1 / 27

Pension plans, Asset Allocation and Fixed Income Investing Topic 9 No Text, no prob …

Pension plans, Asset Allocation and Fixed Income Investing Topic 9 No Text, no prob …. Defined Benefits Pension Plans. In a DB plan, the sponsor specifies a benefit rule: e.g. the average of last five years salary multiplied by a factor that

zora
Download Presentation

Pension plans, Asset Allocation and Fixed Income Investing Topic 9 No Text, no prob …

An Image/Link below is provided (as is) to download presentation Download Policy: Content on the Website is provided to you AS IS for your information and personal use and may not be sold / licensed / shared on other websites without getting consent from its author. Content is provided to you AS IS for your information and personal use only. Download presentation by click this link. While downloading, if for some reason you are not able to download a presentation, the publisher may have deleted the file from their server. During download, if you can't get a presentation, the file might be deleted by the publisher.

E N D

Presentation Transcript

  1. Pension plans, Asset Allocation and Fixed Income InvestingTopic 9No Text, no prob…

  2. Defined Benefits Pension Plans • In a DB plan, the sponsor specifies a benefit rule: e.g. the • average of last five years salary multiplied by a factor that • depends on the number of years of service. • Inflation risk – as wages increase at least at the rate of • inflation. • Longevity risk – life span of retired employees. • Duration risk – Duration of liabilities of active employees • with vested benefits can be very high. • Incentives – DB plans covered by Pension Benefits • Guarantee Corporation or PBGC. – incentives for funding • and asset allocation.

  3. Example of a Defined Benefits Pension Plan Consider an employee in a DB plan with a 4% “benefit factor” . Work experience with the firm: 10 years. Status: Fully vested. Current salary: $90,000 per annum. The employee’s pension benefits per year (if he were to leave the firm now) 4% x 90,000 x 10 = $36,000 Moreover, many public DB plans offer cost of living adjustments, which vary by plan. Note that for employees, both the years of service and the salary will grow with each year of work, so that the nominal retirement benefit that a worker expects to receive increases more than proportionately with the worker's age.

  4. Risk in a Defined Benefits Pension Plan The plan sponsor must be able to meet the future obligations. One measure is the following: if all employees were to quit now, what is the annuity payments that must be made? This can be thought of as the “termination benefits” or “accumulated benefits obligations.” Often, sponsors state the present value of liabilities by discounting the projected annuity payments at some permissible actuarial rates. These are “stated liabilities”.

  5. Defined Contribution Pension Plans • In a DC plan, the employer pays every month (contributes) a • certain amount of cash into the employee’s pension account. • 2. The employee then chooses: • Asset allocation. • Bears all the risk of future performance. • The plan is fully vested and portable. • Employer bears little risk, beyond funding the plan. • Many corporations are switching from DB to DC plans.

  6. Status of Public Defined Benefits Pension Plans In the United States • Plan assets held are estimated at $1.94 trillion. • Plan liabilities are estimated at $5.17 trillion. • These estimates were before the credit crisis of 2008! • The shortfall is about 4 to 5 times the outstanding • value of debt issued by the states. • Unless the benefits are re-contracted, this shortfall • should be counted as a potential liability of tax payers.

  7. Table 1: State Underfunding as Percent of Tax Revenues and Gross State Product Pension liabilities are collected from the Comprehensive Annual Financial Reports (CAFRs) for the 116 largest state public pension plans and adjusted to reflect an Accumulated Benefit Obligation liability discounted using the Treasury yield curve. Pension assets are taken from Pensions and Investments for September 2008 and projected forward to December 2008 using asset allocation data and realized asset class investment returns. Tax revenues are from the U.S.Census Bureau Census of Governments, and Gross State Product (GSP) is from the Bureau of Economic Analysis. Pension assets and liabilities are aggregated to the state level. B7308 Spring 2012

  8. Source: “The Liabilities and Risks of State-Sponsored Pension Plans” Robert Novy-Marx and Joshua D. Rauh

  9. DB Pension Sponsors: Assets and Liabilities Currently, many of the DB plans are underfunded: market value of assets well below the present value of liabilities.

  10. Asset allocation for Pension Plans • Modern Portfolio Theory (MPT) suggests that the optimal portfolio should have two components: • Mean-variance efficient market portfolio, which is fully diversified. This can be thought of as the Performance Seeking Portfolio (PSP). • Risk-free asset, which can be thought of as a defensive fixed income portfolio. • The split between these two asset classes will be determined by the manager’s risk aversion. • Note that in this analysis, the liabilities of the pension sponsor is not directly considered. • The sponsor may allocate mandates to different portfolio managers, with some receiving the mandate for PSP and other receiving the mandate for defensive fixed income.

  11. Asset allocation for Pension Plans PSP – indexed portfolio? Expected Return Fixed Income – defensive portfolio? Risk

  12. DB Pension Sponsors: Assets and Liabilities

  13. Penalty for not meeting liabilities – dedicated portfolio construction • If the penalty for not meeting the liabilities is very high, then the portfolio manager will simply fund the liabilities as follows: • Project the cash flow obligations associated with the pension liabilities. • Find in the capital markets the minimum cost at which fixed income assets can be purchased so that the aggregate cash flows generated from the fixed income portfolio exactly matches the cash outflows associated with pension liabilities. • This approach is known as “dedicated fixed income portfolio construction.”

  14. Penalty for not meeting liabilities – dedicated portfolio construction • Usually in selecting the securities for including in the dedicated portfolio, portfolio manager will apply the following considerations: • Securities should not be callable within the dedication horizon. • Securities should have a low level of reinvestment risk. • Securities need not be very liquid. • Securities should not be subject to a high degree of default risk. • Applying the above criteria will typically lead to the selection of strips, off-the-run securities, and high-grade corporate debt securities. Since the pension liabilities have a long duration, the portfolio will tend to have long duration as well.

  15. Penalty for not meeting liabilities – Pension portfolio immunization • If the penalty for not meeting the liabilities is not very high, then the portfolio manager might want to do the following: • Select a minimum cost portfolio such that the duration of the portfolio is the same as the duration of the pension liabilities. • The important point here is that only the duration is matched, not the cash flows. • An immunizing portfolio has the same interest rate risk as the pension liabilities, but must be rebalanced often to make sure that the immunization is effective, as • Time elapses, • Withdrawals are made, • Securities are sold.

  16. Penalty for not meeting liabilities – Liability Driven Investment (LDI) • LDI strategies are sometimes used by corporate DB plans to focus on the fact that it is ultimately the liabilities that must be met, and that is the reason for managing the pension assets portfolio. • Recognizing that the liabilities are not risk-free, and that they do carry a level of duration risk, the strategy then requires an explicit recognition of this in the asset allocation process. • Often, a combination of PSP and LDI portfolios are used, with the risk aversion of the sponsor/portfolio manager determining the actual weights in each portfolio.

  17. Asset allocation for Pension Plans: LDI and PSP PSP – indexed portfolio, actively managed “long only” or Alternatives and absolute returns strategies? Expected Return Fixed Income – LDI portfolio Risk

  18. Asset allocation - Indexation 4. The pension sponsor may want the portfolio manager to perform indexation, i.e., track the performance of a well-diversified fixed income indexes. Indices produced by Citibank alone!

  19. Asset allocation - Indexation Indices produced by Barclays

  20. Asset allocation - Indexation Indices produced by Barclays

  21. Criteria for Indexation The case FOR market cap weighted index • Market-cap weighted indexes are motivated by MPT. If the markets are efficient, then a market-cap weighted index approximates mean-variance efficient portfolio and it makes sense to hold it. • Advantages: • Solves the principal-agent problem. • Easy to replicate, and promotes transparency in measuring performance. • Goal setting is easy: achieve excess return over a transparent and replicable index at an acceptable level of tracking error. • A large amount of capital in equity and fixed income space is manage via market cap weighted indexes.

  22. Criteria for Indexation The case AGAINST market cap weighted index • Markets are not fully efficient. • Yields may not fully reflect macroeconomic fundamentals. • It is possible that “low quality issuers” dominate the issuance in a period of low risk aversion, and get attractive prices for their securities. • Should investors use macro-weighted indexes? • Should investors use market cap indexes, but use discretion to change the weights?

  23. The case against market cap weighted index – Although the macro fundamentals of Greece, Portugal and Ireland were weak in 2005-2007, their spreads to Germany was low!

  24. Criteria for Indexation The case for macro weighted index Some macro factors that may be of relevance • GDP – PIMCO has already an index that is GDP-weighted. GDP measures roughly the country’s ability to pay. • Current account deficit/Government deficit. These measures reflect the ability of a country to pay when there is a crisis. • Household debt. This may affect future ability to tax and hence the ability to pay. • Financial sector debt (often, this is assumed by tax payers!)

  25. Source: Introducing the PIMCO Global Advantage™ Bond Index (GLADI™) - PIMCO

  26. State Pension Systems Investing in Hedge Funds Source: Cliffwater, January 2011.

  27. State Pension Systems Investing in Hedge Funds Source: Cliffwater, January 2011.

More Related