INSTITUTIONAL INVESTORS ANSWERSQuestion Part A Comment Is the comment correct? (circle one) ”We should increase the risk of our investments in order to make up some of the shortfall in the pension fund.” Yes ”The fact that the firm is likely to lose money over the next couple of years also means we should take on greater risk.” Yes ”If more people retire, that is going to increase the liquidity requirements of the plan.” Yes No No No Explanation The plan’s underfunded status leads to a decreased ability to take risk Weak profitability at a company renders it less able to take investment risk in its portfolio Increasing the number of retired lives increases the liquidity needs of the fund Sample Scoring Key: point each for correctly identifying whether the comment is correct point for each explanation points if yes/no decision is wrong Part B Average age of the workforce at 57 versus retirement at 60 means that many workers will be retiring soon and increasing the plan benefit payouts A large proportion of plan participants (40%) are already retired and taking benefit payments Average age of retirees is relatively young, resulting in their payout from plan assets continuing for a longer time period into the future Early retirement or lump-sum payouts if they are adopted will immediately increase disbursements Sample Scoring Key: point each for identifying factors point for each explanation Part C The correlation should be low to minimize the risk that the firm will need to make contributions into the plan during periods of poor operating performance of the firm when the funds may be unavailable Sample Scoring Key: point for stating the correlation should be low and points for the explanation Question Part A Comment "The MMW plan must offer employees a sufficient number of investment vehicles for suitable portfolio construction." Is the comment correct? (circle one) Explanation Yes In a defined benefit plan, the sponsor assumes the investment risk and makes the investment decisions for the plan in aggregate No or The statement would apply to a defined contribution plan, not a defined benefit plan "BanqueMonde's time horizon would be long-term to virtually infinite because the firm is a well-capitalized on-going business." “An investment in private equity, an ownership interest in a non-publicly-traded company, would be appropriate for Kingston since private equity has higher return potential and a long time horizon.” Yes No Yes No The bank may be perpetual but the portfolio assets are used to maintain an overall balance between total asset and liability duration Bank liability durations are relatively short Foundations and endowments can and take higher risk Kingston is large and perpetual, consistent with the high due diligence costs and long time horizon of private equity Sample Scoring Key: point each for correctly identifying yes or no If the identification is correct, point for a correct explanation Candidate discussion Note that for Kingston a generic statement endowments can take high risk is insufficient as it ignores the more specific information available in the case and readings Part B Risk: The MMW pension has lower relative risk tolerance While the + surplus and long 20-year liability duration increases ability to take risk, pensions have contractual liabilities and high risk would benefit the sponsor but not the plan participants In contrast, the foundation has no contractual liabilities, is perpetual, and if successful, the high risk will increase the ability to meet foundation objectives Return: the pension plan should meet its assumed actuarial discount rate to maintain the positive surplus The foundation should meet its distribution and assumed inflation of 1.05 x 1.03 – = 8.15% Sample Scoring Key: Risk: point for correct conclusion, point each for the factors increasing and decreasing the pension’s ability, point for why the foundation’s ability is higher, and point each for the two return discussions Candidate discussion: Stating one is higher or lower risk would be wrong if not supported by the case facts Question A Life insurance payouts are nominal, so there is little inflation risk P&C companies may insure replacement value and, in that case, would have inflation risk Liquidity needs for life insurance are usually low as the liabilities are longer term and, in aggregate, fairly predictable P&C have shorter-term liabilities with higher and lesspredictable liquidity needs Sample Scoring Key: One point each for correctly identifying inflation risk and liquidity needs of the two companies Candidate discussion: Explain or discuss suggests more than just saying one is higher or lower than the other Discussing how the nature of the liabilities determines the answers is a way to this, which is consistent with the assigned readings B P&C face a long tail when claims become involved in litigation and may be paid further in the future This reduces short-term liquidity needs but increases liquidity needs at more distant future dates To manage the risk, companies usually buy fixed-income assets that match the anticipated payment date of the claim settlement Sample Scoring Key: One point for P&C and one point for discussing how the long tail reduces short-term and/or increases long-term liquidity needs for P&C One point for explaining that fixed-income assets are usually matched to the anticipated claim payment date Note that the long tail applies to only a small portion of P&C company liabilities and still leaves aggregate liability duration relatively short, compared to typical life insurance companies C The risk exists when policies include a provision allowing policyholders to cash out or borrow a portion of the policy’s face value This is more likely to be done when rates are high, forcing the company to make payouts when asset values are down and thereby reducing the surplus Sample Scoring Key: One point for discussing what causes disintermediation risk Two points for any discussion that payouts are more likely when asset values are lower due to policyholders exercising their right to cash out when interest rates are higher, leading to a reduction in surplus D First, hold lower duration (less than 2.8) securities so that the average duration of loans and securities more closely matches the liability duration of 2.8 Second, hold highly liquid securities to offset the loan assets illiquidity Sample Scoring Key: One point for prioritizing the two primary objectives correctly One point each for pointing out why the securities portfolio will need low duration and high liquidity Candidate discussion: The desire to improve profit margins and credit or geographic diversification are unacceptable answers Under the residual concept, they will be considered only after the two more important issues ... time horizon.” Yes No Yes No The bank may be perpetual but the portfolio assets are used to maintain an overall balance between total asset and liability duration Bank liability durations are relatively... be low and points for the explanation Question Part A Comment "The MMW plan must offer employees a sufficient number of investment vehicles for suitable portfolio construction." Is the comment... securities portfolio will need low duration and high liquidity Candidate discussion: The desire to improve profit margins and credit or geographic diversification are unacceptable answers Under