Managing Institutional Investor Portfolios －LO

A pension plans contribution level can be impacted by the expected return on plan assets.  The contribution amount can be greatly reduced or eliminated altogether by setting high enough return expectations. Pension expenses must be recognized on a sponsors income statement and, hence, must be considered in the overall return objective. Interestingly, negative pension expense, or pension income, can also be recognized.

Overall, the data Smith has gathered so far indicate an average tolerance for risk. The plan surplus indicates that the present value of plan liabilities is more than covered by the present value of plan assets. Pension plans with restrictive plan features, such as no early retirement or lump-sum distribution provisions increases the duration of the liabilities which, in turn, allows for a higher risk tolerance. The workforce is young; a high active to retired lives ratio indicates a large portion of the workforce is still working while only a small portion of beneficiaries is receiving plan benefit payments. All of these factors indicate an above-average ability to take risk. However, if the Pension Committee were to decrease the discount rate, the PBO would rise and the surplus could disappear. Also, a spike in commodity prices (silver required and only one supplier) and/or the cyclicality of the auto industry could adversely affect Branchs sales and profit margins. Hence, Branchs ability to make contributions if the economy slumps, could be compromised. In addition, Branch is more heavily leveraged than its competitors. This could also impact its ability to make timely contributions in an economic downturn. These factors imply less ability to take risk, especially in light of the Pension Committees expressed desire to control the volatility of contributions.

The investment style of a portfolio manager has no affect on a plans ability and willingness to take risk. Portfolio managers are chosen after risk considerations are determined. To varying degrees, all of the other factors will have a direct affect on a plans ability and willingness to take risk.

The correlation between the sponsors operating profitability and plan asset returns comes directly to bear on the firms required contributions and its ability to make them. When operating profitability and plan asset returns are high, the probability of having to make greater than average contributions is low, but at a time when the sponsor is most able to make a contribution. Alternatively, when operating profitability and plan asset returns are low, the probability of having to make contributions is high, but at a time when the sponsor may have difficulty making a contribution. Minimizing the correlation between the sponsors operating profitability and plan asset returns will maximize the probability that the sponsor will be able to make contributions when required to do so.

A larger pension surplus indicates higher risk tolerance. Although willingness to take risk may be low, ability to take risk exists. Under-funded plans, however, may be willing to take high risk to make up pension shortfalls, but less ability to take risk exists due to an existing deficit between pension assets and liabilities.

The discount rate used to determine present value of pension liabilities is that rate which discounts pension benefits, and hence, dictates the rate of return on pension assets that must be met to fund pension benefits. A funds desired return, however, may be higher and could relate to the amount of contributions a firm makes to the plan and/or the amount of benefits a plan wishes to offer participants.

Pension plan liquidity requirements are increased by the proportion of participants currently receiving benefits. Hence, a high proportion of retired lives, those currently receiving benefits, indicates a larger liquidity requirement.