Overall risk tolerance: institutional vs individual investor

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31ejm

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Hi all,
Been mostly lurking for the last few years, but thought I’d pop in with a question for L3 that I haven’t seen answered in 2012 search results.
I thought I finally firmed up setting up a decent frameowork for ris/ return objectives of an IPS, which I think translates into easy points if you pay attention. Until I got to Schweser practice exam 5 AM session, which goes for an institutional investor (insurance company, I believe). So here our framework of writing out “willingess, ability, overall” goes out the window, and we end up getting savaged on points.
Anyone have a similarly reliable framework for answers to IPS questions related to institutional investors? Thanks everyone and good luck.
 
Institutional IPS in general is more straight forward than individiual - heres a quick outline of what I have learned/memorized
Pensions
  • Return: Min return based on actuarial assumptions. The point is to have the plan fully fudned (assets = PBO). Mgmt may want to earn higher return to avoid having to make contributions in futures years.
  • Risk: Will vary - depends on profitability and balance sheet, avg age and active/retriement lives, if there are early retirement features, and the current funded status of the plan.
  • Liquidity - again will vary like risk depending on the age of the plan etc
  • Legal - Prudent Expert rule
  • Time Horizon - usually long (infinite for a continuing plan)
  • Taxes - None
  • Unique - current fudned status, investment constraints, other.
Foundations
  • Return - Will depend a bit on each foundation. In general, 5% (for private and Company sponsored) spending rule, and for operating you need to spend 85% (?) income plus possiby 3.33%. So to get total return needed, it will be: (1+Spending rate required) * (1+Inflation) * (1+ Mgmt fees) . Total return is appropriate
  • Risk - Usually higher than Pension plans. It will depeend on the importance of what the foundation is covering, and the % of the total budget it covers. Higher % will mean lower risk tolerance
  • Tax - None (1% on dividends and income for private foudnation i think)
  • Time - usually long, infinite
  • Legal - Predent investor
  • Liquidity - need to cover spending rate
  • Unique - anything unique (like SRI)
Endowments
  • Retrun - Similar to foundations, but no spending requirement so will depend on the objectives of the endowment
  • Risk - high risk tolerance, usually even higher than foudnations
  • Taxes - none
  • Time - long, infinite
  • Legal - Prudent rules
  • Liquidity - will depend on the purpose of the endowment and its spedning rules etc
  • Unqie - other
Life Insurance
  • Return - Min return is actuarial rate. Enhanced margin - trying to get a net interest spread to make money. The surplus account is more aggressive.
  • Risk - Enhanced margin is low, surplus account is high. Market value risk, cash flow risk, valuation risk and credit risk are all important aspects to consider
  • Taxes - taxable entitiy so important.
  • Time horizon - long, although decreasing. Now about 20-40 years
  • Liquidity - will depend on the policies, but usually high as they need to be able to pay out policies values
  • Legal - heavily regulated
  • Unique - types of product offerings etc
Non Life Insurance
  • Return - high liquidity needs. Fixed income portion focus on meeting claims, surplus on maximizing growth
  • Risk - inflation big concern, high liquidity lowers ability to take risk
  • Time - short because of cliams
  • Taxes - taxable
  • Liquidity - High because of claim natur
  • Legal- less than Life insurance companies
  • Unique - other
Banks
  • Return - Positive Net interest spread
  • Risk - need to meet liabilities, so low risk
  • Liquidity - high liquity because need to meet withdrawals
  • Time - short - intm
  • Taxes - taxable entities
  • Legal - Highly regulated
  • Unique - diversification and liquidity needs
Im hoping this is enough detail to do well on the exam.
 
For pension plan time horizon does anyone else look at average age of workers instead of assuming they have an infinate time horizon?
 
age of the workers is only important to determine liquidity and risk tolerance. The plan itselff has ( or should have , for a going concern ) an infinite horizon
 
The answer for Q2 Schweser Practice test #5 AM indicates that their plan time horizon is shorter than average due to the fact that the average employee age > industry average.
 
Yes. lower duration of liqabilities suggest higher average age of work force which leads to lower risk tolerance.
Also look out for if plan is not a going concern.
 
Fin: is that the company has going concern problem, other than that old worker will be replaced by new young one. That why they concern rate of active/retired
that my thinking
 
when average employee age > industry average -> this means more number of people here are likely to retire sooner. The older age of the employers also means that the PBO would generally be bigger. A bigger retiring population would also mean that the liquidity requirements would also be higher. Liquidity requirements would be bigger - because more benefit payments each year.
 
Foundations
  • Return - Will depend a bit on each foundation. In general, 5% (for private and Company sponsored) spending rule, and for operating you need to spend 85% (?) income plus possiby 3.33%. So to get total return needed, it will be: (1+Spending rate required) * (1+Inflation) * (1+ Mgmt fees) . Total return is appropriate
  • Risk - Usually higher than Pension plans. It will depeend on the importance of what the foundation is covering, and the % of the total budget it covers. Higher % will mean lower risk tolerance
  • Tax - None (1% on dividends and income for private foudnation i think)
  • Time - usually long, infinite
  • Legal - Predent investor
  • Liquidity - need to cover spending rate + Mgmt fees
  • Unique - anything unique (like SRI)
-Well done. Looks good.
 
Thanks, Spanishesk and all other replies. Solid info, really appreciate it!
 
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