IPS Pension Funds (Def B)
OBJECTIVES
Factors affecting risk tolerance:
(Factor change - Effect):
1. Plan surplus (↑-↑)
2. Sponsor financial status
D/A ratio (↓-↑)
profitability (↑-↑)
3. Corr of sponsor's operations and
pension asset returns (↓-↑)
4. Plan features (early retirement
R-isk
lump-sum)
availability (No-↑)
5. Workforce Characteristics
age (↓-↑)
active/retired ratio (↑-↑)
Objectives:
1. Min return requirement is discount
rate applied to compute pension liabilities
(achieve a total return sufficient to fund its
liabilities on an infl-adj basis.)
2. Minimize future contributions
3. Generate pension income
R-eturn
Greater risk tolerance => greater return
objectives
CONSTRAINTS
Liq requirement = Benefit payments -
pension contributions
Factors affecting liq req:
1. Active lives (↓-↑)
2. Workforce age (↑-↑)
L-iquidity
3. Plan features are available (Yes-↑)
L-egal
1. ERISA
2. Plan's trustee has a fiduciary duty
3. Prudence Rule
Factors affecting time horizon:
1. Open to new entrants (Yes-↑)
2. Workforce age (↓-↑)
T-ime
3. Active/retired ratio (↑-↑)
Time horizons can be multi-stage (active
lives until retirement and after)
Pension income and capital gain are tax
T-axes
exempt
1. Self-imposed constraint against
investing in certain "unethical" industries
U-nique 2. Plan managers are sometimes not
Circum available in small firms
Foundations
No defined liability stream => Above
average risk tolerance
Normally:
Minimum return objective = min
spending rate + infl + investment mgnt
exp;
OR
E(R) = (1+SpRate)*(1+infl)*(1+inv
mgnt exp) - 1
Anticipated (required min spending
rate) or Unanticipated liquidity
requirements
Minimum spending requirement
(payout rate) includes salaries of
program officers and exec; but does
not include investment mgnt fees
To avoid large fluctuations, use
smoothing rules
UMIFA, Prudence Rule
Majority of foundations exist into
perpetuity => long time horizon
As long as minimum spending rate is
maintained, excise tax is 2% (but can
be reduced to 1%) on "Net Investment
Income"
1. Restriction by the donor to diversify
2. Prohibited investments
Endowments
Factors affecting risk tolerance:
(Factor change - Effect)
- Short term affect:
1. Strong recent returns and if smoothed spending
rate < target rate => greater short-term risk
tolerance
2. Managers are evaluated on short time frames =>
reduced willingness to accept risk
- Long term affect:
1. Endowment's role in operations (↑-↑)
2. Institutions ability to adapt to drops in spending
(↑-↑)
3. Institution's debt (↓-↑)
- Low investment risk is not the same as low risk
of purchasing power impairment
Objectives:
1. Maintain LT purchasing power (E(R) > Spending
Rate + infl + investment mgnt fees)
2. Provide substancial resources to programs
Smoothing rules of spending rates (SR):
1. Simple spending rule = SR* LastYr MV_end)
2. Rolling 3-yr ave spending rule = SR*(sum of past
3 years MV_end)/3
3. Geometric smoothing rule (smoothing rate = w
(60-80%)
= w* (Last years spending*(1+infl) + (1-
w)*(SR*LastYr MV_beg)
Due to their perpetual nature, liquidity requirements
are low. However, need to have some cash
reserves for distribution (in case large capital
project is planned)
UMIFA, Prudence Rule
Because of the objective to maintain purchasing
power, time horize is extremely long-term.
However, if there are large projects to be
implemented soon, these cash flows will dictate
short-term time horizon
Tax-exempt (unrelated income is taxed)
1. Investment managers are not always available to
perform due diligence if alternative investments
are being considered
2. Ethical investment policies
Life Insurance
-Conservative fiduciary principles limit risk
tolerance:
1. Maintain an asset valuation reserve;
2. Valuation concerns (losses during periods of
rising interest rates) limit risk taking activities
3. Control reinvestment risk
4. Credit risk (control by broad diversification)
5. Cash Flow volatility (uncertainty)
However, recently, competition has modified
conservatism of life insurance companies,
motivating them to accept and manage varying
degrees of risk to earn competitive investment
returns
1. Earn a sufficient return to fund all liabilities
and match or exceed the expected returns
2. contribute to the growth of surplus through
capital appreciation.
Derivatives market enabled life ins companies
to manage interest rate risk and reduced
companies' need to hold reserves.
Consider:
1. Disintermediation (switching to higher
interest paying investments => forced to sell
assets at loss to meet liquidity needs)
2. Asset marketability risk (liquid v. illiquid
investments)
Highly regulated (primarily at the State level) 1.
Eligible investments (which classes and of what
quality)
2. Prudent investor rule
3. Valuation methods administered by NAIC
Different portfolio segments have different time
horizons (duration)
1. Tax-paying
2. Very important: can defer taxes on
accumulated cash within a life insurance
contract
1. company size
2. sufficiancy of surplus
Property & Casulty Ins Banks
- Face greater uncertainty than Life due to possibility - Risk measures:
of higher claims frequency => limited risk tolerance 1, Leverage-adjusted duration gap measures
- Not directly exposed to interest rate risk interest rate exposure:
- inlfation risk is a concern gap = D A - k*DL, where k = L/A
- Premium income to Total surplus should be if gap=0 then balance sheet is immunized
mainained between 2-to-1 and 3-to-1
if Int ↑
- Commond stock to surplus ratio (self imposed
and gap>0 => MV(A-L) ↓
limitation) maintained at low levels when markets are
gap=0 => MV(A-L) does not change
volatile
gap<0) => MV(A-L) ↑
2. VAR
3. Credit measures
- Have a below average risk tolerance
- Risk relative to Liab is a primary concern (not
absolute risk)
- RBC regulations further limit risk tolerance
Objectives: To earn a positive interest spread
1. Offer competitive policy pricing
2. Increase investment profitabilty (casualty premium
rates are not sufficient to cover underwriting costs)
3. Growth of surplus
4. Tax considerations
5. Total return management
High liquidity constraints due to uncertainty in CF Liquidiy requirements are determined by:
1. Net outflow of deposits
2. demand for loans
- Asset valuation reserve (AVR) is not required, but ris- Highly regulated. RBC regulations (depending on
base capital (RBC) requirements are established. the risk on the balance sheet, capital requirements
- Assets equal to 50% of "unearned premium are determined by this regulation)
+ loss reserves" be maintained in "eligible bonds and
mortgages." The rest can be invested in a relatively
broad array of assets
Time-horizon is a function of two factors (usually 15-30 Generally 3-7 years (intermediate term)
years):
1. duration of casulaty liab (short-term)
2. underwriting cycle
Tax-paying
"The complexities and implications of the taxation of Fully taxable
tax-exempt bond income for casualty companies are
beyond the scope of this reading"-p.425 Vol2)
Same as LIFE Historical banking relationships, community needs