Pension Funds

Pension funds are vehicles that assist workers in saving for retirement. There are two types of pension plans: defined benefit, in which a plan sponsor agrees (legally) to pay a specified retirement benefit, and defined contribution, in which contributions are defined but the ultimate retirement benefit is neither specified nor guaranteed by the sponsoring firm.

$$ \begin{array}{c|c|c}
\textbf{Feature} & \textbf{Defined Benefit} & \textbf{Defined Contribution} \\ \hline
\textbf{Benefits} & \text{Pre-determined} & {\text{Determined by plan}} \\
& & {\text{performance}} \\ \hline
\textbf{Contributions} & \text{Primarily employer} & \text{Primarily employee} \\ \hline
\textbf{Investment Decisions} & \text{Pension fund} & \text{Employee} \\ \hline
\textbf{Investment Risk} & \text{Employer bears risk} & \text{Employee bears risk} \\ \hline
\textbf{Mortality/ } & \text{Pooled in plan} & \text{Employee bears risk} \\
{\textbf{Longevity Risk}} & & \\
\end{array} $$

While the curriculum flows through this section giving equal attention to both DB and DC plans, as a summary, this reading will focus a little more on DB plans. As DC plans are largely similar to an individual portfolio (just perhaps tax-advantaged and company-sponsored), most of the following sections will be much more as they relate to DC plans.

Stakeholders in the Portfolio

Stakeholders are individuals or entities that have some interest in the institution. For pensions, these could include the employer, employees, retirees, unions, management, the investment committee and/or board, and shareholders. In addition, the government and taxpayers will bear some of the shortfall risks in instances of employers failing to pay agreed-on defined benefit payments and where individuals fail to accumulate sufficient wealth for retirement.

In the case of a defined benefit plan, the plan sponsors are likely the biggest stakeholders. This includes the employer and the investment team hired to run the plan. In the case of the defined contribution plan, employees are the foremost stakeholder, as they largely fund the plans themselves and rely on their long-term performance to fund retirement needs.

Liabilities

A DB pension plan's liabilities are its future payments due to beneficiaries upon retirement, disability, or death. The first step in determining DB liabilities is to calculate the expected future cash flows out of the plan. These depend on the design and specifics of the pension plan. Some of the key elements among DB plans in the calculation of expected cash flows are:

• Service/tenure: Employees are expected to receive a defined benefit based on how long they have worked for the company or organization (or service years).
• Salary/earnings: Employee salaries and earnings impact the amount of defined benefits they are expected to receive upon retirement.
• Death/longevity: Calculating expected cash flows is dependent upon how long retirement benefits will be paid to participants. This requires assumptions about employees' and retirees' life expectancies.
• Vesting refers to the portion of the plan assets that are the employees to keep, that is, those not still owned by the employer. Only vested funds will be included in the calculation of current plan liabilities. Once expected future benefits are calculated, they must be discounted to determine their present value.

  $$
  \text{PV of plan assets} – \text{PV of plan liabilities} = \text{Funded status} $$

  -Also-

  $$ \frac {\text{Fair Value of plan assets}}{\text{PV of defined benefit obligations}} = \text{Funded ratio} $$

Investment Time Horizons

All in all, DB plans are considered to have ‘long’ time horizons. The actual investment time horizon for a DB plan can fluctuate, depending on a few factors. The higher the proportion of retirees relative to the proportion of active participants, the more mature the plan–hence, the lower its risk tolerance. The younger the average age of the workforce, the longer the time horizon. Also, plan participant life expectancy plays a role. Generally, the more mature a pension fund is, the shorter its investment horizon.

If a plan becomes frozen (closed to new participants), it will now have a fixed and finite time horizon, which will be equal to the last remaining payment made to the last remaining survivor.

Calculating the time horizon of a DC plan would be done the same way as with any individual portfolio. It is likely to be equal to the average remaining life expectancy of the investor unless they plan to spend it down sooner. This would be considered much shorter than a dynamic investment horizon found in a DB plan, which in theory, could continue extending out in time forever as new participants are taken on.

Liquidity Needs

Maintaining liquidity for a DB plan is extremely important. Plan participants who are retired may be completely dependent on the benefits to pay living expenses. If a plan were to miss a payment, it could be a disaster for both the participants and the sponsor. DB plan liquidity needs are driven by the following:

• Proportion of active employees relative to retirees: More mature pension funds have higher liquidity needs.
• Age of workforce: Liquidity needs to increase as the age of the workforce increases.
• Plan-funded status: Well-funded plans require sponsors to hold higher liquid asset balances to pay benefits due to reduced contributions.
• Flexibility: The ability of participants to switch among the sponsor’s plans or to withdraw from the plan.

In a pension plan with lower liquidity needs, a higher proportion of assets can be invested in equities and credit and a larger percentage in private investments, including real estate, infrastructure, private equity, and hedge funds. Pension plans with higher liquidity needs, however, must invest more in cash, government bonds, and high-quality corporate bonds.

A regular liquidity stress test, which includes stressing the value of assets and modeling reduced liquidity of certain asset classes, is required by pension plans during a market downturn.

Sovereign Wealth Funds

A sovereign wealth fund (“SWF”) is a private investment fund set up by a government. Often the funds come from a budget surplus and are set up for a variety of purposes. The major types of SWFs are as follows:

• Budget Stabilization funds: Created to protect the budget and economy against commodity price fluctuations and external shocks.
• Development funds: Dedicated to prioritizing socioeconomic projects, usually infrastructure.
• Savings funds: Create diversified financial assets from nonrenewable assets and share wealth across generations.
• Reserve funds: Designed to lower foreign currency reserve carry costs or generate higher returns on surplus reserves.
• Pension Reserve funds: Created to meet pension-related liabilities related to contingent liabilities on governments' balance sheets.

Stakeholders in the Portfolio

Governments, external asset managers, SWFs' management, investment committees, and boards of directors are all stakeholders of SWFs. A primary beneficiary of the program is the current generation of citizens and the next generation of citizens. A sovereign wealth fund may make direct payments to the citizenry (as in a pension reserve SWF) or may be designed to indirectly benefit them, as in the case of a reserve fund that stabilizes the national currency or a development fund that improves infrastructure. In the case a SWF does not meet its objectives, higher future taxes to pay for the shortfall are a logical and unfortunate consequence.

Liabilities/ Investment Time Horizons

Because SWFs have varying missions, they generally do not have clearly defined liabilities, so they do not typically engage in asset/liability matching strategies like other institutional investor types.

For example, a development fund will have a goal in mind: “Improve and expand our country's airports”, the specific cash flow of which will not be known until later dates. It is for this reason that the liabilities are said to be “not clearly defined”.

Since each fund has differing time horizons and liabilities, they will be discussed separately.

Budget stabilization funds: These funds are established to protect a nation's fiscal budget against commodity price volatility and other external shocks, particularly if the nation's revenue is dependent on natural resource production or other cyclical industries. These funds have unknown liabilities and fairly short investment horizons.

Development funds: These funds are established to help a nation's economy grow by investing in essential infrastructure, helping with innovation, or supporting key industries. A project's timeline can vary depending on its nature and could be a one-time project or the ongoing maintenance of a public transportation system.

Savings funds: A savings fund is usually established to convert proceeds from the sale of nonrenewable natural resources into long-term wealth and diversification of financial assets. By smoothing out the profits from oil sales, for instance, future generations will still benefit from profits when the oil resources are depleted. As such, their liabilities are long-term.

Reserve funds: Reserve investment funds are established from central bank excess foreign currency reserves. Their investment horizons are very long, with typically no immediate or interim payout expectation.

Pension reserve funds: Pension reserve funds are established to help pre-fund contingent pension-related liabilities on the government's balance sheet. Pension reserve funds are usually funded from fiscal surpluses during economic booms. The goal is to help reduce the burden on future taxpayers by pre-funding social security and health care costs arising from aging populations, so these funds generally have long-term investment horizons

Liquidity Needs

$$ \begin{array}{l|l}
\textbf{Fund type} & \textbf{Liquidity Needs} \\ \hline
\textbf{Budget Stabilization Funds} & \text{Usually, high} \\ \hline
\textbf{Development Funds} & \text{Variable depending on projects of the fund} \\ \hline
\textbf{Savings Funds} & \text{Low} \\ \hline
\textbf{Reserve Funds} & { \text{Lower than those of stabilization funds yet} \\ \text{higher than those of savings funds}} \\ \hline
\textbf{Pension Reserve Funds} & {\text{Low during the accumulation phase;} \\ \text{High during the decumulation phase.}}
\end{array} $$

University and Private Endowments

Endowments are investment pools of hospitals, churches, museums, charities, universities, etc., typically funded through gifts and donations, with the purpose of helping an entity achieve its mission in perpetuity. This reading will focus primarily on university endowments, as does the CFA curriculum.

Stakeholders in the Portfolio

Stakeholders of a university endowment include current and future students, alumni, current and future university faculty and administrators, and the larger university community. This also includes board or investment committees and alumni who are investment professionals running or working for financial services organizations.

Liabilities

Endowments function on an asset-only model, aiming to support the university's operational expenses while upholding the principle of intergenerational equity.

An endowment's obligations involve future payouts to the university, usually outlined in an official spending policy. The spending policy serves two crucial purposes:

• Preserving intergenerational fairness.
• Stabilizing endowment payouts to shield university contributions from market fluctuations.

Beyond the spending policy's annual asset disbursement, other liability aspects should be examined when crafting an effective investment policy. These include:

• What is the university's capacity for fund-raising: How much in gifts and donations are contributed (on average) each year?
• What percentage of the university's operating budget is supported by the endowment?
• Balance sheet health: Does the endowment or university issue debt?

There are three different types of endowment spending policies:

• Constant Growth Rule: The endowment provides a fixed amount annually to the university, typically adjusted for inflation (the growth rate). US inflation rates are usually calculated based on the Higher Education Price Index or a consumer price index, possibly with an additional spread. A shortcoming of constant growth spending rules is that spending does not adjust based on the endowment's value.
• Market Value Rule: The endowment pays a pre-specified percentage (the spending rate) of the moving average of asset values, typically between 4% and 6%. The value of assets is usually smoothed using a 3- to 5-year moving average. A disadvantage of this spending rule is that it tends to be pro-cyclical; when markets have performed well (poorly), the overall payout increases (decreases).
• Hybrid Rule: Spending is calculated based on the weighted average of both the constant growth rule and the market value rule. Commonly referred to as the Yale spending rule, weights range from 30% to 70%. As a result of this spending rule, the deficiencies of the respective spending rules were balanced.

The following formula can be adjusted to represent all of the three spending rule types above:

$$ \begin{align*} \textbf{Spending Amount in Year } \bf{t + 1} & = w \times [\text{Spending Amount in Year t} \\ & \times (1 + \text{Inflation Rate}) ] \\ & + (1 – w) \times \text{Spending Rate} \\ & \times \text{Average AUM} \end{align*} $$

Where “w” denotes the prior year's spending.

Investment Time Horizons

The investment horizon for endowments is thus perpetuity, and their main objective is to maintain long-term purchasing power. There is no official ‘end date’ for a university's services.

Liquidity Needs

The liquidity needs of university endowments are relatively low (compared to foundations). On average, endowments' annual net spending is 2% to 4% of assets, after factoring in gifts and donations.

There is less flexibility for foundations to spend their assets than endowments; in the US, foundations are legally required to pay out 5% of their assets annually to maintain their tax-exempt status.

Banks and Insurers

A bank is a financial institution that takes deposits, lends money, safeguards assets, executes transactions in securities and cash, acts as a counterparty in derivatives transactions, provides advisory services, and invests in securities.

Insurers are financial intermediaries that sell policies designed to reduce various forms of risk. They do this by taking in policy premiums and paying claims when due. The universe of insurance companies can be divided into two broad categories:

• Life insurers Property.
• Casualty insurers (P&C).

The life insurance products include whole and term insurance, variable life insurance, and annuity products, as well as health insurance. P&C products encompass insurance against a wide range of perils–covering commercial property and liability, homeowner's property and liability, and automotive, as well as such multiple specialty coverage lines as marine, surety, and workers' compensation.

Stakeholders in the Portfolio

Among the external stakeholders involved in the banking industry are shareholders, creditors, customers, rating agencies, regulators, and even the communities in which they operate. Internal stakeholders are employees, management, and boards of directors.

Internal stakeholders include a bank's employees, management, and board of directors.

On the liability side, bank customers are comprised of a variety of depositors and legal entities. On the asset side, bank customers include both retail and commercial borrowers. Individuals borrow money from banks to finance large purchases, such as houses, that are often financed with mortgages.

On the corporate side, real estate developers often use bank financing through commercial real estate loans. Additionally, large companies require commercial and industrial loans from banks in order to finance working capital, ongoing operations, or capital improvements.

Liabilities

Banking and insurance companies manage both portfolios of assets and institutional liabilities. This is done to achieve an extremely high probability that obligations on deposits, guarantees, derivatives, policyholder claims, and other liabilities will be paid properly.

Banks' liabilities are comprised of deposits and also include short-term funding, such as commercial paper, as well as longer-term debt. Deposits are the largest component of liabilities, usually more than half of total liabilities.

Bank deposits include the following:

• Time deposits or term deposits – Accounts that pay interest and have a specified maturity date. There are two types of savings accounts in this category: savings accounts and certificates of deposit (CDs). As banks require advance notice for withdrawals, they have visibility into the duration of these deposits.
• Demand deposits – These accounts can experience a withdrawal regularly and without notice. This category may include checking accounts and certain savings accounts that are often accessible through online banks or automated teller machines. Since banks have limited visibility into the expected lifespan of these accounts, they tend to assume they will be short-lived.

Investment Time Horizons

Banking and insurance companies have unending time horizons. The investment horizon for a bank's investment portfolio is directly impacted by the nature and maturities of its asset base and liability structure. Although commercial banks, as corporations, have a perpetual time horizon, the instruments held in a bank portfolio tend to have far shorter maturities than those held by other financial institutions.

Liquidity Needs – Banks

Liquidity management is a central consideration in the management of bank portfolios. Apart from asset or cash flow securitization, banks must have the ability to liquidate their investment portfolios by a certain date to generate adequate cash in the event of a crisis. Banks are unique in that assets on their balance sheet are formal liabilities for their clients (as in a mortgage). Banks must have enough liquidity on hand to satisfy withdrawals from the various types of deposit accounts their customers hold.

Liquidity Needs – Insurers

Insurance companies must actively manage and monitor the liquidity of their portfolios. The level of liquidity required has important implications across the portfolio management process, including the insurer's ability to utilize leverage. Further, liquidity needs can vary greatly based on the business line.

There are two major components of an insurer's general account investment portfolio: reserve portfolios and surplus portfolios.

Insurers are typically required to maintain a reserve portfolio that ensures the company's ability to meet its policy liabilities. The surplus portfolio is intended to realize higher expected returns. Insurance companies manage reserve assets relatively conservatively. The size of the reserve portfolio is typically dictated by statute, and assets must be highly liquid and low risk. Insurance companies will have more of an ability to assume liquidity risk in the surplus portfolio, and they are often willing to manage these assets aggressively with exposure to alternative assets, including private equity, hedge funds, and non-security assets.

Portfolio Construction: Learning Module 5: Portfolio Management for Institutional Investors; Los 5(c) Discuss the stakeholders in the portfolio, the liabilities, the investment time horizons, and the liquidity needs of different types of institutional investors