ok… so I saw that behav stuff post and I was jelous 
I was joking. I tried to write everything “useful” when facing questions on IPS of institutional investors, and here it is. Any comment will be appreciated. I had a look at it when reading schweser practice exams (6 and 7) and I think more or less I get it… DEFINED BENEFIT PLAN 1. Risk tolerance + Funded status + Sponsor financial status and profitability + Correlation between sponsor´s operating results and pension assets returns + Plan features (early retirement, lump sum distributions) + Workforce characteristics (active lives relative to retired lives, average age) = Above average / Average / Below average risk tolerance + Reference to surplus volatility + Reference to shortfall risk + Reference to minimize volatility of contribution payments + Reference to minimize probability of making future contributions + Reference to diversification to avoid single asset loss impairing ability to achieve its funding and return objectives 2. Return objective + Achieve a total return that adequately fund its pension liabilities on an inflation-adjusted basis + Required “base” rate of return = discount rate used to calculate the present value of the liabilities + Additionally, a. Reference to a higher total return objective rate (if risk tolerance allows to) b. Reference to long term growth orientation with focus on capital appreciation c. Try to minimize future pension contributions d. Try to generate pension income (negative pension expense) e. Reference to maximize returns for the level of risk taken f. Reference to achieve a return that exceeds the return of benchmark (indexes) 3. Liquidity + Liquidity needs = net cash outflow = benefit payments – pension contributions + As in risk tolerance: a. Number of retired lives, average age b. Current funded status c. Plan features (early retirement, lump sums) 4. Time horizon + Overall if going concern = long time horizon, usually multi-stage (active + retired, life expectancy) 5. Tax concerns + Income and capital gains within private defined benefit pension plans usually exempt 6. Legal and regulatory + ERISA (employee retirement income security act) + Standard of care, fiduciary duty, invested for the sole benefit of plan participants 7. Unique circumstances + Appropriate due diligence (lack of resources) + Ethical investment considerations (“socially responsible investing”) FOUNDATIONS 1. Risk tolerance + No contractually defined liability + Long time horizon + Spending needs = High risk tolerance + Desired target volatility 2. Return objective + Depending on time horizon + For long time horizon, to preserve the real (inflation-adjusted) value of the investment assets while allowing spending at an appropriate rate + Required return = (1 + spending) x (1 + inflation) x (1 + fees) – 1 + Additionally, a. Reference to achieve a return equal or better than benchmark b. Reference to total return 3. Liquidity + Anticipated needs (periodic distributions prescribed by the spending rate) + Unanticipated needs + Contributions made to the foundation (inflow, not outflow) + Smoothing rules for spending + Prudent to keep a cash reserve 4. Time horizon + Usually long term (intent of lasting into perpetuity) + Others created to be spent down, short term (less risk tolerant) 5. Tax concerns + Unrelated business income = subject to regular tax + Tax on net investment income = 2% (1% if spending = 5% +1% of net investment income) 6. Legal and regulatory + US: most states = UMIFA (uniform management of institutional funds act) + Prudent investor rule applies + Other tax-related regulations 7. Unique circumstances + Concentrated equity positions + Prohibited investments ENDOWMENTS 1. Risk tolerance + Long term time horizon = high risk tolerance + Smoothing rule for spending = lower spending volatility = higher risk tolerance (and viceversa) + Endowment is big % of the institution´s budget = lower risk tolerance (and viceversa) + Large fixed expenditures = lower risk tolerance (and viceversa) + Good previous, with return above spending rate = higher risk tolerance (and viceversa) + Must weather short term negative performance or volatility in order to achieve long term objectives + Predictable cash flows = higher risk tolerance (and viceversa) 2. Return objective + Goal = provide a significant, stable and sustainable flow of income to operations + Maintain their long-term purchasing power after inflation (institution inflation, not general inflation) + Required return = spending rate + inflation + fees + Spending should be lower than return in order to preserve its purchasing power + Smoothing rules for spending + Reference to total return 3. Liquidity + Low liquidity requirements + Spending distributions + Gifts, sale of securities, maturation of bonds (cash inflows) + Higher tolerance for illiquid, non-marketable securities 4. Time horizon + Long term, perpetuity 5. Tax concerns + Tax exempt + Unrelated business income 6. Legal and regulatory + US: most states = UMIFA (uniform management of institutional funds act) + External advisors and managers allowed + Prudent investor rule applies + Prohibit improper behaviour and avoid conflicts of interest + Respect restrictions imposed by the donor 7. Unique circumstances + Ethical investment policies, socially responsible investing + Alternative investments and resources needed (due diligence, active management) + External managers LIFE INSURANCE COMPANIES 1. Risk tolerance + Fiduciary principles limit the risk tolerance + Responsibility to fulfil all short-term and long-term obligations to policy-holders + Asset valuation reserve required by NAIC (national association of insurance commissioners) + Risk-based capital requirements + Valuation concerns (changes in assets Vs liabilities = write-down of surplus, capital adequacy problems) + Reinvestment risk (for annuity products, for example) + Credit risk + Cash flow volatility (minimize volatility in order to get reinvestment returns) + Competitive requirements of various product lines / segments 2. Return objective + Minimum return requirement = actuarial rate for reserves to meet mortality predictions + Earn a positive interest spread (interest earned – interest credited to policyholders) + Enhance margin to achieve a competitive advantage in setting premium for policies + Grow the surplus to support expanding business volume + Return requirements may vary by portfolio segments that have been established for certain product lines and groups 3. Liquidity requirements + Historically low, now increasing + Risk of asset-liability mismatch + disintermediation + Asset marketability risk + Minimize the need to hold lower yielding cash reserves 4. Time Horizon + Long term + Segmentation: duration targets for the portfolio and any product segments based on appropriate asset/liability management specifications 5. Tax concerns + Taxable entities + Investment income: a. Policyholder´s share = not taxed b. Funds transferred to the surplus = taxed 6. Legal and regulatory + Heavily regulated + Eligible investments + Prudent person rule + Valuation methods (security valuation book, NAIC) 7. Unique circumstances + Various NON-LIFE INSURANCE COMPANIES 1. Risk tolerance + Quasi-fiduciary duty + High volatility of cash flows + Limits (self-imposed) to common stocks to surplus (ratio) + Risk tolerance based on the competitive requirements of various product lines, risk-based capital considerations, and the responsibility to fulfil s/t and l/t obligations 2. Return objective + Competition + Profitability (maximize return on capital and surplus under allowed limits) + Provide growth of surplus + After tax returns + Total return (income return + capital gain) + Reference to threefold return objective: a. Earn a sufficient return to fund all policyholder liabilities b. Support the competitive pricing of all products c. Contribute to the growth of surplus through capital appreciation 3. Liquidity requirements + High, because of uncertainty of claims + Importance of marketability and maturity characteristic of portfolio assets + Holding a portfolio of s/t liquid securities = immediate liquidity reserve 4. Time horizon + Long term investor + Compared to life, shorter time horizon but longer maturity of portfolio (more tax-exempt bonds) + Equities held to grow the surplus 5. Tax concerns + Taxable entities + Tax considerations determine the optimal allocation within the bond portfolio between taxable and tax-exempt bonds + Tax considerations may also play a role in the realization of gains and losses for both the bond and stock portfolios 6. Legal and regulatory + Less regulated than life + Eligible assets + Risk-based capital regulations 7. Unique circumstances + Various BANKS 1. Risk tolerance + Below average risk tolerance as concerns the securities portfolio + Satisfy depositors and other liabilities, safety of principal, asset-liability framework + Diversification to avoid the risk of loss as a result of an individual issuer default 2. Return objective + Earn a positive spread over the cost of funds 3. Liquidity requirements + Determined by net outflow of deposits and demand for loans + Highly liquid securities in the securities portfolio 4. Time horizon + Usually short-to-intermediate, driven by the average maturity of its liabilities 5. Tax concerns + Taxable entities 6. Legal and regulatory + Highly regulated + Eligible assets + Risk-based capital retulations 7. Unique circumstances + Various
HALA!!! Amazing, you just saved me a bunch of time. If someone could post something like the above for Option Strategies, then we are set!!!
Good post! Only point I would dispute is prudent person rule for insurance – you sure about that? I didn’t think prudent person was used for anything anymore. Other question for all is – basic comments that apply to anyone and anything, like “maximize return for given level of risk”, “beat the benchmark”, “total return perspective”, are you going to say these, or is this a waste of time? i.e. If CFAI asks for IPS for a DB pension plan, do they want the points that are unique to DB plans, or will they want everything?
total return is not a waste for individual IPS. Almost every IPS solution i’ve read had it. Other points to remember Foundation risk can be below average. Please refer to CFAI books for found that spends spend down it is investment in years. Endowment uses spending rules to smoothing cash outflows so it could take on more vol (risk) in their portfolio Additionally, i believe both foundation and endowments are subject to IRS rule 501© (might be wrong here, have to look it up) Other then that: Excellent! I am actually going to save this one for a review
thanks. with pension, TH needs to look in to whether it is going concern, whether the plan is frozen for future participants or not, reference to duration of liability, and age of participants(long TH if avg age is lower).
ERISA, UMIFA, IRS 501©, NAIC,… Do you have to cite these to get the marks? CFAI goes out of its way to be seen as “global”. I would hope that they grade globally too.
you have to cite those. you wont loose points for sure then what is the harm? be flexible, i know you say that you are too for all this…
make sure you say “MAY” apply (i think 501© is mandatory though )
By “MAY” i mean it is state dependant in US
great post thanks hala
TooOld4This Wrote: ------------------------------------------------------- > Good post! > > Only point I would dispute is prudent person rule > for insurance – you sure about that? I didn’t > think prudent person was used for anything > anymore. > > Other question for all is – basic comments that > apply to anyone and anything, like “maximize > return for given level of risk”, “beat the > benchmark”, “total return perspective”, are you > going to say these, or is this a waste of time? > > i.e. If CFAI asks for IPS for a DB pension plan, > do they want the points that are unique to DB > plans, or will they want everything? page 344 in CFAI includes discussion of prudent investor rule in context of insurance.
Man, I hate this topic. Reading about insurance co IPSs makes my eyes glaze over. hate it hate it hate it hate it
this is the most useful post i found so far… thx
Many thanks. This is incredibly useful!
i revised it a bit Didnt go through all but here it is DEFINED BENEFIT PLAN 1. Risk tolerance + Funded status + Sponsor financial status and profitability + Correlation between sponsor´s operating results and pension assets returns + Plan features (early retirement, lump sum distributions) + Workforce characteristics (active lives relative to retired lives, average age) = Above average / Average / Below average risk tolerance + Reference to surplus volatility + Reference to shortfall risk + Reference to minimize volatility of contribution payments + Reference to minimize probability of making future contributions + Reference to diversification to avoid single asset loss impairing ability to achieve its funding and return objectives 2. Return objective + Achieve a total return that adequately fund its pension liabilities on an inflation-adjusted basis + Required “base” rate of return = discount rate used to calculate the present value of the liabilities + Secondary objectives: To minimize future contributions and to generate pension income + Additionally, a. Reference to a higher total return objective rate (if risk tolerance allows to) b. Reference to long term growth orientation with focus on capital appreciation c. Try to minimize future pension contributions d. Try to generate pension income (negative pension expense) e. Reference to maximize returns for the level of risk taken f. Reference to achieve a return that exceeds the return of benchmark (indexes) 3. Liquidity + Liquidity needs = net cash outflow = benefit payments – pension contributions + As in risk tolerance: a. Number of retired lives, average age b. Current funded status c. Plan features (early retirement, lump sums) 4. Time horizon + Overall if going concern = long time horizon, can be multi-stage (active + retired, life expectancy) 5. Tax concerns + Income and capital gains within private defined benefit pension plans usually exempt 6. Legal and regulatory + ERISA (employee retirement income security act) + Standard of care, fiduciary duty, invested for the sole benefit of plan participants 7. Unique circumstances + Appropriate due diligence (lack of resources) + Ethical investment considerations (“socially responsible investing”) DEFINED CONTRIBUTION PLAN 1.Principal investment issues + Diversification: The sponsor must offer a menu of invsment options that allows pariticpants to construct suitable portfolios - at least 3 investment choices diversified versus each other - provision for participant to move freely amount the options + Holdings of sponsor-company stock should be limited to allow particiapnts wealth to be adequately diversified + Hybrid plans: cash balance plan, pension equity plan, target benefit plan, floor plan - cash balance plan: - DB characteristics: Employer bears investment risk - DC charactersitics: Employee gets personalized statement - ESOP (Employee stock/share (us/uk) ownership plan - Important concern for ESOP participants is that their overall investment (financial and human capital) reflect adequate diversification FOUNDATIONS 1. Risk tolerance + No contractually defined liability + Long time horizon + Spending needs = High risk tolerance + Desired target volatility 2. Return objective + Depending on time horizon + For long time horizon, to preserve the real (inflation-adjusted) value of the investment assets while allowing spending at an appropriate rate + Required return = (1 + spending) x (1 + inflation) x (1 + fees) – 1 + Additionally, a. Reference to achieve a return equal or better than benchmark b. Reference to total return 3. Liquidity + Anticipated needs (periodic distributions prescribed by the spending rate) + Unanticipated needs + Contributions made to the foundation (inflow, not outflow) + Smoothing rules for spending, goverment allows for carry-back and cary-fowards + Prudent to keep a cash reserve (10-20% for private and familiy foundations) 4. Time horizon + Usually long term (intent of lasting into perpetuity) + Others created to be spent down, short term (less risk tolerant) 5. Tax concerns + Unrelated business income = subject to regular tax - Gift shop in a meseum - not task, Motorcycle business - taxed - Income from real estate is taxable as unrelated business income in proprotion to the property’s cost financed with debt + Tax on net investment income = 2% (1% if spending = 5% +1% of net investment income) 6. Legal and regulatory + US: most states = UMIFA (uniform management of institutional funds act) + Prudent investor rule applies + Other tax-related regulations 7. Unique circumstances + Concentrated equity positions + Prohibited investments ENDOWMENTS 1. Risk tolerance + Long term time horizon = high risk tolerance + Smoothing rule for spending = lower spending volatility = higher risk tolerance (and viceversa) + Endowment is big % of the institution´s budget = lower risk tolerance (and viceversa) + Large fixed expenditures = lower risk tolerance (and viceversa) + Good previous, with return above spending rate = higher risk tolerance (and viceversa) + Must weather short term negative performance or volatility in order to achieve long term objectives + Predictable cash flows = higher risk tolerance (and viceversa) 2. Return objective + Goal = provide a significant, stable and sustainable flow of income to operations + Maintain their long-term purchasing power after inflation (institution inflation, not general inflation) + Required return = spending rate + inflation + fees + Spending should be lower than return in order to preserve its purchasing power + Smoothing rules for spending + Reference to total return 3. Liquidity + Low liquidity requirements + Spending distributions + Gifts, sale of securities, maturation of bonds (cash inflows) + Higher tolerance for illiquid, non-marketable securities 4. Time horizon + Long term, perpetuity 5. Tax concerns + Tax exempt + Unrelated business income 6. Legal and regulatory + US: most states = UMIFA (uniform management of institutional funds act) + External advisors and managers allowed + Prudent investor rule applies + Prohibit improper behaviour and avoid conflicts of interest + Respect restrictions imposed by the donor 7. Unique circumstances + Ethical investment policies, socially responsible investing + Alternative investments and resources needed (due diligence, active management) + External managers LIFE INSURANCE COMPANIES 1. Risk tolerance + Fiduciary principles limit the risk tolerance + Responsibility to fulfil all short-term and long-term obligations to policy-holders + Asset valuation reserve required by NAIC (national association of insurance commissioners) + Risk-based capital requirements + Valuation concerns (changes in assets Vs liabilities = write-down of surplus, capital adequacy problems) + Reinvestment risk (for annuity products, for example) + Credit risk + Cash flow volatility (minimize volatility in order to get reinvestment returns) + Competitive requirements of various product lines / segments 2. Return objective + Minimum return requirement = actuarial rate for reserves to meet mortality predictions + Earn a positive interest spread (interest earned – interest credited to policyholders) + Enhance margin to achieve a competitive advantage in setting premium for policies + Grow the surplus to support expanding business volume + Return requirements may vary by portfolio segments that have been established for certain product lines and groups 3. Liquidity requirements + Historically low, now increasing + Risk of asset-liability mismatch + disintermediation + Asset marketability risk + Minimize the need to hold lower yielding cash reserves 4. Time Horizon + Long term + Segmentation: duration targets for the portfolio and any product segments based on appropriate asset/liability management specifications 5. Tax concerns + Taxable entities + Investment income: a. Policyholder´s share = not taxed b. Funds transferred to the surplus = taxed 6. Legal and regulatory + Heavily regulated + Eligible investments + Prudent person rule + Valuation methods (security valuation book, NAIC) 7. Unique circumstances + Various NON-LIFE INSURANCE COMPANIES 1. Risk tolerance + Quasi-fiduciary duty + High volatility of cash flows + Limits (self-imposed) to common stocks to surplus (ratio) + Risk tolerance based on the competitive requirements of various product lines, risk-based capital considerations, and the responsibility to fulfil s/t and l/t obligations 2. Return objective + Competition + Profitability (maximize return on capital and surplus under allowed limits) + Provide growth of surplus + After tax returns + Total return (income return + capital gain) + Reference to threefold return objective: a. Earn a sufficient return to fund all policyholder liabilities b. Support the competitive pricing of all products c. Contribute to the growth of surplus through capital appreciation 3. Liquidity requirements + High, because of uncertainty of claims + Importance of marketability and maturity characteristic of portfolio assets + Holding a portfolio of s/t liquid securities = immediate liquidity reserve 4. Time horizon + Long term investor + Compared to life, shorter time horizon but longer maturity of portfolio (more tax-exempt bonds) + Equities held to grow the surplus 5. Tax concerns + Taxable entities + Tax considerations determine the optimal allocation within the bond portfolio between taxable and tax-exempt bonds + Tax considerations may also play a role in the realization of gains and losses for both the bond and stock portfolios 6. Legal and regulatory + Less regulated than life + Eligible assets + Risk-based capital regulations 7. Unique circumstances + Various BANKS * Security portfolio goals - Overall interest rate risk of the balance sheet - To manage liquidity - To manage credit risk - to produce income 1. Risk tolerance + ALM considerations + Below average risk tolerance as concerns the securities portfolio + Satisfy depositors and other liabilities, safety of principal, asset-liability framework + Diversification to avoid the risk of loss as a result of an individual issuer default + Below average risk tolerance 2. Return objective + Earn a positive spread over the cost of funds 3. Liquidity requirements + Determined by net outflow of deposits and demand for loans + Highly liquid securities in the securities portfolio 4. Time horizon + Usually intermediate (3-7 years), driven by the average maturity of its liabilities 5. Tax concerns + Taxable entities 6. Legal and regulatory + Highly regulated + Eligible assets + Risk-based capital retulations 7. Unique circumstances + Various
don´t forget to quote original author, or you would be in a violation of standard I.C… I forgot defined contribution plans, good point
Another bump for this great post. First of all worth qualifying that the investment income on private foundations (only) is at 1% (in the US only). Secondly, where does the other 1% come from? I cant find any mention of it in my notes?!
bump
I think it was addressed somewhere but never confirmed Insurance - use prudent person rule Others - prudent investor rule I asked one of the schweser profs and he said institutional accounts put prudent expert rule although i haven’t seen this anywhere
HALA YOU ARE AWESOME! Two questions: 1) is Prudent Investor the same as Prudent Expert? 2) is there anything we need to know about the content of UMIFA and ERISA, other than that they apply to Foundations/Endowments and Pension Plans, respectively?