Cfa Level Iii - Study Session 5

Front 1

Portfolio Management for Institutional Investors
(SS5)

Advantages and disadvantages of DC vs DB

Back 1

1. DB the plan sponsor has an obligation in terms of the benefits to participants (from working at a firm). A promise from the employer to pay out during the retirement stage.
2. DC the plan sponsor has an obligation in respect to what the participants have contributed. Promise is made for the current stage where the employer contributes now on behalf of the employee.
Most DC's are participant directed, where they choose from a list of what to invest in.

Front 2

Portfolio Management for Institutional Investors
(SS5)

Defined benefit background

Back 2

i. Value of plan's assets against the plan's PVliabilities is its funded status.
ii. Fully-funded ratio is 100% (underfunded is <100%)
iii. Pension surplus is plan assets less PVliabilities.
iv. 3 liability concepts ABO (PVpension benefits if the plan terminated now), PBO (funded status runs off this and includes future wage increases) and total future liability (most complete but uncertain measure of plan liability).

i. also think about split between retired and active lives.

Front 3

Portfolio Management for Institutional Investors
(SS5)

Defined benefit risk objectives

Back 3

i. Risk taken for DBs depends on the plan status, sponsor financial status, common risk exposures for sponsor and plan (buying co's stock) and workforce characteristics (age, active vs retired)
ii. If underfunded they make want to take more risk to make it up.
iii. If overfunded they may have the ability to take more risk (even though they may choose not to)
iv. Older workers mean shorter durations, higher payouts and decreasing risk tolerance.
v. ALM - asset liability management
Shortfall risk (probability below a minimum acceptable level, for 100% funded status or above some regulatory threshold or to avoid reporting a pension liability)
vi. Choose risk based on low yr-to-yr volatility
vii. Choose risk to avoid losing your overfunded status so you don't have to keep making contributions.

Front 4

Portfolio Management for Institutional Investors
(SS5)

Defined benefit return objectives

Back 4

1. #1 goal is to get returns that properly fund pension liabilities on an inflation-adjusted basis.
2. Start by defining the discount rate.
3. Aim to make future pension contributions equal zero. (More realistic goal is to minimise contributions)

Front 5

Portfolio Management for Institutional Investors
(SS5)

Defined benefit constraints

Back 5

1. Liquidity requirements: e.g. 8% to not erode capital, high retired lives, option to take early retirement or making low contributions
2. Time horizon (going concern or plan termination expected and the age of the workforce)
3. Tax concerns: usually exempt from taxation. (unless the UK government doesn't let them receive dividends tax free or something like that)
4. Legal and Regulatory factors (fiduciary and their standard of care)
5. Unique circumstances - human and financial resources available to the plan sponsor.

Front 6

Portfolio Management for Individual Investors
(SS5)

Defined Contributions

Back 6

i. Directed by plan sponsor or participant directed.
ii. DC plans should have a menu of investment options to build suitable pf's and sponsor-company stock should be limited (to promote diversificaiton)
iii. DC doesn't set objectives and constraints, participants set their own risk and return objectives/constraints. They should still try and educate their participants.

Front 7

Portfolio Management for Individual Investors
(SS5)

Hybrid Plans

Back 7

i. Cash Balance Plans (a DB plan that looks like a DC to the employee even though there is no separate account)
ii. Pension Equity Plans
iii. Target Benefit Plans
iv. Floor Plans

Use DC good things - portability, participants understand it and easy to administer
Use DB good things - years of service rewards, link retirement pay to a % of salary

Other plans:
i. ESOP - sold at discount to employees.
Sometimes used to liquidate a large managers position or to prevent an unfriendly takeover.
Employees need to watch out for these and make sure that they are still diversified.

Front 8

Portfolio Management for Individual Investors
(SS5)

Foundations

Back 8

1. Foundations - make grants (US tax law requires minimum level of annual spending)
i. Independent (private and family)
ii. Company sponsored (short term focus to make philanthropic funding available from the co)
iii. Operating (income to support specific programs)
iv. Community (grants to fund a variety of purposes, no payout requirement)
2. Private and family foundations get all their new money from investment returns and they have to have a payout (endowments don't have to).
3. Company and operating get money from the company or donations.
4. Foundations have a higher risk tolerance than pension funds because they don't have a defined liability stream.
5. Foundations all have different return objectives because they have different purposes. They really just want to preserve the real value (inflation adjusted).
6. Expenses to run the foundation are added ON TOP of the payout %. Salaries of program office does count to payout. You can smooth this %.
7. Foundations last into perpetuity, more room to take risk and make up any loss. Some foundations 'spend down' and aren't meant to last forever.
8. Foundations legal risk when they act in a way that jeopardises carrying out its tax-emept purposes.
9. Foundations Unique Circumstances - may have a large holding in one stock, which they can diversify by swap options.

Front 9

Portfolio Management for Individual Investors
(SS5)

Endowments

Back 9

Endowments have long term funds to operate non-profit institutions like uni or charities. (Made up of contributions from many people)
1. No required spending level, but it should be substantial, stable and sustainable. (simple, 3 year rolling, geometric spending rules)
2. Risk objectives ties to spending policies. If you have a smoothing policy, then you can take more risk. If they have made a lot of money recently then they may be able to take more risk.
3. Return objectives are high because they have to give big money to programs. Should try to keep returns stable able inflation.
4. Liquidity requirements are low but they always have some cash available to make spending distributions. Therefore they can invest in illiquid securities.
5. Time horizon - long term because they want to maintain their purchasing power in perpetuity. Some have multi-stage time horizon, like when they are funding large capital projects.
6. Taxes aren't a big problem for endowments, as most are exempt.
7. Regulartory issues are things like how endowments can be invested.
8. Unique considerations - may have inexperienced board members and if they are doing private equity investments the endowment should be big enough to handle it.