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Retirement Benefits & Investment Risk Management ACTEX Learning Learn Today. Lead Tomorrow. ACTEX Study Manual for Retirement Benefits & Investment Risk Management Fall 2017 Edition Anna Wong, ASA, MBA ACTEX Study Manual for Retirement Benefits & Investment Risk Management Fall 2017 Edition Anna Wong, ASA, MBA ACTEX Learning New Hartford, Connecticut ACTEX Learning Learn Today. Lead Tomorrow. Actuarial & Financial Risk Resource Materials Since 1972 Copyright © 2017, ACTEX Learning, a division of SRBooks Inc. ISBN: 978-1-63588-055-7 Printed in the United States of America. No portion of this ACTEX Study Manual may be reproduced or transmitted in any part or by any means without the permission of the publisher. YOUR OPINION IS IMPORTANT TO US ACTEX is eager to provide you with helpful study material to assist you in gaining the necessary knowledge to become a successful actuary. In turn we would like your help in evaluating our manuals so we can help you meet that end. We invite you to provide us with a critique of this manual by sending this form to us at your convenience. We appreciate your time and value your input. Publication: ACTEX RB & Investment Risk Management Study Manual, Fall 2017 Edition I found Actex by: (Check one) A Professor School/Internship Program Employer Friend Facebook/Twitter In preparing for my exam I found this manual: (Check one) Very Good Good Satisfactory Unsatisfactory I found the following helpful: I found the following problems: (Please be specific as to area, i.e., section, specific item, and/or page number.) To improve this manual I would: Name: Address: Phone: E-mail: (Please provide this information in case clarification is needed.) Send to: Stephen Camilli ACTEX Learning P.O. Box 715 New Hartford, CT 06057 Or visit our website at www.ActexMadRiver.com to complete the survey on-line. Click on the “Send Us Feedback” link to access the online version. You can also e-mail your comments to [email protected]. TABLE OF CONTENTS Retirement Plan Investment And Risk Management Exam – Fall 2017 Instructional Objective 1 Litterman, Modern Investment Management Ch. 2 1 Ch. 17 5 Ch. 21-24 7 Ch. 27 (pp. 501-505 only) 24 Ch. 28 (pp. 516-520 only) 26 McGill, Fundamentals of Private Pensions, McGill, 9th Edition Ch. 26 – Ch.28 28 Morneau Shepell Handbook of Canadian Pension and Benefit Plans, 16th edition, Ch. 7 35 RPIRM-102-13: Equities in DB Plans – Is the Traditional 60/40 Mix a Dinosaur? 42 RPIRM-103-15: Fiduciary Liability Issues for Selection of Investments 44 RPIRM-104-15: Maginn and Tuttle, Managing Investment Portfolios, Third Edition Chapter 12 through Section 5 only 50 RPIRM-107-13: Reflections on the Efficient Market Hypotheses: 30 Years Later 62 RPIRM-108-13: Introduction and Overview of Retirement Plan Investments 63 RPIRM-132-14: CAPSA, Guideline No. 6, Pension Plan Prudent Investment Practices Guideline ` 67 RPIRM-133-14: CAPSA, Guideline No. 7, Pension Plan Funding Policy Guideline 69 RPIRM-142-17: Morningstar Target-Date Fund Landscape, 2016, pp. 1-9 and 13-28 only 71 RPIRM-143-17: How to Address Due Diligence Concerns From Sponsors 77 RPIRM-144-17: Patient Capital, Private Opportunity: The Benefits and Challenges of Illiquid Alternatives 80 RPIRM-145-17: An Introduction to Infrastructure as an Asset Class 83 Instructional Objective 2 RPIRM-110-13: Plan Sponsor Guide to Liability –Driven Investing 1 RPIRM-111-13: Mind the Gap: Using Derivatives Overlays to Hedge Pension Duration 2 RPIRM-112-13: Asset/Liability Modeling and Asset Allocation for Pension Plans 7 RPIRM-114-13: Top 10 Myths about Liability-Driven Investing 18 RPIRM-115-13: Asset/Liability Management in the Public Sector 20 RPIRM-116-13: Financial Economics and Actuarial Practice 23 RPIRM-136-15: Longevity Risk Management: New Tools for Defined Benefit Pension Plans, Coughlan, Institutional Investor Journals, Fall 2013 31 RPIRM-138-16: FSCO’S IGN 001 – Buy in Annuities for Defined Benefit Plans 35 RPIRM-139-16: FSCO’s IGN 002 – Prudent Investment Practices for Derivatives 37 RPIRM-140-16: OSFI’s Policy Advisory #2014-002- Longevity Insurance and Longevity Swaps 42 RPIRM-146-17: The Pension Risk Transfer Market at $260 Billion 46 RPIRM-147-17: Charting the Course: A Framework To Evaluate Pension De-Risking Strategies 48 RPIRM-148-17: Key Rate Durations: Measures of Interest Rate Risks 59 RPIRM-149-17: Practical De-Risking Solutions: Asset Duration and Interest Rate Risk 68 RPIRM-150-17: De-risking in a Low Interest Rate Environment 70 Can Pensions Be Valued as Marketed Securities, Bader, Pension Section News, June, 2009 71 Instructional Objective 3 RPIRM-120-13: The Case Against Stock in Public Pension Plans 1 RPIRM-121-13: The Case for Stock in Pension Funds 8 RPIRM-122-13: Guaranteed Trouble: The Economic Effects of the Pension Benefit Guaranty Corporation 11 RPIRM-123-13: Risk Management and Public Plan Retirement Systems (appendix background only) 13 RPIRM-124-13: Bader and Gold’s Rebuttal to The Case for Stock in Pension Funds 21 RPIRM-125-13 :The Pension Bomb 22 RPIRM-126-13: Funding Regulations and Risk Sharing, pp. 15-24 23 RPIRM-127-13: Retirement Benefits, Economics and Accounting: Moral Hazard and Frail Benefit Designs 25 RPIRM-128-13: The Impact of the Financial Crisis on Defined Benefit Plans and the Need for Counter-Cyclical Funding Regulations, excluding appendices 29 RPIRM-135-17: CAPSA Guideline No.4 Pension Plan Governance Guidelines and Self-Assessment Questionnaire 30 RPIRM-141-16: Chapter 9 of Recreating Sustainable Retirement: Resilience, Solvency and Tail Risk 34 Corporate Pension Risk Management and Corporate Finance SOA August 2015 39 Adequate Funding for a Pension Plan, Sze, Pension Forum 46 “Pension Funds: Company Manager’s View”, SOA, June 2003, Exlely & Mehta 48 Pension Actuary’s Guide to Financial Economics; Pension Arbitrage Example Worksheet 53 _________________________________________________________________________________________________ Objective 1 – 1 MODERN INVESTMENT MANAGEMENT (LITTERMAN) CH 2 - THE INSIGHTS OF MODERN PORTFOLIO THEORY I. THE ADVERT OF FINANICAL ECONOMICS (FE) 1. Axiom: More risk, more return 2. Risk a) quantifies the probability and size of loss. A loss => postponed/ no consumption b) Loss is a random event c) may generate loss => impact net worth => reduce risk appetite in the future => limited future growth, and reduced risk appetite d) is a scarce resource 3. A Investment process helps investor prepare for assuming risks 4. Investors have limited risk appetite => needed to budget it wisely a) Goal: max return per unit of risk (Micro-economics) i) => same utility per dollar spent on every purchase ii) => same return per unit of portfolio risk iii) If (return/risk)A > (return/risk)B, then invest (return/risk)A and drive down (return/risk)A until they equalize 5. Basics a) E(T) = E(T1) + E(T2) +... + E(Tn), linear relationship b) Return can be compounded c) Var(X + Y) = Var(X) + Var(Y) – 2Cov(X,Y), risk holds non-linear relationship i) Play around the correlation term to lower the risk through diversification d) Diversification can either i) Increase the return given the same level of risk ii) Or decrease the overall portfolio risk e) Loosely speaking, assets roughly independent, risk compounds ~ sqrt (Time), while expected returns is linear over time i) Assume 0.01% of risk generates 0.02% of return per day. ii) Take 0.01% risk a day over a long term (e.g. 1 yr) => sqrt(252 trading days * 0.01%) ~ 16%/yr =>252 days *0.02% ~ 5% return/yr iii) However, take 16% in ONE day, generates 0.02%*16 = 0.32% of expected return (simple proportion), this is the math for long term investors 6. Modern Portfolio Theory a) Insight – through the size, control the expected return of targeted asset in relation to the impact on the risk of the total portfolio b) Hard to quality return and variance (historical/ forward-looking definition, etc) c) Focus on the correlation among assets, how one value move up and down relate to others d) Avoid concentration of risk => diversification => look at overall risk profile! i) Quantify how much a risk budget that an investment should consume e) An application. A business owner sells his business, obtain proceeds, and park in money market fund for a long time before making further decision ________________________________________________________________________________________________ ACTEX Learning Retirement Benefits & Investment Risk Management _________________________________________________________________________________________________2 – Objective 1 i) Bad idea – too much wealth in unproductive fund (negative real return after tax) too long ii) better fully diversify the proceeds and earn a better return f) Process of helping your client i) Identify risk tolerance ii) Experience reveals that the client’s risk appetite swings from the extreme risky (business) to virtually riskless (money market fund), clients go to either extreme, seldom in between. Avoid this situation. g) A good investment decision and a good investment outcome do not necessarily have a cause-and-effect relationship. A good outcome is due to luck in short term. h) Risk management framework i) Identify the sources of risk ii) Deploy risk effectively max Ri, Ri =(return i / unit of portfolio risk), i = ith assets. How to measure risk? Many definitions, e.g., volatility, mean-absolute deviation, etc... iii) Find out your risk tolerance => fix the risk you accept, then max return. If risk budget isn’t fixed, you can always increase return by adding risks. iv) Adjust the size, then improve returns, control the risk v) Building blocks - diversifier – asset relatively independent of others, risky by itself, little risk to the overall portfolio vi) People ask how to invest?? Proper thinking should be measuring and monitoring the universe of assets, how much to invest to improve return and reduce overall risk. vii) Good stuff are => add less risk to the portfolio => use up less risk budget => buy more! (Heuristic meaning of the mathematics of the portfolio theory) i) Process of optimizing portfolio i) Identify all assets in your universe ii) Determine portfolio risk tolerance, fix risk budget iii) Recall, Ri =(return i / unit of portfolio risk), i = ith assets.
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