Samenvatting van de colleges van Institutional Investments van de master Business Administration - Financial Management aan de Vrije Universiteit. Naast de collegesheets is er ook een deel van literatuur samengevat.
Employee Pension arrangement Pension fund Execution party
asset
managers
- Employer pays part of contribution of pension, other part is paid by employee.
- Employer doesn’t play a part in pension arrangement
- Board of pension fund decides the investment allocation
- Asset managers invest the pension funds money in assets according the conditions
given by the execution party. The pension funds board stated these conditions.
- Pension fund holds in account all kind of factors in determining the money they
need to meet their future liabilities.
- Risk exposure of 111,3% of assets has to do with the use of leverage.
- Funding ratio = dekkingsgraad
- Nominal matching portfolio = portfolio of assets, which are, considered as, risk
free (bonds & swaps)
- Return portfolio = portfolio of ‘risky’ assets (everything becides bonds & swaps).
Institutional investors usually invest in assets that are rated from
AAA+ to BBB.
Question 3: Suppose you have to pay me 100 Euros in real terms in 30 years from
now and I would give you 50 Euros right now, how would you invest?
- It is not possible to guarantee the 100 in real terms, so there are 2 options: take risk
or accept a lower guaranteed amount of money.
- Real terms = including inflation (100 now is more than 100 in future. You want to be
able to buy the same now as at maturity)
Basics of pension funds: (defined benefit pension fund)
- Pension fund has a liability to the participants; they owe them something,
because participants have paid contribution.
- This contribution is an asset to which you can invest.
- The investment policy of pension funds depends on the value of assets vs.
liabilities
In defined benefit pension plans the pension rights, i.e. the liabilities, are
guaranteed.
- To offer this guarantee, the contributions are not fixed.
- In case the guarantee is at risk, some stakeholders (active participants, future
actives or the plan sponsors) have to pay extra contribution.
- This is often called 'Intergenerational Risk Sharing'. This means: a pensioner
still can take quite some risk because if things go wrong the other stakeholders are
supposed to pay in order to make sure that pension rights are not cut.
- The current debate in the Netherlands is about the sustainability, because is the
burden for sponsors and future generations simply not too high?
The other extreme is a defined contribution system.
1
,- In this system the contributions are fixed and consequently, benefits are not
guaranteed.
- Investment risk is fully with the individual participant.
- Expectation for the future: combine the best of defined benefit and defined
contribution.
- Nowadays, ABN AMRO Pension Funds is a collective defined contribution scheme.
Participants invest collectively, contribution still varies with interest rates but benefits
are not guaranteed anymore.
Simplistically said, a defined benefit pension fund is:
a lot of participants (active participants, deferred (= slapers) participants,
pensioners)
a lot of liabilities towards the participants
a lot of payments to the pensioners (until they pass away)
a lot of contributions from the active participants (employees)
a lot of assets from present and past contributions plus investment gains /
losses
- From this simplistic representation you can already see that a pension fund is a
highly dynamic vehicle.
From the previous slides you can already ask a number of questions:
Do pension fund provide an explicit guarantee to their participants?
What is the ambition of the pension fund with respect to inflation
compensation?
Which risk level is acceptable in order to meet this ambition?
Who pays the contribution and how large should it be?
What is the optimal investment policy?
Nowadays it is popular in the pension fund community to summarize all these
questions in three major decision themes:
Ambition
Risks
Costs
- There is obviously a trade-off between these concepts, e.g., a higher ambition
comes with higher risk or with higher costs.
- The Boards of pension funds need to make the trade-off in such a way that the
interests of all stakeholders involved are served in a satisfying way.
Funding ratio (= dekkingsgraad)
- The nominal funding ratio is defined as the pension fund's assets over its nominal
liabilities:
FRt = At / Lt
* Where the liabilities are defined as:
Lt = ∑ T CFi
i=t (1 + Yt:i)^i-t
* In which y represents the discount rate observed at time t and CFi is the
expected payment at time i (= indexation)
What are the factors that drive the change in the nominal funding ratio?
FRt+1 = At x (1 + rAt:t+1) – Bt+1 + Ct+1
Lt x (1 + it ) x (1 + rLt:t+1) – Bt+1 + PRt+1 + Et+1
* Where rAt:t+1 is the return on the investment portfolio (return on assets)
* Bt+1 pension benefits that are paid by the pension fund to the pensioners
* Ct+1 contribution of the employer / employee that ow into the fund
* it is indexation
2
, * rLt:t+1 is the return on liabilities, i.e. change in pension fund liabilities due to
interest rate accrual and interest rate changes. Voorwaarden van berekeningen
veranderen.
* PRt+1 is present value of new pension rights
* Et+1 unknown factor that represents the possibility that people live longer and
it is the indexation given at time t: if the pension fund is sufficiently rich it will
increase all nominal rights with realised inflation (fully or partially). E is in this
case epsilom
Samengevat: Funding ratio =
Assets * (1 + return on assets) – pension benefits + contribution
Liabilities * (1 + indexation) * (1 + return on liabilities) – pension benefits + PV new
pension rights + unknown factor
- The liabilities can be interpreted as the present value of future obligations.
- The value of the assets is simply the value of the investment portfolio.
- Hence, the ratio of assets over the nominal liabilities says something about the
financial position of the pension fund.
- A ratio below 1 (or 100%) therefore says that the pension fund has insufficient
assets to cover its (future) obligations.
- The difficulty is that the pension fund doesn't need to pay the full amount of money
today. So, is a funding ratio below 1 really a problem?
From the formula for the nominal funding ratio, we can identify three possible policy
instruments:
Contribution policy: higher contributions lead to higher funding ratios
Indexation policy: no indexation leads to no increase in nominal liabilities
Investment policy: by taking more or less investment risk, funding ratio risk
can be steered
- These are usually the policy parameters in a so-called Asset and Liability
Management study.
- The policy instruments can be utilized (=gebruikt) to make the trade-off between
ambition, risks and costs.
Development funding ratios of three large pension funds:
- It turned out that pension funds took to much risk so when the crisis hit funding
ratio dropped.
The real funding ratio differs from the nominal funding ratio in the sense that future
expected cash- flows are corrected for (break-even) inflation:
FRrt = At / Lt
* Where the real liabilities are defined as:
Lrt = ∑ T CFi x (1 + πBEt:i)i-t
i=t (1 + yt:i)i-t
* Where y represents the discount rate observed at time t and πBE is the break-
even inflation that is observed in the inflation swap market.
* The difference between break-even inflation and expected inflation is the
inflation risk premium.
- For the exam it is not necessary to know the difference between expected inflation
and break-even inflation. It is sufficient to know how the real funding ratio is defined
and how it differs from the nominal ratio.
Pension funds continued
- Pension funds are interesting to know more about because more than 1,200 billion
euros is involved. This money is invested in all kinds of assets, because bank deposits
yields are too low.
3
, So what happens with the money? It is invested in a clever way. At least, that is the
aim.
- Some of the elements of the investment process:
Choosing a strategic investment policy (ALM study)
Choosing benchmarks for the asset classes
Determining risk budgets for individual portfolios
Implementing portfolio decisions, e.g. trading securities in the markets
Storage of physical assets
Performance measurement of individual portfolios
(Risk)-monitoring of balance sheet and contract parties
- A lot of these activities are outsourced by the Board of Trustees to asset managers,
custodians and performance specialists.
- Against fees, of course: on average Dutch pension funds pay 30-35bps for asset
management / consultancy plus 15bps transaction costs.
- Important examples in the Netherlands are APG and PGGM who advise and invest
for the largest Dutch pension schemes. But also traditional asset managers like
BlackRock, UBS Asset Management, PIMCO, ING Investment Management and Robeco
offer a lot of services to pension funds.
- Trading usually happens with banks as counterparty. So, revenues of large banks
like JPMorgan, RBS, Morgan Stanley, Goldman and Deutsche depend also on pension
fund trading.
Assume the following pension fund: (EXAMPLE)
the pension fund consists of 1 person
the pension fund promises to pay this person 100 Euros in 30 years from now
the pension fund has the knowledge that this person dies after he has received
the payment
the pension fund receives a contribution from the person
the ambition of the pension fund is to provide full indexation on top of the
promised 100 Euros
- In reality, we make a projection of the expected payments for all individual
participants.
- If the 30-years zero nominal interest rate is 3% then the present value of the
nominal obligation is: 100
(1 + 3%)^30 = 41.2
- If the 30-years annual expected inflation is 2% then the present value of the
ambition is:
100 x (1 + 2%)^30
(1 + 3%)^30 = 74.6
- This is the real liability value, i.e. the nominal liability value increased with expected
inflation (i.e. we assume that break-even inflation equals expected inflation). i.e. =
that is … (dat wil zeggen)
Let us consider two cases:
Case 1: the contribution equals 41.2 Euros
Case 2: the contribution equals 74.6 Euros
- Question: how would you invest in each of these cases?
Case 1: you could invest all the money in the matching portfolio: a portfolio that
matches the value of the liability perfectly (a single nominal zero coupon bond, in this
case). So the value goes from 41.2 to 100 in 30 years.
- The result is a stable nominal funding ratio
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