Chapter 3 Managing Institutional Investor Portfolios

1. Chapter 3 Managing Institutional Investor Portfolios

2. 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

3. 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

4. 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: US$237.5 billion • Largest in the world • Government Pension Investment Fund of Japan June 30, 2012: US$1.45 trillion

5. Global Pension Assets Source: Towers Watson (Figures as of Dec 30, 2011)

6. 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

7. 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

8. 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

9. 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

10. 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 > = 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

11. 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

12. 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 • Sponsor’s 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

13. 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

14. 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

15. 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

16. 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

17. 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

18. 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)

19. 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

20. 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.

21. 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 University’s operating budget Asset allocation: Advocates the so-called “Endowment Model” that de-emphasizes traditional stocks and bonds, early adoption of alternative assets (next class)

22. Responsible Investing Examples: • Last class: CPPIB (engagement policy) • Other extreme: Government Pension Fund of Norway