The Ultimate Guide to Tackling IPS Questions - Institutional Investors

Sophie · April 2013

Since @lakshya25 's epic question on this a few weeks ago, which I only answered for Individual Investors, I thought I'd follow up with the various RRTTLLU summaries for Institutional Investors, e.g. Pension funds, Life / non life insurance, Foundation or Endowments and Banks.

So Level 3 candidates out there ( @AjFinance, @MattJuniper, @artyeasel, @jimmyg, @lakshya25, @marc etc) - stay tuned for updates on this over the next few days/weeks, I'm hoping this will be handy when tackling the darn practice IPS questions.

In fact, I can't remember what IPS or GIPS actually stand for anymore, as after a while (especially when you review them for the nth time), they morph into (Generally) Impossible Piece of Sh*t(s)...

Sophie · April 2013

PENSION PLANS

Before we go into the usual RRTTLLU details, make sure you know the differences between Defined Benefit (DB) and Defined Contribution (DC), for employer vs. employee. I'm not gonna elaborate on that here, but why not you have a go at explaining the differences in the comments below?

Usually DB pensions are the focus in IPS questions, so that's what I'll discuss here:

DB Pensions Overview

Overall objective: Pension assets >= pension liabilities
Plan surpluses is the excess of pension assets over pension liabilities
Underfunded plans have negative surplus and a lower ability to take risk, but may have a higher willingness to take risk

Risk & Return - things you should observe

Sponsor financial status and profitability
- Indicated by balance sheet - debt-to-asset & other leverage ratios
- Low debt ratios and high profitability indicates higher ability to take risk
Sponsor & pension fund common risk exposure
- Correlation between the firm & pension’s asset returns
- High correlation indicates lower risk tolerance
Plan features
- Early retirement & lump sum payments increase liquidity requirements and lower risk tolerance
Workforce characteristics
- Age & ratio of retired:active - the younger and the more active workforce, the higher the risk tolerance

Constraints

Time horizon - affected by workforce age, ratio of active:retired, whether plan is going concern
Liquidity - affected by number of retired lives, sponsor contributions & plan features
Legal & regulatory factors - in US ERISA governs DB plans, pension fund assets must be invested for the sole benefit of plan participants
Unique circumstances
- ERISA requires sponsors to exercise appropriate due diligence when investing
- Possible requirements/restrictions in some asset choices

lakshya25 · April 2013

In response to

Sophie said:
why not you have a go at explaining the differences in the comments below?

It's all in the name ! Defined Benefit - Plan sponsor's liability is in terms of the benefits.(a retirement income based on certain criteria,may adjust for inflation,pay structure etc.) while Defined Contribution- Only the contribution is promised,no financial liability of the plan sponsor.DC Plans are of two types-1.Sponsor Directed-Almost same as DB Plan & 2.Participant Directed- Most common DC plan.
Key differences between DB & DC plans :

-->Risk of investing
DC Plan - Borne by the plan participants (employees).DB PlanEmployer bears this risk but employees face the risk of early termination of the plan(by the employer)
-->Record Keeping& Investment Returns
DC Plan - Individual-account basis.This induces portability DB Plan-Firm level.

Sophie · April 2013

Nice one @lakshya25! How is tackling the IPS coming along?

lakshya25 · April 2013

@Sophie,I have done the Schweser and curriculum EOC questions but I had to see the answers for everything that was asked and while checking my answers I suffer from confirmation and hindsight biases as well !

Sophie · April 2013

No worries @lakshya25, I felt the same with L3 practice questions/papers. Reviewing the answer for essay section is especially tough as you don't know if you'd got them right. The only sure way to know is to assume your answers must be identical to the model answer, which is 99% never the case (+ stressful). So don't fret, try them, check against the answer, understand why yours and theirs differ, and move on.

AjFinance · April 2013

This is great @Sophie. Just checked this. I hadn't got the notification. @Zee it happened again.

Sophie · April 2013

My bad @Ajfinance. I typed it near the bracket "(" without spacing, and somehow it doesn't recognise it even though I've amended it. But you get the new comment/new topic colour notifications on the side too!

AjFinance · April 2013

@Sophie I know this is a thread for discussing Institutional Investors, but I had this question on individual IPS. I was going through the 1999 exam paper, and did get some points right on that. However, what bothered me is,

1. The guideline answers are totally different to what I wrote. While I stuck to pointing out the facts in the IPS, the guideline answers try to bring in additional points from other parts of the IPS as well. I know that its not the way one should write in the exams. But its just so annoying ~X( . How do you gauge your performance?

2. The guideline answer did not include numerical facts for the return objective. Just a long description of client circumstance.

3. The Unique circumstances, according to the guidelines included Low Basis Stock issues. It was also included in Liquidity. I included it only in Tax Considerations.

4. Also, do you include or mention the prospective inheritance of a client in return requirements, if they have explicitly mentioned that it shouldn't be considered a part of the Asset base. Or would mentioning it in the Unique circumstances suffice?

The questions are related to the 1999 Morning session. (The Muellers)

https://sites.google.com/site/cfalevel3examprep/extras/practice-exams

Sophie · April 2013

Hi @Ajfinance,

1) there would be many ~X( moments when taking trying out Level 3 essay section, I'd mentioned this before on how it's not entirely clear on how to gauge your accuracy of your answer unless you follow word for word. I experienced this too and I didn't fret too much as long as I 'roughly' got the content that answers the question. I also tend to write quite briefly compared to the answer. For example, if your answer contained "total return approach" and explain in your own words why you chose your recommendation, it should be fine. I'm certain that in the exam they allow a certain band of answers to go through, as long they apply key principles of what you've learnt.

2) If you added numerical facts (and they are correct), I'd think that should be a plus to strengthen your answers. I wouldn't worry about that.

3) I think this is ok. In future if you think one point is applicable in at least one section, feel free to elaborate in one (tax), and reference it (only the relevant parts briefly) in another section (unique consideration).

4) IPS in general is more of putting yourself in the shoes of a investment advisor. So if you think it is relevant, but although the client explicitly mentioned that it shouldn't be considered a part of an asset base, you could put a brief note in return requirement mentioning that (and why you think it may be beneficial for the client). I'm afraid there's no hard and fast rule here, it depends on the question. Try not to fall into the trap of mentioning it in every section either. Only the relevant ones. In the case of Mueller, I think the answer is right to highlight that excluding that huge capital base would alter the return objective (as it relates to that section), but acknowledge that the client's wish to do so.

Sorry I couldn't be more specific, but I hope these alleviate some of your concerns. This is the curve ball of the essay bit! I can't give a hard and fast rule except the IPS guide of what to watch out for... Let me know if you have more questions anyway!

AjFinance · April 2013

Thanks @Sophie. Yup, more questions on the way for sure

Sophie · April 2013

Ok, 2nd instalment, this time on Foundations & Endowments.

FOUNDATIONS

Types of foundations:

Foundation	Purpose	Source of Funds	Annual Spending Requirement
Independent	Grants to charities, edu, social orgs etc	Private (individual or group)	5% of assets, expenses cannot be counted towards spending amount
Company-sponsored	Same as independent, but can be skewed towards corporate interests	Corporate	5% of assets, expenses cannot be counted towards spending amount
Operating	Sole purpose of funding a e.g. museum, zoo, public library, or ongoing research	Private (individual or group)	Must spend at least 85% of dividend & interest income for own ops, also maybe 3.33% of assets
Community	Fund social, edu, religious etc	General public	No requirements

Objectives

Risk - foundations usually more aggressive than pensions (no contractual liabilities)
Return - minimum return equal to the required payout plus expected inflation & fund expenses

Constraints

Time horizon - except for special foundations, infinite time horizons
Taxes - unrelated business income is taxable at regular corporate tax rate
Legal & regulatory - most US states adopted UMIFA regulatory framework, otherwise Prudent Investor Rule
Liquidity - same as return
Unique circumstances - depending on foundation

ENDOWMENTS

Differences from foundations:

Created to act as funding for an institution (e.g. university)
Intent is to perpetually preserve asset principal value & use income generated for SPECIFIC activities
UBIT (unrelated business income tax) applies for asests donated to endowment that generates unrelated business income (vs corp tax for foundations)
Investment objectives & constraints very similar to foundations
RR-TTLLU is almost the same as foundations - spending limits around 5%

Sophie · April 2013

How are all our dear Level 3-ers out there doing?

AjFinance · April 2013

@Sophie Last bit of revising. Also, wading through EOC questions and trying to get a feel of the Essay format. I must admit that I feel pathetic after going through the essay section of a couple of past exam papers. Maybe thats something to do with the fact that its very old (1999 & 2000).

I need to squeeze in the Blue box examples in between practice exams once I start taking them. Its not easy to remain unfazed at the moment, but I guess thats how it should feel at this point of time. #:-S

Sophie · April 2013

@AjFinance I guess that's what I was trying to explain but now you know how I felt! The uncertainty of the essay bit catches all of us out, but it's ok and completely normal. Just gotta plough through the practice questions! Good to hear that things are progressing well, it's the last one!

lakshya25 · April 2013

@Sophie, My state is like that of a trekker who has just got to know about the actual height of mountain,The problem is that just climbing up isnt enough,you have to get down to the starting point and then start the trek again !! These summaries help us find the way

Sophie · April 2013

Hi @lakshya25, I know what you mean! Sometimes it's better to just keep walking up without looking at how far the peak is, taking one step at a time, so that it doesn't overwhelm you. On the bright side this is the last hurdle to charterholdership! What do you do now @lakshya25 and why did you choose to take CFA then?

No problem on the summaries, it's all I can do to help on the essay side as it's hard to ask questions on those. There's another one coming later today on life and non life insurance...

Sophie · April 2013

Hello all! Here's the 3rd instalment on the world of Life and Non Life Insurance...

LIFE INSURANCE
Requirements of life insurance company investments

Objectives

Risk - considered quasi-trust funds. National Association of Insurance Commissioners (NAIC) directs insurance companies to maintain asset valuation reserve (AVR) as a cushion against substantial losses
Return - built-in minimum return rates based on individual insurance policies

Constraints

Time horizon - shorter as duration of liabilities decrease (due to increased interest rate volatility, competition). Individual segments also have separate time horizons
Taxes - regular taxable entities. Investment income divided into 2 parts:
- policyholder’s share (not taxed)
- funds transferred to surplus (taxed)
Legal & regulatory - heavily regulated primarily at state level

Eligible investments
Valuation methods
Prudent Investor Rule - each investment must be analysed from portfolio perspective rather than standalone basis

Liquidity - 3 primary concerns

disintermediation (annuity holders withdraw prematurely)
asset-liability mismatch (underfunded, interest rate risk)
asset marketability risk (can’t sell, large bid-ask spreads)

Unique circumstances - depending on factors such as

Diversity of product offerings
Company size
Level of asset surplus

NON LIFE INSURANCE

How are they different from life insurance companies?

Greater uncertainty than life insurance companies (higher claims frequency), liability durations tend to be shorter.
However not as interest rate sensitive as do not pay periodic returns.

Objectives

Risk tolerance
- Related to liquidity constraints (relatively uncertain) - average to below average risk tolerance
- Inflation risk also a concern (due to replacement cost coverage)
Return objectives

Maximise return on fixed income portfolio to immunize claims
Use returns from equity portion of portfolio to grow surplus
Use surplus portfolio to provide funds for the unexpected, large liability claims

Return is influenced by

Competitive pricing
Profitability
Growth of surplus
After-tax returns
Total return

Constraints

Time horizon - shorter than life companies due to shorter liability duration
Taxes - regular taxable entities
Legal & regulatory - less strict than for life companies. Asset valuation reserve is not required, but risk-based capital (RBC) requirements in place
Liquidity - relatively high due to uncertainty of claims
Unique circumstances - mainly influenced by types of policies (e.g. auto vs home vs pet)

lakshya25 · April 2013

Sophie said:
What do you do now @lakshya25 and why did you choose to take CFA then?

Fresh MBA grad,going to join one of theBig4 as analyst.I decided to take CFA because I am new to the world of finance and wanted to expand my horizon,to show that I am really interested in finance and all that rot !

Sophie · April 2013

Oh wow, good for you @lakshya25! MBA plus a CFA is a super achievement, well done!

Sophie · May 2013

quick question to Level 3 people out there - @Ajfinance, @lakshya25, @Marc, @sankrutimehta, @Mattjuniper, @padniaki ... does this year's Level 3 curriculum include the concept of Leverage-adjusted duration gap (LADG)?

padniaki · May 2013

Not that I recall, @sophie. And I've gone through (almost) all of the curriculum twice.

Sophie · May 2013

Ok thanks @padniaki. Seems like mine's outdated then. But there is banks (under institutional investors) is still there isn't it?

padniaki · May 2013

Sophie said:
But there is banks (under institutional investors) is still there isn't it?

Yep.

padniaki · May 2013

Whoops, I take that back...leverage-adjusted duration gap is definitely in the material. Study Session 5, Reading 15, Page 431, in the section about Banks as institutional investors. Sorry if I mislead anyone.

Sophie · May 2013

) Thank you for the confirmation @padniaki! I shall put my banks IPS stuff down sometime today then. I think it's just one of those lost-in-outerspace concept that may bite in the exam as it received so little attention, but yet in the syllabus

Sophie · May 2013

Hi all! Here's the 4th and last instalment on the world of Banks...

BANKS
Security portfolio usually comprised of residual of funds (i.e. excess funds that have not been loaned out)

Objectives

Return - usually to earn a positive interest spread (i.e. above risk-free)
Risk - determined in an asset-liability framework, have to meet bank liabilities. therefore usually below average risk tolerance

Leverage-adjusted duration gap (LADG) is used to measure of interest rate sensitivity of the bank’s equity
LADG = D[assets] - (L / A) D[liabilities], whereby

D[assets / liabilities] = asset or liability duration
L / A = leverage measure = mkt value of liabilities / mkt value of assets

For an increase in interest rates (vice versa applies):

if LADG < 0, mkt value of equity rises
if LADG > 0, mkt value of equity falls
if LADG = 0, mkt vale of equity immunised

Constraints

Time horizon - driven by its liabilities (less than ten years)
Taxes - regular taxable entities
Legal & regulatory - highly regulated, risk-based capital guidelines require capital reserves of 8% against most loan categories. Also have to pledge collateral (e.g. short-term treasuries) against certain uninsured public deposits
Liquidity - high liquidity requirements due to nature of deposit withdrawals, loan demand & regulation
Unique circumstances - varies, e.g. loan concentrations, inability to sell loans

sankrutimehta · May 2013

@sophie, @padnaiki: its there in the syllabus..but none of the papers i solved had any mention of it!!

Sophie · May 2013

yea @sankrutimehta - it is rare. But still there, so thought I'd cover it in the notes just in case! Hope all's well

sankrutimehta · May 2013

ofcoz, won't harm anyways..its easier to do anyway

AjFinance · May 2013

@Sophie, I came across a few Risk Objective answers in Schweser Book 2.

For example:

Ability : Above average
Willingness: Average
Overall : Average. Need to reconcile differences.

I know its been stated many times that bullet points are sufficient. However, its hard to believe that you can get 2 points each for the above answer. I usually try to back my answer with a statement. Is the above format sufficient? Provided that the question does not ask to justify the reason.

They have similar answers for other questions as well. At times I notice I've written a couple of sentences whereas the guideline answer is just 3-4 words. 8-|

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