CFA CFA level 3 CFA level 3 CFA level 3 CFA level 3 CFA volume 2 finquiz curriculum note, study session 6, reading 13

Managing Institutional Investor Portfolios INTRODUCTION Institutional investors refer to corporations or other legal entities that serve as financial intermediaries between individuals and investment markets These include pension plans, foundations, endowments, life insurance companies, non-life insurance companies, and commercial banks These entities have diverse investment objectives and constraints PENSION FUNDS Pension funds are used to support a promise of retirement income made by an organization, called plan sponsor Types of Pension Funds: Defined-benefit (DB) plans: The defined-benefit plans are plans under which the plan sponsor (i.e employer) promises to pay plan participants (i.e retirees) a predefined amount (commonly a % of salary) each month during retirement • These benefit payment promises represent “pension liability” of sponsor because the risk associated with funding the benefit obligation is borne by the employer/plan sponsor • The pension liability in DB plans is based on various assumptions (e.g number of years of service and final earnings) and thus it is uncertain and difficult to estimate Defined-contribution (DC) plans: The definedcontribution plans are plans under which the employer (i.e plan sponsor) is only required to contribute a specific amount to the employee’s retirement fund each year • Under DC plans, the pension fund belongs to the employee (beneficiary), such that, he/she does not lose the benefit upon changing jobs; the participants are entitled to receive the value of the pension account as either a lump-sum or a series of payments upon withdrawal from the plan or upon retirement However, employees are subject to vesting requirements of 3-5 years i.e they cannot withdraw their employer contributions until after they have been employed with the sponsor for a specified period of time o This portability feature allows participants to diversify retirement portfolio to suit their needs • Any risk (benefit) associated with pension plan assets is born by the employee • In addition, the DC pension plans are tax-deferred and thus lower taxable income of participants • DC pension plans are attractive for employers as they involve lower liquidity requirements, require fewer resources to meet contributions and are subject to fewer regulations There are two arrangements in DC plans: i Pension plans in which the plan sponsor only promises the contribution, not the benefit; ii Profit-sharing plans in which contributions are based on profits of the plan sponsor Types of DC plans: Sponsor directed: In a sponsor directed DC plan, the investments are chosen by the sponsor (like in DB plan) However, it is less complex than DB plans Participant directed: In a participant directed DC plan, the participants determine their own personalized investment policy by choosing investments from a menu of diversified investment options provided by plan sponsor Most DC plans are participant directed Hybrid plans: Hybrid plans have the characteristics of both DB and DC plans It is discussed in detail in section 2.3 The key differences between DC and DB plans DB plans DC plans A specific future benefit is promised which has generated pension liability for the plan sponsor; no specific present obligation Only present contribution is promised; not future benefit Promise is made for the retirement stage Promise is made for the current stage Investment risk is borne by plan sponsor/employer Investment risk is borne by plan participants Plan participants are exposed to risk of early plan termination (e.g if a company is liquidated) Plan participants are NOT exposed to early termination risk because the pension account legally belongs to the plan participants DB plans are NOT portable DC plans are portable to plan participants upon changing jobs However, they are subject to certain –––––––––––––––––––––––––––––––––––––– Copyright © FinQuiz.com All rights reserved –––––––––––––––––––––––––––––––––––––– FinQuiz Notes Reading 13 Reading 13 Managing Institutional Investor Portfolios DB plans DC plans rules, vesting schedules, and possible tax penalties and payments 2.1 Defined-Benefit Plans: Background and Investment Setting Three basic liability measures for determining pension liability are as follows: 1) Accumulated benefit obligation (ABO): The ABO represents the present value of pension benefits that are owed to an employee to date(i.e associated with accumulated service), whether vested or not ABO does not include any future benefits to be earned by employees • It is the most appropriate estimate of total pension liability for a terminated plan FinQuiz.com status is > 100% • When value of plan’s assets < present value of plan liabilities plan is under-funded i.e plan’s funded status is < 100% • When value of plan’s assets = present value of plan liabilities plan is fully-funded i.e plan’s funded status is = 100% Important to Note: Maintaining funded status of a plan requires increase in contributions to the plan by the plan sponsor 2.1.1) Risk Objectives The ability of a DB pension plan to tolerate investment risk is governed by several factors, such as: A Plan status: When pension plan is overfunded (i.e positive funded status or plan surplus), the plan sponsor has greater ability to tolerate risk (all else equal), implying an aboveaverage risk tolerance Reason: 2) Projected benefit obligation (PBO): The PBO represents the present value of all benefits that employees are expected to earn during employment The PBO measure incorporates the impact of expected future compensation increases • It is the most appropriate estimate of total future pension liability for a going concern companies Commonly, the funded status is computed using PBO 3) Total future liability: It represents the present value of accumulated and projected future service benefits and takes into account the impact of expected future compensation increases as well as changes in the workforce and benefit changes associated with inflation It is the most comprehensive but also the most uncertain pension liability measure The primary objective of plan assets is to fund future pension liabilities The ability of a pension fund to meet its future liabilities is measured by the funded status of a plan Funded Status of Pension Plan = Market value of Pension plan assets – Present value of pension plan liabilities Where, Present value of pension liabilities is found by discounting the value of pension liabilities at some discount rate, typically, the yield of high quality, long-term, investment grade corporate bonds) The lower (higher) the discount rate, the greater (smaller) the present value of pension liabilities • When value of plan’s assets > present value of plan liabilities plan is over-funded i.e plan’s funded • Because plan surplus acts as a cushion and enables pension fund to tolerate some level of negative returns without jeopardizing plan’s ability to meet pension liability payments using plan assets • In addition, over-funded pension plan implies lower costs for the sponsor in terms of lower contributions When pension plan is underfunded (i.e negative funded status), the plan sponsor has lower ability to tolerate risk (all else equal),implying under-funded plan has belowaverage risk tolerance • It is important to understand that when pension plan is underfunded, then the plan sponsor may have higher willingness to take risk in order to generate higher returns so that the plan can be made fullyfunded • An under-funded plan status increases costs of the sponsor in the form of requirement of greater contributions to the plan B Sponsor’s financial status and profitability: Sponsor’s financial status is determined using debt-to-assets ratio, and profitability is judged through current and expected profitability of a company • When the sponsoring company is financially strong (i.e has low debt ratios/low financial leverage) and has higher current and expected profitability (i.e profitable despite operating in a cyclical industry), it has greater ability to take risk, implying an aboveaverage risk tolerance (all else equal) Reason: A financially strong and profitable sponsoring company has greater ability to fund shortfalls attributed to negative returns by making additional contributions to the plan • When the sponsor is financially weak, (i.e has high Reading 13 Managing Institutional Investor Portfolios debt ratios/high financial leverage) and has lower current and expected profitability, it has lower ability to take risk, implying below-average risk tolerance (all else equal) C Common risk exposures between sponsor and pension fund: From asset/liability management perspective, the pension plan assets should be highly correlated with pension plan liabilities BUT minimally correlated with sponsoring company’s operating assets • When operating results of a sponsoring company are highly correlated with pension asset returns, higher operating risk tends to limit the amount of investment risk assumed by the plan, implying lower risk tolerance, all else equal Reason: High correlation implies that when the sponsor’s operating results are weak, the pension asset returns will also be poor; but, due to weak operating results, the sponsor will be unable to make additional contributions to support payment of benefit obligations • In contrast when sponsor operational risk is unrelated with the investment risk, then if a pension portfolio faces negative returns, the sponsor will be able to increase contributions to support payment of benefit obligations D Plan features: A pension plan which has specific plan features i.e., early retirement options or option to receive a lump-sum distributions has lower risk tolerance (all else equal) because such options tend to shorten the time horizon of pension plan by reducing the duration of plan liabilities E Workforce characteristics: It includes two things i.e a) Age of workforce: A pension plan with younger or growing workforce has greater risk tolerance because the younger the workforce, the greater the duration of plan liabilities, the lower the liquidity requirements and the longer the time horizon b) Proportion of active lives versus proportion of retired lives: A pension plan with high ratio of active lives to retired lives has greater risk tolerance because the greater the proportion of retired lives, the greater the pension fund’s liquidity requirements (i.e greater cash outflows each month to retirees), the smaller the duration of plan liabilities and thus the shorter the time horizon Summary: Funded status Financial status Pension plan has above-average risk tolerance Pension plan has below-average risk tolerance Over-funded Under-funded Strong balance sheet with low financial leverage Weak balance sheet with high financial leverage FinQuiz.com Pension plan has above-average risk tolerance Pension plan has below-average risk tolerance Profitability Profitability is not adversely affected by business cycles Profitability is adversely affected by business cycles Age of workforce Younger or growing workforce, implying longer duration of pension liabilities Older workforce or currently closed to new participants, implying shorter duration of pension liabilities % of active lives relative to retired lives High % of active lives relative to retired lives, implying low immediate liquidity needs High % of retired lives relative to active lives, implying high immediate liquidity needs Plan features No early retirement or lump-sum payment option Early retirement or lump-sum payment option Practice: Example 1, Volume 2, Reading 13 Stating a risk objective of DB pension plans: The risk objective of DB plans can be manifold, such as: A Shortfall risk relative to specified funded status: For example, • Pension plan wants a funded status of 100% or > 100% or above some regulatory threshold level • Pension plan wants to minimize the probability that funded status falls below 100%; or • Pension plan wants to minimize the probability that funded status falls below 100% to be ≤ 10% B Pension surplus volatility (i.e standard deviation): For example, • Pension plan wants the volatility of pension surplus to be ≤ 6% • Pension plan wants to minimize the volatility of pension surplus (assets relative to liabilities) IMPORTANT TO NOTE: The plan surplus has lower volatility when the value of plan assets is positively correlated with changes in the value of plan liabilities C Risk related to contributions: For example, Reading 13 Managing Institutional Investor Portfolios • Pension plan wants to minimize the year-to-year volatility of future contribution payments • If currently the plan is over-funded and thus no contributions are being made by the sponsor, the pension plan may want to minimize the probability of making any future contributions D Absolute risk: For example, a pension plan may want to minimize the risk of large losses within any one asset class, investment type, industry or sector distributions, maturity date, or geographic location Practice: Example 2, Volume 2, Reading 13 FinQuiz.com Return objective in numerical terms can be stated as follows: Minimum Required return for a fully-funded pension plan = Discount rate used to calculate the PV of plan liabilities Desired return for a fully-funded pension plan = Discount rate used to calculate the PV of plan liabilities + Excess Target return • The stated return of DB plans may be higher than the minimum required return in an attempt to minimize the probability of making future contributions by the plan sponsor and/or to decrease pension expense (or increase pension income); however, the high return requirement must be consistent with plan’s ability to tolerate risk 2.1.2) Return Objectives Like risk objectives, the return objectives of a DB pension plan can be manifold Primary return objective is “To earn sufficient, inflationadjusted returns that adequately meet expected pension liabilities” In addition to the primary return objectives, the DB plans may have the following objectives Return objectives related to both funding of benefit payments and future pension contributions: To earn sufficient, inflation-adjusted returns that adequately meet pension benefit payments and to minimize the probability of making future contributions to the plan or to minimize the amount of sponsor’s future contributions to the plan so that the company can use its cash for other productive uses • Stretch target: A stretch target refers to the objective of DB plans to make future pension contributions equal to zero Return objectives for a fully funded or over-funded plan: A fully-funded or over-funded pension plan may have an objective to maintain the plan’s funded status (pension surplus) relative to plan liabilities Return objectives for an underfunded pension plan: An underfunded pension plan may have an objective to earn return equal to the benchmark return i.e the return sufficient to meet pension benefit payments IMPORTANT TO NOTE: The greater (lower) the risk tolerance ability of a pension plan, the more (less) aggressive risk and return objectives can be adopted Practice: Example 3, Volume 2, Reading 13 2.1.3) Liquidity Requirement Pension plan’s liquidity requirement i.e its Net cash outflow can be estimated as: Net cash outflow = Benefit payments – Pension contributions – Investment income Example: Suppose a pension fund has obligation to pay pension benefits of $100 million per month It has an asset base of $10 billion and receives no pension contributions Annual liquidity requirement = ($100 million × 12) / 10 billion = 12% This implies that in order to meet pension benefit obligations without eroding capital base, the asset base needs to grow to 10 billion (1.12) = $11.2 billion Pension plan’s liquidity requirement depends on various factors, including: A comprehensive return objective may be stated as: To earn sufficient, inflation-adjusted returns that adequately meet pension benefit payments, minimize the probability of making future contributions to the plan and generate pension income (negative pension expense), resulting in increase in the sponsor’s reported earnings Proportion of retired lives relative to active lives: The greater the number of retired lives relative to active lives, the greater the liquidity requirement, all else equal; e.g a pension plan of a company operating in a declining industry will have greater proportion of retired lives • A well-funded pension plan with pension income may have the objective of maintaining or increasing pension income in order to boost profitability Size of annual Sponsor’s contributions to the plan relative to annual benefit payments: The smaller the sponsor’s contributions relative to benefits payments, the greater the liquidity requirement, all else equal Reading 13 Managing Institutional Investor Portfolios Age of workforce served by the plan: A plan with young, growing (older, declining) workforce tends to have smaller (greater) liquidity requirements Early retirement options and/or the option of retirees to take lump-sum payments: A pension plan with such options provided to participants tends to have greater liquidity requirements Funded status of a plan: A fully-funded or overfunded (under-funded) pension plan tends to have low (high) liquidity needs, all else equal Managing high liquidity needs: Higher liquidity needs of pension fund can be met by: • Holding a cash reserve or investments in money market instruments; • Taking a long position in stock index futures contracts to gain equity market exposure; • Taking a long position in bond futures contracts to gain bond market exposure; Practice: Example 4, Volume 2, Reading 13 2.1.4) Time Horizon The time horizon of a DB plan is governed by the following factors: Going-concern DB plans versus terminated DB plans: A going-concern DB plan has a long time horizon, all else equal By contrast, a DB plan that is expected to terminate has a short time horizon Age of workforce and proportion of active lives: A DB pension plan with younger workforce and greater proportion of active lives has a longer time horizon, all else equal Plan open to new entrants: A DB plan that is open to new entrants tends to have a long time horizon, all else equal The time horizon can be single-stage or multi-stage For example, going-concern DB plans have multi-stage time horizons related to active lives and retired lives portions of plan participants Time horizon for active-lives portion = Average time to the normal retirement age Time horizon for retired-lives portion = Average life expectancy of retired plan beneficiaries Practice: Example 5, Volume 2, Reading 13 FinQuiz.com 2.1.5) Tax Concerns Pension funds are either tax-exempt or are taxed at very favorable tax rates Hence, there is little or no need for tax-sheltered income and the investor can focus on total return In addition, tax-exempt bonds are not appropriate investment vehicles for pension plans Investment income and realized capital gains are typically exempt for taxation However, corporate contribution and plan termination does involve the tax issues Practice: Example 6, Volume 2, Reading 13 2.1.6) Legal and Regulatory Factors All retirement plans are governed by laws and regulations that attempt to ensure protection for beneficiaries by specifying standards of care that must be met by plan sponsors • For example, in the U.S., corporate plans and multiemployer plans are governed by the Employee Retirement Income Security Act of 1974 (ERISA) whereas the state and local government plans are governed by state law and regulations • ERISA imposes a higher standard of due diligence on the investment selection process and also legally obligates that DB plan must be operated for the sole interests of beneficiaries (plan participants), not the sponsor 2.1.7) Unique Circumstances This section of the IPS documents any circumstances unique to the DB pension plan and/or any details that are not covered elsewhere in the IPS For example, • A preference for socially responsible funds; • Investing in companies with high environmental standards; • Self-imposed restrictions on investing in certain sector/industry/companies or certain asset classes e.g company with poor labor practices, company with poor environmental standards, high-risk assets like equities etc • Size of the pension plan e.g smaller pension plans have lack of human and financial resources available to manage plan assets and to perform complex due diligence needed to investigate the investment characteristics of alternative investments (e.g private equity, hedge funds, and natural resources) • Other specific considerations may include: o Considerably high average employee age relative to industry average; o Low active to retire ratio relative to industry average; o Funded status of a plan Reading 13 Managing Institutional Investor Portfolios Investment policy statement (IPS) of a DB plan and strategic asset allocation: • The IPS must be reviewed annually or more frequently as required by significant changes in: o Laws or regulations; o Funded status of the plan; o Capital market conditions; • The plan’s strategic asset allocation depends on the following factors: o Plan’s time horizon; o Funded status of the plan; o Company’s financial strength; • The level of risk assumed by the plan is largely determined by the plan’s strategic asset allocation IMPORTANT TO NOTE: The investment objectives of all the institutional investors are set by its investment committee Practice: Example 7, Volume 2, Reading 13 2.1.8) Corporate Risk Management and the Investment of DB Pension Assets From asset/liability management perspective, pension investments should be managed relative to pension liabilities as well as operating investments rather than any external index benchmarks For example, since pension plan liabilities are interest rate sensitive, ALM approach involves a substantial use of interest rate sensitive securities (particularly bonds) Defined-Contribution Plans: Background and Investment Setting 2.2 NOTE: In the following section, the investment policy statement of participant-directed plans is discussed 2.2.1) The Objectives and Constraints Framework Roles and Responsibilities of a Plan Sponsor in a DC retirement plan: • The plan sponsor is responsible to ensure adequate diversification by offering a menu of plan investment options, by limiting holdings in the sponsor’s company stock and by monitoring the fund objectives to facilitate participants to invest according to their varying investment needs • The plan sponsor is responsible to provide sufficient investment information to participants on a regular basis, basic principles of investing as well as educational resources (e.g., sophisticated retirement planning tools like Monte Carlo simulation techniques) to plan participants to help them in investment decision-making FinQuiz.com • The plan sponsor is required to monitor the investment performance (including fees) of funds made available to plan participants o Each fund’s performance is evaluated by the plan sponsor by comparing its time-weighted returns and volatility of returns over at least past five years or longer than that of appropriate market indexes and to peer group universes • Terminating and replacing funds, selecting, monitoring and recommending the replacement of the Trustee/Recordkeeper of the plan when judicious and appropriateness is also the responsibility of plan sponsor • The plan sponsor must allow plan participants to transfer funds between investment choices at least once every 90 days • The plan sponsor has a legal obligation to establish a written IPS which helps the members of the plan in effectively establishing, monitoring, evaluating, and revising the investment program established for the DC plan An IPS for a participant-directed DC plan documents the following: o A set of governing principles and rules o The responsibilities of the plan sponsor, the plan participants, the fund managers, and plan trustee/record-keeper selected by the plan sponsor o The procedure of selecting and evaluating a menu of plan options for meeting the fiduciary responsibility of ensuring diversification and ensuring that individual objectives and constraints can be met o The investment strategies and alternatives available to the group of plan participants with varying risk and return characteristics and with sufficient diversification properties o Criteria for monitoring and evaluating the performance of investment managers and investment vehicles relative to appropriate investment benchmarks o Criteria for selecting, terminating and replacing manager/fund o Effective communication procedures for the fund managers, the trustee/recordkeeper, the plan sponsor, and the plan participants • It is important to note that Plan sponsor of a DC pension plan complies with ERISA Section 404 (c) regulations Roles and Responsibilities of Plan participants (beneficiaries) in a DC retirement plan: • Each plan participant is individually responsible for selecting a risk and return objective and constraints consistent with his/her personal financial circumstances, goals, and risk tolerance • In a participant-directed DC plan, the plan sponsor is not required to counsel or advise the participants with regard to selecting and periodically evaluating investments; rather, it is the responsibility of plan participants (like individual investors) to decide asset allocation among investment alternatives, to Reading 13 Managing Institutional Investor Portfolios establish their savings and investment strategies and to reallocate assets among funds as needed, depending on significant changes in personal circumstances Practice: Example 8, & 11, Volume 2, Reading 13 2.3 Hybrid and Other Plans Hybrid plans have the characteristics of both DB and DC plans and thus, provide the combined benefits of traditional defined benefit and defined contribution plans Benefits of DC plans include: • Portability of assets • Easy to administer for plan sponsors • Easy to understand for plan participants Benefits of DB plans include: • Guaranteed retirement benefits available to participants • Benefit payments linked with years of service • Benefit payments linked to a percentage of salary Types of Hybrid retirement plans: 1) Cash balance plans: It is the most common type of hybrid plan In a cash balance plan, a certain percentage of salary of each employee is set aside by the employer and interest is credited on these contributions • Like DB plans, the investment risk in cash balance plans is borne by the plan sponsor In some cash balance plans, the participants are allowed to select among fixed-income and equity-based options that generates investment risk for the participants • Like DC plans, the employees (participants) receive a personalized statement outlining their individual ownership, account balance, an annual contribution credit, and an earnings credit that facilitates portability to a new plan • However, unlike a DC plan, the account balance is hypothetical because the employee does not have a separate account FinQuiz.com Contribution credit = % of pay based on age, salary and/or length of employment Earnings credit = % increase in the account balance • At retirement, the participant has the option to either receive a lump-sum distribution which can be rolled into another qualified plan or receive a lifetime annuity • Grandfather clause: Under a “Grandfather” clause, older workers are allowed to choose between joining a new cash balance plan and continuing with an existing traditional DB plan 2) Employee stock ownership plan (ESOP): It is a form of DC plans under which the employees invest all or majority of plan assets in employer’s stock ESOPs encourage employee ownership in a company • Like DC plans, the contribution credit in ESOPs is determined as a % of pay • The final value of the plan for the employees depends on the vesting schedule, the level of contributions, and the change in the per-share value of the stock • These plans are subject to different regulations that vary among countries E.g some ESOPs require employee contributions, some ESOPs prohibit employee contributions, some ESOPs are allowed to sell stock to employees at a discount to market prices, while others may not, some ESOPs are required to rely on contributions and are not permitted to borrow to purchase large amounts of employer stock • The plan participants in ESOPs must pay special attention to the overall diversification of their investments because the employees have both human (by working in a sponsoring company) and financial capital (by sponsoring company’s stock holdings) at stake in the company Objectives of ESOPs: • To encourage employee ownership in a company; • To facilitate liquidation of a large block of company stock held by an individual or small group of people; • To avoid a public offering of stock; • To discourage an unfriendly takeover by increasing employee ownership in a company; 3) Pension equity plans 4) Target benefit plans 5) Floor plans Reading 13 Managing Institutional Investor Portfolios 3.1 FinQuiz.com FOUNDATIONS AND ENDOWMENTS Foundations: Background and Investment Setting Foundations are grant-making institutions funded by gifts and investment assets Four types of foundations: 1) Independent foundations or private/family foundations: These are independent grant-making institutions that are established to support social, educational, charitable, or religious activities • Sources of Funds: Independent foundations are funded by an individual donor, family or group of individuals to fund philanthropic goals Most of private foundations not receive additional assets into their funds • Decision-making Authority: Donor, members of donor’s family, or independent trustees • Annual Spending Requirement: The minimum amount that private foundations are required to spend for charitable purposes is known as “annual spending requirement” In a given fiscal year, a private foundation is required to spend 5% or more of the average market value of its total asset values in that year plus expenses associated with generating investment return i.e Minimum annual spending requirement = 5% of the average market value of its total assets • These foundations not engage in fund-raising campaigns, may not receive any new contributions from the donor and not receive any government support As a result, most private foundations must generate their entire grant-making and operating budget from their investment portfolio 2) Company-sponsored foundations: It is a private foundation whose grant-making funds are derived primarily from the contributions of a corporation (profit-making companies) • Source of Funds: Endowment and/or annual contributions from a profit-making corporation • Decision-making Authority: Board of trustees, usually controlled by the sponsoring corporation’s executives • Annual Spending Requirement: A companysponsored foundation is required to spend annually ≥ 5% of 12-month average market value of its total assets plus expenses associated with generating investment return Minimum annual spending requirement = 5% of the average market value of its total assets • Investment focus: Short-term, to fund philanthropic activities • It is subject to the same rules and regulations as other private foundations 3) Operating foundations: Operating foundations are private foundations that use their income to support their own charitable activities rather than supporting other charitable organizations e.g a museum • Sources of Funds: Funded by an individual donor, family or group of individuals They not depend on grants from third parties • Decision-making Authority: Independent board of directors • Annual Spending Requirement: An operating foundation is required to spend 85% of interest and dividend income to support an institution’s own programs In addition, it must spend at least 3.33% of the average market value of its total assets • They are similar to public charities or educational endowments with respect to distributional requirements and tax treatment for donors 4) Community foundations: Community foundations area type of public charity that makes grants for social, educations, charitable, or religious purposes in a specific geographic area, community, or region • Sources of Funds: Multiple donors as they are funded by the public • Decision-making Authority: Board of directors • Annual Spending Requirement: No spending requirement 3.1.1) Risk Objectives Unlike pension funds who have contractually defined pension liability (i.e benefit payments), foundations have undefined liabilities As a result, they can have moderate to higher risk tolerance and may accept higher year-to-year volatility, depending on spending rate and time horizon The above-average risk tolerance is also implied by their long time horizon reflected by their aim to exist in perpetuity • A higher risk tolerance enables foundations to have aggressive risk and return objectives and adopt aggressive asset allocation by focusing more on equities, illiquid assets, and alternative assets • Foundations with shorter time horizon (e.g due to being “spent down” over a predefined period of time and due to constant spending of funds on charitable programs) tend to have below-average risk tolerance Foundations with short time horizon follows conservative investment policy e.g with S.D of annual returns between 5-7% (intermediate-term bonds typically fall in this range) Risk objective may be stated as: “To minimize large fluctuations/volatility in spending to avoid disruption of the institution’s budget and finances and to provide a stable flow of funds” Reading 13 Managing Institutional Investor Portfolios 3.1.2) Return Objectives • When a foundation is a primary or sole source of funding, then the primary objective of its investment portfolio will be to provide a stable, reliable flow of funds to support ongoing operations of the organization • When foundations are intended to operate in perpetuity (i.e have infinitely long time horizon), their long-term return objective is to preserve the real (inflation-adjusted) value of the investment assets while maintaining the minimum spending rate requirement for providing a stable, reliable flow of funds o This total return approach helps to meet intergenerational equity or neutrality (i.e equally treating the interests of current beneficiaries and future beneficiaries of the foundation’s support) by both maintaining year-to-year budget stability and protecting future purchasing power of the fund against the impact of inflation FinQuiz.com NOTE: When a foundation is established to fund independent programs for only at most few years and it is not the primary source of funding available to those programs, then it may have the ability to accept short-term portfolio volatility while seeking high long-term investment returns 3.1.3) Liquidity Requirements In general, foundations have low liquidity needs due to their predictable nature of cash outflows Foundation’s liquidity requirements = Anticipated cash needs (captured in a foundation’s minimum spending rate*) + Unanticipated cash needs (not captured in a foundation’s minimum spending rate) – Contributions made to the foundation * It includes Minimum annual spending rate (including “overhead” expenses e.g salaries) + Investment management expenses Return objective can be stated as: “To earn rate of return that is sufficient to meet annual spending needs, to pay expenses associated with generating investment returns (e.g fees of managers, consultants, custodians etc.) and to keep pace with inflation” In numerical terms, the required rate of return can be stated as follows: Minimum return requirement = Minimum annual spending rate + Investment management expenses (i.e cost of generating investment returns) + Expected inflation rate Or Minimum return requirement = [(1 + Minimum annual spending rate) × (1 + Investment management expenses (i.e cost of generating investment returns)) × (1 + Expected inflation rate)] -1 Where, minimum annual spending rate is the benchmark rate for foundations • In addition, some foundations may have the objective to earn a rate of return greater than the return needed to maintain the purchasing power of assets in an attempt to increase its grant-making ability over time • When a foundation is established to meet some urgent need (i.e with limited/short time horizon), it may have the objective to earn a higher return consistent with its risk tolerance ability The performance of investment portfolio of a foundation is evaluated (at least annually) by comparing the value of foundation’s investment assets against the spending rate + expenses + inflation Spending rules (i.e averaging or smoothing rules) can be used by Foundations to: • Dampen the adverse effect of volatility in asset values on spending distributions; • Avoid large fluctuations in operating budget; • Avoid erosion in the portfolio’s real value over time; In addition, the tax authorities in the U.S allow carryforwards(which facilitate foundations to avoid penalties for under-spending in one year by spending more in a subsequent year) and carry-backs (which allow foundations to under-spend in a subsequent year in case of over-spending in prior years) These carry-forwards and carry-backs facilitate implementation of smoothing rules as well as enable foundations to increase grant-making in a single year without jeopardizing the long-term sustainability of its investment program Cash Reserve: Since the average of total asset values or the dollar value of its spending for a given fiscal year is not known to a foundation until the end of that year, a foundation needs to keep a cash reserve (e.g 10% or 20% of its annual grant-making and spending budget) This cash reserve is used to avoid spending all of the budgeted money before the year is ended and the 12month average of asset values is known with greater certainty Uses of Cash Reserve: Keeping cash reserve allows foundations to increase grants at the year-end during “up” market years and avoid overspending in flat or “down” market years 3.1.4) Time Horizon • Most foundations are intended to operate in perpetuity which implies that they have infinitely Reading 13 Managing Institutional Investor Portfolios long time horizon and consequently higher risk tolerance, all else equal • However, all foundations not aim to exist in perpetuity and may intend to spend down the principal over a predefined period of time As a result, as time passes, their time horizon shortens, resulting in decrease in risk tolerance over time 3.1.5) Tax Concerns The foundation is tax-exempt under present U.S law as long as it meets its minimum (5%) spending requirement But, foundation’s unrelated business income is subject to regular corporate tax rate An unrelated business income is the income that is not related to charitable purposes of a foundation For example, if the real estate property is debt financed then income from real estate is taxed as unrelated business income (however, in proportion to the fraction of the property’s cost financed with debt) % of portfolio that may be invested in any given security • Concentrated stock holdings and selling restrictions imposed by donor for the purpose of retaining voting rights Such selling restrictions impede an institution’s ability to diversify the risk associated with a concentrated position o Some foundations are allowed to use swap contracts or other derivative contracts to achieve diversification and to avoid fluctuations in the asset value associated with concentrated stock holdings of a single company Practice: Example 12, Volume 2, Reading 13 3.2 • A private foundation must pay a 2% excise tax annually on its net investment income However, if the charitable distribution for the year ≥ both 5% and (Average of the previous years’ payout + 1% of the net investment income), then excise tax can be reduced to 1% This favorable tax treatment is basically provided to encourage spending on charitable activities NOTE: Net investment income = (Dividends + Interest income + Capital gains) –Foundation’s Expenses directly associated with generation of investment income (investment management & brokerage fees) 3.1.6) Legal and Regulatory Factors Foundations may be subject to different legal and regulatory constraints which vary among countries and types of foundations In the U.S., foundations are governed by Uniform Management of Institutional Funds Act (UMIFA) and IRS (internal revenue service) regulations In addition, all foundations must adhere to prudent investor rule which means that all investments must be evaluated from a portfolio perspective rather than on a stand-alone basis This implies that a foundation can invest in high risk investments that have low correlations with portfolio assets 3.1.7) Unique Circumstances This section of the IPS documents any circumstances unique to the endowment or foundation and/or any details that are not covered elsewhere in the IPS For example, • A preference for socially responsible funds; • Investing in companies with high environmental standards; • Restrictions on investing in certain companies or asset classes e.g gambling or tobacco; • Investment manager-level constraints i.e limiting the FinQuiz.com Endowments: Background and Investment Setting Endowments are long-term, permanent funds established to provide income for continued support of a not-for-profit organization i.e universities and colleges, museums, hospitals, and other organizations • Endowments are funded by individual gifts over time Some endowments may expect additional contributions from donor in the future • Endowments are not subject to minimum spending requirements Types of Endowments: A True Endowments: A true endowment refers to funds (i.e gifts) received from external donors with permanent restriction that the principal (gift amount) must be invested and maintained in perpetuity and cannot be spent; only the spending distributions can be spent to support programs B Quasi-endowments or Funds functioning as endowment (FFE): FFE refer to endowments established by the institution rather than by an external source with no restrictions on the use of principal They are treated as long-term financial capital They may be subject to self-imposed restrictions by the board; however, in extraordinary circumstances, the board may decide to remove its self-imposed restriction and spend the FFE because the monies are not permanently restricted Restricted versus Unrestricted Endowment Funds: Restricted Endowment funds: Restricted Endowment Funds are funds in which the spending is restricted by the donor to specified purposes e.g just to support a professorship Unrestricted Endowment funds: Unrestricted Endowment Funds are funds in which there are no spending restrictions and the endowed income can be used for general purposes of the beneficiary institution Reading 13 Managing Institutional Investor Portfolios An endowment fund has two conflicting goals i.e • Short-term goal is to provide a substantial, stable and sustainable flow of income without frequent, large fluctuations to support current operations of the beneficiary institution; and • Long-term goal is to preserve purchasing power of endowment assets (i.e by protecting the real value of the Endowment over time) FinQuiz.com Examples of Spending Rules: 1) Simple spending rule: Spending t = Spending rate × Endowment’s Ending market value t-1 NOTE: Ending market value t-1 = Beginning market value t Advantages: Trade-off between short-term and long-term objectives: Too much current spending will erode the principal value of the endowment fund, reducing its ability to support operations in the future; too little current spending will benefit future beneficiaries of the endowment fund at the expense of current beneficiaries • Similarly, investing in higher-yielding assets allows the fund to increase spending distributions but ruins endowment’s principal value by decreasing its ability to generate adequate inflation-adjusted longterm returns • In addition, large fluctuations in year-to-year spending can disrupt the endowed institution’s operating budget, finances and staffing • It is simple to implement; • This rule accounts for volatility in portfolio value; Disadvantages: • In this rule, spending entirely depends on market values; • This rule can result in significant volatility in the amount of spending; 2) Rolling three-year average spending rule: Spending t = Spending rate × Endowment’s Average market value of the last three fiscal year-ends To efficiently manage the trade-off between these two competing objectives, an endowment needs to adopt a spending rule that strikes a reasonable balance between current spending distributions and reinvestment of the remainder to protect the real value of the Endowment over time Spending t = Spending rate × (1/3) [Endowment’s Ending market value t-1+ Endowment’s Ending market value t-2 + Endowment’s Ending market value t-3] Spending Rules: In general, Drawbacks: It places equal emphasis on market values three years ago and recent market values As a result, highly volatile returns three years ago may cause a dramatic change in spending in the current year despite stable returns in the last two years Annual amount of Spending = % of an endowment’s current market value Or Annual amount of Spending = % of an endowment’s average trailing market value • Spending rule based on average trailing market value is preferred to use as it provides greater stability in the annual amount of spending Uses of Spending Rule: • Helps in preserving the long-term objectives of the endowment; • Ensures smooth and predictable spending distributions; • Protects endowment assets against inflation; • Dampens the adverse effect of volatility in asset values on spending distributions and consequently allowing the endowed institution to accept shortterm portfolio volatility while seeking high long-term investment returns necessary to fund programs and to maintain purchasing power Advantage: This spending rule provides greater stability in the annual amount of spending 3) Geometric smoothing rule: In this rule, annual spending amount is estimated as % of geometrically declining average of trailing endowment values adjusted for inflation i.e Spendingt = Weighted average of the prior year’s spending adjusted for inflation + Spending rate × Beginning market value of the prior fiscal year Spending t = Smoothing rate × [Spending t-1 × (1 + Inflation t-1)] + (1 – Smoothing rate) × (Spending rate × Beginning market value t-1 of the endowment) It is considered as a more appropriate spending rule because: • It places more emphasis on recent market values and less on past values • By incorporating previous year’s beginning spending rather than ending endowment market value, this spending rule eliminates large fluctuations in year-toyear spending and aids the beneficiary institution to plan in advance for its operating budget needs Reading 13 Managing Institutional Investor Portfolios • By adjusting spending levels towards the long-term target spending level and for the changes in endowment market value, this spending rule provides stability in long-term purchasing power NOTE: Interpretation of a 75/25 smoothing rule: 75% of last year’s spending and 25% of 5% of last year’s endowment market value 3.2.1) Risk Objectives The Risk objectives of an endowment fund can be stated in the following ways: • To minimize the risk of dramatic decline in endowment purchasing power (real value) over a certain time horizon; or • To minimize the risk of volatile short-term declines in asset values or annual spending flows; • To minimize the risk of substantial decline in support for the operating budget It is important to understand that taking low investment risk does not necessarily imply low risk of purchasing power impairment or low risk of not meeting endowment objectives because low risk investments provide low expected returns which decrease an endowment’s ability to provide stable and sustainable flow of funds In general, endowments have high risk tolerance (but lower than that of foundations due to short-term budgetary needs of beneficiary institution) and thus higher ability to accept higher volatility in the short-term to maximize long-term total returns as implied by the following reasons: • Long time horizon • Predictable cash flows relative to spending requirements Risk Tolerance of Endowments is governed by the following factors: a) Smoothing rule: Endowments that use a smoothing spending rule tend to have high tolerance for assuming short-term portfolio risk (i.e volatile shortterm declines in asset values or annual spending flows)which increases the endowment’s ability to take on risk while striving for higher long-term returns compared to endowments with no spending rule, all else equal b) Relative importance of the Endowment in the operating budget of the beneficiary institution and institution’s ability to adapt to drops in spending: When an endowment’s contributions constitute a substantial (minimal) portion of the beneficiary institution’s annual budget, the endowment fund may have below-average (above-average) risk tolerance because poor investment returns may have serious (little) impact on the endowed institution, all else equal FinQuiz.com c) Level of debt/ financial leverage and operating leverage in the Endowed Institution: All else being equal, when an endowed institution is debt-free and/or has low operating leverage, it has aboveaverage risk tolerance In contrast, when an endowed institution has high financial leverage and/or high operating leverage, it has belowaverage risk tolerance, all else equal d) Common risk exposures between donor and endowment fund: When both donor and its endowment fund are affected by same market forces then during poor market conditions donations and endowment income will fall at the same time, which implies below-average risk tolerance for the endowment fund e) Short-term performance of endowment fund: An endowment with strong (poor) recent performance tends to have above-average (below-average) risk tolerance on short-term basis • Despite long-term investment objective of endowment fund, it is important to have high tolerance for short-term volatility and strong shortterm performance for several reasons i.e o Poor recent investment returns may cause a decline in the level of endowment spending o Investment staff and trustees are evaluated on relatively short-term frames o The performance of endowment funds are often evaluated on an annual basis f) Smoothed spending rate relative to target spending rate: When the smoothed spending rate is less (greater) than the long-term average or target rate then, on short-term basis, an endowment’s risk tolerance can be greater (lower) due to low (high) risk of a severe loss in purchasing power g) Amount and Source of external funding: Endowments with a more stable or reliable external funding source (e.g public donations) tend to have higher risk tolerance, all else equal Similarly, the greater the external funding (donations), the lower the % of invested assets is required to meet current spending needs and consequently, the higher the risk tolerance NOTE: It must be stressed that a high required return objective and an objective to meet relatively high spending needs imply a high willingness (not high ability) to accept risk For example, increase in expected inflation rate may make endowment to demand a higher real return to offset perceived increase in risk, reflecting higher risk tolerance in the form of higher willingness to take risk 3.2.2) Return Objectives The primary objective of endowments is “to maintain or grow the value (i.e purchasing power after inflation) of endowment’s assets in perpetuity” and the secondary objective is “to achieve investment returns sufficient to provide substantial, stable, and sustainable flow of income needed to support ongoing operations” Reading 13 Managing Institutional Investor Portfolios In numerical terms, it can be stated as: Minimum Required rate of return = Spending rate + Cost of generating investment returns + Expected inflation rate Or Minimum Required rate of return = [(1 + Spending rate) × (1 + Cost of generating investment returns) × (1 + Expected inflation rate)] -1 To provide a substantial flow of spending distributions to institutions that are affected by high rates of inflation compared to the general economy* (e.g universities have higher education expenses as it is difficult to increase faculty productivity without impairing the quality of education), endowments needs to generate relatively high long-term rates of return to offset impact of higher inflation NOTE: *Higher Education Price Index (HEPI) is greater than CPI or GDP deflator by approx 1% IMPORTANT TO NOTE: • When returns are Volatile: In order to preserve purchasing power in the long-term, an endowment’s long-term average spending rate must be less than the long-term expected real rate of return so that the returns in excess of spending will be reinvested, thus allowing for real growth of endowment assets • When returns are Stable (or not volatile): An endowment’s spending rate can be equal to the expected real rate of return 3.2.3) Liquidity Requirements Endowment funds have relatively limited liquidity needs due to their goal to exist in perpetuity and measured spending Liquidity needs = Annual spending needs + Expenses of generating investment earnings – Contributions by donor • However, some cash is needed to make spending distributions, to meet capital commitments, to meet emergency needs, and for rebalancing transactions Such liquidity needs can be met from investment yield, bond maturation, sale of securities and gifts • In addition, Quasi-endowments may need cash for major capital projects (i.e for the construction of a building) which represents higher liquidity requirements until the capital expenditure is completed In general, due to limited liquidity requirements, endowments can invest in illiquid, non-marketable securities FinQuiz.com 3.2.4) Time Horizon • In general, the endowments have a single-stage, long-term, indefinite time horizon due to their objective of maintaining purchasing power in perpetuity As a result, they can assume aboveaverage level of return volatility in exchange for generating higher expected rate of returns over the longer time horizon • However, endowments may have a multi-stage time horizon due to their short-term liquidity needs i.e to provide spending distributions on an annual basis as well as planned de-capitalizations (reductions in capital e.g to fund large projects for quasiendowments) IMPORTANT TO NOTE: The endowment funds follow a concept of “intergenerational equity or neutrality” i.e treating the next generation as fairly as the present generation Intergenerational equity requires the endowment to balance its short-term income needs with its long-term need of preserving the real, inflation-adjusted value of endowment assets • The intergenerational equity exists when endowment investment portfolio has zero real growth rate which implies that the inflation-adjusted distribution received by future beneficiaries = Inflation-adjusted distribution received by current beneficiaries The spending rate that helps to achieve intergenerational equity is estimated as follows: Neutrality Spending Rate = Real expected return = Expected total return – Inflation 3.2.5) Tax Concerns Endowments are tax-exempt organizations, and in most circumstances, returns on their investments (e.g interest, dividends, capital gains, rents, and royalties) are not taxed Hence, taxes are not generally a meaningful constraint for the endowment fund and therefore, taxexempt securities are not appropriate investment vehicles • However, under certain situations, unrelated business taxable income from operating businesses or from assets acquired using borrowed funds may be subject to tax • In addition to that, a portion of dividends from nonU.S securities may be subject to withholding taxes that can neither be reclaimed nor credited against U.S taxes 3.2.6) Legal and Regulatory Factors Generally, endowments are subject to fewer regulations However, it is important to consider prudent investor rule, the legal structure of the fund as well as any state or federal regulation that might influence the Reading 13 Managing Institutional Investor Portfolios management of the investment portfolio of an endowment • Endowments are primarily governed by the Uniform Management of Institutional Funds Act (UMIFA) which provides rules regarding how much of an endowment a charity can spend, for what purpose, and how the charity should invest the endowment funds • At the federal level, the endowed institutions must comply with tax and securities laws and reporting requirements For example, in order to achieve and maintain tax-exempt status, an endowed institution is required to ensure that its net earnings not benefit any single, private individual • In addition, endowment funds must comply with any spending restrictions imposed by the donor; and when an endowment’s market value is less than its original gift value then it must only spend its income, not principal Practice: Example 13, Volume 2, Reading 13 Foundations Endowments Timing of Funding • Receive funds at the initiation of the foundation; • No further funds are added to it in the future • Build up over time by individual gifts; • Can fundraise on an ongoing basis; • May expect new contributions in the future Time Horizon • Established to exist in perpetuity (long/infinite time horizon); • Some are established with a plan to spend down the principal over a predefined period Established to exist in perpetuity (long/infinite time horizon) and follow “intergenerational equity, implying long time horizon Minimum annual spending requirement 5% of the average market value of total assets Not subject to spending requirements Liquidity requirements Higher liquidity needs due to minimum spending requirement Limited liquidity needs due to existence in perpetuity and measured spending Degree of support to the charitable program • May be the primary or sole source of funding with few alternative sources of funding; • May be one of the many sources of funding; Besides endowment funds, endowed institution’s spending needs can be met by other revenue sources e.g tuition, grants, fees, etc Since endowments are subject to fewer regulations, it is necessary for the endowed institutions to develop, maintain, and enforce clear guidelines and policies to avoid improper behavior and manage conflicts of interest 3.2.7) Unique Circumstances This section documents specific or unique circumstances of an endowment that dictate the types of potential investments and investment strategies used by endowments For example: Resources (including staff resources) and size of an endowment: Endowments need to have substantial resources and expertise for investing in nontraditional asset classes or alternative investments which require complex due diligence and active management • In addition, endowments must generally have at least $25 million of investments to qualify for the investment in alternative investment funds Self-imposed restrictions by the fund trustees or board: For example, ethical investment policies, socially responsible investing policies etc Other issues not discussed elsewhere in the IPS: These include • Type of Industry in which an endowed institution operates e.g cyclical or non-cyclical; • Financial status of endowed institution; • Operating results of endowed institution; E.g endowment fund will have a more conservative investment strategy if the endowed institution operates in a cyclical industry, is financially distressed and suffers from persistent, growing operating deficits FinQuiz.com Reading 13 Managing Institutional Investor Portfolios FinQuiz.com THE INSURANCE INDUSTRY By providing financial protection, insurance industry plays a critical role in the economic growth and development of a country Like DB pension funds, insurance companies have contractual obligations to policyholders; as a result, they follow conservative investment strategies in their policies at below-market, contractually defined policy loan rates Increase in demand for policy loan leads to reduction in the duration of liabilities; consequently, insurers need to reduce the average duration of their portfolios and need to hold greater liquidity reserves Two types of Insurance Companies: Disintermediation risk: It occurs when during rising interest rate environment, policyholders withdraw their funds from a life insurance company and reinvest those proceeds in other financial intermediaries or investments offering a higher return (yield) Due to disintermediation, liabilities of life insurers have become more interest rate sensitive and the duration of liabilities is shortened, leading to reduction in average duration of portfolio and higher demand for liquidity reserves Life Insurance Companies: Life insurance companies provide protection against the possibility of death, illnesses, and retirement Non-life insurance or Casualty Companies: Non-life insurance or casualty companies provide health, property, personal injury, liability, marine, survey, and workers’ compensation insurance etc The insurance industry can be divided into three broad product categories: 1) Life insurance 2) Health insurance 3) Property and liability insurance Types of Ownership for Insurance companies (life or casualty): Insurance companies can be organized in two different ways i.e Stock Companies: A stock company is owned by the shareholders Mutual Companies: A mutual company is owned by policyholders • When a mutual company is converted into a stock company to gain access to stock market by distributing its existing capital and reserves to its policyholders, the process is referred to as “Demutualization” 4.1 Life Insurance Companies: Background and Investment Setting • For interest-rate sensitive life insurance products, cash surrender rates are more critical factor than mortality rates as they are relatively difficult to predict Thus, volatile investment returns in recent years and competitive pressures have forced insurers to be less conservative in their interest rate assumptions and to offer competitive cash value accumulation rates or credited rates Consequently, interest rate changes have a substantial impact on the profitability of life insurance companies 2) Term Life Insurance: This policy provides death benefits for a specified length of time i.e protection expires at the end of the policy period, unless renewed Unlike ordinary life insurance, it does not have the benefit of cash values and premiums are much lower than whole life policies To offset disintermediation risk, life insurance companies has developed the following new products: Risks associated with high interest rates faced by Insurers in Ordinary Life Insurance: a) Universal life: It is a type of ordinary (or whole) life policy but provides more flexibility than whole life as it allows the policyholder to shift money between the insurance and savings component of the policy and to decide the amount and frequency of payments In addition to providing protection against premature death, it has a saving account component with an adjustable death benefit, which provides policyholders an opportunity to save or invest at variable interest rates i.e that vary with capital market and competitive conditions In universal life policy, investment risk is borne by the policyholder instead of the insurance company and the income on the savings component accumulates on a tax deferred basis Policy loans: During rising interest rate environment, policyholders of ordinary life policies have the option to borrow some or all against the accumulated cash value b) Variable life insurance (unit-linked life insurance): It is a type of ordinary life insurance where the premiums are fixed but death benefit and the cash value are Types of Life Insurance Policies: 1) Ordinary Life Insurance: It is also known as Whole Life Insurance This insurance policy provides lifetime protection by paying fixed death benefits for the whole of the insured’s life as well as cash value component that increases with credited rate (i.e the interest rate credited to policyholder) Cash value = Initial premium paid + Any accrued interest on that premium Reading 13 Managing Institutional Investor Portfolios both linked to investment performance of investment selections made by the policyholder i.e the better the performance of investments, the larger the death benefits and cash values However, the death benefit cannot fall below a certain floor value, irrespective of investment performance Like universal life policy, returns are generally not guaranteed and investment risk is assumed by the policy holder instead of the insurance company Term Insurance FinQuiz.com c) Variable universal life (flexible-premium variable life): As the name implies, it is a combination of universal life and variable life policy i.e it provides the flexibility of universal life and also allows the policyholder to select investments for the savings portion of the account Ordinary Life Insurance Variable Life Insurance Universal Life Insurance Variable Universal Life Insurance Death benefit paid Level or decreasing death benefit Level death benefit Guaranteed minimum death benefit plus increased amount from favorable investment returns Either level or an increasing death benefit Either level or an increasing death benefit Cash value No cash value Guaranteed cash values Cash value depends on investment performance (non guaranteed) Guaranteed minimum cash value plus excess interest credited to the account Cash value depends on investment performance (not guaranteed) Premiums paid Premiums increase at each renewal Level premiums Fixed-level premiums Flexible premiums Flexible premiums Policy loans No Yes Yes Yes Yes Partial withdrawal of cash value No No No Yes Yes Surrender charge No No explicit charge stated (reflected in cash values) Yes Yes Yes Source: Pearson Addison-Wesley 4.1.1) Risk Objectives Policy reserves, also called legal reserves, are a major liability item of the life insurance companies Policy reserve = Present value of future benefits - Present value of future net premiums Due to the contractual obligations to policyholders (future liabilities) and greater sensitivity to interest rate related risk, life insurance companies have a low tolerance for the risk of loss of principal or the disruptions in investment income (i.e uncertain cash flows) • Due to their nature of liabilities, insurance companies are considered as “Quasi-trust” funds • To manage the risk of meeting insurance liabilities, investment portfolio is invested in low-risk assets of similar durations and surplus funds are invested in riskier securities Surplus is a key indicator of financial strength of an insurance company and helps to support expansion of business volume Surplus = Total assets of an insurance company - Total liabilities of an insurance company For mutual insurance company Policyholders’ surplus For stock insurance company equity for a stock company Surplus = Surplus = Stockholder’s Risk objectives can be stated as “To minimize the risk of insolvency and inability to meet policyholder claims and risk of principal loss by maintaining sufficient cash reserves and surplus relative to liabilities and by efficiently managing interest rate risk” Asset Valuation Reserve (AVR): The National Association for Insurance Commissioners (NAIC), which is the national regulator in the U.S., requires life insurance companies to maintain a cushion to guard against substantial losses This cushion is known as Asset Valuation Reserve (AVR) Reading 13 Managing Institutional Investor Portfolios • The size of the appropriate AVR depends on the risk characteristics of their investments e.g bonds, preferred stocks and real estate may be carried at amortized cost, while common stocks may be carried at market value In addition, the maximum amount of reserve may vary by the class of assets • When size of AVR is insufficient to absorb significant losses, the losses in excess of asset valuation reserve are charged against the surplus (i.e surplus is written down/reduced) Some life insurance companies are also subject to riskbased capital (RBC) requirements i.e to maintain adequate surplus to mitigate risk exposures associated with both assets and liabilities Due to the distinct features of life insurance and annuity contracts, most life insurance companies construct their portfolios by segmenting them in a way such that the most appropriate securities (i.e with interest-rate sensitivity similar to that of product/liability segment) fund each product segment The risk tolerance of a life insurance company may vary by portfolio segments e.g minimum return segment has lower risk tolerance while the surplus segment has greater risk tolerance Life insurance companies are exposed to interest-raterelated risk because their liabilities (e.g annuity contracts) are interest rate sensitive Life insurance companies are exposed to the following two types of interest rate risks: Valuation concerns: It refers to a decline in the value of surplus resulting from changes in interest rates due to mismatch between the duration of an insurance company’s assets and duration of an insurance company’s liabilities For example, • If average duration of assets > average duration of liabilities, then during periods of rising interest rates fall in the value of assets will be greater than that of liabilities leading to losses and reduction in surplus This implies that when average duration of assets > average duration of liabilities, then an insurer has low risk tolerance due to valuation concerns • Similarly, If average duration of assets < average duration of liabilities, then during periods of declining interest rates increase in the value of assets will be smaller than that of liabilities leading to losses and reduction in surplus • The impact of disintermediation risk is also greater during high interest rates when there is a mismatch between asset/liability duration Reinvestment risk: Reinvestment risk is the risk of reinvesting cash from an interest payment or principal at a lower interest rate than that of previous investment This risk is particularly greater in annuity and guaranteed investment contracts with fixed credited rates During declining interest rates, insurance companies offering such contracts face the difficulty to earn their required return in order to FinQuiz.com earn positive interest rate spread above that of the required return Other risks include: Credit risk: It refers to the risk of default of securities held by the life insurance companies in their investment portfolio This risk is managed by careful and intensive credit analysis, by broadly diversifying the investments within the portfolio and/or by demanding higher expected return or interest rate spread for investing in high credit risk investments Cash flow volatility: It refers to the risk of uncertainty and volatility in the timing of receipt of cash flows, e.g loss of income or delays in collecting and reinvesting cash flow investments In summary, key risk objectives include: • To minimize interest rate sensitivity i.e o To control valuation concern risk by targeting portfolio duration to match liabilities’ duration; o To manage disintermediation risk; o To control reinvestment risk; • To manage credit risk by achieving portfolio diversification, both at a sector and issuer level; • To manage cash flow volatility risk by maintaining sufficient short term cash and liquidity to fund immediate and short-term liabilities; While insurance companies are required to control risk, many companies are forced to mismatch asset/liability durations or downgrade the credit quality of their investments in an attempt to achieve higher returns for competitive reasons 4.1.2) Return Objectives The primary return objective of life insurance companies is to earn a certain minimum required return on their investments to fund future policyholder benefit claims Any return in excess of the minimum required return represents profit for the life insurance company The return objective of a life insurance company can be threefold: 1) To earn a minimum required return, sufficient to meet future policyholder benefit claims In numerical terms, it can be stated as: Minimum required rate of return = Credited rates • This objective can be best met by investing in safe/low-risk and high income securities (e.g fixed income and preferred stocks) 2) To earn a positive net interest rate spread (i.e interest earned on its assets - interest paid to policyholders) in order to generate additional profits and/or to achieve competitive advantage by setting lower insurance premiums In numerical terms, it can be stated as: Reading 13 Managing Institutional Investor Portfolios Required rate of return = Credited rates + Excess Target rate 3) To achieve surplus growth in an attempt to support expanding business volume and to achieve competitive advantage by setting lower insurance premiums; • Return objectives of earning positive net interest spread and growing surplus capital can be best met by investing in high risk, high return securities and securities with greater capital appreciation (e.g common stocks, equity investments in real estate, and private equity etc.) Like risk tolerance, the return objectives vary by portfolio segments e.g minimum return segment has less aggressive return objectives while the surplus segment has aggressive return objectives 4.1.3) Liquidity Requirements Liquidity requirements include cash needed to pay death benefit payments, to meet demand for policy loans, to meet working capital needs etc Life insurance companies have low liquidity needs due to the following reasons: i Cash flows from customer premiums are usually more than sufficient to meet these liquidity needs; ii Growth in the volume of business; iii Longer-term nature of liabilities; iv Rollover in portfolio assets from maturing securities and other forms of principal payments; Due to low liquidity requirements, life insurance companies can invest in long-term, non-marketable investments (e.g real estate, private placements) • However, uncertain timing of cash needs due to potential for policy loans or disintermediation during rising interest rate environments contributes to the increased liquidity needs Hence, to avoid incurring losses on the sale of less marketable (illiquid) investments to meet liquidity needs, the life companies must properly assess their liquidity requirements and invest in less liquid investments so long as liquidity requirements are not compromised • Asset marketability risk: Due to volatile interest rates and consequently, uncertain timing of cash needs, life insurance companies are not allowed to invest a greater portion of their portfolio in less marketable, illiquid asset classes The liquidity requirements and its related risk can be managed by: • Using derivative contracts • Maintaining lines of credit with banks FinQuiz.com 4.1.4) Time Horizon Traditionally, life insurance companies are considered as long-term investors with investment holding periods between 20 to 40 years Hence, they tend to invest in long-term maturities for bond and mortgage investments (for matching liabilities’ durations) and in real estate, common stocks, convertible securities, and venture capital (to earn higher returns i.e capital appreciation and protection against inflation risk) Other factors that affect duration of liability and in turn the time horizon of a life insurance company include: Policy surrenders (disintermediation) and/or loans: During periods of rising interest rates, disintermediation and/or policy loans tend to reduce the duration of liabilities and consequently shorten the time horizon Duration of insurance products offered by the company: For example, a two-year guaranteed investment contract will have shorter duration, contributing to a decline in the duration of liabilities and shortening of time horizon Similarly, group annuities tend to have shorter time horizon In general terms, time horizons have simply become shorter due to use of asset/liability management practices e.g minimum return segment has a shorter time horizon while the surplus segment has a longer time horizon 4.1.5) Tax Concerns Unlike pension funds and endowments, insurance companies are taxable entities; hence, they need to focus on maximization of their after-tax returns by selecting the mix of investments that provide the most favorable after-tax returns For tax purposes, the investment income of life insurance companies can be divided into two categories: 1) 2) Policyholder’s share i.e accumulated cash values that are based on the credited rate (minimum return determined by actuary): It is tax-deferred investment for the policyholder Corporate share i.e company’s excess returns or surplus capital: It is taxed as ordinary income The insurance companies are vulnerable to likely changes in the tax code; hence, portfolio managers face uncertainty with regard to tax implications of various portfolio strategies 4.1.6) Legal and Regulatory Factors In most countries, insurance companies are subject to heavy regulations and they must comply with all the regulations of the state in which they are domiciled These regulations have substantial impact on both the risk and return of portfolio of life insurance companies because they limit the universe of eligible investments, asset allocation, and operating flexibility of insurance companies Reading 13 Managing Institutional Investor Portfolios Non-life Insurance Companies • In the U.S., the life insurance companies are subject to state rather than federal regulations Important concepts related to regulatory and legal considerations include: • Eligible investments: The universe of eligible investments and quality standards for each asset class are determined by the regulations e.g in the U.S., insurance companies can invest ≤ 20% of total assets in common stocks • Prudent investor rule: According to prudent investor rule, life insurance companies are required to prudently analyze investment choices consistent with their investment objectives and constraints rather than only investing in investments approved under traditional “laundry lists” • Valuation methods: In the U.S., for the purpose of valuation of their portfolio securities, insurance companies are required to use the values or valuation bases compiled by NAIC’s Security Valuation Book This book contains the valuation data listed in Schedule D (a list of inventory of all bond and stock holdings at year-end and a recap of the year’s transactions) line Non-Life Insurance Companies: Background and Investment Setting Fairly quick compared to Non-life companies Risk exposures • Most (not all) nonlife companies are exposed to inflation risk because they offer replacement cost coverage • They are not exposed to interest rate risk because their policies not typically pay returns on a periodic basis Directly exposed to interest rate risk Value of liabilities Uncertain Certain Timing of liabilities Uncertain Uncertain Operating results Relatively more volatile operating results due to highly uncertain liabilities Relatively less volatile operating results due to certain value of liabilities Investment returns Vary significantly from company to company due to: • Differences in regulations • Differences in product mix and liabilities duration • Differences in tax position • Differences in preference with Almost identical among companies Like life insurance companies, casualty insurance companies are considered as quasi-trust funds Differences between Non-life Insurance and Life Insurance Companies Customers or buyers of insurance policies Duration of Liabilities Non-life Insurance Companies Life Insurance Companies Commercial customers Individuals Relatively Shortterm liabilities Liability duration vary by product Relatively Longterm liabilities Liability duration vary by product line Longer than life companies i.e long time span (months and years) between the date of the occurrence and reporting of the claim and the actual payment of a settlement to a policyholder Hence, the nature of liability of nonlife companies is referred to as “Long-tail” Insurance companies (whether life or non-life) may have unique circumstances that dictate the types of potential investments and investment strategies used by them These may include: 4.2 Life Insurance Companies Insurance Claim processing and payments periods 4.1.7) Unique Circumstances • Size of the insurance company; • Sufficiency of surplus capital of an insurance company; • Diversity of product offerings of an insurance company; • Strength of the balance sheet of an insurance company; FinQuiz.com Reading 13 Managing Institutional Investor Portfolios Non-life Insurance Companies Life Insurance Companies regard to capital appreciation versus the income component • Differences in capital and surplus positions Liquidity needs Depend on business cycles and underwriting cycles Depend on interest rate cycles Earnings of non-life insurance companies consist of underwriting profitability plus investment income Underwriting profits = Premiums earned during the period -Incurred losses - Loss adjustment expenses - Other underwriting expenses Investment income is a source of financial stability to the company because it helps to offset substantially large underwriting losses that occur periodically, e.g due to natural disasters Investment income also contributes to the growth of the surplus that enables the company to expand its underwriting business volume because more underwriting business can be done when capital increases 4.2.1) Risk Objectives Non-life insurance companies have highly uncertain and unpredictable policy liabilities as the timing and values of cash outflows associated with potential claims are highly uncertain in nature Since sufficient funds are needed to cover unpredictable liabilities, non-life companies have very low tolerance for the risk of principal loss Property/casualty companies also have lower risk tolerance due to their sensitivity to inflation i.e when inflation rate rises, liabilities increase In setting risk objectives, the casualty companies must consider the following factors: A Cash flow Characteristics: Due to the uncertain timing and values of cash outflows associated with potential claims, non-life companies need to have higher safety of principal and sufficient investment income to meet extraordinary large underwriting losses In general, • The portion of investment portfolio related to policyholder reserves has a low tolerance for risk of principal loss or disruptions in investment income whereas the surplus capital portion may have greater tolerance for risk of principal loss or disruptions in investment income • Regulators and rating agencies closely monitor the ratio of a casuality insurance company’s premium FinQuiz.com income-to-its total surplus.The casualty companies are generally required to maintain this ratio between 2-to-1 and 3-to-1 B Common stock to surplus ratio: The potential impact of bear (declining) equity markets on the surplus capital can be measured by examining proportion of assets (total surplus) represented by common stocks i.e the larger the proportion of common stock holdings, the greater the erosion of surplus during declining equity markets and consequently, the lower the ability to provide sufficient financial stability, leading to lower risk tolerance for the portion of the investment portfolio related to surplus • Unlike life insurance companies, the non-life companies have no restrictions with regard to common stocks as a % of surplus 4.2.2) Return Objectives Like life insurance companies, non-life companies divide their investment assets into two parts i.e a) Core holdings or fixed-income segment: They are held to meet the potential claims of policyholders Since non-life companies are not required to meet a minimum return requirement, core holdings constitute a smaller portion of assets for non-life companies • The return objective for the core holdings portion is to maximize the fixed-income return in order to meet liabilities (claims) It may be considered as a shortterm goal b) Surplus capital segment: It is invested in common stocks, convertible securities, and alternative investments to achieve growth of surplus • The return objective for surplus portion is to generate greater capital appreciation to enable the company to adopt competitive pricing on policy premiums and to expand business volume It may be considered as a long-term goal The return objectives of Non-life insurance companies vary depending on the following factors: A Competitive Policy Pricing: In order to support the competitive pricing on policy premiums of all products, the company seeks to earn a high expected return on its investment portfolio • However, it is not advisable to only rely on investment returns to cover underwriting losses because the financial stability of a company also depends on its underwriting quality and profitable pricing • In addition, the return objectives should be consistent with capital market assumptions and the insurance company’s ability to accept risk Reading 13 Managing Institutional Investor Portfolios B Profitability: Unlike life insurance companies, the minimum required return of non-life insurance companies does not reflect the credit rate for their policies; rather, they seek “to maximize the return on capital and surplus (consistent with asset/liability management, surplus adequacy considerations, and management preferences) in an attempt to enhance profitability; maintain liquidity; and to smooth the earnings volatility of the typical underwriting cycle” The underwriting profitability of the insurance company can be measured using “combined ratio” which is estimated as: Combined Ratio = (Total amount of claims paid out + Insurer's operating costs) / Premium income • When the combined ratio is > 100%, it means that for every premium dollar received, more than a dollar was spent on losses and expenses • The lower the combined ratio is (i.e < 100%) the more profitable the insurer The return objective related to profitability may also be stated as “to generate a high level of income to supplement or offset insurance underwriting gains and losses (i.e claims – premium income)” C Growth of Surplus: The insurance company may seek to contribute to the growth of surplus through capital appreciation that enables the company to expand its underwriting business volume In order to grow capital surplus, it must be invested in equities and other assets with greater capital appreciation D Tax considerations: Most non-life insurance companies prefer to maintain some balance of taxable and tax-exempt bonds in their portfolios in order to maximize their after-tax returns E Total return management: Most non-life insurance companies have adopted active bond portfolio management strategies in order to maximize total return on their investment portfolios 4.2.3) Liquidity Requirements Non-life insurance companies have high liquidity requirements compared to life insurance companies due to the following reasons: 1) Unpredictable cash outflows; 2) Need to shift the portfolio mix between taxable and tax-exempt bonds depending on the underwriting performance i.e during periods of underwriting profits (loss), a portion of bond portfolio is liquidated to increase tax-exempt (taxable) income 3) Shorter time horizon; 4) Underwriting and business cycles: Unlike life insurance companies, the liquidity needs of non-life companies are determined through business cycles not interest rate cycles Underwriting or profitability cycle (averaging 3-5 years, in general) follows general business cycle i.e premium rates rise faster than claim costs in the up phase of the cycle (economic expansion), leading to higher earnings and greater FinQuiz.com capital accumulation; consequently, the premium rates are lowered to expand business volume Afterwards, during the down phase of the cycle (economic recession), claim costs rise faster than premium rates • The liquidity requirements are particularly high at the end of the underwriting cycle when claims are most likely to be paid Due to high liqudity needs, non-life insurance companies, typically, • Hold an immediate liquidity reserve of short-term securities i.e commercial paper or Treasury bills); • Invest in high-quality, readily marketable government bonds of various maturities; • Maintain a balanced or laddered maturity schedule to ensure sufficient liquidity; • Match duration of assets with liabilities associated with seasonal cash flow needs; • Do not invest in highly illiquid investments; 4.2.4) Time Horizon Casualty insurance companies have short-time horizons as implied by two factors i.e 1) The short time frame of the underwriting cycle that impacts the portfolio mix of taxable and tax-exempt bond holdings 2) Shorter durations of casualty liabilities • Casualty companies may invest in longer maturity bonds to earn higher yields offered on those securities • The investment strategy for surplus capital segment of the company focuses on achieving long-term growth and thus implies longer time horizon 4.2.5) Tax Concerns • Tax considerations are a very important factor in determining casualty insurance companies’ investment policy and the optimal asset allocation because unlike life insurance companies, all invested assets of non-life insurance companies are taxable o During periods of underwriting profits, the non-life companies should invest in tax-exempt bonds, preferred stocks and common stocks in high-tax regimes in order to achieve some tax-shelter o By contrast, during periods of underwriting losses, non-life companies should invest in taxable bonds • The insurance companies are vulnerable to the likely changes in tax code, which ultimately increases uncertainty for portfolio managers with regard to tax implications of various portfolio strategies 4.2.6) Legal and Regulatory Factors Reading 13 Managing Institutional Investor Portfolios The non-life insurance companies are subject to few regulations compared to life insurance companies as they are not required to maintain an asset valuation reserve and have no restrictions related to the choice of investment assets and the amount of portfolio invested in any particular asset class However, • They are subject to risk-based capital requirements i.e they need to maintain minimum capital requirements depending on the size and degree of various risks that can be assumed by the insurer These risks include: o Asset risk (risk related to fluctuations in market value); o Credit risk o Underwriting risk (risk related to underestimating liabilities from business already written or improperly pricing current or prospective business); o Off-balance sheet risk (risk related to items not recorded on the balance sheet); • They are required to keep assets equal to 50% of unearned premium • They are required to maintain combined loss reserves in eligible bonds and mortgages 5.1 FinQuiz.com • Casualty insurance companies are required to maintain premium-to-surplus ratio between 2-to-1 and 3-to-1 Unique Circumstances: • The primary unique circumstance that affects a nonlife insurance company is the financial strength of a company i.e financially weak companies need to be more conservative in their investment process • Most non-life insurance companies have selfimposed restrictions on the types of investment assets (e.g are not allowed to invest in private placement bonds, commercial mortgage loans, and real estate due to liquidity concerns) and the amount that can be invested in specific asset classes (e.g common stocks at market value must represent one-half to three-quarter of the total surplus) BANKS AND OTHER INSTITUTIONAL INVESTORS Banks: Background and Investment Setting Banks are financial intermediaries who are in the business of taking deposits and making loans Liabilities of a bank include: a) Deposits e.g time deposits (in which depositor cannot withdraw funds without advance notice) and demand deposits (in which the depositor can withdraw funds without prior notice i.e checking account) Deposits are the major liabilities of banks b) Purchased funds; c) Publicly traded debt; Assets of a bank include: a) Loans including real estate, commercial, individual, and agricultural loan; b) Portfolio of investment securities; c) Other assets i.e trading accounts, bank premises and fixed assets, other real estate owned, cash and federal funds; The chief financial variables that affect bank profitability include sources of income and expenses Banks’ sources of Income include: • Interest revenues from loans It depends on the quantity, duration and credit quality of loans • Interest income on investment securities of portfolios It depends on the quantity, duration and credit quality of securities • Fees and other non-interest sources of income; Banks’ expenses include: • Interest costs on deposits; • Non-interest expenses; The profitability measures of a Bank include: 1) Net interest margin: It measures the net interest income earned by the bank on its income-producing assets It is estimated as: Net interest margin = (ூ௡௧௘௥௘௦௧ ூ௡௖௢௠௘ିூ௡௧௘௥௘௦௧ ா௫௣௘௡௦௘) ஺௩௘௥௔௚௘ ா௔௥௡௜௡௚ ஺௦௦௘௧௦ ே௘௧ ூ௡௧௘௥௘௦௧ ூ௡௖௢௠௘ = ஺௩௘௥௔௚௘ ா௔௥௡௜௡௚ ஺௦௦௘௧௦ • Income-producing or earning assets include loans and bonds They not include discount instruments i.e acceptances • The higher the net interest margin, the more profitable the bank will be and the greater the bank’s ability to profitably manage interest rate risk Reading 13 Managing Institutional Investor Portfolios 2) Interest spread: It measures the bank’s ability to invest in assets with high interest income and to raise deposits (liabilities) with low interest costs It is estimated as: Interest spread = Average yield on earning assets – Average percent cost of interestbearing liabilities • The higher the interest spread, the more profitable the bank will be and the greater the bank’s ability to profitably manage interest rate risk The risk measures of a Bank include: 1) Leverage-adjusted Duration Gap (LADG): It is used to measure a bank’s overall sensitivity to changes in interest rates Leverage-adjusted duration gap = DA – (k ×DL) Where, DA = Duration of assets DL = Duration of liabilities k= Market value of liabilities / Market value of assets = L/A Impact of interest rate risk on market value of net worth of a bank: Change in market value of net worth of a bank (resulting from interest rate shock) ≈ - LADG × Size of bank × Size of interest rate shock Where, • Market value of net worth represents the value of equity claims on the bank • LADG = Leverage-adjusted duration gap The larger the gap, the greater the exposure of bank to changes in interest rates • Size of bank is measured by assets The larger the size of bank, the greater the exposure of bank to changes in interest rates • Size of interest rate shock = Change in interest rate / (1 + Interest rate) The larger the size of interest rate shock, the greater the exposure of bank to changes in interest rates IMPORTANT TO NOTE: Both LADG and size of bank is under the control of a bank while the interest rate shock is not under the control of a bank For a bank with Positive LADG positive (negative) interest rate shock i.e unexpected increase (decrease) in rates results in decline (increase) in the market value of net worth For a bank with Negative LADG positive (negative) interest rate shock i.e unexpected increase (decrease) FinQuiz.com in rates results in increase (decrease) in the market value of net worth For a bank with Zero LADG (i.e an immunized balance sheet) positive or negative interest rate shock will have no effect on the market value of net worth 2) Position and aggregate Value at Risk (VAR): Value at Risk (VAR) reflects the minimum amount of potential loss expected to incur over a given time period (say day, week, quarter, year) with a given level of probability (say 5% or 1%) E.g VAR of $100 million on an asset at a one-week with 95% confidence level means that there is only a 5% probability that the value of the asset will decline more than $100 million over any given week 3) Credit measures of risk: These may include both internally developed credit risk measures and commercially available credit risk measures i.e Credit Metrics Role and Objectives of Securities Portfolio of a Bank: The securities portfolio of a bank plays a critical role in managing a bank’s risk and liquidity positions relative to its liabilities and in meeting its financial performance objectives The important objectives of bank’s securities portfolio include the following in descending order of importance: a) To manage overall interest rate risk of the balance sheet: Banks tend to hold negotiable and highly liquid and marketable securities in their investment portfolio in order to manage and control overall interest rate risk of the balance sheet For example, when duration of bank’s equity is higher than desired, then it can be shortened by reducing the maturity of securities portfolio by investing in short duration securities b) To manage liquidity: Banks tend to hold negotiable and highly liquid and marketable securities in their investment portfolio to ensure availability of adequate cash to meet liquidity needs c) To produce income: Banks hold securities portfolios to generate higher income in an attempt to enhance profitability Excess or residual cash resulting from deposits that have not been loaned out or from low demand for loan are invested in high-earning investment assets d) To manage credit risk: Securities portfolio is used to diversify risk associated with geographically concentrated or risk-factor concentrated loans of a bank E.g a bank invests in high credit-quality (i.e low credit risk) securities to manage and diversify its overall credit risk exposure to some desired level e) To meet pledging requirement: Banks are required to hold (pledge collateral) government securities against the uninsured portion of deposits From asset/liability management perspective, banks primarily hold fixed-income securities in their investment portfolio because both assets (loans) and liabilities (deposits) are interest-rate sensitive Reading 13 Managing Institutional Investor Portfolios Investment securities (in order of their proportion) in the balance sheet of a Typical Bank include: • • • • • U.S government agency and corporate securities Other domestic debt securities Municipal securities U.S Treasury securities and Non-U.S debt securities Equities NOTE: Banks also use off-balance sheet derivatives to manage interest rate and credit risk 5.1.1) Risk Objectives Banks tend to have below-average risk tolerance for interest rate, credit, and liquidity risk in its securities portfolio because of their critical need to be able to meet its liabilities to depositors and other entities when they come due, commonly at short notice The primary risk objective of banks is to minimize the risk of loss of principal and the risk of inadequate liquidity that may impair a bank’s ability to fund its liabilities to depositors (withdrawals) and other entities Risk objective related to credit risk: To minimize the risk of loss from defaults of an individual issuer/borrower To meet this risk objective, banks seek to diversify risk associated with geographically concentrated or riskfactor concentrated loans by assuming less credit risk in their securities portfolio Risk objective related to interest rate risk: Typically, the liabilities of banks (deposits) are short-term in nature while assets (loans e.g mortgages) are long-term in nature Hence, another important risk objective of banks is to minimize the interest rate risk exposures of market value of net worth by managing a mismatch between the duration of assets and liabilities 5.1.2) Return Objectives Generally, a bank’s return objective for its securities portfolio is to maximize portfolio return over the long term in a manner that is consistent with liquidity needs, pledging requirements, asset/liability management strategies and safety of principal” The return objective of a Bank can be divided into one of the three categories: 1) To earn or maintain positive interest rate spread (and net interest rate margin) between the asset in which it invests and the cost of its funds Positive interest rate spread facilitates a bank to meet its operating expenses and earn a fair profit on its capital 2) To maintain substantial liquidity to meet its withdrawals (net deposit outflows), loan demand, or other emergency needs 3) To maximize return earned on the excess or residual cash holdings due to net deposit inflows or low loan demand in an attempt to enhance profitability 5.1.3) Liquidity Requirements FinQuiz.com Banks have substantial liquidity requirements with regard to meeting net deposit withdrawals, to meet loan demands and to meet regulatory requirements 5.1.4) Time Horizon The time horizon of banks tends to be short to intermediate-term in nature (typically between 3-to-7 years) as implied by the following reasons: • Short-term liquidity needs to meet withdrawal demand of depositors • Focus on short-term investments to avoid interest rate risk in order to maintain adequate interest rate spread • Shorter maturity of liabilities (deposits) compared to maturity of loan portfolio, which demands investment in short-term investments to match the duration of assets and liabilities It must be stressed that short to intermediate term time horizon also implies below-average risk tolerance for banks 5.1.5) Tax Concerns Banks’ securities portfolios are fully taxable As a result, banks need to evaluate performance of taxable and tax-exempt investments on an after-tax basis to maximize their after-tax returns 5.1.6) Legal and Regulatory Factors Banks are heavily regulated and are required to comply with all the state and federal banking regulations These regulations include: Restrictions on the amounts that can be invested in equities or non-investment grade bonds Legal reserve and pledging requirements: Under pledging requirements, banks are required to pledge collateral (short-term government securities) against certain uninsured public deposits Risk-based Capital (RBC) requirements: The RBC requirements seek to limit the risk-taking activity of banks by setting the amount of required capital as a % of both on and off balance sheet assets of banks E.g ratio of total capital to risk weighted assets must be at least 8% • When an asset has a risk weight of 100%, the capital charge on it is 8% • When an asset has a risk weight of 50%, the capital charge on it is 4% Restrictions on engaging in short sales Restrictions on hiding investment loss by using adjusting trade i.e banks are not allowed to hide an investment loss by selling a security at a fictitiously high price to a dealer and simultaneously buying another overpriced security from the same dealer 5.1.7) Unique Circumstances Reading 13 Managing Institutional Investor Portfolios Generally, banks not have any common unique circumstances related to their securities portfolio However, some unique circumstances that may affect lending activities of banks include: • Historical banking relationships; • Geographically concentrated or risk-factor concentrated loans: Increased lending to lowincome community, or agricultural loans etc • Community needs; • Area where it is located: A bank situated in a small community may have customers (depositors) who deposit money with it primarily for the sake of convenience and may face less competition By contrast, banks situated in highly populated areas have more interest-rate sensitive deposits and face high competitive pressures from nearby banks • Inability to sell loans; 5.2 Other Institutional Investors: Investment Intermediaries Instead of investing their own funds like pension funds, foundations, insurance companies etc., institutional investors pool and invest investor funds Other institutional investors include: A Investment companies: These refer to pure investment vehicles where pooled funds of investors are invested in equity and fixed-income markets e.g • Mutual funds (open-end investment companies); • Closed-end funds (closed-end investment companies); • Unit trusts; • Exchange-traded funds; B Commodity pools: They refer to investment vehicles where pooled investor funds are invested in commodities futures and options contracts rather than equity and fixed-income markets FinQuiz.com C Hedge funds: Hedge funds are the investment vehicles, which are only available to institutional investors and to high-net-worth individuals They are not highly regulated D Nonfinancial corporations (i.e businesses): They primarily invest in money markets instruments (fixedincome securities with maturities of ≤ year) primarily for cash management purposes Cash can be divided into two types: i Liquid cash: It refers to cash invested in demand deposits and very short-term money market securities ii Long-term or Core cash: It refers to cash invested in longer-term money market securities • From cash management perspective, the primary investment objective of non-financial corporations as well as the financial institutional investors is to actively manage the composition of the cash position in a manner consistent with liquidity needs (including seasonal cash needs), nondomestic currency needs, tax concerns as well as safety of principal It is important to understand that unlike other types of institutional investors, we cannot generalize about the investment objectives and constraints of these types of institutional investors For example, each mutual fund would have its specific investment objectives and constraints Practice: End of Chapter Practice Problems for Reading 13 &FinQuiz Item-set ID# 12424  ... concentrated stock holdings of a single company Practice: Example 12, Volume 2, Reading 13 3 .2 • A private foundation must pay a 2% excise tax annually on its net investment income However, if the... more (less) aggressive risk and return objectives can be adopted Practice: Example 3, Volume 2, Reading 13 2. 1 .3) Liquidity Requirement Pension plan’s liquidity requirement i.e its Net cash outflow... portion = Average life expectancy of retired plan beneficiaries Practice: Example 5, Volume 2, Reading 13 FinQuiz. com 2. 1.5) Tax Concerns Pension funds are either tax-exempt or are taxed at very favorable