PENSION FUNDS - Financial Institutions and Markets by Fabozzi

CHAPTER 9

PENSION FUNDS

INTRODUCTION TO PENSION FUNDS

A pension plan is a fund that is established for the payment of retirement benefits. Pension plans are set up by plan sponsors to pay retirement benefits. Monies are placed in the funds by the employer/employees and earnings compound tax-free until withdrawn at retirement. The key factor explaining pension fund growth is that the employer’s contributions and specified amount of the employee’s contributions, as well as the earnings of the fund assets, are tax exempt. In essence, a pension is a form of employee remuneration for which the employee is not taxed until funds are withdrawn.

TYPE OF PENSION PLANS

Defined Benefit Plan

In a defined benefit plan, payments are specified upon retirement by the sponsor. The amount available upon retirement becomes a function of the amount placed in the fund and years of service. The pension obligations are effectively the obligation of the plan sponsor, who assumes the risk of insufficient funding to meet contractual payments. Plan sponsors often buy annuities from insurance companies, thereby shifting the risk to these companies. Such plans are called insured benefit plans, though the phrase is a misnomer in that the benefits are guaranteed only so far as the insurance company can provide the funds.

The Pension Benefit Guaranty Corporation (PBGC), established under ERISA provides only for vested benefits payments in event of discontinuation by the plan sponsor. Defined benefit plans are expensive and hard to implement when few employees work for only one company over many years.

Benefits become vested when employees reach a certain age and complete enough years of service to meet minimum requirement for receiving benefits. In recent years, firms have not adopted defined benefit plans. Major firms that have them have been freezing their plans. This is because they are costly and firms have found that the plans hinder their competitiveness.

Defined Contribution Plans

In a defined contribution plan, the plan sponsor provide only for specified contributions to the fund. No guarantees are given as to the amount of benefits that will be available upon retirement. Thus the risk of poor performance is borne by the employee. Such plans are usually provided under Section 401 K of the Revenue Code, and the employee can usually direct what group will manage these funds. The fastest-growing sector of DCP is the 401k, 403(b) and 457. By end of 1999, over one trillion dollars had been placed in 401k. The largest public sponsor of a defined contribution plan is the Federal Retirement Thrift ($233 billion).

Hybrid Pension Plans

In an effort to offset the flaws of the defined contribution and benefit plans, a number of companies have started to select hybrid pension plans, wherein an employer contributes a certain amount each year. A pre-set minimal benefit level is specified, but if the plan does not meet this goal, the employee must make up the deficit.

A cash balance plan is basically a defined benefit that has some of the features of a defined contribution plan. A cash balance plan defines future pension benefits. Each participant in a cash balance plan has an account that is credited with a dollar amount that resembles an employer contribution and is generally determined as a percentage of pay. The plan usually provides benefits in the form of a lump-sum distribution as annuity. Interest is credited to the employee’s account at a rate specified in the plan and is unrelated to the investment earnings of the employer’s pension trust.

INVESTMENTS

Defined benefit plans allocate more than 65% of their funds to equities and fixed-income securities. Defined contribution plans favor insurance company GICs. Since some qualified pension funds are exempt from federal taxes they have little use for municipal bonds in their portfolio. There are no federal restrictions on foreign securities investments, although sponsors may deny management this privilege.

REGULATION

Because pension plans are crucial for U.S. workers, pension plans are regulated under the Employee Retirement Income Security Act of 1974 (ERISA). Its major provisions include:

1. Minimum funding standards: a plan sponsor must make to he pension plan; cannot “pay as you go”;

2. Fiduciary responsibility: must follow “prudent man” rule in investment practices;

3. Minimum vesting standards; for example that after five years of employment, a participant is entitled to 25% of accrued pension benefits.

4. Created PBGC for vested benefits funded by premiums under direct benefit plans.

MANAGERS OF PENSION FUNDS

A plan sponsor chooses one of the following to manage assets: (1) in-house staff, (2) outside money management firms, (3) combination of both. In addition to money managers, advisers called consultants provide other advisory services provided to pension plan sponsors. These include:

1.      Developing an investment policy and asset allocation;

2.      Providing actuarial advice;

3.      Designing benchmark performance measures;

4.      Monitoring performance;

5.      Providing specialized research.

DEFINED BENEFIT CRISIS

Today, there is a crisis facing defined benefit pension plans. At the end of 2003, corporate pension underfunding or deficit was close to $250 billion. Some estimates double this number. In essence, corporate and public plan sponsors have systematically underestimated pension liabilities. Pension funding is a cost that affects earnings. The returns on pension assets can be an earning if the projected return exceeds liabilities. This creates a perverse incentive to overstate projected returns and understate liabilities.  The bottom line is that the failure to properly value pension liabilities because of the use of an inappropriate discount rate and the impact it had on the allocation decision among major asset classes to justify a high forecast return on assets were the two major contributing factors to this financial crisis.

PENSION PROTECTION ACT OF 2006

The Pension Protection Act of 2006 (PPA) contains two major parts. The first part modifies ERISA in the following way:

1.      It required underfunded plans to pay additional premiums to the Pension Benefit Guaranty Corporation.

2.      It extended the requirement that companies that terminate their pension plans provide extra funding to the pension system.

3.      It closed loopholes that allowed underfunded plans to skip pension payments.

4.      It raised the caps on the amount that companies can contribute to their pension plans so they can contribute more during prosperous times.

5.      It required that companies measure their pension plan obligations more accurately.

6.      It prevented companies with underfunded pension plans from providing extra benefits to their workers without paying for these benefits up front.

The second part of the PPA relates primarily to individuals’ use of defined contribution plans. According to the PPA, employers can automatically enroll their employees in a defined contribution plan. It also permits employers to choose default options on behalf of the plan participants who do not make an election on how to invest their funds, and enables employers to obtain more investment advice for their employees by removing the fiduciary liability based on the perceived conflict of interest of self-interested investment advice provided by the employer.

ANSWERS TO QUESTIONS FOR CHAPTER 8

(Questions are in bold print followed by answers.)

1. What is a plan sponsor?

A plan sponsor is a corporation or public agency that establishes a retirement plan for its employees. Plan sponsors include private businesses, federal, state, and local governments, unions, not-for-profit organizations, and even individuals setting up plans for themselves.

2. How does a defined-benefit plan differ from a defined-contribution plan?

In a defined contribution plan, the sponsor and/or employees are responsible only for making specified (hence “defined”) contributions to the plan. There is no guarantee of what amount will be available upon retirement. Hence the employee bears the risk of whether he will have an adequate retirement income. Under a defined benefit plan the sponsor agrees to provide specified dollar payments to employees upon their retirement. The amount to be paid is usually determined by a formula, which considers length of time of employment and income level. Herein the employer takes the risk of having sufficient funding to meet future needs. Vested benefits are guaranteed by the Pension Benefit Guaranty Corporation (PBGC), wherein an employer contributes a certain amount each year. A pre-set minimal benefit level is specified, but if the plan does not meet this goal, the employee must make up the deficit.

3. Why have some corporations frozen their defined benefit plans?

Pension plans are too costly and some companies have found it difficult to compete with other firms.

4.

1. What is a cash balance plan?
2. Discuss the resemblance of a cash balance plan to a defined-benefit and a defined-contribution plan.

a.       A cash balance plan is basically a defined benefit that has some of the features of a defined contribution plan. It defines future pension benefits. Each participant in a cash balance plan has an account that is credited with a dollar amount that resembles an employer contribution and is generally determined as a percentage of pay. The plan usually provides benefits in the form of a lump-sum distribution as an annuity. Interest is credited to the employee’s account at a rate specified in the plan and is unrelated to the investment earnings of the employer’s pension trust.

b.      A cash balance plan is similar to defined benefits in the sense that benefits are fixed based on a formula. Investment responsibility is borne by the employer, and employees are automatically included in the plan. It is similar to defined contribution in the sense that assets are accumulated in an “account” for each employee and vested assets may be taken as a lump sum and rolled into an IRA.

5.

1. What is an insured pension plan?
2. What is the function of PBGC?

a.       An insured plan is one administered by an insurance company providing annuities upon retirement. Unless the PBGC is involved for defined benefits, there is no further insurance.

b.      The Pension Benefit Guaranty Corporation insures vested benefits under defined benefits plans in the event of corporate failures. It charges premiums for this service. Currently, the PBGC itself is close to insolvency due to fact that many corporate plans are under-funded and PBGC itself has little enforcement power. Also, many companies have dropped defined benefit plans in favor of defined contribution plans to save themselves premium payments and pass on the risks of providing adequate retirement income to the employees themselves.

6. What role do mutual funds play in 401(k) plans?

A 401k plan is a defined contribution plan. The employee can select a qualified plan in which to place his retirement contributions. These contributions are tax deferred as is the income generated by the fund. A mutual fund can qualify as a 401k plan, thus allowing it to generate tax-deferred earnings on behalf of the employee.

7. Can and do pension plans invest in foreign securities or tax-exempt securities?

U.S. pension funds are free to invest in foreign securities. However, plan sponsors may set local restrictions. It is also true for tax-exempt securities.

8.

1. What is the major legislation regulating pension funds?
2. Does the legislation require every corporation to establish a pension fund?

a.       Pension plans are regulated under the Employee Retirement Income Security Act of 1974 as amended. This legislation establishes the types of plans covered, funding and vesting requirements, and the PBGC.

b.      There is currently no legislation that requires a corporation to establish a pension plan. But if it does so, it must comply with ERISA regulations.

9. Discuss ERISA’s “prudent man” rule.

ERISA’s “prudent man role” establishes fiduciary standards for pension fund trustees and managers. The rule seeks to determine which investments are proper to make sure that the trustee takes the role seriously in acquiring and using the information pertinent to making an investment decision.

10. Who are plan sponsor consultants and what is their role?

In addition to money managers, advisors call plan sponsor as consultants they provide other advisory services to pension plan sponsors. Among the functions that consultants provide to plan sponsors include developing plan for investment policy, providing actuarial advice, designing benchmarks and measuring and monitoring the performance of the fund’s money managers.

11. In 2001, investor Warren Buffett had this to say about pension accounting: Unfortunately, the subject of pension [return] assumptions, critically important though it is, almost never comes up in corporate board meetings. . . . And now, of course, the need for discussion is paramount because these assumptions that are being made, with all eyes looking backward at the glories of the 1990s, are so extreme.

1. What does Mr. Buffett mean by the “pension return assumption”?
2. Why is the pension return assumption important in pension accounting in accordance with generally accepted accounting principles?
3. Why is the pension return assumption important in pension accounting in accordance with Internal Revenue rules?
4. Mr. Buffet went on to warn that too high an assumed return on pension assets risks litigation for a company’s chief financial officer, its board, and its auditors. Why?

a.       The assumptions that management or plan administrator uses to project pension fund growth rates, and amounts of assets and liabilities. 

b.      The assumptions determine whether plan assets can meet liabilities. Overly optimistic return lead to conclusions that liabilities will be met and that the fair value of the plan is positive.

c.       There are IRS regulations that determine the actual amount of funding required.

d.      Too high an assumed return on pension assets may mislead plan participants on the issue of plan solvency. Such deception may lead to litigation. 

CHAPTER 8 INVESTMENT COMPANIES AND EXCHANGE-TRADED FUNDS - Financial Institutions and Markets by Fabozzi

CHAPTER 8

INVESTMENT COMPANIES

AND EXCHANGE-TRADED FUNDS

TYPE OF INVESTMENT COMPANIES

Open-End Funds (Mutual Funds)

More popularly known as mutual funds. As open-end funds they stand ready to buy and redeem shares at a price based on net asset value, which is total asset value less liabilities. Prices are quoted on a bid/offer basis. For a no-load fund the bid/offer prices will be the same. The net asset value (NAV) per share equals the market value of the portfolio minus the liabilities of the mutual fund divided by the number of shares owned by the mutual fund investors.

There are several important characteristics of open-end or mutual fund. First, investors in mutual funds own a pro rata share of the overall portfolio. Second, the investment manager actively manages the portfolio. Third, the share price is the NAV. Fourth, the NAV is determined only once each day, at the close of the day.

In the case of a load fund the offer price will exceed the bid price by the amount of a sales commission charged upon purchases of shares. Some funds have back-end loads, wherein commissions are charged upon redemption of funds within a few years. Others, known as Section 12b-1 funds, charge a small percentage of assets annually to cover sales costs. In any case, all funds earn small percentage annual fees to cover administrative costs. These funds comprise the third largest group of financial institutions, behind banks and insurance companies.

Closed-End Funds

These funds issue a limited number of shares and are very similar to shares of common stock. They are then sold on the open market like other securities. Investors pay a broker’s commission. The NAV of closed-ended funds is determined by supply and demand. The market price of these shares may thus differ from net asset value, often at a discount from it. The discount results from large tax liabilities on capital gains that swell the net asset value, while investors are pricing future after-tax distributions. Premiums can result because such funds often have inexpensive access to overseas stocks.

Under the Investment Company Act of 1940, closed-end funds are capitalized only once. They make an IPO, and then their shares are traded on the secondary market, just like any corporate stock.

The relatively new exchange traded funds (ETFs) pose a threat to both mutual funds and closed-end funds. ETFs are essentially hybrid closed-end vehicles, which trade on exchanges but typically trade very close to NAV.

Unit Trusts

 A unit trust is similar to a closed-end fund in that the number of unit certificates is fixed. They are different from closed-end funds in the following. First, they typically invest in bonds. Second, they do not trade. Third, a fixed amount of securities is assembled with a defined termination date. The major benefit of such funds is lower operating costs due to the absence of trading.

FUND SALES CHARGES AND ANNUAL OPERATING EXPENSES

There are two types of costs borne by investors in mutual funds. The first is shareholders fee, usually called the sales charge. This type of charge is related to the way the fund is sold and distributed. The second cost is the annual fund operating expense usually called the expense ratio, which covers the fund's expenses. The largest of which is for investing managements. Other expenses include primarily the cost of, 1) custody 2) the transfer agent cost, 3) independence public accountant fee, and 4) directors’ fee. The sum of annual management fee, the annual distribution fee and other expenses is called the expense ratio.

Sales Charge

Sales charges on mutual funds are related to their method of distribution. The two types of distribution were sales force and direct. Sales force occurs via an intermediary agent. Direct distribution takes place without an intermediary. Funds with no sales charges are called no-load mutual funds. Some have speculated that load funds would eventually disappear, but the trend has gone the other way. Among the recent adaptations of the sales load are back-end loads.

Annual Operating Expenses (Expense Ratio)

The operating expense, also called the expense ratio, is debited annually from the investor’s fund balance by the fund sponsor. Operating expenses are deducted from NAV and therefore reduce the reported return. The management fee, also called the investment advisory fee, is the fee charged by the investment advisor for managing a fund’s portfolio. In 1980, the SEC approved the imposition of a fixed annual fee, called the 12b-1 fee, which intended to cover distribution costs. Such 12b-1 fees are now imposed by many mutual funds.

Multiple Share Classes

Share classes were first offered in 1989 following the SEC’s approval of multiple share class. Initially share classes were used primarily by sales-force funds to offer alternatives to front-end load as a means of compensating brokers. Later, some of the funds used additional share classes as a means of offering the same fund or portfolio through alternative distribution channels in which some fund expenses varied by channel.

ECONOMIC MOTIVATIONS FOR FUNDS

An investment company is a financial intermediary because it pools the funds of market participants and uses those funds to buy a portfolio of securities. They provide at least one of the following six economic functions: (1) risk reduction via diversification, (2) lower costs of contracting and processing information, (3) professional portfolio management, (4) liquidity, (5) variety, (6) payments mechanism.  

TYPES OF FUNDS BY INVESTMENT OBJECTIVE

Investment funds tend to have a variety of investment objectives. In general, there are stock funds, bond funds, money market funds and others. They seek to accommodate a wide range of desires and needs, among them income, capital gains, growth, and income. Some funds specialize by securities, examples of which are indexed funds, government bond funds, municipal bond funds, corporate bond funds, money market mutual funds, and balanced funds--combination of bonds and stocks.

CONCEPT OF FAMILY OF FUNDS

Now many management companies offer investors a choice of numerous funds. Some firms provide a choice of funds and objectives. Changing from one to the other to reflect changing needs can then be accomplished at low or no cost to the investor. The funds in a family usually include choices ranging from money market funds to global funds, and funds devoted to particular industries such as medical technology or gold mining companies. Concentration in the mutual funds industry continues to increase.

INVESTMENT VEHICLES FOR MUTUAL FUNDS

Mutual funds may be included in different investment vehicles. An investment vehicle can be a non-qualified vehicle because it does not quality for tax advantages. The same fund can also be included in a retirement plan such as 401(k), Roth 401(k), IRA or Roth IRA. These retirement plans are called qualified plans.

MUTUAL FUND COSTS

From 1980 to 2006, the measure of mutual fund costs declined from 2.32% to 1.07% for stock funds and from 2.05% to 0.84% for bond funds. There were three reasons for this decline. First, loads in general declined. Second, no-load mutual funds grew. Third, mutual fund expenses have also declined due to economies of scale and intense competition.

TAXATION OF MUTUAL FUNDS

Mutual funds must distribute at least 90% of their net investments income earned, exclusive of realized capital gains or losses to shareholders to be considered a regulated investment company (RIC) and, thus not be required to pay taxes at the fund level prior to distribution to shareholders. Consequently, funds make these distributions. Capital gains distributions must occur annually, and typically occur late during the calendar year. New investors in the fund may assume a tax liability even though they have no gains. The investors must also pay ordinary income taxes on distribution of income.

REGULATION OF FUNDS

All investment companies are regulated under the Investment Company Act of 1940. They must register with the SEC and file periodic reports. No taxes are levied on funds, which distribute 90% of their income. There are minimum diversification and liquidity requirements as well as maximum fees that can be applied. Currently under consideration is a proposal allowing less redemption over a quarter, thus permitting funds to hold smaller proportions of liquid assets.

Among the recent SEC priorities, which directly affect mutual funds, are:

1.           Reporting after taxes.

2.           More complete reporting fee.

3.           More accurate and consistent reporting of investment performance.

4.           Requiring fund investment practices to be more consistent with the name of a fund to more accurately reflect their investment objectives.

5.           Disclosing portfolio practices such as "window dressing".

6.           Various rules to increase the effectiveness of independent fund boards.  

STRUCTURE OF A FUND

A mutual fund organization is structured as follows: (1) board of directors, (2) mutual fund, (3) investment advisor, (4) distributor, (5) other service providers. The role of the board of directors is to represent the fund shareholders. External advisers are called subadvisers, and they are used because (1) to develop a fund in an area in which the fund family has no expertise, (2) to improve performance, (3) to increase assets under management, (4) to obtain an attractive manager at a reasonable cost.

RECENT CHANGES IN THE MUTUAL FUND INDUSTRY

Distribution Channels

Traditionally, funds were sold direct or through a sales force. However, funds have moved increasingly to nontraditional sources of sales.

Supermarkets: The organizer of a supermarket, like Charles Schwab, offers funds from a number of different mutual fund families.

Wrap programs: Wrap accounts are managed accounts, typically mutual funds or ETFs, wrapped in a service package. The service provided is often asset allocation counsel, i.e., advice on the mix of managed funds or ETFs.

Fee-based financial advisors: Fee-based financial advisors are independent financial planners who charge a fee rather than a transaction charge for investment services. These fees are typically a percentage of assets under management or alternatively an hourly fee or a fixed retainer.

Variable annuities: Variable annuities represent another distribution channel.

Changes in the Costs of Purchasing Mutual Funds

The purchase cost of mutual funds has declined significantly. In general, load funds responded to the competition of no-load funds by lowering distribution cost.

Mix and Match

The investors’ demands for choice and convenience, and also the distributors’ need to appear objective, have motivated essentially all institutional users of funds and distribution organizations to offer funds from other fund families in addition to their own.

Domestic Acquisitions in the US Funds Market

There merger and acquisition business in the US asset management business has been active. The US asset management business continues to grow and consolidate across the various types of asset management firms.

Internationalization of the US Funds Business

The combination of a US fund company and international asset manager could occur in either two directions, i.e., with either being the acquirer. But the dominant direction has been the acquisition of US funds by international institutions.

EXCHANGE TRADED FUNDS

While mutual funds have become very popular with investors, they are often criticized for two reasons. First, mutual funds shares are priced at, and can be transacted only at the end of day (closing) price. The second relates’ to taxes and the investors’ control over taxes. Withdrawals by some shareholders may cause taxable realized capital gain for shareholders who maintain their positions.

Closed-end funds trade all during the day on stock exchange, but there is often a difference between the NAV and the price of the closed-end funds. Both mutual funds and closed-end funds are similar in that they are instruments based on the portfolio of their securities, but closed-end funds are transacted continuously throughout the day.

An investment that embodies a combination of the desirable aspects of mutual funds (open-end funds) and closed-end funds is the exchange-traded fund (ETF). These are mostly index funds. They are traded on an exchange, and they are like open-end funds in that the number of shares can change.

ETC Creation/Redemption Process

For ETCs, individuals do not deal directly with the provider of the ETF. That privilege is reserved for a few very large investors called authorized participants (AP) who are arbitragers. Authorized participants are mainly large institutional traders who have contractual agreements with ETF funds. They are the only investors who may create or redeem shares of an ETF with the ETF sponsor and then only in large specified quantities called creation/redemption units. These unit sizes range from approximately 50,000 to 100,000 ETF shares.

ETF Sponsors

Like mutual funds, ETFs require a company to sponsor them. The ETF sponsor must (1) develop the index, (2) retain the authorized participants, (3) provide seed capital to initiate the ETF, (4) advertise and market the ETF, (5) engage in other activities.

Mutual Funds versus ETFs: Their Relative Advantages

The following are ETF advantages. Mutual funds are priced only once a day. But ETFs are traded on an exchange and so there is continuous pricing. Both passive mutual funds and ETFs have low fees, but ETF fees tend to be somewhat lower. All ETFs trade on an exchange and incur commission. As to taxes, mutual funds may lead to capital gains taxes for investors who do not even liquidate their fund. Because of the unique structure of ETFs, ETFs can fund redemptions by in-kind transfers without selling their holdings, which have no tax consequences.

Mutual funds have the following advantages. While ETFs have been exclusively passive or indexes, mutual fund families offer many types of active funds as well as passive funds. Additionally, no-load mutual funds, both active and passive, permit transactions with no loads or commissions.

Separately Managed Accounts

Many high net worth people object to mutual funds because (1) lack of control over taxes, (2) lack of any input into investment decision, (3) absence of services. The use of separately managed accounts responds to all these limitations of mutual funds.

ANSWERS TO QUESTIONS FOR CHAPTER 7

(Questions are in bold print followed by answers.)

1. An investment company has $1.05 million of assets, $50,000 of liabilities, and 10,000 shares outstanding.

1. What is its NAV?
2. Suppose the fund pays off its liabilities while at the same time the value of its assets double. How many shares will a deposit of $5,000 receive?

a.       Net asset value = (Total assets minus liabilities) / numbers of shares

                                = 1,050,000 – 50,000 = $100

                                             10,000

b.      Net asset value = 2,100,000 – 0 = $210

10,000

No of shares = 5000 = 23.81 shares.

                                210

2. “The NAV of an open-end fund is determined continuously throughout the trading day.” Explain why you agree or disagree with this statement.

Disagree. NAV of open-ended fund is the closing price of the day.

3. What are closed-end funds?

These funds issue a limited number of shares, are sold on the open market.

     

4. Why do some closed-end funds use leverage to raise more funds rather than issue new shares like mutual funds?

Under the 1940 Act, these funds are capitalized only once. The number of shares is fixed. Thus many funds become leveraged to raise more funds without issuing new (additional) shares.   

5. Why might the price of a share of a closed-end fund diverge from its NAV?

The price of closed-end funds may differ from NAV (often at a discount) because the fund has a large built-in tax liabilities and investors are discounting the share’s price for future tax liabilities. Leverage may be another factor for price below NAV.

6. What is the difference between a unit trust and a closed-end fund?

With a unit trust a number of securities are assembled in a portfolio package and held for a specified number of years and then liquidated. The charges are low since there is no trading of securities or redemption prior to maturity.

7.

1. Describe the following: front-end load, back-end load, level load, 12b-l fee, management fee.
2. Is there a limit on the fees that a mutual fund may charge?

a.       Back-end load funds charge sales fees upon redemption within a period of a       few years. Front end is commissioned charged up front of the time of sale. A level load is amount of sales commission a fund may charge. A 12b-1 fund is a no-load fund that charges an annual sales fee of around 1.5% annually.

b.      Yes the security rule specifies these fees.

8. Why do mutual funds have different classes of shares?

Different classes of shares offered by mutual funds is determined by the needs of the investors and their risk preferences. It permits the distributor and its client to select the type of load they prefer.

9. What is an index fund?

An index fund e.g. Fidelity Magellan and Vanguard S&P 500 are mutual funds, which invests in stocks included in S&P 500, and aim to achieve its performance to the benchmark S&P500 returns.

10.

1. What is meant by a target-date fund?
2. What is the motivation for the creation of such a fund?

a.       Target date funds are mutual funds that base their asset allocations on a specific date, the assumed retirement date for the investor, and then rebalance to a more conservative allocation as that date approaches.  

b.      These funds are designed to be “one-size-fits-all” portfolios for investors with a given number of years to retirement.  

11. What are the costs incurred by a mutual fund?

Costs typically incurred by an investment company (Mutual fund) include advisory fees, selling/marketing expenses, custodial/accounting fees, and transactions costs. There are two types of costs borne by investors in mutual funds. The first is shareholder fee, usually called the sales charge. This type of charge is related to the way the fund is sold or distributed. The second cost is the annual fund operating expense usually called the expense ratio, which covers the fund’s expenses. The largest of which is for investing managements.

12. Why might the investor in a mutual fund be faced with a potential tax liability arising from capital gains even though the investor did not benefit from such a gain?

Investor in a closed fund is faced with a potential tax gain on capital gains that swell the net asset value. The investor is pricing future-tax distributions.

13. Does an investment company provide any economic function that individual investors cannot provide for themselves on their own? Explain your answer.

Yes. An investment company provides risk reduction through diversification and lower costs of transactions and information processing, which is hardly to come by an individual investor.

14. Why might a family of funds hire subadvisors for some of its funds?

They are used because (1) to develop a fund in an area in which the fund family has no expertise, (2) to improve performance, (3) to increase assets under management, (4) to obtain an attractive manager at a reasonable cost.  

15.

1. How can a fund qualify as a regulated investment company?
2. What is the benefit in gaming this status?

a.       A regulated investment company must provide information on its fees and its objectives. It must file financial reports and indicate amount of income distributed.

b.      A regulated investment company is exempt from taxation on all its ordinary and capital gains income as long as at least 90% of these funds are distributed to the stockholders. Such distributions are then taxable to the stockholders.

16. What is an ETF?

An exchanged traded fund is a new investment vehicle that is similar to mutual funds but trade like a stock on an exchange. The price is determined continuously rather than the closing price e.g. QQQ.

17. What are the advantages of an ETF relative to open-end and closed-end investment companies?

As said earlier, price is continuously changing during the trading period.

18. Explain the role of the authorized participant in an ETF.

The role of the authorized participants is to engage in arbitrage transactions that maintain the market price of the ETF as compared to an index portfolio.

19. Why is tracking error important for an ETF?

Since ETFs are based on passive indexes where value is represented by the NAV, investors in ETFs expect their return to be equal to that of the portfolio’s NAV. Large tracking error s are bad for ETFs because it undermines the investor’s expectation.

20. Comment on the following statement: “Exchange traded funds are typically actively managed funds.”

Since they are mostly index funds, they are passively managed.

21. Briefly describe the following in the context of mutual funds:

1. supermarket
2. wrap program
3. segregated managed accounts
4. family of funds

a.       Supermarkets: The introduction of the first mutual fund supermarket in 1992 by Charles Schwab & Co. introduced its One Source service. These supermarkets allow investors to purchase funds from participating companies without investors having to contact each fund company.

b.      Wrap program: Wrap accounts are managed accounts, typically mutual funds “wrapped” in a service package. The service provided is often asset allocation counsel; that is advice on the mix of managed funds.

c.       Segregated managed accounts: are in response to individuals who object to mutual funds because of their lack of control over taxes and other investment decisions. Many investors with medium-size portfolio are utilizing segregated accounts.

d.      Family of funds: In the U.S. system, a family of funds consists of an investment company that offers several different funds. In Japan the family fund allows investors to buy new certificates in a grouping of existing unit trusts.

INSURANCE COMPANIES - Financial Institutions and Markets by Fabozzi

CHAPTER 7

INSURANCE COMPANIES

TYPE OF INSURANCE COMPANIES

Insurance companies sell insurance policies for a premium. They have two sources of income: underwriting income, and investment income.

Life Insurance

The life insurance company pays the beneficiary of the life insurance policy in the event of the death of the insured.

Health Insurance

The health insurance company pays the insured all or a portion of the medical treatment of the insured. Until the last decade, the major type of health insurance available was indemnity insurance. Due to the lack of constraints and incentives for cost savings, the medical service insured by indemnity insurance became very expensive. In response, various forms of managed health care have been developed. In general, these forms of managed health care put constraints on the choice of the provider by the insured and on the types of service provided by the provider.

Property and Casualty Insurance

Property and casualty (P&C) insurance companies insure the risk of damage to various types of property.

Liability Insurance

The risk insured against is litigation, or the risk of lawsuits against the insured due to actions by the insured or others. This is typically a third-party claim.

Disability Insurance

Disability insurance insures against the inability of employed persons to earn an income. Typically, “own occ” disability insurance is written for professionals in white-collar occupations, and “any  occ” for blue-collar workers. There are two types of policies regarding the sustainability of the policy. First, guaranteed renewable is a term where the issuer has to sustain the policy for a specified period of time, but can change the premium rates for the entire class. The other type is noncancellable and guaranteed renewable whereby the issuer has no right to make any changes in any policy during the specified period.

Long-Term Care Insurance

Long-term care insurance provides coverage for custodial care for the aged who are no longer able to care for themselves.

Structured Settlements

Structured settlements are fixed, guaranteed periodic payments over a long period of time, typically resulting from a settlement on a disability policy or other type of policy.

Investment Oriented Products

A guaranteed investment contract or guaranteed income contract (or simply GIC), is a pure investment product.  In a GIC, a life insurance company agrees, for a single premium, to pay the principal amount and a predetermined annual crediting rate over the life of the investment, all of which is paid at the maturity date. A life insurance company agrees in return for a premium to pay the principal amount and a predetermined annual crediting rate over the life of the investment. Effectively, a GIC is a zero coupon bond issued by a life insurance company and as such exposes the investor to the same credit risk. Some GICs require a single premium payment (bullet), others provide windows wherein deposits are accepted over time at the same interest rate.  GICs are popular contracts for pension funds, since interest rate risk assumed by insurance company.  But investors still have to worry about the credit risk of the insurance company.

Annuity

An annuity is often described as a mutual fund in an insurance wrapper. The income and realized gains are not taxable if not withdrawn from the annuity product. Thus, the “inside buildup” of returns receives a favorable tax treatment. Annuities can be either fixed, or variable. For a single payment or premium the insurance company will provide fixed payments for the life of the policyholder.  It can also provide a “lump sum” payment to the retiree after a number of years of accumulating and investing premium payments.

Monoline Insurance Companies

Monoline insurers guarantee the timely repayment of the bond principal and interest when a bond insurer defaults on these payments. The insured securities have traditionally been municipal bonds, but they now include structured finance bonds, CDOs, CLOs, and asset-backed bonds. Monoline insurers have been rated AAA and must have this high rating to be effective since they transfer their rating to the bond issue being insured.

INSURANCE COMPANIES VERSUS TYPES OF PRODUCTS  

Traditionally, life and health products were coupled by an insurance company because of some of the similarities of the products. Property and casualty products were also provided by P&C companies. Companies that provide both types of insurances (life, health, property, casualty) are called multiline insurance companies. Investment products tend to be sold by life insurance companies.

Recently, health insurance companies have separated from life insurance. This change has been due to mainly federal regulation of the health industry. Life insurance companies have focused on investment products. Also, disability insurance is now sold primarily by pure disability companies.

FUNDAMENTALS OF INSURANCE INDUSTRY

A fundamental aspect of the insurance industry results from the relationship between the revenues and costs. A company collects its premium income initially and invests these receipts in its portfolio. The payments on the insurance policy occur later and, depending on the type of insurance, in a perhaps very unpredictable manner. The payments are contingent on potential future events.

An insurance policy is a binding contract for which the policyholder pays premium in exchange for the insurance company’s promise to pay specified amounts contingent on future events.  The accepted policy is an asset for the owner and a liability for the insurance company.

Life insurance and property and casualty insurance companies are financial intermediaries that, for a price, will make a payment if a certain event occurs.  They function as risk bearers. The principal event that the life insurance company insures against is death:  a life insurance company agrees to make either a lump sum payment to the beneficiary of the policy or make a series of payments.  However, life insurance protection is not the only financial product sold by these companies.  A major portion of the business of life insurance companies is now in the area of providing retirement benefits. The key distinction between life insurance and property and casualty insurance (P&C) companies is the difficulty of projecting whether a policyholder will be paid off and how much the payment will be.

REGULATIONS OF INSURANCE INDUSTRY

Regulation is primarily at the state level as a result of 1945 federal statute (McCarran-Ferguson Act). Model laws and regulations are developed by National Association of Insurance Commissioners (NAIC). Insurance companies are also rated by the rating agencies.

To assure financial stability, insurance companies must maintain reserves or surplus, which are the excess of assets over liabilities. State statutory surplus requirements are called statutory surplus, which is distinguished from generally accepted accounting principles (GAAP) surplus.

STRUCTURE OF INSURANCE COMPANIES

Insurance companies are really a composite of three companies. First there is the “home office” or actual insurance company. Second, there is the investment component, which invests the premium collected in the investment portfolio. This is the investment company. The third is the distribution component of the sales force. There are different typed of distribution forces. Finally there are also brokers who sell insurance products of many companies.

Insurance companies are attracted by commercial bank customer contacts. As a result, commercial bank distribution of insurance company products has grown. This relationship is called bankassurance.

FORMS OF INSURANCE COMPANIES

There are two forms of insurance companies: stock and mutual. A stock insurance company is similar in structure to any corporation or public company. Shares (of ownership) are owned by independent shareholders and are traded publicly. The shareholders care only about the performance of their shares that is the stock appreciation and the dividends. The insurance policies are simply the products or business of the company. In contrast, mutual insurance companies have no stock and no external owners. Their policyholders are also their owners. The owners, that is the policyholders, care primarily or even solely about the performance on their insurance policies, notably the company’s ability to pay on the policy. Since theses payments may occur considerably into the future, the policyholders view may be long term.

Finally a new form of insurance company, which is a hybrid between a pure mutual and a pure stock company has been approved by some states and implemented by some insurance companies in these states since their introduction in 1996. This form is called a mutual holding company (MHC).

INDIVIDUAL VERSUS GROUP INSURANCE

Insurance products can be sold on individual and group bases. Also, in the P&C business, insurers can sell personal lines and commercial lines of insurance products.

TYPES OF LIFE INSURANCE

There are two fundamentally different types of life insurance: term (life) insurance and cash value life insurance.

Term Insurance

Term policies pay off only on death.  Three are no investment benefits and so the premiums are substantially lower than those on whole life policies.  Most group policies are term policies.  “Term” implies that coverage is available only during the premium-paying term of the contract.

Cash Value or Permanent Life Insurance  

There is a broad classification of life insurance, which is cash value, or permanent or investment type life insurance. A common type of cash value life insurance is whole life insurance. This cash value can be withdrawn and can also be borrowed against by the owner of the policy. If the owner wishes to let the policy lapse, he or she can withdraw the cash value. A major advantage of this type of policy is that the inside buildup is not subject to tax, i.e., is taxed as either income or capital gains. Neither is the beneficiary subject to income tax.

Guaranteed cash value life insurance: This insurance provides a cash value based on a minimum dividend paid on the policy. Additionally, the policy can be either participating or nonparticipating. For a nonparticipating policy, the minimum dividend and the minimum cash value on the policy are the guaranteed amounts. For the participating policy, the dividend paid on the policy is based on the realized actuarial experience of the company and its investment portfolio.

Variable life insurance: Contrary to the guaranteed or fixed cash value policies based on the general account portfolio of the insurance company, variable life insurance policies allow the policy owner to, within limits, allocate their premium payments to and among separate investment accounts maintained by the insurance company.  Variable life insurance, which typically has common stock investment options, has grown quickly with the stock market rally of the 1990’s.

Flexible premium policies—universal life insurance:  The key element of universal life is the flexibility of the premium. The policy cash value is set up as the cash value fund to which the investment income is credited and from which the cost of term insurance for the insured is debited. This separation of the cash value from the pure insurance is called the unbundling of the traditional life insurance policy.

Variable universal life insurance: Variable universal life insurance combines the features of variable life and universal life policies, i.e., the choice of separate account investment products and flexible premiums.

Survivorship (Second to Die) Insurance

An added dimension of the whole life policies is that two people are jointly insured and the policy pays the death benefit not when the first person dies, but when the second person dies. This is called survivorship insurance or second-to-die insurance.  

GENERAL ACCOUNT AND SEPARATE ACCOUNT PRODUCTS

The general account of an insurance company refers to the investment portfolio of the overall company. Insurance companies must support the guaranteed performance of their general account products to the extent of their solvency. These are called general account products.

Other types of insurance products receive no guarantee from the insurance company’s general account, and their performance is not based on the performance of the insurer’s general account but solely on the performance of an account separate from the general account of the insurer. These products are called separate account products.

PARTICIPATING POLICIES

The performance of some general account products is not affected by the performance of the general account portfolio. The policy performance may not participate in the investment performance of the insurer’s general account investment portfolio. Such a policy is nonparticipating policy. Other general insurance products participate in the performance of the company’s general account performance. Such a policy is called a participating policy. Both stock and mutual insurance companies write both general and separate account products, but most participating general account products are written in mutual companies.

INSURANCE COMPANIES INVESTMENT STRATEGIES

In general the characteristics of insurance company investment portfolio should reflect their liabilities - the insurance products they underwrite. There are many differences among the various types of insurance policies.  Among them are:

§  The expected time at which the average payment will be made by the insurance company (Technically, the “duration” of the payments)

§  The statistical or actuarial accuracy of estimates

§  Other factors

The key distinction between life insurance, property and casualty insurance companies lies in the difficulty of projecting whether or not a policyholder will be paid off and how much the payment will be. There are also differences in investment strategy between public (or stock) and mutual insurance companies of the same type. The major difference is that stock companies tend to have less common stock than mutual companies. 

Most insurance company assets consist of debt, both public and private.  In fact, life insurers as a group are the largest holders of bonds.  Since life insurers are effectively taxed at very low rates, there are no advantages to holding municipals.  The reason for bond holdings are (1) to match maturities, since liabilities are often long-term and at a fixed rate, and (2) regulations require that bonds be booked at cost, while stocks must be written at market value.

CHANGES IN THE INSURANCE INDUSTRY

There have been three major types of changes in the insurance industry in the last two decades: (1) deregulation of the financial system; (2) internationalization of the insurance industry; (3) demutulization.

Deregulation of the Financial System

In 1933, Congress passed the Glass-Steagall Act, which separated commercial banking, investment banking, and insurance. This act resulted in the breakup of the House of Morgan into separate investment banking and commercial banking entities. . On November 12, 1999 the Gramm-Leach-Bliley Act (GLB), called the Financial Modernization Act of 1999, was signed into law. This act removed the 50 year old “anti-affiliation restrictions” among commercial banks, investments banks and insurance companies.  The passage of this act has eliminated the barriers between insurance companies, commercial banks, and investment banks and various combinations of these types of companies will continue to evolve. Since then, however, Citigroup sold its insurance business (Travelers) to MetLife, and no other major combinations between banking and insurance have taken place.

 

Internationalization of the Insurance Industry

Globalization has occurred in many industries, including insurance industry. With respect to the U.S. globalization operates in two directions. First, U.S. insurance companies have both acquired and entered into agreements with international insurance companies and begun operations in other countries. Second, international insurance companies, mainly European, have become even more active in acquiring U.S. insurance and investment companies. The reasons are: (1) more rapid growth of the US financial business, (2) attractive demographics and income potential of the US market, and (3) less regulations.

Demutualization

Since the mid-1990s, several insurance companies have changed from mutual to stock companies. Many industry observers believe that the recent demutualized insurance companies will either acquire other financial companies or will be acquired by other financial companies.

EVOLUTION OF INSURANCE INVESTMENT AND RETIREMENT PRODUCTS

Even prior to the Financial Modernization Act of 1999, there was an increasing overlap of insurance, investment and pension products and the distribution of those products. The passage of this Act has accelerated this convergence.

Three decades ago there were three distinct types of products for individuals: insurance, savings/investment, and retirement. Retirement products include individual retirement accounts. During the last two decades, many products have been developed that fit into two or even three of these categories. Products that are hybrid of retirement and investment products are 401k and Roth 401k.

401(k) Plans and Roth 401(k) Plans

401(k) plans are plans provided by an employer whereby an employee may elect to contribute pretax dollars to a qualified tax-deferred retirement plan.

IRAs and Roth IRAs

While a 401(k) is an employer-sponsored retirement program, the most common types of IRAs are personal tax-deferred retirement plans. Individually sponsored IRAs include traditional IRA, Roth IRA, and rollover IRA. Employer-sponsored IRA included Simplified Employee Pension (SEP) plans, and Savings Incentives Matching Plan for Employees (SIMPLE).

ANSWERS TO QUESTIONS FOR CHAPTER 6

(Questions are in bold print followed by answers.)

1.

1. What are the major sources of revenue for an insurance company?
2. How are its profits determined?

a.       An insurance company's revenue is generated from two sources: (1) premium income for policies written during the year; (2) investment income resulting from the investment of both the reserves established to pay off future claims and the P&C's surplus (asset less liabilities).

b.      Profit is determined by subtracting from the revenue for the year (as defined above in question 1a) each of the following items: (1) claim expenses: funds that must be added to reserves for new claims for policies written during the year; (2) claim adjustment expenses: funds that must be added to reserves because of underestimates of actuarially projected claims from previous years; (3) taxes; (4) administrative and marketing expenses associated with issuing policies.  If annual premiums exceed the sum of (1), (2) and (4), the difference is said to be the underwriting profit.  An underwriting loss results otherwise.

2. Name the major types of insurance and investment oriented products sold by insurance companies.

The major types of insurance products sold are: Life insurance, Health insurance, Property and casualty insurance, Liability insurance, Disability insurance, long-term care insurance, GIC and annuities.

3.

1. What is a GIC?
2. Does a GIC carry a “guarantee” like a government obligation?

a.       A guaranteed investment contract (GIC) guarantees a fixed interest income compounded over the life of the contract.  It is like a zero-coupon bond issued by an insurance company, usually to pension funds. A GIC shifts the interest rate risk from a pension fund to the issuer.

b.      The guarantee is given only by  the insurance company.  There is no government bailout in case of insolvency of the issuer.

4. What are some key differences between a mutual fund and an annuity?

In a mutual fund, all income is taxable, and no guarantees are given in its performance.  An annuity is an investment product often called a “mutual fund is in an insurance wrapper”. The wrapper is the guarantee by the insurance company. The company will pay the annuity holder.

5. Why should a purchaser of life insurance be concerned about the credit rating of his or her insurance company?

The credit rating of an insurance company is extremely important to the purchaser of the LIC product. The credit risk of insurance company has been prominent by the default of several major issues of GIC e.g. mutual Benefits and Executive Life in 1991.

6.

1. Does the SEC regulate all insurance companies?
2. If not, who regulates them?

a.       No. The insurance industry is regulated by individual states and only the SEC regulates those insurance companies whose stock is publicly traded.

b.      State laws and NAIC, a voluntary association of state insurance commissioners.

7. Does the insurance industry have a self-regulatory group and, if so, what is its role?

Model laws and regulations are developed by the National Association of Insurance Commissioners (NAIC), a voluntary association of the state insurance commissioners, for application on insurance companies in all states. An adoption of a model law or regulation by the NAIC is not, however, binding on any state. States typically use these as a model when writing their own laws and regulations.

8. What is the statutory surplus and why is it an important measure for an insurance company?

For an insurance company, surplus is simply total assets minus liabilities, or net worth. Due to state regulations the size of the surplus dictates the amount of common stock that an insurance company can hold and ultimately the amount of business it can write.

9. What is bank assurance?

 “Banc assurance” means combining the activities of banking and insurance companies. Several factors could explain the growing interest in banc assurance in certain regions: (1) deregulation and increased competition are forcing banking and insurance firms to seek new markets and products, (2) a growth in savings, and (3) an increased demand for insurance with investment features. 

10.

1. What is meant by “demutualization”?
2. What are the perceived advantages of demutualization?

a.       Demutualization refers to changing structure of insurance companies from being mutual companies stocks to ownership companies. This recent trend of demutualization in 1990’s is changing the landscape of insurance industry.

b.      The advantages of demutualization is more competition, transparency and pressure for better performance for the shareholders.

11. Comment on the following quotation from Frank J. Jones, “An Overview of Institutional Fixed Income Strategies,” in Volume 1 of Professional Perspectives on Fixed Income Portfolio Management (Hoboken, NJ: John Wiley & Sons, 2000):

An important impediment to the use of the total rate of return objective by stock life insurance companies is the role of equity analysts on Wall Street. . . . These equity analysts emphasize the stability of earnings and thereby prefer stable income to capital gains. Therefore, they consider only income and not capital gains, either realized or unrealized, in operating income—an important measure in their overall rating. While this practice of not considering capital gains may be appropriate for bonds, it certainly is inappropriate for common stock and provides a significant disincentive to life insurance companies for owning common stock in their portfolios. . . . this equity analyst practice does a disservice to policyholders of stock life insurance companies since their insurance companies end up having inferior asset allocations.

The statement by Jones has elements of subjective judgment and has several dimensions. It begs the merit of stocks vs. mutual structure of ownership and the respective rates of returns for the shareholders. It may be true that equity analysts emphasize the stability of earnings at the cost of capital gains. But those capital gains are reflected in the current price of the stock. It is up to the shareholders to realize those gains. Thus, the total rate of return objective by stock life insurance companies is not a real impediment.

12. What are term insurance, whole life insurance, variable life insurance, universal life insurance, and survivorship insurance?

Term insurance is pure life. If the insured person dies while the policy is intact, the beneficiary receives the death benefit.

      Whole life insurance pays off a stated amount upon the death of the insured and accumulates a cash value that can be redeemed by the policyholder.

Universal life pays a dividend that is tied to market interest rates.  Essentially, the cash value of a universal life policy builds and is used to buy term insurance.

Variable life insurance provides a death benefit that depends on the market value of the investment at the time of the insured’s death.  The premiums are typically invested in common stock; hence such policies are referred to as equity-linked policies.  While the death benefits are variable, there is a guaranteed minimum death benefit that the insurer agrees to pay regardless of the market value of the portfolio.

      Universal Life Insurance: the main element of the universal life insurance is the flexibility of premium for the policyholder. It separates term insurance from cash value element of the policy.

13. Why are all participating policies written in an insurance company’s general account?

All participating policies by the insurance company are written in the general account. The general account of an insurance company refers to the investment portfolio of the overall company. Such products “Written by the company itself” are said to have a “general account guarantee” i.e. they are a liability of the insurance company. The rating agencies provide a credit rating based on products written by or guaranteed by the general account.

14. Whose liabilities are harder to predict, life insurers or property and casualty insurers? Explain why.

Property and casualty insurers P&Cs. Life insurance actuaries can predict death rates among various age groups based upon historical data.  With P&Cs, the timing and amount of payoffs are almost random by nature.  Past experience provides little predictive assistance.  Homeowner claims are just as likely to arise in the first year of a policy or ten years later.  Even then, the dollar amount of damage claims can be small or for the entire value of the policy.

15. How does the Financial Modernization Act of 1999 affect the insurance industry?

The Financial Modernization Act of 1999 will affect significantly the insurance industry in several ways. Even before this act, there was an increase overlap of insurance, investment, pension products and the distribution of products. The passage of this act has accelerated this convergence. This act has eliminated the barriers between insurance companies, commercial banks, and investment banks and various combinations will continue to evolve.