andytrader

In setting a risk objective for a defined benefit plan, which of the following should NOT be considered?

A) Investment education expertise of employees.

B) Sponsor financial status.

C) Workforce characteristics.

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Employees are not responsible for investment performance for defined benefit plans. However, the plan must concern itself with the workforce characteristics (ages), and sponsor financial status (is it capable of funding the plan now and in the future).

andytrader

The Smitherson’s Family Foundation was created to fund causes dear to the family. An initial grant of $35,000,000 was established in the hopes of finding deserving projects to receive funding. The Foundation was established with a perpetual life, and one of its investment goals is to maintain the purchasing power of present assets. Which of the following represents a reasonable objective in the Foundation’s investment policy statement?

A) The perpetual life of the plan indicates a moderate to high risk tolerance. Return objectives are to meet the required 5% private foundation spending requirement in addition to covering inflation expectations. Evaluating investments from a total return perspective is warranted.

B) The perpetual life of the plan indicates a low to moderate risk stance. In order to preserve purchasing power, investment in the safest of all assets is critical. Investing in assets returning in excess of the required 5% spending requirement should be discouraged.

C) All family foundations must have high risk tolerance to maintain perpetual purchasing power. Return objectives should be commensurate with the risk stance and, therefore, achieving highest growth oriented returns is prescribed.

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The perpetual life of the Smitherson Family Foundation indicates a moderate to high risk tolerance. Return requirements are at least the regulatory-dictated 5% spending requirement plus inflation expectations. A total return investment objective is warranted.

andytrader

Which of the following return objectives is most appropriate for a defined benefit pension plan?

A) The return on plan assets should be 50 basis points greater than the actuarial rate applied to the plan's liabilities.

B) The return on plan assets should be equal to or greater than the plan's spending rate.

C) To earn an inflation-adjusted return that is adequate to fund plan liabilities.

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The ultimate goal of a pension plan is to have pension assets generate returns sufficient to cover pension liabilities on an inflation-adjusted basis. The specific return requirement will depend on the plan’s funding status and contributions dictated by accrued benefits.

andytrader

Which of the following statements would NOT be consistent with an investment policy statement (IPS) for a defined benefit plan?

A) No objectives and constraints are needed.

B) Tax consequences can be ignored.

C) Adequate liquidity must be maintained to meet liabilities.

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No objectives and constraints are needed for defined contribution plans in that each employee is responsible for his/her investing. They are very much needed for defined benefit plans.

andytrader

When formulating an investment policy statement for a defined benefit pension plan, legal and regulatory factors, in addition to unique circumstances, must be considered. In this regard, which of the following statements is least accurate?

A) In the United States, the provisions of the Employee Retirement Income Security Act (ERISA) must be adhered to regardless of any state or local laws and regulations that govern pension investment activity.

B) The basic tenet of the Employee Retirement Income Security Act (ERISA) is that pension plans be managed with equal regard for the interests of plan sponsors and plan beneficiaries.

C) Due to either ethical or political objections, a pension plan may disallow investments in certain types of traditional or alternative asset classes.

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The fundamental standard of care required by ERISA is that pension fund assets must be invested for the sole benefit of plan participants and not that of plan sponsors.

andytrader

Genentron is a small biotechnology firm that is developing new therapies and drugs for different types of cancer. Genentron has a number of benefits for its employees, including a defined benefit pension plan. The plan is overseen by Rolf Pyle and Shannon DeGroot, both senior executives with Genentron. Most of Genentron’s employees are younger, so Pyle and DeGroot have invested the pension plan’s investment portfolio aggressively. Currently, the pension portfolio allocation is 30% in the Russell 1000 Growth Index and 70% in the Commodore Health Care Fund. Pyle and DeGroot are discussing the allocation of the plan at the most recent meeting. Pyle states, “If the health care industry leads the market again this year, it is unlikely that our pension expense will have much impact on our strong earnings, and we will be able to share more of those earnings with our shareholders.” DeGroot replies, “The allocation of our pension assets should ensure that Genentron will not have to make large pension contributions even if profitability is low.”

With regard to their statements about Genetron’s pension plan:

A) Pyle’s statement is correct; DeGroot’s statement is correct.

B) Pyle’s statement is correct; DeGroot’s statement is incorrect.

C) Pyle’s statement is incorrect; DeGroot’s statement is incorrect.

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With 70% of Genentron’s pension assets allocated to a health care fund, the correlation between the firm’s pension assets and profits is likely to be strong. Pyle’s statement is correct – if the health care industry has strong performance, both Genetron’s profits and the performance of the pension plan are likely to be high. When a firm is generating high profits simultaneously with high returns, the probability of the firm having to make a pension contribution is low, and if a contribution is made, the amount is likely to be small.

DeGroot’s statement is incorrect. Since the correlation between Genentron’s operations and its pension portfolio is high, if the firm’s profitability is low, the firm has a higher probability of making a large pension contribution. To avoid the problem of having to make a large contribution at a time when the ability to make contributions is low, companies should seek to have a low correlation between pension assets and firm operations.

andytrader

The pension plan at Ferrell Manufacturing currently has a surplus. Ferrell’s management team wants to maintain the level of the surplus and keep it as stable as possible. In order to accomplish their goal, how should they position the correlation of the pension plan’s assets with the pension liabilities and the firm’s operations respectively?

Correlation of Assets with Liabilities

Correlation of Assets with Firm Operations

A) Low Low

B) High Low

C) High High

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In order to have a more stable pension plan surplus, the firm should construct plan liabilities and assets in such a way that changes in pension plan asset valuations are highly correlated with pension plan liabilities, but uncorrelated (low correlation) with the firm’s core operations. This would ensure that pension fund assets increase in value at the same time liabilities do, keeping funding status unaffected by the firm’s ability or inability to make contributions.

andytrader

Brown Textiles has constructed its pension plan investment policy so that its pension assets have a high correlation with pension plan liabilities and a zero correlation with the firm’s operations. Which of the following is the most likely impact of following such an investment policy?

A) The firm will have a high probability of making pension payments when its ability to fund those payments is high.

B) A positive long-run impact on firm valuation, and a more stable pension surplus.

C) The firm will have a high probability of making pension payments when its ability to fund those payments is low.

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If pension plan assets are highly correlated with liabilities, but have a zero correlation with firm operations, this would ensure that pension plan assets increase in value at the same time liabilities increase, while the funding status of the plan will be unaffected by the firm’s ability or inability to make contributions. In the long run, the effect on firm valuation and the firm’s constituents will be positive due to decreased volatility in fund surplus and the firm’s earnings. Note that a high correlation between the firm’s operations and its pension assets means the firm would have a low probability of making pension payments when its ability to fund those payments is high, and a high probability of making pension payments when its ability to fund those payments is low.

andytrader

Which of the following would be included in an investment policy statement (IPS) for a defined contribution plan?

A) A description of the investment alternatives available to plan participants.

B) Risk objectives.

C) Time horizon.

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In a defined contribution plan, the plan sponsor does not establish objectives and constraints but rather the plan participants set their own risk and return objectives.

andytrader

Which of the following statements about defined contribution investment policy statements (IPS) is least accurate?

A) Plan sponsors should provide education about investing plan funds.

B) Procedures are established to insure that a myriad of individual investor objectives and constraints can be handled.

C) IPS for defined benefit and defined contribution plans are similar in nature.

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Defined contribution plans call for quite a different IPS than do defined benefit plans.