Chapter 3 Managing Institutional Investor Portfolios

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Chapter 3 Managing Institutional Investor
Portfolios
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DB vs DC Plans

• DB plans promise a certain benefit in the future,
  DC plans promise a certain contribution today
• DB Pension amount based on a formula function
  of years of service and final earnings
• DC Pension amount depends on investment returns
• DC plans confer no future liability to the plan
  sponsor, in contrast to DB plans
• Common claim DB plan sponsor bears investment
  risk DC plan participants bear investment risk
• DB plan participants bear risk of early plan
  termination (e.g., if company is liquidated)
• In a DC plan, participants own their account.
  Very portable if participants change jobs

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DB Plan Assets

• What is being invested?
• Surplus/reserve funds in the plan that is not
  needed for short-term payouts
• CPP not expected to withdraw funds for payouts
  until 2019
• Largest Canadian pension funds
• Canada Pension Plan
• Caisse de depot et placement du Quebec
• Ontario Teachers' Pension Plan
• Ontario Municipal Employees Retirement System
• Hospitals of Ontario Pension Plan

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Global perspective on size (AUM)

• Largest funds in Canada
• Canada Pension Plan Investment Board
• June 30, 2012 165.8 billion
• Caisse de depot et placement du Quebec
• December 30, 2011 159 billion
• Largest in North America
• CALPERS
• June 30, 2011 US237.5 billion
• Largest in the world
• Government Pension Investment Fund of Japan
• June 30, 2012 US1.45 trillion

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Global Pension Assets
Assets ( US) GDP
Australia 1301 96
Brazil 321 15
Canada 1303 78
France 129 5
Germany 468 14
Hong Kong 84 34
Ireland 101 50
Japan 3363 55
Netherlands 1046 133
South Africa 227 62
Switzerland 693 115
UK 2394 101
US 16080 107
Total 27509 72
Source Towers Watson (Figures as of Dec 30,
2011)
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OTPP Stock versus Flow

• From December 30, 2011 annual report
• Stock
• Net assets 117.1 billion
• Flow
• Investment income 11.7 billion 
• Benefits paid 4.7 billion  
• Annual contributions 2.8 billion 
• Plan members (teachers) and the Ontario
  government

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DB Plan Objectives and Constraints

• First DB plan 1928 American Express
• Return objective achieve inflation-adjusted
  returns that adequately fund its pension
  liabilities
• Constraints
• Liquidity - difference between inflow (annual
  contributions, investment income) and outflow
  (pension payments)
• Time horizon - long if plan is continuing, but
  age of workforce is a consideration
• Taxes - investment returns are tax exempt
• Legal and regulatory - governed by law (e.g.,
  Ontario Pension Benefits Act)
• Others - sponsor financial condition and specific
  investment prohibitions

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Evaluating Risk Tolerance for DB Plans

• Risk tolerance categories
• Below average, average, above average
• Governed by multiple factors
• Financial health of plan (e.g., plan
  surplus/deficit)
• Sponsor financial status and profitability
• Sponsor and pension fund common risk exposures
• Plan features, and
• Workforce characteristics

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Evaluating Risk Tolerance for DB Plans

• Plan surplus (assets in excess of PV of
  liabilities) risk tolerance could potentially
  increase with surplus
• Sponsor financial status A sponsor with less
  debt and higher profits can tolerate more
  investment risk as shortfalls can be made up with
  additional contributions
• Common risk exposures between sponsor and plan
  The lower the correlation between sponsor
  operating results and plan returns, the higher
  the investment risk tolerance
• Plan features early retirement or lump sum
  options reduce plan duration and reduce risk
  tolerance
• Workforce characteristics more risk can be
  tolerated by plans serving relatively young
  workforce and by plans with a higher ratio of
  active lives to retired lives

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Investing Pension Plan Assets Risk Management

• Primary purpose of plan assets is to fund future
  liabilities
• Measure of financial soundness of a plan funding
  ratio
• Fully funded plan Ratio of asset value to PV of
  liabilities gt 100 percent
• Discount rate yield of high quality investment
  grade corporate bonds
• Asset/Liability management
• Most plans were asset-focus until the new
  millennium
• Liability Driven Investment (LDI) most involve
  some elements of liability hedging to reduce
  inflation and interest rate risk, using a
  portfolio of bonds and swaps

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Investing Pension Plan Assets Risk Management

• Plan may set a risk objective relative to the
  volatility of the plan surplus/deficit (asset
  minus PV of liabilities)
• e.g., volatility ? 6
• Risk can also be expressed as a shortfall risk
  relative to a specified funding ratio
• e.g., if target funding ratio 100, no less
  than 95 at any time
• Side pension surpluses/deficits are now more
  transparent on corporate balance sheets, courtesy
  of new mark-to-market accounting measures

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Investment Policy Statements for DC Plans

• Main investment issues for sponsor are
  diversification (via menu of plan options) and
  limits to investments in company stock
• Sponsors IPS documents ways to meet fiduciary
  responsibility with regard to plan options and
  procedures to ensure that individual objectives
  and constraints can be met
• Each plan participant is responsible for defining
  his/her own investment objectives and constraints

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Hybrid Pension Plans

• Hybrid plans seek to combine the best aspects of
  both DC plans (investment returns) and DB plans
  (benefit guarantees, awards for length of
  service, ability to link retirement income to a
  percentage of salary)
• In most hybrid plans, employer bears investment
  risk (e.g., built-in DB plan as a minimum
  guarantee), but employee can also benefit from
  favourable returns from pension assets

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Types of Foundations

• Independent (private or family)
• Makes grants to aid social, educational,
  charitable or religious activities
• Funds provided by individual or family
• Decision making authority lies with donor, family
  member or independent trustees
• Must spend at least 5 of 12-month average asset
  value, plus expenses

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Types of Foundations

• Company sponsored
• Legally independent, but with close ties to
  corporation
• Funds provided via annual contributions by a
  for-profit company
• Decision-making authority lies with board of
  trustees, usually controlled by company
  executives
• Must spend at least 5 of average assets, plus
  expenses

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Types of Foundations

• Operating Foundation
• Uses resources to conduct research or provide
  service (such as running a museum or hospital)
• Funds typically provided by individuals, families
  or private sector
• Decisions made by an independent board of
  trustees
• Must use 85 of investment income in operational
  activity. Some also must spend at least 3.3 of
  average assets per year

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Types of Foundations

• Community Foundation
• Publicly supported organization making grants for
  social services, environmental, health,
  educational, or religious purposes (public
  charities)
• Funds provided by the public, multiple donors
• Decisions made by Board of Directors
• In Canada, we also have an organization called
  the Community Foundations of Canada
• Not subject to minimum annual spending requirement

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Foundations Investment Objectives

• Risk objective
• High risk tolerance because maintaining spending
  level is more a desire than a necessity
• Return objective
• Preserve real value of assets while permitting
  desired spending rate
• Intergenerational equity arises when spending
  rate can be sustained in real terms in perpetuity
  (i.e. mandated 5 spending rate investment
  expenses inflation rate required return to
  assure intergenerational equity)

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Foundations Investment Constraints

• Constraints
• Liquidity needed to provide for spending levels
• Time horizon perpetuity
• Legal and Regulatory must comply with UMIFA or
  non-US equivalent
• Uniform Management of Institutional Funds Act
  law governing how much of a foundation a charity
  can spend, for what purpose, and how the charity
  should invest the foundation funds

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Endowments Investment Objectives and Constraints

• Risk objective
• Must be consistent with goal of stable, real
  income over time (inter-generational equity)
• Can be higher if institution can adapt to
  fluctuations by altering spending
• Return objectives
• Maintain sustainable real income
• Constraints
• Liquidity sufficient to cover short-term
  spending needs
• Time horizon is long-term, with short term
  spending considerations
• Tax considerations are minimal
• Legal and Regulatory UMIFA or equivalent, tax
  exempt status, etc.

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Harvard University Endowment Fund
AUM (June 30, 2011) 32 billion (36.9 billion
pre-crisis). Largest endowment in the U.S.
Managed by Harvard Management Co. Funds about
35 of the Universitys operating budget Asset
allocation Advocates the so-called Endowment
Model that de-emphasizes traditional stocks and
bonds, early adoption of alternative assets (next
class)
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Responsible Investing

• Examples
• Last class CPPIB (engagement policy)
• Other extreme Government Pension Fund of Norway