Managing Institutional Investor Portfolios

Institutional investors are corporations or other legal entities that ultimately serve as financial intermediaries between individuals and investment markets.

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. This organization is referred to as the plan sponsor.

A cash balance plan is a defined-benefit plan whose benefits are displayed in individual recordkeeping accounts. These accounts show the participant the current value of his or her accrued benefit and facilitate portability to a new plan.

All DB plans share one common characteristic: They are promises made by a plan sponsor that generate a future financial obligation or “pension liability.”

The sponsor’s promise for DB plans is made for the retirement stage—what the employee will be able to withdraw. In contrast, the promise for DC plans is made for the current stage—what the plan sponsor will contribute on behalf of the employee.

DC plans encompass arrangements that are
1. pension plans, in which the contribution is promised and not the benefit
2. profit-sharing plans, in which contributions are based, at least in part, on the plan sponsor’s profits.

The common elements of all these plans are:
1. a contribution is made into an account for each individual participant,
2. those funds are invested over time,
3. the plans are tax-deferred
4. upon withdrawal from the plan or reaching retirement, the participants receive the value of the account in either a lump sum or a series of payments.

From an investment standpoint, DC plans fall into two types:

Sponsor directed, whereby much like a DB plan, the sponsor organization chooses the investments. For example, some profit-sharing plans (retirement plans in which contributions are made solely by the employer) are sponsor directed.
Participant directed, whereby the sponsor provides a menu of diversified investment options and the participants determine their own personalized investment policy. Most DC plans are participant directed.

The key differences between DC and DB plans are as follows:
For DC plans, because the benefit is not promised, the plan sponsor recognizes no financial liability, in contrast to DB plans.
DC plan participants bear the risk of investing (i.e., the potential for poor investment results). In contrast, in DB plans the plan sponsor bears this risk (at least in part) because of the sponsor’s obligation to pay specified future pension benefits. DB plan participants bear early termination risk: the risk that the DB plan is terminated by the plan sponsor.
Because DC plan contributions are made for individual participants’ benefit, the paid-in contributions and the investment returns they generate legally belong to the DC plan participant.

Three basic liability concepts exist for pension plans:

Accumulated benefit obligation (ABO).
Projected benefit obligation (PBO).
Total future liability.

Accumulated benefit obligation (ABO). The ABO is effectively the present value of pension benefits, assuming the plan terminated immediately such that it had to provide retirement income to all beneficiaries for their years of service up to that date (accumulated service). The ABO excludes the impact of expected future wage and salary increases.

Projected benefit obligation (PBO). The PBO stops the accumulated service in the same manner as the ABO but projects future compensation increases if the benefits are defined as being tied to a quantity such as final average pay. The PBO thus includes the impact of expected compensation increases and is a reasonable measure of the pension liability for a going concern that does not anticipate terminating its DB plan. Funding status is usually computed with respect to the PBO.

Total future liability. This is the most comprehensive, but most uncertain, measure of pension plan liability. Total future liability can be defined as the present value of accumulated and projected future service benefits, including the effects of projected future compensation increases. This financial concept can be executed internally as a basis for setting investment policy.

Asset/liability management is a subset of a company’s overall risk management practice that typically focuses on financial risks created by the interaction of assets and liabilities; for given financial liabilities, asset/liability management involves managing the investment of assets to control relative asset/liability values

1. DB plans may state a risk objective relative to the level of pension surplus volatility (i.e., standard deviation).

2. Another kind of ALM risk objective relates to shortfall risk with respect to plan liabilities. Shortfall risk may relate to achieving:

a funded status of 100 percent (or some other level) with respect to the ABO, PBO, or total future liability;
a funded status above some level that will avoid reporting a pension liability on the balance sheet under accounting rules; and
a funded status above some regulatory threshold level.

Shortfall risk is the risk that portfolio value will fall below some minimum acceptable level over some time horizon; it can be stated as a probability.

A DB pension plan’s broad return objective is to achieve returns that adequately fund its pension liabilities on an inflation-adjusted basis.
For a DB pension plan, the return requirement (in the sense of the return the plan needs to achieve on average) depends on a number of factors, including the current funded status of the plan and pension contributions in relation to the accrual of pension benefits.
For a fully funded pension plan, the portfolio manager should determine the return requirement beginning with the discount rate used to calculate the present value of plan liabilities.

The investment time horizon for a DB plan depends on the following factors:
whether the plan is a going concern or plan termination is expected; and
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.
The horizon can also be multistage: for the active-lives portion the time horizon is the average time to the normal retirement age, while for the retired-lives portion, it is a function of the average life expectancy of retired plan beneficiaries.

Investment income and realized capital gains within private defined-benefit 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.
A pension plan trustee is an example of a fiduciary, a person standing in a special relation of trust and responsibility with respect to other parties.

Investment in alternative investments (for example, private equity, hedge funds, and natural resources) often requires complex due diligence. Due diligence refers to investigation and analysis in support of an investment action or recommendation; failure to exercise due diligence may sometimes result in liability according to various laws.
Another unique circumstance for a plan might be a self-imposed constraint against 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 has been raised.

A DB pension plan can potentially so significantly affect the sponsoring corporation’s financial performance that the study of DB pension asset investment in relation to pension and corporate objectives has developed into a wide-ranging literature.
Practically, we can make several observations. From a risk management perspective, the two important concerns are:
managing pension investments in relation to operating investments; and
coordinating pension investments with pension liabilities.

The principal investment issues for DC plans are as follows:
Diversification. The sponsor must offer a menu of investment options that allows participants to construct suitable portfolios.
Company Stock. Holdings of sponsor-company stock should be limited to allow participants’ wealth to be adequately diversified.
Participants in DC plans bear the risk of investment results. As a consequence, an investment policy statement for a DC plan fulfills a much different role than an investment policy statement for a DB plan.

Foundations are typically grant-making institutions funded by gifts and investment assets.
Endowments, on the other hand, are long-term funds generally owned by operating non-profit institutions such as universities and colleges, museums, hospitals, and other organizations involved in charitable activities.

Independent grant-making organization established to aid social, educational, charitable, or religious activities. Source of Funds_ Generally an individual, family, or group of individuals. Decision-Making Authority_ Donor, members of donor’s family, or independent trustees. Annual Spending Requirement_ At least 5% of 12-month average asset value, plus expenses associated with generating investment return_

Description: A legally independent grant-making organization with close ties to the corporation providing funds.
Source of Funds: Endowment and/or annual contributions from a profit-making corporation
Decision-Making Authority: Board of trustees, usually controlled by the sponsoring corporation’s executives.
Annual Spending Requirement: Same as independent foundation.

Description: Organization that uses its resources to conduct research or provide a direct service (e.g., operate a museum).
Source of Funds: Largely the same as independent foundation..
Decision-Making Authority: Independent board of directors.
Annual Spending Requirement: Must use 85% of interest and dividend income for active conduct of the institution’s own programs. Some are also subject to annual spending requirement equal to 3.33% of assets.

Description: A publicly supported organization that makes grants for social, educational, charitable, or religious purposes. A type of public charity.
Source of Funds: Multiple donors; the public.
Decision-Making Authority: Board of directors.
Annual Spending Requirement: No spending requirement.

The most noteworthy aspect of foundations is that they can vary widely in their investment goals and time horizons
Often, a foundation’s mission may address a problem with a limited time horizon or an urgent need.
Another distinctive characteristic of the foundation sector, as contrasted to endowments, is that most private and family foundations must generate their entire grant-making and operating budget from their investment portfolio for the following reasons: these institutions generally do not engage in fund-raising campaigns; they may not receive any new contributions from the donor; and they do not receive any public support.

Because foundations’ goals differ somewhat from those of traditional defined-benefit pension funds and other asset pools, foundations can have a higher risk tolerance.
Foundations have no defined liability. The desire to keep spending whole in real terms, or to grow the institution, is simply that: a desire.
Foundation investment policy can thus be more fluid or creative, and arguably more aggressive, than pension fund policy.

Some foundations are meant to be short lived; others are intended to operate in perpetuity. For those foundations with an indefinitely long horizon, the long-term return objective is to preserve the real (inflation-adjusted) value of the investment assets while allowing spending at an appropriate (either statutory or decided-upon) rate.
If we look at the 5 percent annual spending minimum for foundations as a benchmark and add 0.3 percent as a low-end estimate of investment management expenses (i.e., the cost of generating investment returns), we thus have calculated that the fund must generate a return of 5.3 percent, plus the inflation rate, to stay even in real terms. We can use 5.3 percent plus the expected inflation rate as a starting point for setting the return objective of a foundation.

The majority of foundation wealth resides in private and other foundations established or managed with the intent of lasting into perpetuity.
Investors often assume that a longer time horizon implies a greater ability to bear risk because a longer horizon affords them more time to recoup losses.

In the United States, income that is not substantially related to a foundation’s charitable purposes may be classified as unrelated business income and be subject to regular corporate tax rates.
In the United States, a private foundation must estimate and pay quarterly in advance a tax (currently set at 2 percent) on its net investment income. So, it is not tax exempt.
Private foundation investment income is taxable, whereas other foundations and endowments are not.

Foundations may be subject to a variety of legal and regulatory constraints, which vary by country and sometimes by type of foundation.

A special challenge faces foundations that are endowed with the stock of one particular company and that are then restricted by the donor from diversifying. The asset value of such an institution is obviously subject to the large market fluctuations attendant to any one-stock position.