A number of years ago Palmer Steel Company began offering a defined contribution pension plan only to new employees, while retaining a defined benefit plan for current employees. As a result the firm must now administer two pension plans: a defined contribution plan for its 2,500 current employees and a defined benefit plan for 1,000 older employees, almost all of whom are now retired. The firm expects to fund pension payments to retired employees out of the defined benefit plan for the next 20 years. Recent operating problems in the volatile steel industry have resulted in several years of losses and layoffs at Palmer Steel, as well as a weak company balance sheet. The assets in the defined benefit plan have a moderate degree of correlation with the firm's operating income. The fund currently has a 10 percent surplus. Inflation is expected to average 3 percent per year for the foreseeable future. The required real rate of return in the defined benefit plan based on actuarial assumptions is 5%. The duration of the fund's liabilities is 8 years. Because the firm is in the position of having to administer two types of pension plans, Todd Thoms, the CFO, is reviewing the relevant management issues in preparation for a presentation to the Board of Directors. Which of the following issues is framed properly from the perspective of both Palmer Steel and its employees?
A) | One shortcoming of the defined contribution plan from the employees' perspective is that the long-term rate of return is highly uncertain, and depends on investment choices made by employees. |
| | B) | One shortcoming of the defined contribution plan from the perspective of Palmer Steel is that it is more costly to administer. |
| | C) | Palmer Steel should focus more of its attention on the management of the assets in the defined contribution fund, because the company bears the investment risk in the defined contribution plan, but not the defined benefit plan. |
| | D) | Palmer Steel should diversify the assets of BOTH plans so that the correlation between those assets and the operating cash flow of the firm itself is low, in order to improve the probability of BOTH funds meeting their respective obligations. |
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Answer and Explanation
Defined benefit pension plans tend to be more costly for the company to administer. The company bears the investment risk in a defined benefit plan, and employees bear the investment risk in a defined contribution plan. The correlation between plan assets and company cash flow is an important consideration for a defined benefit plan but not a defined contribution plan. With a defined benefit plan, the firm faces the potential risk that in slow economic conditions, the investment performance of the fund will be reduced, increasing the firm's funding obligation to keep the plan fully funded, at the same time as the firm's operating cash flow is reduced.
Choose the answer that best completes the return objective for the defined benefit plan. The return objective is to generate total returns sufficient to meet projected pension liabilities while protecting against inflation. The effective maturity of the pension liabilities and the volatility of the firm's earnings require an emphasis on:
| A) | income-producing assets with a nominal return of 5% and a portfolio with a duration of 20 years. |
| B) | income-producing assets with a nominal return of 8% and a portfolio with a duration of 8 years. |
| | C) | income-producing assets with a nominal return of 8% and a portfolio with a maturity of 20 years. |
| | D) | long-term capital gains to minimize taxes and a nominal after-tax return of 8% and a portfolio with a duration of 8 years. |
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Answer and Explanation
The return requirement is the real return required on the plan assets plus the expected inflation rate, 5% + 3% = 8%. Because of the short-term nature of the liabilities, the portfolio should be managed to match the duration of the liabilities (8 years), not the expected final maturity of the last payment (20 years). Taxes are not a consideration in a pension plan.
Which of the following factors is NOT consistent with a low risk tolerance for the defined benefit fund?
| A) | Palmer Steel has a weak balance sheet. |
| | B) | Palmer Steel has volatile operating earnings. |
| | C) | The beneficiaries of the fund are older, retired employees. |
| D) | The plan has a surplus. |
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Answer and Explanation
Over-funded pension plans can be somewhat more risk tolerant, all else equal, because the over-funding is a cushion against short-term fluctuations in investment returns. All other choices are consistent with a lower risk tolerance.
Which of the following constraints is appropriate to include in the defined benefit plan's Investment Policy Statement?
A) | Taxes are not a major issue for the fund because earnings are tax-exempt. |
| | B) | Liquidity needs are low because of the low correlation between the fund assets and the firm's operating income. |
| | C) | The time horizon is infinite because the fund will be paying out benefits under the plan for the next 20 years, which is longer than the typical market cycle. |
| | D) | The fund is constrained to operate under the regulations of ERISA, which require the fund be managed solely in the interest of the plan sponsors and beneficiaries, using the standard of the Prudent Man Rule. |
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Answer and Explanation
The short-term pension liabilities require significant liquidity. The investment horizon should approximately match the duration of the liabilities, which is 8 years. ERISA requires the standard of the Prudent Expert Rule, rather than the more restrictive Prudent Man Rule, and that the fund is managed in the sole interests of the plan beneficiaries, not the plan sponsors.
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发表于 2008-9-17 11:20
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