Non-Market Exposures

• Liability noise: ○ Due to plan demographics: affected by number of participants and can be estimated using statistical model. ○ Model uncertainty: less predictable and is different for inactive versus active participants. • Inactive partipants ○ Retirees: mortality assumption... if incorrect there is little that can hedge ○ Deferreds: there is risk from mortality risk as well as uncertainty arising from when retirement occurs. The sooner the defer red retire, the smaller the benefit paid for a longer period of time. Thus, for deferred, there is uncertainty in the timing and amount of liability as well as longevity risk.Thus the liability risk is larger and less easily hedged than for retirees. • Active participants: ○ Liability noise is even larger ○ Often years from retirement and there is much uncertainty regarding the plan's future obligation.

Bank constraints

• Liquidity: a banks liquidity needs are driven by deposit withdrawals and demand for loans as well as regulation. The resulting portfolio is generally short and liquid. • Time horizon: the time horizon is short and linked to the duration of the liabilities. • Taxes: banks are taxable entities. After tax return is the objective. • Legal and regulatory: banks in industrialized nations are highly regulated. Risk based capital (RBC) guidelines require banks to establish RBC reserves against assets; the riskier the asset, the higher the required capital. This tilts the portfolio towards high quality, short term, liquid assets. • Unique- there are no particular issues.

Non-life insurance company constraints

• Liquidity: needs are high given the uncertain business profitability and cash flow needs. Company typically 1. Holds significant money market securities such as t bills and commercial paper 2. Holds a laddered portfolio of highly liquid government bonds, and 3. Matches assets against known cash flow needs. • Time horizon ○ Generally short due to the short duration of the liabilities. ○ Can be a subsidiary issue to consider in the united states. The asset duration (time horizon) tends to cycle swings from loss to profit in the underwriting cycle and decreasing or increasing use of tax-exempt bonds.In periods of loss, the company will use taxable bonds and owe no taxes. When profitable, may switch to tax-exempt bonds but the tax exempt bonds generally have a very steep yield curve. There is a strong incentive to purchase longer maturities for better yield.

Life insurance companies constraints

• Liquidity: volatility and changes in the market place have increased the attention life insurance companies pay to liquidity issues. Two key issues ○ Disintermediation risk: led to shorter durations, higher liquidity reserves, and closer ALM matching. Duration and disintermediation issues can be related. Say have asset duration greater than lab. If interest rates rise, asset value will decline faster than liability value. If company needs to sell assets to fund payouts it Wold ne doing so at low values. ○ Asset marketability risk: use to have more illiquid assets but the increased liquidity demands on portfolios have lead to greater emphasis on liquid assets. ○ Growth of derivatives has lead many companies to look for derivative based risk management solutions. • Time horizon: traditionally long at 20-40 years, it has become shorter for all the reasons discussed previously. Segmentation and duration matching by line of business is the norm. • Tax considerations: life insurance companies are taxable entities. Laws vary by country but often the return up to the actuar ial assumed rate is tax free and above that is taxed. Reality is complex and tax laws are changing. Ultimately after tax return is the objective. Complex and extensive!! Use that phrase. • Legal and regulatory constraints: heavily regulated, in US at state level. Often address the following: ○ Eligible investments: by asset class are defined and percentage limits on holdings are generally stated. Criteria such as the minimum interest coverage ratio on orpoate bonds are frequently specified ○ US, prudent investor rule: has been adopted by some states. Replaces the list of eligible investments approach above in favor of portfolio risk versus return. ○ Valuation methods commonly specified. Usually some form of book accounting.. Limits total return focus. • Unique circumstances: concentration of product offerings, company size, and level of surplus are some of the most common fact ors impacting each company.

What do banks also use the securities portfolio to do?

• Manage credit risk and diversification (if loans become geographically concentrated). Loans are illiquid and the investment portfolio will emphasize very liquid securities to compensate. The bank investment portfolio is heavily or exclusively short term government securities. • Can generate income but this should be a consideration after the other items discussed here have been addressed.

LOS 16.b: discuss the fundamental and economic exposures of pension liabilities and identify asset types that mimic these liability exposures

• Many pension managers measure their pension liability through duration management. This approach focuses on short -term changes in the liability relative to changes in interest rates. This is valid when pension risk is short term, as in the case of firms near bankruptcy. For ongoing plans, it is super ior to asset-only, but liability relative management is better. • Most pension plans are ongoing and the more appropriate liability modeling captures the risk of the funds not satisfying shor t term obligations as well as the risk of nit satisfying the longer term liabilities. Need decomposition of the liabilities risk exposures. Will help manager determine the appropriate di scount rate for pension liabilities.

DB Plan Constraints (Taxes)

• Most retirement plans are tax exempt and this should be stated. • If any portions are taxed, this should be stated in the constraints and considered when selecting assets.

Non life insurance company constraints (tax considerations)

• Non-life insurance companies are taxable entities. Applicable tax rules in the united states have been changing. After tax return is the objective.

LOS 15.b: Discuss investment objectives and constraints for defined-benefit plans

• Objectives and constraints are the same as the other.

Bank UPS (bank objectives) Risk and return

• Risk: acceptable risk should be set in an ALM framework based on the effect on the overall bank balance sheet. Banks usually have a below average risk tolerance because they cannot let losses in the security portfolio interfere with their ability to meet their liabilities. • Return: return objective form the bank securities portfolio is to earn a positive interest spread. The interest spread is th e difference between the banks cost of funds and the interest earned on loans and other investments.

Endowment Objectives (risk and return)

• Risk: dependent on funding from the endowment portfolio to meet its annual operating budget. Also considered with volatility in spending. ○ Because the time horizon for endowments is usually infinite, the risk tolerance or most endowments is relatively high. Need to meet spending requirements and keep up with inflation can make higher risk appropriate. ○ Ultimate decision is up to the board (and manager) • Return: one goal is to provide a permanent asset base for funding specific activities. Attention to preserving the real purchasing power of the asset base is paramount. ○ Total return appropriate. Form of return not important. Cuz if met, long run distributions will be covered. ○ Inflation needs to be covered. Should be the inflation rate related to what the endowment spends. For example health care. ○ Typical to add the spending rate, relevant inflation Rate, and an expense rate if specified, others argue for using the higher compound calculation.Monte Carlo can be used. If asset values fall and spending amount is fixed, distribution can disproportionately reduce the size of the portfolio available. Set return target higher than conventionally done.

Foundation objectives

• Risk: no contractually defined liability requirements, so foundations may be more aggressive than pensions on the risk tolera nce scale.If successful, then can increase social funding. If not, then can fun less in future. In either case, the benefit and risk are symmetrically borne. ○ The board of the foundation (and manager) will generally consider the time horizon and other circumstances of the foundation in setting the risk tolerance. • Return: time horizon is an important factor. I was set up for perpetual support, then preservation of real purchasing power is important. ○ Guideline is to set a minimum return equal to the required payout plus expected inflation and fund expenses. This might be done by either adding or compounding the return elements. (note: this issue is discussed under endowments

Life insurance company objectives

• Risk: public policy views insurance company investment portfolios as quasi trust funds. Being able to pay death benefits is important. • NAIC directs life insurance companies to maintain an asset valuation reserve (AVR) as a cushion against substantial losses of portfolio value or investment income. Movement is towards risk based capital, which requires company to have more capital and less financial leverage the riskier the assets in the portfolio.

Three forms of spending rules for endowments are as follows:

• Simple pending rule: most straightforward spending rule is spending to equal the specified spending rate multiplied by the be ginning period market value of endowment assets: ○ Spending = S(mrket value t-1) Where s = the specified spending rate • Rolling 3 year average spending rule ○ Spending amount that equals the spending rate multiplied by an average of the three previous Year's market value of endowment assets. Idea is to reduce the volatility of what the portfolio must distribute and of what the sponsor will receive and can spend ○ Spending t= (spending rate)(market valuet-1 + market valuet-2 + market value t-3 / 3) • Geometric spending rule ○ The geometric spending rule gives some smoothing but less weight to older periods. ○ It weights the prior yrs spending level adjusted for inflation by a smoothing rate, which is usually between 0.6 and 0.8, as well as the previous years' beginning-of-period portfolio value: Spendingt= (R )(spending t-1)(1+It-1)+(1-R)(S)(mrket value-1) R=smoothing rate i=rate of inflation S=spending rate

Insurance Companies

• Stock companies and mutual companies. Recently, many mutual have been demutualized and become stock companies

DB Plan Constraints (Liquidity):

• The pension plan receives contributions from the plan sponsor and makes payments to beneficiaries • Any net outflow represents a liquidity need. Liquidity requirements will be affected by: ○ The number of retired lives. The greater the number of retirees receiving benefits relative to active participants, the greater the liquidity that must be provided. ○ The amount of sponsor contributions. The smaller the corporate contributions relative to retirement payments, the greater the liquidity needed. ○ Plan features: Early retirement or lump-sum payment options increase liquidity requirements.

LOS 15.d: Prepare an investment policy statement for a defined-benefit plan

• The primary objective of a DB plan is to meet its obligation to provide promised retirement benefits to plan participants. • The risk of not meeting this objective is best addressed using an asset/liability management (ALM) framework ○ Under ALM, risk is measured by the variability (Standard deviation) of plan surplus. ○ Alternatively, many plans still look at risk from the perspective of assets only and focus on the more traditional standard deviation of asset returns.

DB Plan Constraints (Time Horizon):

• The time horizon of a defined-benefit plan is mainly determined by two factors: ○ If the plan is terminating, the time horizon is the termination date ○ For an ongoing plan, the relevant time horizon depends on characteristics of the plan participants. Legally, may have infinite life. Can view as multistage time horizon, one for active lives and one for retired lives... view portfolio as 2 sub portoflios. □ Active horizon to retirement □ Life expectancy for retired

DB Plan Constraints: (Unique Circumstances):

• There are no unique issues to generalize about. Possible issues include: ○ A small plan may have limited staff and resources for managing the plan or overseeing outside managers. This could be a larger challenge with complex alternative investments that require considerable due diligence. ○ Some plans self impose restrictions on asset classes or industries. This is more common in government or union-related plans.

What about unplanned changes to the plan that increase benefits?

• These are not funded with current assets or reflected in the projected liabilities, so they are not reflects in the benchmark . • The plan sponsor must pay for these with contributions and the earnings on those future contributions.

Lo 15.f: Prepare an investment policy statement for a defined contribution plan

• This is simpler than the other • With a participant directed DC plan, there is no one set of objectives and constraints since they may be different over time and across participant accounts • The ips for this type of plan deals with the sponsor's obligation to provid3 investment choices (at least three under ERISA) that allow for diversification and to provide for the free movement of funds among the choices offered. • Sponsor should provide some guidance and education for plan participants so they can determine their risk investment choices offered. • When the sponsor offers a choice of company stock, the UPS should provide limits on this as a portfolio choice to maintain ad equate diversification (think Enron) • SO OVERALL: ○ The ips outlines the policies and procedures for offering the choices, diversification, and education to participants that they need to addres their own objectives of risk and return, well as there constraints. Sponsor directed plan has no specified future liability to consider in setting the objectives and constraints.

Foundation Constraints

• Time Horizon: most have infinite, tolerate above average risk and choose securities that tend to offer high returns as well a s a preservation of purchasing power. • Liquidity: foundation's anticipated spending requirement I termed its spending rate. Many countries specify a minimum spending rate, and failure to meet this will trigger penalties. US has a 5% rule to spend 5% of previous year assets. Other situations may follow a smoothing rule to average out distributions. ○ Usually need to earn inflation rate to maintain real value of portfolio and distributions. Earning required distribution and inflation can be challenging with conflicting interpretations for risk. It may argue high risk to meet the return target or less risk to avoid the downside of disappointing returns. ○ Many organizations find it appropriate to maintain a fraction of the annual spending as a cash reserve in the portfolio. • Tax: except for private foundations in US, foundation are not taxable entities. One concern relates to unrated business incom e, which is taxable at the regular corporate rate. On average, tax considerations are not a major concern for foundations. • Legal: rules vary by country and even by type of foundation. ○ In US, most states have adopted the uniform management institutional funds act (UMIFA) as the prevailing regulatory framework. Most other regulations concern the tax-exempt status of the foundation. Beyond these basics, foundations are free to pursue the objectives they deem appropriate.

Market exposures due to accrued benefits

• To decompose the liability's exposures, the pension obligation should be separated into that due to inactive and that due to active participants.

DB Plan Return Objective

• Ultimate goal of a pension plan is to have pension assets generate return sufficient to cover pension's liabilities. • The specific return requirement will depend on the plan's risk tolerance and constraints. • At a minimum, the return objective is the discount rate used to compute the present value of the future benefits. • If a plan were fully funded, earns the discount rate, and the actuarial assumptions are correct, the fully funded status will remain stable.

Non-life return

• Use to act like two separate companies, an insurance company and an investment company. Investment returns were not factored into calculating policy premiums charged for insurance. • Things have changed but there is still a mix of factors affecting the return requirement: the competitive pricing of the insu rance product, need for profitability, growth of surplus, tax issues, and total return.

Life insurance return:

• Use to want return that matched actuaries projected policy payouts. • Most desired now is to earn a net interest spread, a return higher than the actuarial assumption. Consistent higher returns w ould grow the surplus and give the company competitive advantage in offering products to the market at a lower price (i.e. lower premiums) • Can be difficult to look at total return. Regulation requires liabilities be shown at some version of book value. Lib at book and assets at market can create aggressive objectives such as stock, real estate, and private equity.

Life insurance risk... valuation risk and reinvestment risk

• Valuation risk: interest rate risk. Any mismatch between duration of assets and of liabilities will make the surplus highly v olatile a the change in value of the asses will not track the change in value of liabilities when rates change. The result is the duration of assets will be closely tied to the duration of liabilit ies. • Reinvestment risk: important for some products. Annuity products. Company must invest the premium and build sufficient value to pay off at maturity. Also need the investments to generate good reinvestment Rte as the coupon cash flow comes into the portfolio. • ALM is main tool to control for both. The risk objective will typically state the need to match asset and liability duration or closely control any mismatch.

LADG should predict the theoretical change in fair market value of bank equity capital if interest rates change. If LADG is:

• Zero, equity should be unaffected by interest rate changes • Positive equity change is inverse to rates (e.g. rates up equity down) • Negative, equity value moves in the same direction as rates.