Managing Institutional Investor Portfolios －LO

Given the tax-deferred status of pension funds, taxes are usually not an important issue. Liquidity constraints depend on the age of the work force, and must be given consideration. A pension funds investment horizon also depends on the age of the work force and whether or not the firm is a going concern. While the work force is mostly young, the firm does have some older workers, and thus cannot ignore liquidity and time horizons. Pension funds are regulated under the Employee Retirement Income Security Act (ERISA), and as such are subject to strict rules.

Manleys fiduciary duty is to the beneficiaries of the plan, not the company. While holding the Cooper stock may benefit the shareholders, it is unlikely to benefit the employees. The company stock provides an undiversified position that is correlated with the employees human capital and should be sold. An equity allocation of 70% would be considered high for most pension plans (the average is around 50%), so while diversifying the bond holdings may be a good move, maintaining the equity weighting is not. Some thought could be given to the fact that the plan is underfunded, and that the plan needs growth. In this situation, the plan also needs to protect the existing assets from too much risk so that the underfunding situation is not exacerbated. In this case, reducing the equity weight to an average level and increasing contributions would be the best course of action.

Most futures transactions are used to manage short-term risks and those transactions might not impact long-term risks. Futures are often used to hedge equity holdings, and nothing in the Prudent Expert Rule would prohibit their use under the proper circumstances. The funds bond holdings are irrelevant, as long as there are equity holdings for which futures could be used to hedge risk.

In a defined-contribution plan, the employee typically makes regular contributions to a fund that the company matches according to some formula, such as a percentage of current pay. The employee bears all of the investment risk in a defined contribution plan, and the employer has no financial obligation beyond making regular contributions on behalf of qualifying employees.

It is easier to optimize portfolios using asset classes with different risk characteristics and low correlation with other asset classes. None of the answers are wrong, but separating international stocks and venture capital into their own classes allows for the most precise optimization.

No matter how young the work force, an all-equity investment mix is inappropriate for a pension fund, which is always going to have at least a slight need for liquidity (particularly when the chairman and his lieutenants retire), and must be managed in such a way as to reduce risk. However, the youth of Chapmans work force suggests a 70% weighting in bonds is too conservative. The mix of large-cap stocks and investment-grade and high-yield bonds is attractive, but most of Chapmans employees are both young and well-paid, suggesting they have a high risk tolerance as well as low liquidity demands. The best option is the mix of investment-grade bonds, small-cap and large-cap stocks, and venture capital, the portfolio that probably offers the highest total return. There is nothing wrong with taking some risks in a pension plan, as long as those risks are well considered and suitable given the characteristics of the work force.

In a defined contribution plan, the plan sponsor does not establish objectives and constraints but rather the plan participants set their own risk and return objectives.

Defined contribution plans call for quite a different IPS than do defined benefit plans.

Instead of stating objectives and constraints (as in defined benefit plans), the purpose of a participant-directed defined contribution investment policy statement is to provide a governing document that describes the investment strategies and alternatives available to plan participants.