Managing Institutional Investor Portfolios
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1 Managing Institutional Investor Portfolios Pension Fund IPS Return Requirement Fully fund ABO, strive towards PBO, Pay all benefit & expense obligations Long term growth, inflation protection Maintain funding cushion: (assets > liabilities) Balance sheet approach: matching CFs assets/liabilities Maintain flexibility regarding future contributions Exceed actuarial earnings assumptions, ie. Return > Disc. Rate 1. Reserves: asset/liability matching (FIS) 2. Surplus: excess funds (LT FIS, int. sensitive stocks) Risk Tolerance Primary risk is inflation risk Contingent upon age of workforce and funded status Time Horizon Time horizon depends on age of workforce (going concern: infinite) Liquidity Needs Usually low, but increases with the maturity of the plan participants You know the nature of your cash flows Tax Constraints Tax exempt, only Surplus pension asset withdrawals are taxed, 10% Regulatory/Legal ERISA, solely in the interest of plan participants Key Pension Accounting Relationships Discount Rate, Growth Rate, E(r) PA, PBO, ABO, SC, IC, Net PC, Earnings PBO, ABO, SC, IC, Net PC, Earnings Net Pension Cost, Earnings Exam Preparation & Investment Sales Training 1 info@examsuccess.ca
2 Pension Fund IPS Example Rogers Cable (RC) is a leading international company with few major competitors and a market capitalization of $10 billion. The assets of the RC Defined Benefit Pension Plan have a current market value of $100 million. Using a 5%, RC s actuary calculates the value of its Projected Benefit Obligation to be approximately $100 million with a duration of 15 years. RC has an early retirement feature which includes annuity and lump-sum pay-out options for long-term employees over 50 years old. Few employees are currently planning to retire early The remainder of this question can be found on our Level 3 Test Bank. The Level 3 Test Bank contains hundreds of minutes of Essay style questions and 30 full Item Sets. The cost of the Test Bank is only $99 (+tax) To gain access, simply click on the Buy Now below and you will be taken to our ecommerce/paypal site where you can complete the transaction. Thank you. Best of luck with your studies! Exam Success Buy Now Exam Preparation & Investment Sales Training 2 info@examsuccess.ca
3 Foundation/Endowment IPS Return Requirement Preserve the purchasing power of the assets through time Provide a stable contribution to the institution s operating budget (current spending) Higher allocation to high return equities TR = Earnings + Capital Appreciation RR = Spending Rate + Inflation Risk Tolerance Primary risk is purchasing power risk High risk tolerance, due to long time horizon Time Horizon Have a perpetual life and perpetual funding requirement Liquidity Needs Usually low You know the nature of your cash flows Distributions can easily be met from a combination of income and readily marketable securities Tax Constraints Tax exempt In U.S. minimum 5% spending requirement to maintain tax exempt status Regulatory/Legal Prudent Investor rule Relatively low when compared to other institutional investors Exam Preparation & Investment Sales Training 3 info@examsuccess.ca
4 Foundation IPS The Xerex Foundation is a U.S. foundation that primarily supports the Heally Retirement Home. Over the past five years, Xerex has directly contributed over 80% of Heally s operating budget. Health care costs have grown at 1 percent above the annual rate of inflation, and this trend is expected to continue.. The remainder of this question can be found on our Level 3 Test Bank. The Level 3 Test Bank contains hundreds of minutes of Essay style questions and 30 full Item Sets. The cost of the Test Bank is only $99 (+tax) To gain access, simply click on the Buy Now below and you will be taken to our ecommerce/paypal site where you can complete the transaction. Thank you. Best of luck with your studies! Exam Success Buy Now Exam Preparation & Investment Sales Training 4 info@examsuccess.ca
5 Life Insurance Company IPS Return Requirement Earning a competitive ROA used to fund liabilities & funds surplus Spread management, surplus (common stocks, RE, VC) Investment practice is liability driven Segment portfolios by grouping liabilities 1. Reserves: assets/liability management (low risk, spread management) 2. Surplus: excess funds (above average risk, growth objective) Risk Tolerance Low - shortening time horizons Primary risk is interest rate risk, reinvestment rate risk Economic viability jeopardized with possible principal loss or interruption in investment income Time Horizon Shortening of time horizons due to volatility in interest rates Segmented portfolios Liquidity Needs High, key investment constraint: know liabilities, unknown timing Prime concern of regulators Higher levels of policy surrenders/loans Tax constraints Policyholder s share of income is tax exempt, surplus is taxable Regulatory/Legal High degree of regulatory scrutiny Prevent company failures Regulators restrict permissible investments Exam Preparation & Investment Sales Training 5 info@examsuccess.ca
6 Non-Life Insurance Co. IPS Return Requirement Profitability and growth of surplus (VC, common stocks) Risk Tolerance Safety a major concern Steady CFs Time Horizon Shorter than life insurance company Shorter duration of liabilities Liquidity Needs Key constraint, due to uncertainty of liabilities Tax constraints Taxable, underwriting cycle: profits: invest in tax free municipals Regulatory/Legal Less restrictions than life insurance companies No valuation reserves required Exam Preparation & Investment Sales Training 6 info@examsuccess.ca
7 Linking Pension Liabilities to Assets Asset-only vs. Liability-relative Approach to Asset Allocation Current accounting rules smoothed out the effects of asset/liability mismatch Setting portfolios from the asset-only perspective assumes that the liability has no market risk Inefficient investment policies Exposure to excessive risk Liability modeling must include, short-term volatility of the plan costs and long-term risk of pension assets being insufficient to offset the liability Pension Liability = PV (future benefits) Liability mimicking portfolio is the low risk investment, meaning it has a high probability of tracking the pension liability as it grows and changes over time Mimicking portfolio is too expensive to maintain over time Fundament and Economic Exposures Inactive Participants (retirees) members currently receiving pension benefits - Indexing for inflation? If not, consider retiree benefits to be fixed (like a bond) - Best mimicking portfolio is a bond with cash flows that match the benefit payments - Indexed for inflation? Yes, best mimicking portfolio is a mixture of real rate bonds and nominal bonds or 100% inflation linked bonds Active Participants current workforce (liability consists of ABO and PBO) Accrued benefits Future Wage Growth Future Participants - estimate liability attributed to future new entrants (if appropriate) Closed Plan Ongoing Plan Bottom line: selection of the appropriate benchmark: Portion of the Investment Benchmark Market Related Exposures Liability Mimicking Assets Inactive participants Term structure Nominal bonds Active accrued liability Term structure Nominal bonds Active future wage liability Inflation Growth Term structure Real rate bonds Equities Nominal bonds Liability noise - non-market related exposures that cause uncertainty (demographics and probabilities) Inactive Participants liability noise is related to the mortality assumption Active Participants - liability noise is related to assumptions regarding withdrawals, disability, etc. Exam Preparation & Investment Sales Training 7 info@examsuccess.ca
8 Traditional Asset-only Portfolio Design vs. Portfolios Designed Relative to Liabilities Liability Mimicking Portfolio Based on the discussed exposures, XYZ Corp's investment benchmark is some combination of nominal bonds, real rate bonds and equities. Crucial Question: What is the combination? Combination of liability mimicking assets - use economic and fundamental factors to link liabilities and assets to determine the investment benchmark. Accrued benefit liability primarily market related exposures relevant factor is the term structure real rate, inflation and nominal bond premium Future wage liability exposed to change in wage level, economic growth and inflation equity growth is a relevant factor as well If the plan provides inflation indexing liability similar to real rate bonds exposed to changes in the real rate bond premium Economic and fundamental factors underlying the asset cash flows real risk-free rate, inflation, risk premiums and equity growth Factor Models Think about CAPM components Set asset and liability sensitivities versus the factors Estimate of residual risk (liability noise) Exam Preparation & Investment Sales Training 8 info@examsuccess.ca
9 Asset-Only vs. Liability Relative Approaches Example: Dean Simmons, CFA, Chairs the Board which manages the Defined benefit pension plan for KISS Corp. Simmons has employs a traditional approach to asset allocation. Simmons believes this is the best way to go because there really are no market related liability risks to be concerned about, since the pension liabilities are only exposed to changes in the term structure. Simmons goes on to say that he should focus on low risk investments, which exhibit high correlations to the pension liabilities. The retiree portion of the KISS Corp. pension plan is fully indexed for inflation, (on a one-to-one basis) and is adjusted based on changes in the Consumer Price Index. The future wage inflation liability is also linked to the CPI and one half of the real wage growth is assumed to be highly correlated to with domestic equities. The Board has recommended eliminating the indexing benefit in an effort to manage costs. Simmons has gathered the following data: Table 1 Components of Estimated Future Benefit Payments in Year 12 Liability Exposure Amount of Payment Retirees 10 Active Accrued 9 Deferreds 5 Future Wage Inflation 6 Future Real Wage Growth 2 The Board asks Simmons to develop a liability mimicking portfolio based on the liability exposures for all future estimated pension payments in Year 12. Boards fiscal review policy request: The Board asks Simmons to develop strategies that will fully hedge the Company s market related pension liability and reduce the expected cost of the plan to the Company. 1. Which comment made by Simmons regarding the traditional approach is most likely correct? A. there really are no market related liability risks to be concerned about B. the pension liabilities are only exposed to changes in the term structure C. low risk investments, which exhibit high correlations to the pension liabilities. Exam Preparation & Investment Sales Training 9 info@examsuccess.ca
10 2. Based on the data Simmons gathered in Table 1, in a liability mimicking portfolio, which of the following amounts is closest to the pension payments in Year 12 that could be mimicked using real rate bonds? A. $10 B. $13 C. $16 3. Based on the data Simmons gathered in Table 1, in a liability mimicking portfolio, which of the following amounts is closest to the pension payments in Year 12 that could be mimicked using nominal bonds? A. $13 B. $14 C. $15 4. Which of the non-market factors would least likely have an impact on the KISS Corp. pension liability? A. an increase in the company retiree s savings rate B. a decrease in the number of participants versus projections C. medical innovations resulting in changes to the mortality rate 5. Which of the following characteristics are most closely associated with a low risk investment for a pension plan in the context of the liability-relative approach? A. high correlations with pension liabilities B. low correlations with other investment assets C. low correlations with the term structure 6. Which of the following strategies will most likely satisfy the Boards fiscal review policy request? A. use derivatives to hedge the market related pension liability and invest the remaining cash using a traditional approach B. use real rate and nominal bonds to hedge the market related pension liability and invest the remaining cash in a well diversified return generating portfolio C. use derivatives to hedge severe declines in the equity and bond markets and invest the remaining cash in a well diversified return generating portfolio Exam Preparation & Investment Sales Training 10 info@examsuccess.ca
11 Solutions: 1. X Solutions to this Item Set can be found on our Level 3 Test Bank. The Level 3 Test Bank contains hundreds of minutes of Essay style questions and 30 full Item Sets. The cost of the Test Bank is only $99 (+tax) To gain access, simply click on the Buy Now below and you will be taken to our ecommerce/paypal site where you can complete the transaction. Thank you. Best of luck with your studies! Exam Success Buy Now Exam Preparation & Investment Sales Training 11 info@examsuccess.ca
12 Allocating Shareholder Capital to Pension Plans Funding Shortfall vs. Asset/Liability Mismatch Funding shortfall present value of the plan assets are less than the present value of the plan liabilities Shortfall amount treated as debt Expected return vs. Actual return and smoothing issues Asset/liability matching refers to duration matching Simple balance sheet numbers representing the shortfall (or surplus) do not provide an indication of the true risk Asset return SWAP: pay fixed, receive total return on equities Bottom line: mismatch presents bigger risk than shortfall in funding Weighted Average Cost of Capital (WACC) Adjustments The question is to include pension risk in capital budgeting WAAC assumes all projects have the same risk, which is equal to the average risk of the firm Pension adjusted leverage ratio Bottom line: not including pension assets and liabilities results in WACC being overstated and the firm may pass up potentially value enhancing projects Pension Asset Allocations and Balance Sheet Issues Companies with underfunded pensions traded at lower P/E and P/BV than firms with fully funded pension plans, so the risk was recognized by the market The market also captured mismatch risk (ie. equity assets funding fixed-income liabilities) as well, reflected as a larger Beta Pension liabilities are often excluded from the debt calculation and not included in the leverage calculation (resulting in an understatement of the leverage ratio) Pension assets are commonly invested in volatile equity securities and that risk is not captured on the balance sheet Fraction of Pension Assets in Equities Pension Asset Allocations Effects Pension Asset Beta Total Asset Beta Firm Equity Beta Increase allocation of pension assets to equities increases the risk of the total assets. If the risk of the assets increase, in order to keep the risk of the equity unchanged, must reduce the leverage (decrease D/E ratio) If you increase the asset risk and leave the capital structure the same, equity risk goes up Exam Preparation & Investment Sales Training 12 info@examsuccess.ca
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