Chapter 22, Problem 1PS

a.

Summary Introduction

To determine:

To develop an investment policy statement for a pension fund described as a mature defined benefit plan with the workforce having average age of 54 years, no unfunded pension liabilities and wage cost increase forecast at 5% annually.

Introduction:

An investment policy statement (IPS) is defined as a document drafted for a portfolio manager by his client that states general principles for investment for the managers. This statement gives the broad investment objectives and constraints of a customer and illustrates the strategies to be formulated by the manager for meeting these objectives.

Answer to Problem 1PS

The objectives and constraints related to pension fund are mentioned.

Explanation of Solution

Given Information:

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

In defined benefit plan, investor receives an assured pension amount irrespective of the return that is generated by the pension fund. In this kind of retirement plan, the total value of pension amount or the retirement benefit is recognized in advance.

The two major objectives of pension fund are to increase its return requirements and risk tolerance. If the pension fund's actual return exceeds the assumed actuarial return, the shareholders will reap profits. The risk tolerance level of the pension fund depends on proximity of payouts.

Constraints usually co-relate with investor circumstances. These circumstances include liquidity, investment horizon, regulations and tax consideration. For pension fund, if the pension fund is young, the liquidity should be low and vice versa. Investment horizon should be long and pension fund is not liable to any tax rates.

b.

Summary Introduction

To determine:

To develop an investment policy statement for a university endowment fund described as conservative, with investment return being utilized along with gifts and donations to help meet annual expenses. The spending rate is 5% per year and inflation in costs is expected at 3% annually.

Introduction:

An investment policy statement (IPS) is a document drafted for a portfolio manager by his client that outlines general rules for investment for the manager. This statement gives the broad investment objectives and constraints of a customer and illustrates the strategies to be formulated by the manager for meeting these objectives.

Answer to Problem 1PS

The objectives and constraints related to university endowment fund are mentioned.

Explanation of Solution

Given Information:

Given that a university endowment fund described as conservative, with investment return being utilized along with gifts and donations to help meet annual expenses. The spending rate is 5% per year and inflation in costs is expected at 3% annually.

An endowment fund is usually created by a foundation. The foundation makes withdrawals from the capital invested in the endowment fund. Such capital is used by the University for its general or operating needs. They are normally funded by donations.

The two major objectives of endowment fund are to determine its return requirements and risk tolerance. The return requirement is henceforth determined by current income needs and need for assets growth to maintain the real value. As given in the question itself, risk tolerance is generally conservative.

Constraints usually co-relate with investor circumstances. These circumstances include liquidity, investment horizon, regulations and tax consideration. Endowment funds require low level of liquidity and long time horizon with no rate of tax applicable.

c.

Summary Introduction

To determine:

To develop an investment policy statement for a life insurance company described as specializing in annuities, policy premium rates are based on a minimum annual accumulated rate of 7% in the first year of policy and a 4% minimum annual accumulation rate in the next five years.

Introduction:

An investment policy statement (IPS) is a document drafted for a portfolio manager by his client that outlines general rules for investment for the manager. This statement gives the broad investment objectives and constraints of a customer and illustrates the strategies to be formulated by the manager for meeting these objectives.

Answer to Problem 1PS

The objectives and constraints of a life insurance company described as specializing in annuities needs to be mentioned.

Explanation of Solution

Given Information:

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

A life insurance company invests to hedge their liabilities, which are defined by their own policy.

The two major objectives of insurance company are to determine its return requirements and risk tolerance. The return requirement should exceed new money rate by sufficient margin to meet the expenses and profits. Also for insurance company, actuarial rates are necessary to be determined. As given in the question itself, risk tolerance is generally conservative.

Constraints usually co-relate with investor circumstances. These circumstances include liquidity, investment horizon, regulations and tax consideration. Life insurance requires low level of liquidity and long time horizon with the rate of tax applicable.