5. In the McKi insey report, \"Bending the third rail: Better investment perform

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5. In the McKi insey report, "Bending the third rail: Better investment performance or US pensions", why do US pensions cannot meet their obligations to th eneficiaries? How should these pensions react to the tough situation? eir (15 viarks) 6· The risk free rate is 5%. You have following information: Return 0.15 0.20 0.10 0.17 0.13 Bota 1.0 1.5 0.6 1.1 1.0 Portfolio 0.05 0.10 0.03 0.06 0.04 Market Compute Sharpe ratios, Treynor ratios, and Jensen's alphas for each portfolio and market portfolio; a) b) Rank the portfolios using each measure, explaining the cause for any differences c) you find in the rankings. If market portfolio is fair priced, are other portfolios also fair priced? (25 Marks)

Explanation / Answer

5.In the McKinsey report , 'Bending the third rail: Better investment performance for US pensions' why do US pensions cannot meet their obligations to their beneficiaries ? How Should these pensions reacts to the tough situation?

In current scenario, funds will not be able to meet all of their obligations to their beneficiaries as between 2006 and today, the average funded ratio of major public pensions has dropped from 83 percent to just 72 percent—meaning nearly 30 percent of pensions will not be paid, unless taxpayers cover the difference. In dollar terms, we estimate that gap at $1.6 trillion.

The situation has been deteriorating for some time and has recently been made worse by three structural changes. First, life expectancy is rising; today’s retirees will be drawing their pensions for about two years longer than in 2000.

Second, in a related phenomenon, the population is aging; fewer working-age people are supporting more retirees.

Third, the markets in which pensions invest have changed.

The gap between expectations and reality has become wide and pensions have begun to gradually reduce their discount rate from 8.2 percent in 1999 to 7.4 percent today. That has pushed up estimates of future liabilities by about $150 billion.

Pensions have also shifted their investments away from low-risk fixed income and toward higher-volatility equities and alternative assets. Pensions’ fixed-income allocations have shrunk from more than 75 percent in 1982 to just 27 percent currently.

6.1. The risk free rate is 5% 0.05 portfolio Portfoilo returns Beta stdev P 0.15 1 0.05 Q 0.2 1.5 0.1 R 0.1 0.6 0.03 S 0.17 1.1 0.06 Market 0.13 1 0.04 Treynor ratios The Treynor measure, also known as the reward-to-volatility ratio, can be easily defined as: (Portfolio Return – Risk-Free Rate) / Beta P 10% Q 10% R 8% S 11% Market 8% Sharp ratio The Sharpe ratio can be easily defined as: (Portfolio Return – Risk-Free Rate) / Standard Deviation      (Portfolio Return – Risk-Free Rate) / Standard Deviation P 2.0 Q 1.5 R 1.7 S 2.0 Market 2.0 Jensen Alpha Jensen's Alpha = Portfolio Return – Benchmark Portfolio Return Benchmark Return (CAPM) = Risk-Free Rate of Return + Beta (Return of Market – Risk-Free Rate of Return)     =0.05+1*(0.13-0.05) 0.13 Market Return    = Portfolio Return – Benchmark Portfolio Return P 0.15 0.02 Q 0.2 0.07 R 0.1 -0.03 S 0.17 0.04 Benchmark return 0.13 2 Rank the portfolio using each measures, explaining the cause for any difference you find in the ranking. By referring Treynor ratio, portfolio S is on the rank one as it has higher ratio and other portfolio will rank in decending order. By referring sharp ratio, portfolio P &S has ratio 2 which is in line with the market ratio. By referring Jensen's alpha , portfolio Q has outperformed than expected return so it will rank first and other will rank in decending order 3 Yes, as the CAPM is most often used to determine what the fair price of an investment should be. When you calculate the risky asset's rate of return using CAPM, that rate can then be used to discount the investment's future cash flows to their present value and thus arrive at the investment's fair value.

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