Mutual Fund and Pension Fund Management Chapter 18
Are asset pools
Managed by professional investment advisors
Owned by investors who are shareholders
Can have assets invested in
Money market instruments
Any combination of the above
Include 95% of professionally managed assets
Mutual Fund Types as a Percentage of Total Assets Municipal Bond Funds, 5% Hybrid Funds, 6% Stock Funds, 50% January 2004 Tax-free Money Market Funds, 4% Taxable Money Market Funds, 23% Taxable Bond Funds, 12%
Mean Monthly Return = 2.03 STD of Monthly Return =3.27% At the 95% confidence interval based on a normal distribution, the VAR is 2.03% - (1.96)(3.27) = - 4.38% There is 2.5% probability of losing no more than $43.80 a month for a $1,000 investment Value at Risk (VAR) for XYZ Fund
Monthly Mean Excess Return = 1.60% Monthly Standard Deviation of Excess Return = 3.28% Sharpe Ratio Annually = 0.49 × the square root of 12 = 1.69 Sharpe Ratio for XYZ Fund
Annualized Mean Excess Return for the Fund = 19.25% Annualized STD of Excess Return for the Fund = 11.36% STD of Excess Returns for the S&P 500 index = 15% M-Squared Measure For XYZ Fund
Divides mutual funds into four categories
Domestic stock funds
International stock funds
Taxable bond funds
Municipal bond funds
Calculates its own return & risk ratios
Fund Rating = Return Score – Risk Score
Funds are ranked by this rating within asset category
Mutual Fund Regulations
Investment Act of 1933 mandates specific disclosures
Securities Act of 1933 sets out antifraud rules
Investment Act of 1940
Requires funds to register with SEC
Limits financial leverage of funds
Established short 3’s test & diversification test
New Regulations Since 1990
National Securities Markets Improvement Act of 1996
In 1998, SEC streamlined disclosure of information required in a prospectus
Sarbanes-Oxley Act of 2002
Late 2003 - 2004
The Mutual Fund Scandals
Proposed New Regulations in 2004
SEC Commission Actions
State Regulators’ Mutual Fund Protections Principles
Current and Proposed Changes by the Mutual Fund Industry
Private pension plans
Types of plans:
Defined benefits (DB)
Defined contribution (DC)
Meet income obligations through the accumulation of assets
Federal pension plan – Social Security is
the largest federal plan.
a “pay-as-you-go” system.
State and local government plans
Defined Benefit Plans
Promise a specified benefit or income stream at retirement.
The employer bears all the investment risk.
Employer makes contributions based on the age of the plan participant, the level of benefits promised, and the plan’s expected investment return.
ERISA of 1974 mandates that plans be fully funded.
A plan is fully funded if the present value of its assets equals the present value of the future pension obligations minus the present value of future contributions.
Fund liabilities are estimated using actuarial methods.
If a company fails,
Existing pension benefits may be reduced or eliminated
Future (accruing) pension benefits may be lost
Pension Benefit Guaranty Corporation (PBGC)
Established to assure payment of up to 85% of the vested benefits if a defined benefits pension fund fails
May fail due to bankruptcy
Defined Benefit Plans (continued)
Defined Contribution (DC) Plans
Per-employee contributions are specified
Control over investment of contributions lies with the employee
Retirement income depends on
the plan’s investment returns (how wisely the employee chooses to manage this investment fund)
the amount of funds invested in retirement accounts
401(k) plans are employer-sponsored DC plans.
Individual retirement accounts (IRAs)
Can be set up by individuals
Provide another investment vehicle to build retirement funds
allow anyone to make a contribution regardless of whether they actively participate in a retirement plan.
Contributions are limited to $2,000 and are not tax-deductible.
Keogh or H.R. 10 plans
Allow self-employed individuals and proprietors with small businesses to set up individual DC plans for themselves and their employees
Defined Contribution (DC) Plans
What Is the Pension contract Between All Stakeholders?
Employer with DC plan
Takes investment risk
Reaps investment gains
Investment gains provide 80% of pension plan wealth
Employer contributions provide only 20%
Greater investment gains reduce contributions which increases corporate profits
Fund Performance Adjusted for Risk and Management Costs
Asset mix policy and implementation determined by
Nature of pension liabilities
Risk tolerance of managers
Funded status of pension plan
Prospects for long-term capital markets
RANVA (risk-adjusted net value added)
Measures performance compared to passive management
Sows passive management (index fund) superior in some cases
Decision depends on:
performance return of the passive policy
management cost to follow an active policy
additional risk entailed in following an active strategy.
Other active management considerations include:
fund managers investment style;
the use of managed futures; and
the timing and frequency of asset rebalancing.
Active or Passive Asset Allocation Policy?
Optimal Allocation for Pension Assets
Funds can invest in
Oil and gas
Commodities, derivatives, managed futures, etc
Diversity is highly advantageous
Active management more complex
Tactical asset allocation
Should pension fund smoothing be used?
Smoothing is used to achieve a return equal to the assumed discount rate used to project pension benefit obligations.
The trade-off is a reduction in a plan’s risk at the expense of higher potential returns.
Techniques employed include:
guaranteed investment contracts (GIC);
dedicated bond portfolios; and
portfolio insurance or insured asset allocation.
Management Issues (continued)
Who Owns Surplus Pension Assets?
Took view they belonged to stockholders
Removed surplus funds from plans
Companies with overfunded pension plans became merger targets
Congress passed a bill
Taxes surplus withdrawn that reverts to employer
Provided an impetus to reduce contributions rather than build up surpluses
Pension Plan Underfunding and the Pension Funding Equity Act of 2004
Pension plan adequacy depends on
Discount rate used to find PV of liabilities
Yield on fund’s assets over time
Pension Funding Equity Act of 2004
Provided temporary relief to corporations
Provided some support for PBGC
The Pension Fund Crisis in 2004
Pension fund failures
Enron, WorldCom, Bethlehem Steel, National Steel
Corporate failure causes pension fund failure
Pension fund underfunding in early 2004
Single employer $350 billion
Multiemployer 100 billion
Solvency of Pension Benefit Guaranty Corporation is in jeopardy
Hybrid Plans Including Cash Balance Plans (CBP)
They are like DB plans in that:
the defined benefit is an agreement to a minimum rate of interest on employees’ accounts;
they are insured by PBGC and are subject to ERISA regulations; and
benefits are generally paid out in lump sums.
CBPs are similar to DC plans in that:
the employer contributes a minimum percentage of pay to the employees’ retirement accounts;
employees receive regular account statements of benefits; and
employees can take the accrued benefits with them if they leave the employer.
The advantages of CBPs to an employer are:
lower administration costs;
lower legal exposure; and
lower cost of educating employees.
Cash Balance Plans (continued)
employer continues to bear the investment risk
Carry the risk of inflation
Risk outliving the accrued benefits of their plans (like in the DC plan)