Managing Institutional Investor Portfolios －LO

Some exposure to high yields is warranted given their favorable risk/return profile versus equities. Somewhere between 5 and 10 percent is probably a reasonable allocation to this asset class. The existing small cap allocation seems reasonable, given the risk/return objective of the fund. However, 15 percent is probably an adequate allocation to this asset class.

Since the time horizon is infinite, it would make sense for more of the bond allocation to be shifted from intermediate into higher-returning long-term bonds.

The comments of both Turner and Davenport are technically correct, although incomplete in terms of an in-depth discussion. The customary arguments for international investing include increased security selection, possible excess returns, and potential risk reduction due to low correlation with the U.S. market. However there are a number of arguments against international investing, including some evidence that correlations are increasing and that they increase when market volatility is highest, thereby diminishing diversification when it is most needed. There have definitely been significant periods of time when international stocks have under-performed the U.S. market. Although transaction costs have been falling, there are still a number of barriers such as legal and accounting differences, tax regulations, lack of liquidity, etc. Finally, it does appear that industry factors now dominate country or regional factors, but country factors still remain important. Using only U.S.-based global companies can expose domestic-only portfolios to significant country risk.

The small size of the Foundation precludes a large allocation to hedge funds, therefore the only reasonable vehicle is a fund of funds.

Private foundations are required to pay out 5 percent of assets annually. Also, foundations set up to provide perpetual support must be concerned with the preservation of capital. Hence, 5.3 percent plus an adjustment for inflation is a useful guideline for quantifying the return objective for a private foundation.

Both foundation and endowment IPS should include a return objective that specifies a total return approach. Additionally, both foundations and endowments have moderate to high risk tolerance levels and an infinite time horizon. Only private foundations are required to set spending rates.

UBIT must be paid by both endowments and foundations if income is produced that is not substantially related to a foundations/endowments charitable purpose.

Net interest spread is the difference between interest earned and interest credited to policyholders. Therefore, net interest spread may be talked about in the return objectives of an insurance companys IPS.

Time horizon The time horizon for this plan is short. Since the plan sponsor, WWT, is currently in bankruptcy and would not be considered a going concern, it cannot provide any funds to minimize the plan deficit. Since there is only a 5-year time horizon for the plan coupled with the uncertainty on the disposition of available funds in five years, the primary goal of this plan is on capital preservation with a secondary focus on income and a third goal of some growth over the time horizon. Five years is a short time frame to achieve these goals. Any IPS developed must consider capital preservation first and then consider a total return approach to preserve the plan from the effects of inflation.

Liquidity The liquidity needs of this portfolio are low primarily because only 1% of the plan assets are currently being paid out and no more employees are expected to retire over the next five years. The average age of the workforce is 30 and young and will not require any distributions until the expected termination upon its fully funded status. Therefore, the plan only has to provide for its current retirees at a rate of 1% per year.

Laws and regulations This pension plan is governed by ERISA and must adhere to the prudent expert rule. As such, diversification is necessary to minimize the risk of large losses to the plan and capital preservation.

Taxes There are none to be considered for the pension plan. However, upon the distribution of the plan assets after five years, there could be a tax impact on the plan participants. Tax counsel is advised here for the plan and its participants to also do some tax planning for the ultimate distribution of the proceeds of the plan in five years.

Unique circumstances WWT, the plan sponsor, is in a Chapter 11 bankruptcy filing and, therefore, cannot provide any funds to meet the plans underfunded status. The plan must also consider the administration of the distribution of the proceeds of the plan after five years to its plan participants. Should the underfunded status remain (assuming a higher than expected level of benefits are paid out to retirees or the expected rate of return does not meet the level of the plan liabilities) special policies and procedures may need to be considered at the time of the distribution of the plan assets.

Time horizon The time horizon for this plan is short. Since the plan sponsor, WWT, is currently in bankruptcy and would not be considered a going concern, it cannot provide any funds to minimize the plan deficit. Since there is only a 5-year time horizon for the plan coupled with the uncertainty on the disposition of available funds in five years, the primary goal of this plan is on capital preservation with a secondary focus on income and a third goal of some growth over the time horizon. Five years is a short time frame to achieve these goals. Any IPS developed must consider capital preservation first and then consider a total return approach to preserve the plan from the effects of inflation.

Liquidity The liquidity needs of this portfolio are low primarily because only 1% of the plan assets are currently being paid out and no more employees are expected to retire over the next five years. The average age of the workforce is 30 and young and will not require any distributions until the expected termination upon its fully funded status. Therefore, the plan only has to provide for its current retirees at a rate of 1% per year.

Laws and regulations This pension plan is governed by ERISA and must adhere to the prudent expert rule. As such, diversification is necessary to minimize the risk of large losses to the plan and capital preservation.

Taxes There are none to be considered for the pension plan. However, upon the distribution of the plan assets after five years, there could be a tax impact on the plan participants. Tax counsel is advised here for the plan and its participants to also do some tax planning for the ultimate distribution of the proceeds of the plan in five years.

Unique circumstances WWT, the plan sponsor, is in a Chapter 11 bankruptcy filing and, therefore, cannot provide any funds to meet the plans underfunded status. The plan must also consider the administration of the distribution of the proceeds of the plan after five years to its plan participants. Should the underfunded status remain (assuming a higher than expected level of benefits are paid out to retirees or the expected rate of return does not meet the level of the plan liabilities) special policies and procedures may need to be considered at the time of the distribution of the plan assets.

Return requirement The plan must consider the preservation of capital as its primary objective over the 5-year time horizon. The plan should focus on a goal of obtaining an expected rate of return of 6.84% to eliminate the plan deficit of $4 million (plan asset of $15 million less plan liabilities of $19 million) and preserve the plan from the effects of inflation.

• PV= -15 FV=19 N=5 PMT=0 CPT I/Y = 4.84%
• Rate of return to achieve fully funded status = 4.84%
• Plus: benefits paid out to retirees = 1.00%
• Plus: expected inflation rate = 1.00%
• Equals the return requirement = 6.84%

Since the bankruptcy court has mandated that the plan liabilities will be held constant at $19 million, the plan assets could be invested at a required rate to achieve fully funded status in five years. Thus, the computation to achieve the rate of return is: (Future Value Present Value) (1/term) or using a financial calculator =4.84%. The result of this calculation is 4.84 percent. Additionally, we must also include the benefits currently paid out to retirees of 1 percent plus the expected inflation rate of 1 percent to arrive at the return requirement of 6.84 percent.

This return requirement allows the plan to close the plan deficit while also providing retirement benefits to its retirees and preserving the capital from the effects of inflation.

Risk Tolerance The risk tolerance for the pension plan is low or below average. The primary objective of the plan is to preserve the plan assets and protect it from the effects of inflation with the ultimate goal of achieving a fully funded status in five years. Given the short time horizon of five years and its current underfunded status and the inability of its plan sponsor to commit any fund to the plan (due to bankruptcy), the plan cannot be subjected to any unexpected levels of market risk. Furthermore, it is currently paying out benefits to retirees, so it must have the liquidity to provide such benefits.

Return requirement The plan must consider the preservation of capital as its primary objective over the 5-year time horizon. The plan should focus on a goal of obtaining an expected rate of return of 6.84% to eliminate the plan deficit of $4 million (plan asset of $15 million less plan liabilities of $19 million) and preserve the plan from the effects of inflation.

• PV= -15 FV=19 N=5 PMT=0 CPT I/Y = 4.84%
• Rate of return to achieve fully funded status = 4.84%
• Plus: benefits paid out to retirees = 1.00%
• Plus: expected inflation rate = 1.00%
• Equals the return requirement = 6.84%

Since the bankruptcy court has mandated that the plan liabilities will be held constant at $19 million, the plan assets could be invested at a required rate to achieve fully funded status in five years. Thus, the computation to achieve the rate of return is: (Future Value Present Value) (1/term) or using a financial calculator =4.84%. The result of this calculation is 4.84 percent. Additionally, we must also include the benefits currently paid out to retirees of 1 percent plus the expected inflation rate of 1 percent to arrive at the return requirement of 6.84 percent.

This return requirement allows the plan to close the plan deficit while also providing retirement benefits to its retirees and preserving the capital from the effects of inflation.

Risk Tolerance The risk tolerance for the pension plan is low or below average. The primary objective of the plan is to preserve the plan assets and protect it from the effects of inflation with the ultimate goal of achieving a fully funded status in five years. Given the short time horizon of five years and its current underfunded status and the inability of its plan sponsor to commit any fund to the plan (due to bankruptcy), the plan cannot be subjected to any unexpected levels of market risk. Furthermore, it is currently paying out benefits to retirees, so it must have the liquidity to provide such benefits.

It is assumed, since it was not stated, that the fund will be a permanent source of scholarship funds.

Since Turner is a trustee as well as the donor, this places a unique twist to the governance of the endowment. Asset/Liability matching relates to insurance companies. The financial status of the college has no impact on this independent scholarship endowment (unless, of course, it completely goes under).

Endowments are tax-exempt. As such, municipal bonds are not appropriate investment vehicles. Also, the endowment may be subject to the Unrelated Business Income Tax (UBIT).

Except for issues related to 501(c)(3) tax regulations, there are very few federal regulations governing the administration of endowments.

Assuming the college uses a 5 percent spending rate, 9 percent is the minimum required return annually based off of a 4 percent annual rise in tuition. 11 percent assumes you are double compensating for inflation (4 percent tuition plus 2 percent inflation rate). Matching/relating returns to a benchmark will not insure that scholarships will be given (a request of Turners).

Typically, the risk tolerance of endowment funds is linked to the relative importance of the fund in the sponsors overall budget picture. Since this endowment is a scholarship endowment, there are no operations at risk of shutting down if the fund does not meet its return objective. On the other hand, Turner has expressed that she wants 10 scholarships awarded annually. This requirement reduces the overall risk profile. Also, a 9 percent return requirement will necessitate higher risks.

The primary objective is to earn a positive interest rate spread which is the difference between the bank's cost of funds and the interest earned on loans and other investments.

The ladder strategy approach staggers investments with equal amounts invested throughout the maturity spectrum. Over time, periodic reinvestment of maturing securities is required. With a barbell approach, investments are made both on the short and long ends of the maturity spectrum; weighted more heavily on one end or the other depending upon the managers interest rate outlook. A bullet strategy concentrates the maturities of the bonds in the portfolio around a single point on the yield curve.

The ladder strategy approach staggers investments with equal amounts invested throughout the maturity spectrum. This approach averages exposure to interest rates and does not necessarily require an aggressive bet on interest rate direction. Over time, periodic reinvestment of maturing securities is required. With a barbell approach, investments are made both on the short and long ends of the maturity spectrum; weighted more heavily on one end or the other depending upon the managers interest rate outlook. When rates are expected to rise (as Clarkson anticipates), short-term securities can be over-weighted using a bullet strategy which concentrates securities in one area on the yield curve.

AFS securities are not intended to be held to maturity. Unrealized gains or losses are reported in the banks equity account but are not reported on the income statement. Realized gains and losses and interest dividend income are reported in income. Because bank capital is affected by changes in their market value, highly liquid, and shorter-duration securities are often selected for this category of assets.

HTM securities are intended to be held until maturity. In certain circumstances, however, they can become available for sale (e.g. substantial credit deterioration, changes in tax treatments, shifts in risk weightings) but not in response to shifts in interest rates or to meet unforeseen liquidity needs.