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The Ultimate Guide to Tackling IPS Questions - Institutional Investors

SophieSophie Posts: 2,036 Sr Partner
edited April 2013 in CFA Level III
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)...



    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
    1. 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
    2. Sponsor & pension fund common risk exposure
      • Correlation between the firm & pension’s asset returns
      • High correlation indicates lower risk tolerance
    3. Plan features
      • Early retirement & lump sum payments increase liquidity requirements and lower risk tolerance
    4. Workforce characteristics
      • Age & ratio of retired:active - the younger and the more active workforce, the higher the risk tolerance
    1. Time horizon - affected by workforce age, ratio of active:retired, whether plan is going concern
    2. Liquidity - affected by number of retired lives, sponsor contributions & plan features
    3. Legal & regulatory factors - in US ERISA governs DB plans, pension fund assets must be invested for the sole benefit of plan participants
    4. Unique circumstances
      • ERISA requires sponsors to exercise appropriate due diligence when investing
      • Possible requirements/restrictions in some asset choices
  • 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.

  • Nice one @lakshya25! How is tackling the IPS coming along?
  • lakshya25lakshya25 Posts: 22 Associate
    edited 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 ! :(
  • 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.
  • This is great @Sophie. Just checked this. I hadn't got the notification. @Zee it happened again.
  • 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!
  • @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)
  • 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!
  • Thanks @Sophie. Yup, more questions on the way for sure ;)
  • Ok, 2nd instalment, this time on Foundations & Endowments.


    Types of foundations:
    FoundationPurposeSource of FundsAnnual Spending Requirement
    IndependentGrants to charities, edu, social orgs etcPrivate (individual or group)5% of assets, expenses cannot be counted towards spending amount
    Company-sponsoredSame as independent, but can be skewed towards corporate interestsCorporate5% of assets, expenses cannot be counted towards spending amount
    OperatingSole purpose of funding a e.g. museum, zoo, public library, or ongoing researchPrivate (individual or group)Must spend at least 85% of dividend & interest income for own ops, also maybe 3.33% of assets
    CommunityFund social, edu, religious etcGeneral publicNo requirements
    • Risk - foundations usually more aggressive than pensions (no contractual liabilities)
    • Return - minimum return equal to the required payout plus expected inflation & fund expenses
    • 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


    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%

  • How are all our dear Level 3-ers out there doing?
  • @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
  • @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!
  • @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 :)
  • 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...
  • Hello all! Here's the 3rd instalment on the world of Life and Non Life Insurance...

    Requirements of life insurance company investments

    • 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
    • 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


    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.
    • 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
    • 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)
  • 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 ! :p

  • Oh wow, good for you @lakshya25! MBA plus a CFA is a super achievement, well done!
  • SophieSophie Posts: 2,036 Sr Partner
    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)?
  • Not that I recall, @sophie. And I've gone through (almost) all of the curriculum twice.
  • SophieSophie Posts: 2,036 Sr Partner
    Ok thanks @padniaki. Seems like mine's outdated then. But there is banks (under institutional investors) is still there isn't it?
  • Sophie said:

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


  • 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.
  • SophieSophie Posts: 2,036 Sr Partner
    edited 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
  • SophieSophie Posts: 2,036 Sr Partner
    Hi all! Here's the 4th and last instalment on the world of Banks...

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

    1. Return - usually to earn a positive interest spread (i.e. above risk-free)
    2. 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
    • 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
  • @sophie, @padnaiki: its there in the syllabus..but none of the papers i solved had any mention of it!!
  • SophieSophie Posts: 2,036 Sr Partner
    yea @sankrutimehta - it is rare. But still there, so thought I'd cover it in the notes just in case! Hope all's well :)
  • ofcoz, won't harm anyways..its easier to do anyway
  • @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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