Comparison of Typical Plan Features in Visual Studio .NET

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Table 8.1 Comparison of Typical Plan Features
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Defined Benefit Plans Regular Participation Contributions Investment risk Disability coverage Loans Distribution form Benefit guaranty Automatic Employer Employer Yes N/A Annuity PBGC Cash Balance Automatic Employer Employer Yes N/A Lump sum PBGC Defined Contribution Plans 401(k) Voluntary Employer and employee Employee No Allowed Lump sum N/A
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PBGC, Pension Benefit Guaranty Corporation.
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General Trends
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get comfortable with the use of derivatives to help control the risk of their pension plans.
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Modern Portfolio Theory Basics
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To understand portable alpha strategies, you need to get comfortable with some basic concepts from modern portfolio theory. Investment return from any actively managed portfolio can be broken into two pieces, as shown in Figure 8.1. Beta is defined as the investment return generated from market exposure and is essentially the return earned for bearing the risk of being invested in the market. Alpha, on the other hand, is the excess return either positive or negative that a fund manager generates from the active management of the portfolio. The holy grail of any investment manager search is to find those managers who can produce alpha.
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Traditional Investment Manager Searches
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Historically, pension funds have attempted to find these alpha-generating managers through traditional investment management searches looking for the best investment manager in various asset classes. So, for example, a pension fund would determine its asset allocation say 15 percent or $15 million targeted to the U.S. long bond asset class. The fiduciaries would then hire an investment consultant to help them find the best manager in that particular asset class. After a search, the fund would give the entire $15 million to the investment manager, who would then deploy the dollars according to their strategy. The investment manager would be compensated at a level say 50 basis points on the entire $15 million or $75,000. The fiduciaries would sit around and hope that this manager could replicate his or her past performance and in fact produce positive alpha while being exposed to the asset class s beta.
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Beta Market Return (index/benchmark/ asset class return)
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Alpha Excess Return (fund manager s value added)
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Portfolio Return
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FIGURE 8.1 A portfolio s return is a combination of beta (the return of the market) and alpha (the excess return, or fund manager s valued added).
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A MANAGER S GUIDE TO STRATEGIC RETIREMENT PLAN MANAGEMENT
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Portable Alpha Process
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Compared with the traditional investment model just described, portable alpha strategies divorce the search for alpha from beta. The following example provides more detail on how strategy is deployed (see Figure 8.2).
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Sample Scenario
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Using the same example above with a $15 million desired allocation to U.S. long bonds, the fiduciaries have confidence in a European equity manager and believe they will produce significant alpha in the near term. In addition, the expected alpha of the European equity manager is significantly higher than the expected alpha of the current U.S. long bond manager. The fiduciaries, however, do not want to be exposed to the European equity market. So, they adopt a portable alpha strategy as follows: 1. 2. 3. Allocate fund to the European equity manager seeking high alpha. Use derivatives to short the European equity market (i.e., sell futures of the Japanese market). Use derivatives to long the U.S. long bond market (i.e., buy futures of the U.S. long bond market). Some key benefits of a portable alpha strategy include:
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Separates the search of alpha from the search of beta (asset allocation exposures). Targets investment management fees to alpha sources and reduces investment management fees for beta sources. Can diversify across multiple, uncorrelated alpha sources while maintaining pension plan s asset allocation exposures. Some challenges of executing a portable alpha strategy include:
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Plan sponsor must find alpha sources on a consistent basis. Successful coordination between alpha generators and the porting process is critical. Plan sponsor must be comfortable with entering into the derivative marketplace. Many pension plan IPS s specifically exclude derivatives from allowable assets.
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Overall, portable alpha strategies can be very appealing to pension plan sponsors as they look for ways to control the risks in their pension plans. And more important than specifically portable alpha strategies, we