Investment Policy Statement

Pension Investment Objectives

To meet pension liabilities, defined benefit plans need to mix investment returns with contributions. The long-term return on pension plan assets must exceed the discount rate typically used by actuaries to value pension liabilities.

Defined contribution pension plans are designed to grow assets prudently so that they can meet spending needs in retirement. As in the case of an individual investor with a taxable retirement portfolio, this would apply in the same way.

Endowment and Foundation Investment Objectives

In general, endowments and foundations seek to generate a real return of 5% over the long term in accordance with their spending policies. Endowments and foundations allocate significant amounts to real assets because of this real return objective and in order to maintain purchasing power. Spending needs will be funded in perpetuity based on intergenerational equity. This means that no generation should be disadvantaged or benefit exclusively because of investment returns or the state of the economy.

Sovereign Wealth Fund Investment Objectives

Legislative instruments that establish SWFs often clearly outline their investment objectives. They are often free of tax in their home country, though they must take foreign taxation into consideration. SWFs will have different investment objectives depending on how they are structured themselves.

Budget Stabilization Funds: The investment objective of budget stabilization funds is capital preservation. This is done by delivering returns in excess of inflation with a low probability of a negative return in any year.

Development Funds: The overall objective of a development fund is to raise a country's economic growth or to diversify its economy. As such, these funds have an implicit real return target: increase real domestic GDP growth and productivity.

Savings Funds: Their primary goal is to maintain the purchasing power of assets for perpetuity while achieving investment returns sufficient to support ongoing government activities.

Reserve Funds: Reserve funds are invested in low-duration, high-quality debt instruments with the aim of generating a higher return than FX reserves and reducing the negative cost of carrying FX reserves.

Pension Reserve Funds: The investment objective of pension reserve funds is to earn returns sufficient to maximize the likelihood of meeting future pension, social security, and/or health care costs as they arise. Therefore, such funds will typically invest in a diversified portfolio with the majority in such equities and alternative investments as property, infrastructure, hedge funds, and private markets.

Banking and Insurance Company Investment Objectives

Investing objectives for banks and insurers include maximizing net present value to capital holders. To accomplish this, liability-driven investing (LDI) can be used tactically over intermediate and shorter horizons. This is similar to most firms that aim to maximize shareholder value. As banks are not always public, they do not always have formal shares to maximize in terms of value, but the heart of the definition remains to increase owner wealth while satisfying all liabilities.

Question

Which of the following entities generally have homogenous, real return objectives?

1. Endowments.
2. Banks.
3. Pension funds.

Solution

The correct answer is A.

Endowments and foundations typically aim to match their long-term spending rates (typically around 5%). This preserves the corpus of capital they have from donations, allowing outflows to more or less match inflows. This means there is little variation across endowments and foundations in this respect (homogenous).

B is incorrect. Banks and insurers aim to maximize net present value to capital holders, which is variable depending on a variety of factors, such as cost of capital and operational expenses.

C is incorrect. DB plans need to achieve a long-term rate of return on plan assets that exceeds the assumed rate of return used by the pension plan actuaries, typically the discount rate used in valuing pension liabilities. This will be affected by the profile of the fund, its workers, the financial aspects of the firm, and sustainable contribution rates.

Portfolio Construction: Learning Module 5: Portfolio Management for Institutional Investors; Los 5(g) Prepare the investment objectives section of an institutional investor's investment policy statement