endowment annual total return = annual contribution + expense growth + management fees
(inflation is captured in expense growth)
the greater the reliance on the endowment to fund operations w/o any other sources of funds, the lower the risk tolerance of the endowment. If endowment can get donations even when it supports 75% of univ operating budget, the risk tolerance is considered high.
min return requirement of DB pension plan -> the rate that equates PV of plan assets to PV of plan liabilities, if plan is fully funded, use the discount rate to compute pernsion benefit obligation.
casualty insurance risk tolerance: uncertain loss claims by clients -> short duration, lower risk tolerance
endowment above average risk tolerance : long investment time horizon
In a defined benefit pension plan, meeting the liability is the investment objective and portfolio's benchmark.
Liability mimicking
The managers create an investment benchmark from assets that mimic the specific market-related risks associated with the pension liabilities. Then managers use derivatives to hedge the market-related exposures of the liability-mimicking assets making up the investment benchmark. This is more efficient than investing in the low risk portfolio defined by the investment benchmark because the derivatives require far less capital, thus freeing up funds. The funds can then be used for efficient return generation within asset-only space once the liabilities have been hedged. The funds invested in this asset-only space allow the pension plan to generate returns in excess of the pension liabilities, thereby decreasing the need for future cash contributions.
Investment Policy Statement (IPS) case study
The Somchai Foundation (SF), was established to provide grants in perpetuity. SF has just received word that the foundation will receive a $45 million cash gift three months from now. The gift will greatly increase the size of the foundation’s endowment from its current $10 million. The foundation’s grant-making (spending) policy has been to pay out virtually all of its annual net investment income. Because its investment approach has been conservative, the endowment portfolio now consists almost entirely of fixed-income assets. The finance committee understands that these actions are causing the real value of foundation assets and the real value of future grants to decline because of inflation effects. Until now, the finance committee believed it had no alternative to these actions, given the large immediate cash needs of the research programs being funded and the small size of the foundation’s capital base. The foundation’s annual grants must at least equal 5 percent of its assets’ market value to maintain SF’s tax-exempt status, a requirement that is expected to continue indefinitely. The foundation anticipates no additional gifts or fundraising activity for the foreseeable future.
Given the change in circumstances that the cash gift will make, the finance committee wishes to develop new grant-making and investment policies. Annual spending must at least meet the 5 percent of market value requirement, but the committee is unsure how much higher spending can or should be. The committee wants to pay out as much as possible because of the critical nature of the research being funded; however, it understands that preserving the real value of the foundation’s assets is equally important in order to preserve its future grant-making capabilities. You have been asked to assist the committee in developing appropriate policies.
Identify and discuss the three key elements that should determine the foundation’s grant-making (spending) policy.
Formulate and justify an investment policy statement for the foundation.
Answer:
Three key elements:
- expected inflation
- expected nominal return
- the 5% min payout requirement to maintain tax exempt status
IPS (Investment Policy Statement)
return objectives:
the foundation must maintain the real value of its capital, after grants. The minimum return requirement should be spending rate + expected inflation + management fee
risk objectives:
based on long time horizon and low liquidity need, the foundation's risk tolerance is above average.
liquidity needs:
low
time horizon:
foundation has long time horizon, unlimited life span
tax considerations:
tax exempt if annual spending more than 5% of its assets' market value
legal and regulatory constraints:
the foundation is governed by IRS and UMIFA regulations.
unique circumstances:
none
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