Client objectives

1. Client objectives MFIN5600 Institutional wealth management

2. A brief history: 1998-2013 NASDAQ S&P 500 4

3. Types of Pension plans: history • Defined benefit (DB) plan • History: American Express in 1928 in the US • Plan defines the amount of benefits in the future. Amount is a function of average earnings in the last 3-5 years and years of service • Plan sponsors (i.e., employers/governments) invest the reserve fund on behalf of the plan members • Defined contribution (DC) plan • Plan defines only the amount of contribution today • Plan members have individual accounts, and pick investment options. Benefits will depend on investment returns • Chile government – early adopter (1981); choose 5 funds from 6 providers • Both plan sponsors and plan members contribute to the plans (both DB and DC)

4. DB/DC split (Towers Watson Global Pension Asset Study 2013)

5. Motivations for dc plans • Changing demographics • DB plans are also known as “pay-as-you-go” plans • Young workers contribute to the plan to fund the retirement of older workers • Risk to employers (plan sponsors) • Burden of the obligation; impact on operating budget in the event of a deficit • DC plans confer no future liability to the plan sponsor • Recent example of shift: Chrysler and General Motor • Freeze DB plan and shift assets to DC accounts

6. DB plans • Common misconception: “Plan sponsors bear investment risk in DB plans; plan members bear investment risk in DC plans” • DB plan members bear risk of early plan termination due to bankruptcy of plan sponsor • In contrast, in a DC plan, members own their accounts • Largest Canadian DB plans • CPP • Caisse de depot et placement du Quebec • Ontario Teachers’ Pension Plan (OTTP/Teachers) • Ontario Municipal Employees Retirement System (OMERS) • Hospitals of Ontario Pension Plan (HOOPP)

7. DB plan: flow • DB plan assets • Accumulate from annual surpluses (contributions + investment income > payouts + expenses) • From OTPP’s 2012 Annual Report” • CPPIB expects contributions > benefits until 2021

8. DB Plans: objectives and constraints • Return objectives: achieve inflation-adjusted returns that adequately fund its pension liabilities • PV of liabilities is discounted at the 10-year corporate yield (AAA ~ 3.4% in July 2013) • Low interest rate environment bad for pension plans: higher PV of liabilities, and lower investment income • Constraints • Liquidity – difference between inflow and outflow (see previous slide) • Time horizon – long for continuing plan, but average age of workforce is a consideration • Legal and regulatory – e.g., Ontario: Pension Benefits Act • Others – sponsor’s financial status and specific investment prohibitions

9. DB plans: risk tolerance • Risk tolerance categories: • Below average, average, above average • Governed by multiple factors: • Financial health of the plan (i.e. surplus/deficit) • Sponsor financial status and profitability (sponsor’s ability to make additional contributions in the event of a shortfall) • Sponsor and pension fund common risk exposure (correlation between sponsor’s operating results and fund’s returns) • Plan features (e.g., early retirement provisions or lump sum options reduce plan’s risk tolerance) • Workforce characteristics (e.g., average age, ratio of active to retired employees)

10. DB plan: risk management • Investment risk • Includes: equity market risk, credit risk, counterparty risk, liquidity risk • Primary purpose of plan’s assets is to fund future liabilities • Funding ratio – net asset value / PV of liabilities • Asset-liability management (ALM) • Most plans were asset-focus until ~ 5-10 years ago • Divide assets into 2 groups: • Liability matching or hedging: income generation for payouts (to supplement contribution); align interest-rate sensitivity on both sides using a portfolio of bonds and swaps • Return seeking: for capital gains to increase the size of the plan’s assets

11. Db plan: risk management • Plan can set risk objective relative to the volatility of its surplus/deficit (asset – liabilities) • E.g. volatility ≤ 6% • Risk can also be expressed as a shortfall relative to a specific funding ratio • E.g. if target funding ratio = 100%, then no less than 95% in any given fiscal year • Note: a company’s pension surplus/deficit is now more transparent on corporate balance sheets because of new mark-to-market accounting rules

12. Db plans: risk management • CPPIB - in addition to investment risk, • Operational risk: internal process and management with the fund • Reputation risk: loss of credibility, affecting public image • Strategic risk: failure to implement a strategy, or make inappropriate choice • Legislative and regulatory risk: non-compliance, loss due to changes to regulation

13. Dc plans: IPS • Even though plan members make their own investment choices, sponsors are still required to provide an IPS • Sponsor is responsible for the menu of plan options, such as the choice of investment managers (mutual fund companies, type of funds) • Should limit plan members’ investment in company stocks • Sponsor has fiduciary duty to make sure plan members are able to meet their individual objectives, via the menu of options in the DC plan • Each plan member is responsible for defining his/her own objectives and constraints

14. Hybrid pension plans • Most seek to combine the best of both worlds: • DC plans - potentially better benefits than DB formula via higher investment returns • DB plans – ability to link retirement income to previous salary and awards length of service • Plan sponsor makes investment decisions. Use DB component as a minimum guarantee; plan members receive a top-up if investment returns had been favourable

15. Types of foundations • Independent (private or family) • Company sponsored • Operating • Community

16. Types of foundations: independent • Independent (private or family) • Makes grants to aid social, educational, charitable or religious activities • Funds provided by individual or family • Decision making authority lies with donor, family member or independent trustees • Must spend at least 5% of 12-month average asset value, plus expenses to maintain status • Example: The J.W. McConnell Family Foundation

17. Types of foundations: company • Company sponsored • Legally independent, but with close ties to sponsoring company • Funds provided via annual contributions by a for-profit company • Decision-making authority lies with board of trustees, usually controlled by company executives • Must spend at least 5% of average assets, plus expenses to maintain status • Example: HBC Foundation

18. Types of foundations: operating • Operating Foundation • Uses resources to conduct research or provide service (such as running a museum or hospital) • Funds provided by individuals, families, or private sector • Decisions made by an independent board of trustees • Must spend 85% of investment income on operational activities every year. Some also must spend at least 3.3% of average assets per year to maintain status • Example: Heart and Stroke Foundation

19. Types of foundations: community • Community Foundation • Public charities making grants for social services, environmental, health, educational, or religious purposes • Raise money from the general public • Decisions made by Board of Directors • In Canada, we also have an organization called the Community Foundations of Canada • Not subject to minimum annual spending requirement • Example: Hamilton Community Foundation

20. Foundations: constraints • Liquidity needed to provide for spending levels • Time horizon = perpetuity • Legal and Regulatory – must comply with UMIFA or non-US equivalent • Uniform Management of Institutional Funds Act (UMIFA): law governing how much of a foundation or a charity can spend, for what purpose, and how the charity should invest the foundation funds

21. Endowment funds • Some foundations are established with an initial donation • Endowment funds continue to fundraise every year • Foundations have minimum spending requirements. Endowments do not • Endowment spending is for the sponsor organization only. Foundations tend to support a variety of institutions and initiatives • Investment objectives and constraints, however, are fairly similar

22. Endowment fund Example: Harvard • AUM (June 30, 2012): $30.7 billion ($36.9 billion pre-crisis) • Largest endowment in the U.S. • Managed by Harvard Management Co. • Funds about 1/3 of the University’s operating budget • Asset allocation: Advocates the so-called “Endowment Model” (popularized by David Swenson of the Yale Endowment Fund) that de-emphasizes traditional stocks and bonds, early adoption of alternative assets

23. Endowment fund example: harvard • Performance