FINANCIAL DERIVATIVES

Lecture 04

Chapter 3Managing Institutional Investor Portfolios #Portfolio Management ProcessPLANNINGCapital Market Expectations E(r)/

PLANNINGInvestor Objective & Constraint

FEEDBACKPerformance/MonitoringPerformance measures SpAttribution analysisREBALANCEPLANNINGStrategic Asset AllocationEfficient FrontierBased on objective/constraints, max return on risk adjusted basisEXECUTIONTactical Asset AllocationSecurity AnalysisTransaction Costs#FOCUS of LECTURE:Pension Funds

Foundations & Endowments

Insurance Industry

Banks & Other Institutional Investors

IPS for institutions is similar to individuals except thatIPS must consider liabilities that have been entered into

Asset/Liability Management (ALM) managing investment of assets to control relative asset/liability values#Pension FundsGeneral DefinitionsPension Planportfolio of assets that supports PROMISE to plan participantspromises MIGHT represent liability of plan sponsor

Plan Sponsor organization (corporation, non profit entity, government) that provides some or all of funds pension plan

Plan Participants receive promise related to retirement#Pension FundsTypes of Pension PlansDefined-benefit (DB) plan agreement that Plan Sponsor promises specific BENEFIT to Plan Participants based on formula (related to years of service & rate of pay)PROMISE generates future financial obligation or liabilityIf individual account is maintained for each individual Plan Participant is defined Cash Balance Plan

Defined-contribution (DC) plan agreement that Plan Sponsors make CONTRIBUTION to Pension Plan. Liability to Plan Sponsor is limited to their contributionTypesPension PlansProfit Sharing Plans which are tax advantagedSponsor directed (profit sharing plan) sponsor selects investmentsParticipant directed Employee allocated retirement among available investment funds#DB vs DCType PlanEmployerEmployeeDBDCPension Benefits are liability for employer

Benefits are determine by criteria such as years of service & salary

Plan Sponsor are responsible for managing plan assets to meet pension obligationsReceived periodic payments at retirement based on formula

Subject to early termination risk if employee is terminated prior to retirement

Does NOT bear risk/return consequences of portfolio performanceCompany promises to keep contributions current

Only financial liability is making contributions

Plan MUST offer employees sufficient number of investment vehicles for suitable portfolio constructionOwns plan assets & can transfer account to other qualified plans

Must make ALL investment decisions given available investment vehicles

Bears ALL investment risk#Defined-Benefit (DB) PlanPension assets MUST FUND payment of LIABITIES related to pension benefits (ALM)

Pension Plans investment performance should be judgedon absolute basis but alsoadequacy of its assets with respect to liabilities

Funding Status relationship between value of plans assets & present value of its liabilitiesPensionSurplusMarket valuePension Assets=Present valuePension Plan Liabilities-Fully Funded Pension surplus > 0

Underfunded plan Pension surplus < 0

QUESTION: How does DEFINITION of Pension Plan Liabilities impact of Pension Surplus? #Defined-Benefit (DB) PlanDefinitions of Pension Plan Liabilities

Accumulated Benefit Obligation (ABO)Present value of pension benefits (liabilities) assumesplan is terminated immediately &provides benefits based on their service to dateexcludes impact of future salary increases

Projected Benefit Obligation (PBO)Present value of pension benefits (liabilities) assumesemployee will continue to work &projects future compensation increases

Total Future Liability used for return objectivePresent value of pension benefits (liabilities) that includes not only future compensation increases but also includesChanges in benefits associated with inflationChanges in workforce#DB Risk ObjectivesRisk Objective willingness & ability to bear riskFactors impacting Risk Objective Plan Surplus (cushion) ability to tolerate risk Plan Deficit willingness to tolerate risk but ability to tolerate risk

Sponsors financial status debt/total assets ability to tolerate risk Current & expected profitability ability to tolerate risk

correlation of sponsor operating results (net income) with pension asset returns ability to tolerate risk

Plan featuresif NO provision for early retirement ability to tolerate riskif NO provision for lump-sum distribution ability to tolerate risk

Work force characteristicsyounger age of workforce ability to tolerate risk ratio of active lives to retired lives ability to tolerate risk

This is task performed by actuary support info in f/s

#DB Risk ObjectivesConsider DB plan / Plan Sponsor with following characteristicsPlan assets are 108% of present value of pension obligations (liabilities) ability to tolerate risk

Balance sheet of Plan Sponsor is very strong: debt/total assets ability to tolerate risk

Earnings of Plan sponsor are very strong despite operating in cyclical industry: correlation of sponsor operating results with pension asset returns ability to tolerate risk

Age of workforce is very low ability to tolerate risk

QUESTION: What is ability of DB plan to tolerate risk?

ANSWER: Ability to tolerate risk is above average

#DB Return ObjectivesPossible Return Objectives for DB Return objective is to achieve returns that funds its pension liabilities (on inflation adjusted-basis) Return pension assets discount rate used to calculate present value of liabilities (PBO)

Return Objectives based on contributionsStretch Target make future pensions contributions = 0Realistic Objective minimize amount of future pension contributions (expressed on undiscounted or discounted basis)

Return Objectives based on pension incomeMinimize pension expense (return on pension assets reduces pension expenses) reflected on income statement

#DB ConstraintsFactors impacting on DB ConstraintsLiquidity Requirement (benefit payments pension contributions) number of retired lives liquidity requirement plan sponsors contribution relative to benefit disbursements liquidity requirementPlan features such as early retirement liquidity requirementTime HorizonPlan is going concern (on going) vs plan termination is expected (shorter)Younger workforce & larger proportion of active lives time horizonTaxDB Plan are tax exempt thus decisions can be made without considering taxLegal & RegulatoryDB Plan must adhere to laws & regulationsUnique CircumstancesLaws & regulations may required plan sponsors to exercise due diligencePlan sponsors may have imposed social responsibility constraints on types of securities that can be held#Defined-Contribution (DC) PlanTypes of DC PlansParticipant directedPlan Sponsor directed

Principal Investment IssuesDiversification Plan sponsor MUST offer menu investment vehicles to construct suitable portfoliosAt least three (3) investment choicesProvision to move between investment choices

Company Stock investment in plan sponsors stock should be limited

DC Investment policy enable number of different individual investor objectives & constraints

#Hybrid & Other PlansHybrid Plans combine features of DB & DC plans

DB plansCash balance plan provides personalized statement includesAnnual contribution credit % of pay based on ageEarnings credit % increase tied to LT interest rate

DC PlansEmployee stock ownership plans (ESOP) encourage employees to become stockholder of their employers which may be either before or after tax plans

#Foundations vs EndowmentsFoundation ford foundationGrant-making institutions (not legal obligations)Funded by gifts & investment assetsInvestment income is dominant source of revenuePrivate foundations funded by single donorLEGISLATED minimum level spending (to qualify as non taxable)% assets (say 5%) or% investment income (say 85%)

EndowmentLong term funds owned by operating nonprofit institutions like universities & hospitals that are intended to provide permanent funding (but not legal obligations)Built up over time by many individual giftsNOT subject to specific legally required spending levelEach gift may have specific conditions regarding intended use

#Foundations - ObjectivesRisk ObjectiveFoundation has NOT entered into contractual agreements to provide grants, they have NO liabilities above average risk tolerance

Return ObjectiveReliability flow of funds is extremely important

Short-lived foundation varying return objectives

Long-lived foundation (perpetuity)Preserve real value investment assets whileAllow spending at appropriate rate = minimum payout + management fee + inflation

#Foundation ConstraintsTime HorizonFinite life Spend Down Rate determines time period, as it approaches end of life, usually becomes more conservativeInfinite life perpetuityLiquidity RequirementDistribution is determined by foundations Spending RateSpending rate tend to be conservative & utilize Smoothing RulesTaxFoundations subject to NO or NOMINAL (1-2%) taxLegal & RegulatoryFoundation must adhere to laws & regulations (minimum spending)Prudent Investor Rule ALL investments evaluated from portfolio perspectiveUnique CircumstancesGift consisting of single stock with condition that it CANNOT be soldFactors impacting on Foundation Constraints#Endowments - GeneralEndowmentsLegal entity with portfolio assets

Goal of providing permanent funding for activ