investment policy statement of all institutions
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Transcript of investment policy statement of all institutions
Lecture 04Chapter 3Managing Institutional Investor Portfolios
2 Portfolio Management ProcessPLANNING
Capital Market Expectations E(r)/σ
PLANNINGInvestor Objective & Constraint
FEEDBACKPerformance/Monitoring Performance measures Sp
Attribution analysisREBALANCE
PLANNINGStrategic Asset Allocation
Efficient Frontier Based on objective/constraints, max return on risk adjusted basis
EXECUTIONTactical Asset Allocation
Security AnalysisTransaction Costs
3FOCUS of LECTURE:
1. Pension Funds
2. Foundations & Endowments
3. Insurance Industry
4. Banks & Other Institutional Investors
IPS for institutions is similar to individuals except that IPS must consider liabilities that have been entered into
Asset/Liability Management (ALM) managing investment of assets to control relative asset/liability values
4 Pension FundsGeneral Definitions Pension Plan
portfolio of assets that supports PROMISE to plan participants
promises 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
5 Pension FundsTypes of Pension Plans Defined-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
liability If 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 contribution Types
Pension PlansProfit Sharing Plans which are tax advantaged
Sponsor directed (profit sharing plan) sponsor selects investments
Participant directed Employee allocated retirement among available investment funds
6 DB vs DCType Plan
Employer Employee
DB
DC
Pension 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 obligations
Received 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 performance Company promises to
keep contributions current Only financial liability is
making contributions Plan MUST offer
employees sufficient number of investment vehicles for suitable portfolio construction
Owns plan assets & can transfer account to other qualified plans
Must make ALL investment decisions given available investment vehicles
Bears ALL investment risk
7 Defined-Benefit (DB) PlanPension assets MUST FUND payment of LIABITIES related to pension benefits (ALM)Pension Plan’s investment performance should be judged on absolute basis but also adequacy of its assets with respect to liabilitiesFunding Status relationship between value of
plan’s assets & present value of its liabilitiesPensionSurplus
Market valuePension Assets= Present value
Pension Plan Liabilities-
Fully Funded Pension surplus > 0Underfunded plan Pension surplus < 0QUESTION: How does DEFINITION of Pension Plan Liabilities impact of Pension Surplus?
8 Defined-Benefit (DB) PlanDefinitions of Pension Plan LiabilitiesAccumulated Benefit Obligation (ABO) Present value of pension benefits (liabilities)
assumes plan is terminated immediately & provides benefits based on their service to date
excludes impact of future salary increasesProjected Benefit Obligation (PBO) Present value of pension benefits (liabilities)
assumes employee will continue to work & projects future compensation increases
Total Future Liability used for return objective Present value of pension benefits (liabilities) that
includes not only future compensation increases but also includes Changes in benefits associated with inflation Changes in workforce
9 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 Sponsor’s 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 features if NO provision for early retirement ability to tolerate
risk if NO provision for lump-sum distribution ability to
tolerate risk Work force characteristics
younger age of workforce ability to tolerate risk ratio of active lives to retired lives ability to tolerate
riskThis is task performed by actuary support info in f/s
10 DB – Risk ObjectivesConsider DB plan / Plan Sponsor with following characteristics Plan 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
11 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 contributions
Stretch Target make future pensions contributions = 0
Realistic Objective minimize amount of future pension contributions (expressed on undiscounted or discounted basis)
Return Objectives based on pension income Minimize pension expense (return on pension
assets reduces pension expenses) reflected on income statement
12 DB – ConstraintsFactors impacting on DB ConstraintsLiquidity Requirement (benefit payments – pension contributions)
number of retired lives liquidity requirement plan sponsor’s contribution relative to benefit disbursements
liquidity requirement Plan features such as early retirement liquidity requirement
Time Horizon Plan is going concern (on going) vs plan termination is expected
(shorter) Younger workforce & larger proportion of active lives time
horizonTax DB Plan are tax exempt thus decisions can be made without
considering taxLegal & Regulatory
DB Plan must adhere to laws & regulationsUnique Circumstances
Laws & regulations may required plan sponsors to exercise due diligence
Plan sponsors may have imposed social responsibility constraints on types of securities that can be held
13 Defined-Contribution (DC) PlanTypes of DC Plans Participant directed Plan Sponsor directed
Principal Investment Issues Diversification Plan sponsor MUST offer menu
investment vehicles to construct suitable portfolios At least three (3) investment choices Provision to move between investment choices
Company Stock investment in plan sponsor’s stock should be limited
DC Investment policy enable number of different individual investor objectives & constraints
14 Hybrid & Other PlansHybrid Plans combine features of DB & DC plansDB plans Cash balance plan provides personalized
statement includes Annual contribution credit % of pay based on
age Earnings credit % increase tied to LT interest
rateDC Plans Employee stock ownership plans (ESOP)
encourage employees to become stockholder of their employers which may be either before or after tax plans
15 Foundations vs EndowmentsFoundation ford foundation Grant-making institutions (not legal obligations) Funded by gifts & investment assets Investment income is dominant source of revenue Private foundations funded by single donor LEGISLATED minimum level spending (to qualify
as non taxable) % assets (say 5%) or % investment income (say 85%)
Endowment Long 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 gifts NOT subject to specific legally required spending
level Each gift may have specific conditions regarding
intended use
16 Foundations - ObjectivesRisk Objective Foundation has NOT entered into contractual
agreements to provide grants, they have NO liabilities above average risk tolerance
Return Objective Reliability flow of funds is extremely important Short-lived foundation varying return objectives Long-lived foundation (perpetuity)
Preserve real value investment assets while Allow spending at appropriate rate = minimum
payout + management fee + inflation
17 Foundation – Constraints
Time Horizon Finite life Spend Down Rate determines time period, as it
approaches end of life, usually becomes more conservative Infinite life perpetuity
Liquidity Requirement Distribution is determined by foundation’s Spending Rate Spending rate tend to be conservative & utilize Smoothing
Rules
Tax Foundations subject to NO or NOMINAL (1-2%) tax
Legal & Regulatory Foundation must adhere to laws & regulations (minimum spending) Prudent Investor Rule ALL investments evaluated from portfolio
perspectiveUnique Circumstances Gift consisting of single stock with condition that it CANNOT be
sold
Factors impacting on Foundation Constraints
18 Endowments - GeneralEndowments Legal entity with portfolio assets Goal of providing permanent funding for activity Gifts may be
Restricted ONLY used for specific purposes Unrestricted used for general purposes
Prior to 1970, Level Spending was based on interest & dividend income portfolio more heavily weighted towards high-yielding fixed income securities
Today, Level Spending based on concept “total return” Spending Rate applied to market value assets
19 Endowments – Spending RatesDefinitions:S = spending rate % of assetsMKt = market value assets @ end of period tR = smoothing rate (0.6 – 0.8)i = inflation rateSimple Spending Rule$ Spendingt S= MKt-1✖
Problem with simple spending rule is level dollar amount of spending will vary function of market value Rolling 3-year average spending Rule
$ Spendingt S= MKt-1 + MKt-2 + MKt-3
3✖
Use average of market values smooth out Level of Spending Geometric smoothing Rule
$ Spendingt = R ✖ Spendingt-1 ✖ (1+it-1)
+ (1-R) ✖ S ✖ (MKt-1)
20 Endowments - ObjectivesRisk Objective IPS? Because they are perpetual, they can accept short-
term portfolio volatility IF portfolios have very low volatility, they will
only provide low expected rates of return IF endowment has high return objective to satisfy
relatively high spending needs it implies it needs high willingness to accept risk
Return Objective IPS? General objective is to provide significant, stable &
sustainable stream of spending distributions tend to have high return objectives
Also should maintain long-term purchasing power after inflation
To maintain purchasing power, endowment must keep its long-term expected real return > long-term average spending rate
21 Endowment – Constraints
Time Horizon Infinite life perpetuity or extremely long
Liquidity Requirement Limited liquidity required other than cash for spending
distributions Appropriate to include illiquid, non marketable securities as assets
Tax In general Endowments not subject to tax
Legal & Regulatory Few laws & regulations Board exercise ordinary business care & prudence Spending must comply with used restrictions imposed by donor
Unique Circumstances Endowment funds are diverse with different unique requirements
Factors impacting on Endowment Constraints
22 Life Insurance - GeneralInsurance companies Viewed absorbers of personal & business risk Because of contractual obligations to policy
holders, investment practices have been characterized conservative
Types of Insurance companies Life uncertainty with timing of payout Non life uncertainty with timing & amount of
payout Health Property & liability
By ownership Stock companies (issued common equity) Mutuals (owned by policyholders) most are in
process of demutualizing & converting to stock companies
23 Life Insurance - ObjectivesRisk ObjectiveTo absorb loss of due to write down of assets, companies are required to maintain Asset Valuation Reserve (minimum amount of equity) based on quality tests for each class of invested assetsMove towards risk-based capital (RBC) to ensure that company has adequate surplus (equity) which considers both asset & liability risk exposures Valuation Concerns in periods of increasing interest
rates, mismatch in duration between assets & liabilities can result in erosion of surplus portfolio & reduces risk tolerance
Cash flow volatility loss of income or delay in collecting income & reinvesting cash flow reduces risk tolerance
Reinvestment risk risk of reinvesting coupon at rate < original market rate of interest reduces risk tolerance
Credit risk associated with investing in corporate bonds generates higher return but at cost of greater probability of default
24 Life Insurance - ObjectivesReturn Objective Assets selected match duration liabilities Minimum return statutory rate determined by
actuaries Enhanced margin minimum return & net interest
spread which is competitive return on assets that funds well-defined liabilities
Surplus return return on surplus portfolio which permits insurance company to offer competitive premiums
Segmentation insurance company establishes return objectives for each major line of business
25 Life Insurance – Constraints
Time Horizon In general 20 to 40 years Because of segmentation, each product line may have different
time horizons
Liquidity Requirement Disintermediation during periods of high interest rates,
policy holders may surrender their policies creating cash outflow Asset Marketability risk portion of assets may be invested in
less liquid securities
Tax Income that belongs to policyholder not subject to tax in hands of
company Income due to surplus portfolio is taxable in hands of company
Factors impacting on Life Insurance Constraints
26 Life Insurance – Constraints
Legal & Regulatory (heavily regulated) Eligible investments regulations dictate eligible investments &
asset classes Prudent Investor Rule Each investment must be analyzed from
portfolio perspective rather than on stand alone basis Valuation method (assets & liabilities) regulations specify
valuation methods Risk based capital requirements
Unique Circumstances Insurance company’s size & amount of surplus portfolio
Factors impacting on Life Insurance Constraints
27 Non Life Insurance - GeneralGeneral Characteristics of Non Life Insurance Liability duration tend to be shorter but claim
processing & payment periods are longer (long tail) relative to life insurance company
Some non-life insurance are expose to inflation risk (insured for replacement cost)
Uncertainty in both timing & amount of liability payment
Non-life insurance have underwriting (profitability) cycle averaging 3-5 years. Beginning of cycle, underwriting losses are
negligible but End of cycle, underwriting losses are
progressively worse
28 Non Life Insurance - ObjectivesRisk ObjectiveDue to relatively high uncertainty, non life insurance companies tend to have limited risk toleranceInflation risk may also be issue Cashflow characteristics may be erratic &
unpredictable especially when taking underwriting cycle into consideration
Common stock-to-surplus ratio set between 50% to 75% (ie < 100% exposure to equity)
29 Non Life Insurance - ObjectivesReturn Objective Competitive pricing policy high levels of returns
on investments can be used to reduce premiums to make company more competitive
Profitability high levels of returns on investments can be used to smooth earnings volatility of underwriting cycle
Growth of Surplus Asset supporting liability tend to be fixed income
(which are duration matched) Surplus portfolio tend to be higher return
securities which are intended to grow surplus After tax returns taxable entity Total return focus on total return (rather than
investment income)
30 Non Life Insurance – Constraints
Time Horizon Shorter than life insurance
Liquidity Requirement Relatively high Increases during end of underwriting cycle
Tax Subject to tax
Legal & Regulatory Fewer laws & regulations than life insurance Risk based capital requirements
Unique Circumstances Current financial status of company
Factors impacting on Non Life Insurance Constraints
31 Bank - GeneralAsset Liability Management (ALM) Process
Management ofAssets & Liabilities
Quantity Duration
Credit quality
Interest revenue expense
Net interest margin
Interest spread
Mk Value Assets
Liabilities
Leveraged adjusted duration
gap
FinancialPerforman
ce
32 Bank - GeneralAsset Liability Management (ALM) ProcessNet Interest margin
Interest Spread
Leverage-adjusted duration Gap (LADG) DA DL k = L/A (L = market value liabilities, A = market value
assets)
If LADG = 0 interest rates change will NOT impact market value equity
Value at Risk (VaR)
Net Interest margin
=Interest income – Interest
expenseAverage earning assets
Interest Spread = Yield on assets - Yield on liabilities
Leverage adjusted
Duration gap= DurationAssets - k ✖
DurationLiabilities
33 Bank - ObjectivesRisk ObjectiveBank’s risk objectives are dominated by funding liabilities Focus is risk relative to liabilities rather than
absolute risk In general they have below average risk
tolerance
Return ObjectivePositive interest spread earn positive interest
spread (difference between bank’s cost of funds & interest earned on loans & other investments)
34 Bank – Constraints
Time Horizon Determined by average maturity of liabilities which tends to be
short term Average age of assets tend to be short to intermediate term (<10
years)
Liquidity Requirement Assets tend to be very liquid Driven by deposit withdrawals
Tax Subject to tax
Legal & Regulatory (highly regulated) Risk based capital requirements (Basel II & Basel III)
Unique Circumstances Lack of diversification due concentration of assets
Factors impacting on Bank Constraints
35 Appendix