Question

You are being interviewed for a job as a portfolio manager at an investment counseling partnership. As part of the interview, you are asked to demonstrate your ability to develop investment portfolio policy statements for the clients listed below:

a. A pension fund that is described as a mature defined benefit plan, with the workforce having an average age of 54, no unfunded pension liabilities, and wage cost increases forecast at 5% annually.

b. A university endowment fund that is described as conservative, with investment returns being utilized along with gifts and donations received to meet current expenses, the spending rate is 5% per year, and inflation in costs is expected at 3% annually.

c. A life insurance company that is described as specializing in annuities; policy premium rates are based on a minimum annual accumulation rate of 7% in the first year of the policy and a 4% minimum annual accumulation rate in the next five years.

List and discuss separately for each client described above the objectives and constraints that will determine the portfolio policy you would recommend for that client.

Short answer

As below

Step-by-step solution

Explanation of Mature defined benefit plan ‘a’

Objectives:

Return requirement: Return must exceed fund’s assumed rate of interest partly based on the anticipated 5% rate for wage cost increase.

Risk tolerance: Tolerance for risk taking up to payout limits. Hence the asset mix of the portfolio should have fixed income assets maturity of high quality.

Constraints:

Liquidity: Proximities of payouts required high liquidity and this high liquidity may limit returns.

Time horizon: Maturity of plan would stress upon a short to intermediate term time horizon which may limit returns.

Tax considerations: Non-taxable

Regulatory and legal: Federal and state laws will affect mix and quality.

Explanation on the conservative endowment fund

Objectives:

Return requirement: Return must exceed 5% spending rate with 3% inflation. Inflation consideration would require long term growth.

Risk tolerance: With 8% of return objective, moderate level of risk tolerance may be required but the certainty of return will temper this risk violence.

Constraints:

Liquidity: Requirement of liquidity for budget needs may limit returns.

Time horizon: Budget considerations would require funding immediate needs but inflation considerations require attention to longer term growth horizon.

Tax considerations: Non-taxable

Regulatory and legal: State regulation.

Explanation on the LIC specializing in annuities

Objectives:

Return requirement: Return must exceed new money rate by sufficient margin to meet expense and profit objectives.

Risk tolerance: With 7% of new money return objective, moderate level of risk tolerance may be required but the certainty of return and avoidance of reinvestment rate risk mandates the risk of an immunized fixed income portfolio.

Constraints:

Liquidity: Requirement of liquidity for surrender and rollover of funds to protect against locking in non-competitive rates.

Time horizon: Shorter than normal time horizon because annuities are subject to dis-intermediation.

Tax considerations: A minor consideration because competition will require high rate of return, most of which would accumulate for policy holders and would not be taxed.

Regulatory and legal: Significant State regulation will affect mix and quality.