BFE 420 Portfolio Engineering Lecture 3

Ms P. Mawire

Harare Institute of Technology

pmawire@hit.ac.zw

February 26, 2019

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Overview

1 Pension funds
Return Objectives for Pension plans
Risk Objectives-Pension Plan
Liquidity Requirements

2 Foundations and Endowments

Foundation-Example

3 Insurance companies

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WAKE UP

A woman was standing in her hotel room, when

somebody knocked on the door. When she opened
the door, there was a man who said that he has
mistaken his door, apologized, and continued
down the corridor. When the woman closed the
door, she called security to warn them about the
thief. Why did she think the man was planning to
rob her?

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Type of investors

Institutional investors are corporations or other legal entities that

ultimately serve as financial intermediaries between individuals and
investment markets.
Institutional-Pension funds, foundations and endowments, insurance
companies, and banks

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Pension funds
Pension funds contain assets that are set aside to support a promise
of retirement income.

Generally, that promise is made by some enterprise or organization

such as a business, labor union, municipal or state government, or not
for profit organization that sets up the pension plan(plan sponsor).

Pension plans divide principally into one of two broad types, based on
the nature of the promise that was made.

They are either defined-benefit (DB) plans or defined-contribution

(DC) plans.

A defined-benefit plan is a pension plan that specifies the plan

sponsor’s
Ms obligations in terms BFE
P. Mawire (HIT) of 228
the benefit to plan participants.
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Pension funds

Pension funds contain assets that are set aside to support a promise
of retirement income.

Generally, that promise is made by some enterprise or organization

such as a business, labor union, municipal or state government.

Pension assets fund the payment of pension benefits (liabilities).

Thus, a pension plan’s investment performance should be judged

relative to the adequacy of its assets with respect to funding pension
liabilities, even if it also judged on an absolute basis.

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Return Objectives for Pension plans

A DB plan sponsor promises the organization’s employees or members

a retirement income benefit based on certain defined criteria.

Factors affecting risk tolerance and risk objectives of Defined Benefit

Plans include

In setting a risk objective, plan sponsors must consider plan status,

sponsor financial status and profitability, sponsor and pension fund
common risk exposures, plan features, and workforce characteristics.

Status of the plan is defined by either surplus or deficit the higher

pension surplus or higher funded status implies greater risk tolerance.

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Risk Objectives-Pension Plan

Current and expected profitability of the plan is measured in terms of

debt ratios the lower debt ratios and higher current and expected
profitability imply greater risk tolerance.

Plan features such as provision for early retirement and provision for
lumpsum distributions tend to reduce the duration of plan liabilities,
implying lower risk tolerance, all else equal.

Workforce characteristics as age of workforce also affect the risk

objective of a pension plan the younger the workforce and the greater
the lives proportion of active lives the greater the duration of plan
liabilities and the greater the risk tolerance.

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Risk Objectives-Pension Plan

Older workforces mean shorter duration liabilities and higher liquidity

requirements, implying lower risk tolerance in general.

In summary, plan funded status, sponsor financial status, plan

features, and workforce characteristics influence risk tolerance and the
setting of risk objectives.

The plan sponsor may formulate a specific risk objective in terms of

shortfall risk, risk related to contributions, as well as absolute risk.

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Liquidity requirements

A pension fund receives pension contributions from its sponsor and

disburses benefits to retirees.

The net cash outflow (benefit payments minus pension contributions)

constitutes the pension’s plan liquidity requirement.

For example, a pension fund paying $100 million per month in

benefits on an asset base of $15 billion, and receiving no sponsor
pension contribution, would have an annual liquidity requirement of 8
percent of plan assets

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Liquidity requirements

The greater the number of retired lives, the greater the liquidity
requirement, all else equal.

The smaller the corporate contributions in relation to benefit

disbursements, the greater the liquidity requirement. The need to
make contributions depends on the funded status of the plan.

For plan sponsors that need to make regular contributions, young,

growing workforces generally mean smaller liquidity requirements than
older, declining workforces.

Plan features such as the option to take early retirement and/or the
option of retirees to take lump-sum payments create potentially
higher liquidity needs.
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Time Horizon

The investment time horizon for a pension plan depends on the

following factors:

Whether the plan is a going concern or plan termination is expected.

The age of the workforce and the proportion of active lives.

When the workforce is young and active lives predominate, and when
the DB plan is open to new entrants, the plan’s time horizon is longer.

Having a younger workforce often means that the plan has a longer
investment horizon and more time available for wealth compounding
to occur.
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Tax Concerns and legal constraints and Unique
circumstances
Tax Concerns and legal constraints
Investment income and realized capital gains within private DB
pension plans are usually exempt from taxation.
All retirement plans are governed by laws and regulations that affect
investment policy.
Virtually every country that allows or provides for separate portfolio
funding of pension schemes imposes some sort of regulatory
framework on the fund or plan structure.

Unique Circumstances
Example of a self-imposed constraint could be that investing in certain
industries viewed as having negative ethical or welfare connotations, or in
shares of companies operating in countries with regimes against which
some ethical objection may be imposed.
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Foundations and Endowments

Foundations provide essential support of charitable activity

Because foundations’ goals differ somewhat from those of traditional
pension funds foundations can have a higher risk tolerance.
Pension funds have a contractually defined liability stream (the
pension payments expected to be made to retirees); in contrast,
foundations have no such defined liability.
Return Objectives- Foundations differ in their purposes, and so vary in
their return objectives.
Some foundations are meant to be short lived; others are intended to
operate in perpetuity.

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Foundation-Example
Question
A group of major foundations has endowed a new organization, the FEI to
supervise elections and political campaigns in countries undergoing a
transition to democracy. The fund is headquartered in a developing
country. It has received initial grants of $20 million, with $40 million
expected to be received in further grants over the next three years. The
fund’s charter expressly decrees that the fund should spend itself out of
existence within 10 years of its founding rather than trying to become a
permanent institution. Determine and justify appropriate investment
policy objectives and constraints for the FEI.

Solution
Although the fund has a 10-year life, it is receiving donations over a period
of years and it is also constantly spending money on programs. Thus, it
can be assumed to have a five-year investment horizon on average and
should initially adopt a conservative or below-average risk profile.
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Foundation-Example
Return Objective
The fund’s broad return objective is to earn the highest inflation-adjusted
return consistent with the risk objective. At inception, the fund’s return
objective is to equal or better the total return of an average five-year
maturity U.S. Treasury note portfolio.

Constraints
Liquidity. The fund must pay out roughly $6 million annually for 10
years.
Time horizon. The fund has a 10-year time horizon.
Tax concerns. The fund is a tax-exempt organization in the country
in which it is organized.
Regulatory factors. No special legal or regulatory factors.
Unique circumstances. The fund has no constraints in the sense of
prohibited investments.
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 The End

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