CFALevel Book - ManagingInstitutional Portfolios Study online at quizlet.com/_ohca2 Banks - IPS Constraints Time - Short - Linked to duration of liabilities Taxes - Taxable - After tax return is objective Liquidity - Short and Liquid Driven by bank w/ds and loan demands Legal - RBC Guidelines Unique - None Endowment - Spending Rules Examples: Simple = Spending rate x $ Rolling year average market value x Spending rate Geometric Spending Rate - Smoothed Rate Calc Banks - IPS Return & Risk Risk - VAR Measures the size/sensitivity of A&Ls LADG - Leverage adjusted duration Gap Duration of Bank Ass - Lev duration of Bank Liabilities LADG - Predicts the change of MV of bank equity cap if In Rates change Use ALM Framework - Below Average Risk Tolerance Return - Positive Interest Rate Spread (Over cost of funds) ESOP Allows employees to buy company stock at a discount either before or after tax 10 Foundations - IPS Constraints Time Horizon - Usually Infinite Tax Consid - Few UBTI Liquidity - Based on Spending Rules - Usually 5% of year end assets could leave a fraction of annual spending as cash reserve Legal - UMIFA Standards - Prudent Investor Rule Unique - Foundation Specific - Moral/ethical investing is common Banks Objectives Directives come from the place of the securities portfolio in the A&L structure of the bank Portfolio is excess funds not lent out Primary goal is to try to match the liabilities (deposits) and assets (Loans) It's easier to adjust the characteristics of Invesment vs Assets and Liabilites, so portfolio duration is liability duration, unless manager wants to take duration risk Income is looked at last 11 Foundations - IPS - Risk & Return Risk - Tend to be more aggressive then pensions - Based on time horizon Return - Driven by a formula like Req Payout + Inflation 12 Foundations VS Endowments Foundations: Grant Making Entities Endowments: Long Term funds owned by non profit firms for OPS 13 IPS for DC vs DB Plan IPS for DC Plan: Sponsor must provide: At least choices that allow for diversification and provide for free movement between investments Education/Guidance Limit Exposure to Company Stock 14 Liability Mimicking For Satisfying future liability - use best mixture of Nom Bonds Tips and Stocks Cash Balance Plan Credited each year w/ a pay credit and Int Credit Sponsor bears investment risk At retirement, you choose annuity or Lump Sum R/O Duration Management Focuses on Short term changes in the liability vs Changes in interest rates - Works best when pension is short term - near bankruptcy Endowment - IPS Constraints Time - Perpetual Taxes - Tax Free - Watch UBTI Liquidity - Usually Low - Large Improvements may require liquidity Legal - 501c3 and UMIFA Adoption - Prudent Investor Rule Unique - Social Issues / Asset Class restrictions Endowment - IPS - Risk & Return Risk - Affected by need for outside funding % of funding needed Concerns are portfolio volatility and spending volatility Return - Preserving Real Purchasing Power is Paramount Focus on TOTAL return, match inflation to inflation of the endowment Cons The Liability portfolio will be costly and not provide a return above liability future services rendered and future participants calculations are uncertain and not modeled or pre-funded additional plan deposits will be required For Pensions, it's best to use the liability portfolio as a benchmark not to actually implement it 15 Liability Relative Management - Actives Actives get divided into categories: Obligation for past service - acts like inactive Obligations for future service - Uses % growth in wages and Calc NPV If wage growth is at rate of inflation use real return on bonds as benchmark If wage growth is above inflation, mimic w/ stocks 16 Liability Relative Management Inactive For Active Pensions Best to decompose the Liabilites: Inactive (retired or not working and not of age) and Active (Currently working for the firm) 21 Non-Life Insurance Companies - Health & P&C - Characteristics ALM Shorter Product Life Claims can be long tailed if disputed Inflation Risk - Replacement Coverage Timing is harder to predict then Life Underwriting has a "Profitability Cycle" - Reduce to retain customers, will reduce surplus Operating Results are more variable then life 22 Non-Life Insurance Companies - IPS Constraints Time Horizon - Short - In periods of company loss you can use taxable bonds Taxes- Taxable Companies - After Tax return is objective Liquidity - Needs are high Typically mmkt, T-bills, laddered bonds, ALM matching Legal - Less onerous than life insurance Risk based capital requirements are established Unique - Financial Status of firm, management or risk, and liquidity requirements 23 Non-Life Insurance Companies - IPS Objectives Risk - Quasi fiduciary requirement / geographic concentration risk Inflation Risk Cash flows are erratic and unpredictable Common Stock / Surplus Ratio has challenges Return - LOW RISK - Key Factors Comp Pricing - High Returns allow you to reduce prices Profitability - Inv Income and ROI are Primary part of Comp Profit Surplus - More Surplus , More Ins you can sell Total Return - Active Port Management is a focus, varied product mixes, returns vary among companies 24 Non-Market Exposures: Liability Noise (2 types) Plan demographics - More predicable to for large plans Model Uncertainty - Less predictable (i.e Mortality of retirees when will deferreds retire?) Inactives Future Benefits could be accrued as Fixed, inflation adjusted or indexed to inflation Use assets that mirror each of these Life Insurance Companies Disintermediation Risk When Int Rates are high, Policy holders are likely to w/d cash This creates increased liquidity Over time Duration and Horizon have decreased 18 Life Insurance Companies - IPS - Constraints Time - Getting Shorter Taxes - High Liquidity - ALM, Marketability Risk Surplus has little liquidity need Legal/Reg - Heavy Regulations at state level Prudent Investor Rule, Specific Valuation Rules, Elligable Investment restrictions Unique - Concentration of product offering, company size and Surplus 19 Life Insurance Companies - IPS - Risk & Return Objectives - NAIC requires an Asset Valuation Reserve (AVR) as reserve against losses There is a movement toward Risk Based Capital with means More Risk = More Reserve Risks: Valuation Risk - Duration of assets should be close to duration of liabilities - ALM Management Reinvestment Risk - Important for Guaranteed Products Cash Flow Volatility - Reinvesting income at good rates Credit Risk on Debt Return: Shoot for Net Interest Spread - Greater than actuarial to grow surplus Match/Segment Investment portfolios by business line Mostly fixed in the portfolio until you hit surplus 17 20 Linking Pension Liabilities to Assets Asset Only Approach - Focus on selecting efficient portfolios This ignores that future liabilities could be subject to market risk Better Solution: Asset Allocation that recognizes Economic Liability Liability Reserve Approach - Portfolio Mimics Liability Risk free Asset becomes the portfolio that mimics the liability 25 Pension IPS - Constraints Time Horizon - Termination Date or Active Lives vs Retired Lives Taxes - (Unlikely anything is taxable) Liquidity - % of retired lives, $ of Contributions vs Ret Payout, Plan Features (Lump Sum) Legal/Reg - Erisa Rules, Pension Trustee is a Fiduciary Unique Circ - ?Self Imposed Restrictions to Asset classes ETC 26 Pension - IPS - Risk/Return Risk - Asset Liability Management based on variability of plan surplus Return - Minimum Return should be Discount Rate used for PBO 27 Pension Risk Tolerance (5 Perspectives) Plan Surplus UP, Risk Tolerance UP Companies Financial Status UP Risk Tolerance UP Company and Pension Fund Correlation UP Risk DOWN Plan Features - Lump Sum Avail > Liquidity UP Risk DOWN Workforce Characteristics - Younger Work Force Risk Tol UP ... Investment portfolios by business line Mostly fixed in the portfolio until you hit surplus 17 20 Linking Pension Liabilities to Assets Asset Only Approach - Focus on selecting efficient portfolios... Allocation that recognizes Economic Liability Liability Reserve Approach - Portfolio Mimics Liability Risk free Asset becomes the portfolio that mimics the liability 25 Pension IPS - Constraints Time... established Unique - Financial Status of firm, management or risk, and liquidity requirements 23 Non-Life Insurance Companies - IPS Objectives Risk - Quasi fiduciary requirement / geographic