LOS d: Formulate an investment policy statement for a defined-benefit plan.

Q1. 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 FALSE?

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

C)   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.

Q2. Which of the following statements would NOT be consistent with an investment policy statement (IPS) for a defined benefit plan?

A)   Tax consequences can be ignored.

B)   Adequate liquidity must be maintained to meet liabilities.

C)   No objectives and constraints are needed.

Q3. 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.

Q4. Waldrop, Inc., has been in the livestock business for 60 years. Total assets of the firm are $25 billion. The firm’s 127 employees are covered by a defined benefit pension plan. The pension has assets of $5 billion and liabilities of $5 billion. The discount rate applied to liabilities is 7%. The average return is 10%, and 5% of participants are currently retired. Approximately 60% of current employees have been with the firm for less than 5 years. The median age of Waldrop’s workforce is 40. Employees can retire with full benefits at age 60 with 15 years of service.

Rubin Edwards, CFA, has been hired by Waldrop to oversee its pension. On his first day of work, he realizes an investment policy statement does not exist. Edwards presents the following to Waldrop management.

Also included in his recommendations are the following asset allocations.

Based on the information provided above, which policy statement has the appropriate language for Waldrop’s investment policy statement (IPS) with respect to return requirements?

A)   Plan C.

B)   Plan A.

C)   Plan B.

Q5. Based on the information provided above, which policy statement has the appropriate language for Waldrop’s investment policy statement (IPS) with respect to risk tolerance?

A)   Plan B.

B)   Plan C.

C)   Plan A.

Q6. Based on the information provided above, which policy statement has the appropriate language for Waldrop’s investment policy statement (IPS) with respect to time horizon?

A)   Plan C.

B)   Plan B.

C)   Plan D.

Q7. Based on the information provided above, which policy statement has the appropriate language for Waldrop’s investment policy statement (IPS) with respect to liquidity?

A)   Plan D.

B)   Plan A.

C)   Plan B.

Q8. Based on the information provided above, which policy statement has the appropriate language for Waldrop’s investment policy statement (IPS) with respect to unique circumstances?

A)   Plan A.

B)   Plan B.

C)   Plan C.

Q9. Waldrop’s plan allocation to Treasury bills should be:

A)   higher.

B)   the same and then increase over time as the median age of their work force increases.

C)   lower.

Q10. 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.

Q11. In setting a risk objective for a defined benefit plan, which of the following should NOT be considered?

A)   Sponsor financial status.

B)   Workforce characteristics.

C)   Investment education expertise of employees.

Q12. A defined benefit plan should:

A)   invest plan assets without distinction between the tax consequences of returns generated from income and returns generated from capital gains.

B)   construct an investment policy statement (IPS) after a manager has been chosen for the plan.

C)   review investment performance on a yearly basis.