Lecture 04

Chapter 3
Managing Institutional Investor Portfolios

Portfolio Management Process

PLANNING
Capital Market Expectations
E(r)/

PLANNING
Investor Objective & Constraint

PLANNING
Strategic Asset Allocation
Efficient Frontier
Based on objective/constraints, max return on risk adjusted basis
EXECUTION
Tactical Asset Allocation
Security Analysis
Transaction Costs
FEEDBACK
Performance/Monitoring
Performance measures Sp
Attribution analysis
REBALANCE

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FOCUS 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

Pension Funds
General 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

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Pension Funds
Types 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 Plans
Profit Sharing Plans which are tax advantaged

DB vs DC
Type
Plan
DB

Employer
Pension Benefits are
liability for employer
Benefits are determine by
criteria such as years of
service & salary

DC

Plan Sponsor are

responsible for managing
plan assets to meet
pension obligations
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

Employee
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
Owns
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) Plan

Pension assets MUST FUND payment of LIABITIES

related to pension benefits (ALM)
Pension Plans investment performance should be
judged
on absolute basis but also
adequacy of its assets with respect to liabilities
Funding Status relationship between value of
plans assets & present value of its liabilities
Pension
Surplus

Market value
Pension Assets

Present value
Pension 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) Plan

Definitions of Pension Plan Liabilities
Accumulated 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 increases
Projected 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

DB Risk Objectives
Risk Objective willingness & ability to bear risk
Factors 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 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

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DB Risk Objectives

Consider 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

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DB Return Objectives

Possible 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

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DB Constraints

Factors impacting on DB Constraints

Liquidity Requirement (benefit payments pension contributions)
number of retired lives liquidity requirement
plan sponsors 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
Tax horizon
DB Plan are tax exempt thus decisions can be made without
considering tax
Legal & Regulatory
DB Plan must adhere to laws & regulations
Unique 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

Defined-Contribution (DC) Plan

13
Types 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 sponsors
stock should be limited
DC Investment policy enable number of different
individual investor objectives & constraints

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Hybrid & Other Plans

Hybrid Plans combine features of DB & DC plans

DB plans
Cash balance plan provides personalized
statement includes
Annual contribution credit % of pay based
on age
Earnings credit % increase tied to LT interest
rate
DC Plans
Employee stock ownership plans (ESOP)
encourage employees to become stockholder of
their employers which may be either before or
after tax plans

Foundations vs Endowments
15
Foundation 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

Foundations - Objectives
16
Risk 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

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Foundation Constraints

Factors impacting on Foundation Constraints

Liquidity Requirement
Distribution is determined by foundations Spending Rate
Spending rate tend to be conservative & utilize Smoothing
Rules
Time Horizon
Finite life Spend Down Rate determines time period, as it
approaches end of life, usually becomes more conservative
Infinite life perpetuity
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
perspective
Unique Circumstances
Gift consisting of single stock with condition that it CANNOT be
sold

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Endowments - General

Endowments
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

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Endowments Spending Rates

Definitions:
S = spending rate % of assets
MKt = market value assets @ end of period t
R = smoothing rate (0.6 0.8)
i = inflation rate
Simple Spending Rule
S
$ Spendingt =
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

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)

Endowments - Objectives
20
Risk Objective IPS?
Because they are perpetual, they can accept shortterm 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

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Endowment Constraints

Factors impacting on Endowment Constraints

Liquidity Requirement
Limited liquidity required other than cash for spending
distributions
Appropriate to include illiquid, non marketable securities as assets
Time Horizon
Infinite life perpetuity or extremely long
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

Life Insurance - General

22
Insurance 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

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Life Insurance - Objectives

Risk Objective
To 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
assets
Move 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

Life Insurance - Objectives

24
Return 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

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Life Insurance Constraints

Factors impacting on Life Insurance Constraints

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
Time Horizon
In general 20 to 40 years
Because of segmentation, each product line may have different
time horizons
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

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Life Insurance Constraints

Factors impacting on 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 companys size & amount of surplus portfolio

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Non Life Insurance - General

General 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

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Non Life Insurance - Objectives

Risk Objective
Due to relatively high uncertainty, non life
insurance companies tend to have limited risk
tolerance
Inflation 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)

Non Life Insurance - Objectives

29
Return 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)

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Non Life Insurance Constraints

Factors impacting on Non Life Insurance Constraints

Liquidity Requirement
Relatively high
Increases during end of underwriting cycle
Time Horizon
Shorter than life insurance
Tax
Subject to tax
Legal & Regulatory
Fewer laws & regulations than life insurance
Risk based capital requirements

Unique Circumstances
Current financial status of company

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Bank - General

Asset Liability Management (ALM) Process

Management of
Assets & Liabilities
Quantity
Duration
Credit quality

Interest
revenue
expense

Mk Value
Assets
Liabilities

Net
interest
margin
Interest
spread
Leveraged
adjusted
duration
gap

Financial
Performan
ce

Bank - General

32

Asset Liability Management (ALM) Process

Net Interest margin
Net
Interest
margin

Interest
Spread

Interest Spread

Interest income Interest

expense
Average earning assets

Yield on assets

Yield on liabilities

Leverage-adjusted duration Gap (LADG)

DA
DL
k = L/A (L = market value liabilities, A = market value
assets)
Leverage
adjusted
Duration gap

DurationAssets

k DurationLiabilities

If LADG = 0 interest rates change will NOT impact market value

equity

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Bank - Objectives

Risk Objective
Banks 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 Objective
Positive interest spread earn positive interest
spread (difference between banks cost of funds &
interest earned on loans & other investments)

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Bank Constraints

Factors impacting on Bank Constraints

Liquidity Requirement
Assets tend to be very liquid
Driven by deposit withdrawals
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
Tax years)
Subject to tax
Legal & Regulatory (highly regulated)
Risk based capital requirements (Basel II & Basel III)
Unique Circumstances
Lack of diversification due concentration of assets

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Appendix