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Level III Managing Institutional Investor Portfolios Summary Graphs, charts, tables, examples, and figures are copyright 2014, CFA Institute Reproduced and republished with permission from CFA Institute All rights reserved 2015 2015 2014 2014 2013 2013 2012 2011 2010 2010 2009 2008 2007 2007 2006 2006 Pension plan: Risk tolerance, calculate return requirement, impact of early retirement option Pension plan: Asset only and liability-relative approach; comparison with foundation Pension plan: Risk tolerance, liquidity requirement, asset-only and liability mimicking approach Endowment: Risk tolerance, return requirement, liquidity requirement Foundation: Risk tolerance, nominal required return, liquidity requirement Pension plan: Shortfall risk Note: Part C and D are not relevant Pension plan: Return objective and return requirement, risk tolerance, asset allocation, asset-only and liability relative approach, DB plan vs participant-directed DC plan Endowment: Return objective, risk tolerance, liquidity and time horizon constraints, maintaining real value and reducing volatility of endowment Insurance company: IPS, behavioral biases Pension plan Pension plan: IPS, constraints, risk factors, spending rule Pension plan: IPS, constraints, risk factors Endowment: IPS, constraints, risk Life insurance: company IPS, constraints, risks Pension plan: IPS, constraints, risk factors Pension plan versus foundation IPS www.ift.world DC Versus DB Pension Plans Defined Contribution Plan • • • • No financial liability for plan sponsor Plan participants bear investment risk Contributions and returns belong legally to participant Retirement assets are portable Defined Benefit Plan • • • Pension liability Sponsor bears investment risk Participants bear early termination risk Advantages of a DC plan to company: • Company does not have the responsibility to set objectives and constraints • Company does not bear the risk of investment results • Company's future pension obligations are more stable and predictable Advantages of a DC plan to employees: • An employee is able to choose a risk and return objective reflecting his or her own circumstances • More readily portable • Defined contribution plans not have early termination risk • Employees can rebalance and re-allocate investments www.ift.world Exhibit 1: Factors Affecting Risk Tolerance and Risk Objectives of DB Plans Category Variable Explanation Plan status Plan funded status (surplus or deficit) Higher pension surplus or higher funded status implies greater risk tolerance Sponsor financial status and profitability Debt to total assets Current and expected profitability Lower debt ratios and higher current and expected profitability imply greater risk tolerance Sponsor and pension fund common risk exposures Correlation of sponsor operating results with pension asset returns The lower the correlation, the greater risk tolerance, all else equal Plan features Provision for early retirement Provision for lump-sum distributions Such options tend to reduce the duration of plan liabilities, implying lower risk tolerance, all else equal Age of workforce Active lives relative to retired lives The younger the workforce and the greater the proportion of active lives, the greater the duration of plan liabilities and the greater the risk tolerance Workforce characteristics www.ift.world Return Objectives Should be consistent with risk objective Achieve returns that adequately fund pension liability on an inflation-adjusted basis • Use discount rate for future obligations as a starting point • Discount future obligations at long-term government bond rate If plan is fully funded and objective is to meet future obligations then minimum return objective = discount rate used for liabilities Might have an objective to minimize pension contributions Might have an objective related to pension income www.ift.world Liquidity Requirement Net cash outflow: Benefit Payments – Pension Contributions Liquidity requirement is higher with: High portion of retired lives Low corporate contributions relative to benefit disbursements Early retirement option Lump-sum payment option Time Horizon Investment time horizon depends on: Whether plan is a going concern or plan termination is expected Average age of workforce and proportion of active lives Could have multi-stage time horizon: For active lives  time horizon = average time to normal retirement age For retired lives  time horizon is a function of life expectancy www.ift.world DB Plan - Risk Management Considerations Coordinate pension investments with pension liabilities (ALM) Consider volatility of pension surplus rather than plan assets Since liabilities are interest rate sensitive, asset allocation weighted towards bonds For DB Plan consider shortfall risk of funded status Shortfall Risk: portfolio might fall below some threshold level over a given horizon Minimize probability that funded status will fall below a certain level Manage pension investments in relation to operating investments www.ift.world Foundation: Risk, Return and Constraints Risk Objective: Unlike pension plans there is no defined liability; hence, can take more risk Return Objective: Return objective depends on specific nature of the organization Typical return requirement: preserve real (inflation-adjusted) value while allowing spending at appropriate rate Example: 5% annual spending; 0.3% admin expenses; 2% inflation  7.3% return requirement Constraints: Liquidity: Anticipated or unanticipated needs for cash in excess of contributions made to the foundation; US Tax Reform Act says spending should be at least 5% of assets Time Horizon: Typically a perpetuity Tax Concerns: Generally tax-exempt but specifics vary by jurisdiction Legal and Regulatory Factors: Vary by jurisdiction; US Tax Reform Act says spending should be at least 5% of assets www.ift.world Endowment: Risk, Return and Constraints Risk Objective: Consider in conjunction with spending policy, endowment’s role in the operating budget of institution and institution’s ability to adapt to drop in spending Return Objective: Not subject to specific spending requirement (unlike foundations) Coordinate investment and spending policies such that return > spending rate Generally need relatively high long term returns: spending rate + admin cost + inflation High return important for academic institutions where spending rates have increased faster than inflation for general economy Monte Carlo simulations Constraints: Liquidity: Generally low liquidity constraint, but must have cash to make spending distributions Plan for capital commitments such as building construction Time Horizon: Typically a perpetuity Tax Concerns: Generally tax-exempt but specifics vary by jurisdiction www.ift.world Endowments Spending Rule Spending typically calculated as a percentage of endowment market value; usually between and 6% in the U.S Simple spending rule Spending equals the spending rate multiplied by the market value of the endowment at the beginning of the fiscal year Spendingt = Spending rate × Ending market valuet–1 Rolling three-year average spending rule Spending equals the spending rate multiplied by the average market value of the last three fiscal year-ends Spendingt = Spending rate × (1/3)[Ending market valuet–1 + Ending market valuet–2 + Ending market valuet–3] Geometric smoothing rule Spending equals the weighted average of the prior year’s spending adjusted for inflation and the product of the spending rate times the market value of the endowment at the beginning of the prior fiscal year The smoothing rate is typically between 60 and 80 percent Spendingt = Smoothing rate × [Spendingt–1 × (1 + Inft–1)] + (1 – Smoothing rate) × (Spend rate × Beg market valuet–1) www.ift.world 10 Life Insurance: Risk, Return and Constraints Risk: Primary investment objective is to fund future policy holder benefits and claims Quasi-trust fund  Conservative fiduciary principles limit risk tolerance Sensitive to interest rate risk ALM is the foundation for controlling interest rate risk and liquidity Return Objective: Primary objective: earn sufficient return to fund all policyholder liabilities Match or exceed expected returns factored into the pricing of company products Secondary objective: contribute to growth of surplus though capital appreciation Constraints: Liquidity: Pay all benefits and expenses in a timely manner Time Horizon: Typically long-term Tax Concerns: Unlike pension funds, foundations and endowments, life insurance companies pay taxes www.ift.world 11 Non-Life Insurance: Risk, Return and Constraints Risk: Quasi-trust fund  Conservative fiduciary principles limit risk tolerance Lower risk tolerance relative to life insurance because benefit payments are more uncertain Return Objective: “The return objectives of the Company are threefold: a) earn a sufficient return to fund all policyholder liabilities, b) support the competitive pricing of all products, and c) contribute to the growth of surplus through capital appreciation The return objectives will be measured in terms of meeting or exceeding projections of investment income and total return.” Constraints: Liquidity: Pay all benefits and expenses in a timely manner Time Horizon: Depends on duration of liabilities; typically long-term Tax Concerns: Unlike pension funds, foundations and endowments, insurance companies pay taxes www.ift.world 12 Banks: Risk, Return and Constraints Risk: Risk objectives dominated by ALM considerations Generally below average risk tolerance Return Objective: Positive return on invested capital Positive spread over cost of funds Constraints: Liquidity: Determined by net outflow of deposits and demand for loans Time Horizon: Typically liability structure has short duration and loan portfolio has long duration; this puts a constraint on securities portfolio Tax Concerns: Fully taxable Legal and Regulatory: Significant regulatory restrictions www.ift.world 13 Investment Objectives and Constraints across Institutions Type of Investor Return Requirement Risk Tolerance Pension Plans (Defined The return that will adequately fund Benefit) liabilities on an inflation-adjusted basis Depends on plan and sponsor characteristics, plan features, funding status, and workforce characteristics Foundations and Endowments Determined by amount of assets The return that will cover annual spending, relative to needs, but generally investment expenses, and expected inflation above-average or average Life Insurance Companies Determined by rates used to determine policyholder reserves Below average due to factors such as regulatory constraints Non-Life-Insurance Companies Determined by the need to price policies competitively and by financial needs Below average due to factors such as regulatory constraints Banks Determined by cost of funds Varies www.ift.world 14 ... (inflation-adjusted) value while allowing spending at appropriate rate Example: 5% annual spending; 0 .3% admin expenses; 2% inflation  7 .3% return requirement Constraints: Liquidity: Anticipated or unanticipated... Shortfall Risk: portfolio might fall below some threshold level over a given horizon Minimize probability that funded status will fall below a certain level Manage pension investments in relation to operating...2015 2015 2014 2014 20 13 20 13 2012 2011 2010 2010 2009 2008 2007 2007 2006 2006 Pension plan: Risk tolerance, calculate return