Set out the kinds of investor and the particular needs of each
The idea
Individuals vary enormously but share a finite horizon and a tax position. Defined benefit pensions have long horizons and defined liabilities, which makes the liability rather than an index the natural benchmark. Endowments and foundations are perpetual but must fund a spending rate, so they need real returns above that rate. Insurers invest against actuarially estimated claims and are tightly regulated; banks manage a spread against a deposit base. Sovereign wealth funds typically have very long horizons and few liquidity constraints. Horizon, liquidity need, liabilities, tax and regulation differ across all of them.
A practice question
Which investor type has a defined set of future liabilities to fund?
- A defined benefit pension plan - correct
- A sovereign wealth fundWhy not: Typically has a broad mandate and no contractual payment schedule, which is what gives it such a long horizon.
- An individual with no dependantsWhy not: Has goals rather than obligations, and can revise them.
A liability is money you must pay in the future. A defined benefit pension plan promises members set pension payments, so it has known obligations to fund. Because of this, it is natural to measure investments against those liabilities, not against a market index. An individual has goals that can be changed. A sovereign wealth fund (money owned by a government) usually has no fixed payment schedule.
A harder one
Chiamaka Eze is preparing an induction briefing for new analysts on three types of institutional client: a defined benefit pension plan, a property and casualty insurer, and a university endowment. She wants to include one statement about their needs that is correct. Which statement should she choose?
- A pension plan's natural benchmark is its liability stream - correct
- An insurer's claims are known in timing and amountWhy not: Insurers invest against claims that are estimated actuarially, so both the timing and the size are uncertain. That uncertainty is what shapes their liquidity needs and regulation.
- An endowment's horizon ends once its spending needs are metWhy not: An endowment is typically perpetual: it funds a spending rate from a permanent corpus, so it needs real returns above that rate for as long as it exists.
A defined benefit pension plan has a long horizon and fixed promises, the pensions it must pay. Its success is best measured against those liabilities rather than a market index, so the liability stream is its natural benchmark. The other statements are wrong. An insurer's claims are estimated by actuaries (insurance mathematicians), so their timing and size are uncertain. An endowment is usually perpetual and must fund a spending rate, so its horizon does not end. Needs differ across investor types in horizon, liquidity, liabilities, tax and regulation.
The hardest tier
Why is a life insurer's asset allocation more constrained than an endowment's despite both having long horizons?
- Because insurers may not invest in equitiesWhy not: They may, and do, within limits. The constraint is on how much, not whether.
- Because insurers have shorter horizons than endowmentsWhy not: The question stipulates both are long. What differs is the nature of the obligations.
- Because its liabilities are contractual - correct
Both have long horizons, but their obligations differ. A life insurer owes contractual payments to policyholders, and it cannot cut them. An endowment's spending is a choice that can be reduced in bad years. Regulators also require insurers to hold capital against a mismatch between what they own and what they owe. Funding gap = Value of assets - Value of liabilities. Because shortfalls are costly and risky, insurers must match assets to liabilities more closely, which limits their allocation.
In the app: 9 practice questions on this outcome, a narrated walkthrough with diagrams, spaced review that brings it back before you forget it.
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