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.
The promised benefits are a known obligation, which makes liability-relative investing the natural framework rather than benchmarking to a market index.
A harder one
Why must an endowment target a real return above its spending rate?
- To satisfy a regulatory minimum returnWhy not: No regulator sets a return floor. The requirement comes from the arithmetic of perpetual spending.
- To preserve the corpus in real terms — correct
- Because endowments are taxed on nominal returnsWhy not: Most are tax exempt, and the real-return requirement would hold even if they were not.
Distributions must be funded in perpetuity without eroding purchasing power. Spending plus inflation is the hurdle, and earning less than that reduces what future generations can be given.
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
Regulated capital requirements also penalise asset-liability mismatch. The endowment's spending is discretionary and can be reduced; the insurer's claims cannot, and solvency rules make the mismatch expensive in capital terms as well as risky.
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