Managing Institutional Investor Portfolios －LO status, class, common

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CFA Institute Area 3-5, 7, 12, 14-18: Portfolio Management
Session 5: Portfolio Management for Institutional Investors
Reading 21: Managing Institutional Investor Portfolios
LOS c: Evaluate pension fund risk tolerance when risk is considered from the perspective of the (1) plan surplus, (2) sponsor financial status and profitability, (3) sponsor and pension fund common risk exposures, (4) plan features, and (5) workforce characteristics.

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Which of the following changes to the fund's IPS should Sargent recommend?

A) The fund's liquidity constraint should be rewritten to reflect moderate liquidity requirements consistent with the fund's low risk tolerance.

B) A return objective of 10% is not consistent with a below average risk tolerance. Therefore, the fund should target a lower return objective in order to be consistent with the low risk tolerance.

C) The fund should add a "legal" component to their IPS that states that ERISA is not applicable to the management of pension funds.

D) The risk tolerance for the fund should be much higher because of the long-term nature of the obligations and the need to preserve capital through equity investment to guard against inflation eroding the value of the assets.

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Answer and Explanation

The fund is able to take on more risk in search of higher returns than suggested in the current IPS because of the long-term horizon and low liquidity constraints. The current employees are relatively young, few retirees are making income demands on the fund, and the plan is over-funded. Therefore the return objective and liquidity constraints are appropriate; the risk tolerance should be rewritten to be consistent. An emphasis on safety (presumably through low-risk bonds and treasury bills) will leave the fund exposed to inflation risk in the long-term.

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Sargent should recommend that the allocation to the equally weighted equity portfolio be:

A) decreased significantly because it is not consistent with the fund's return objective.

B) increased significantly because it is most likely uncorrelated with the firm's operating cash flows.

C) decreased significantly because it is most likely highly correlated with the firm's operating cash flows.

D) increased significantly because it has favorable risk-return characteristics relative to the other funds.

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Answer and Explanation

With a defined benefit plan, the firm faces the potential risk that in an economic downturn, the investment performance of the fund is 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. In this case, the firm's stock returns are highly correlated with the Dow Jones Industrial Average. An equally weighted fund of 25 large industrial stocks is probably also highly correlated with the Dow. Therefore the allocation to this fund should be decreased significantly. In fact, given that it is dominated by the DJIA index fund (lower return, same volatility), Sargent could argue that it should be replaced completely. However, Portfolios B and C are even better choices.

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Sargent should recommend which of the following allocations?

A) AAA Corporate Bonds Treasury Bills decrease decrease

B) AAA Corporate Bonds Treasury Bills increase increase

C) AAA Corporate Bonds Treasury Bills increase decrease

D) AAA Corporate Bonds Treasury Bills decrease increase

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Answer and Explanation

The fund is in a position to take on increased risk. Sargent should recommend decreasing the allocation to bonds and increasing the exposure to equities to provide inflation protection. A significant allocation to treasury bills is unnecessary given the low liquidity requirements.

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Ace Manufacturings pension plan is currently under-funded by $15,000,000. Earnings for Ace have been under pressure for the past five years, and although the downward trend seems to have been slowed, prospects for earnings growth are not promising. The average age of Aces current workforce is 53, and the retired-lives proportion of pension plan participants is 62 percent. Which of the following statements most appropriately fits in Aces investment policy statement for its pension plan?

A) Due to the current under-funded status, relatively older workforce age, and high retired-lives proportion, Ace's pension plan risk tolerance profile needs to be moderate to high. The plan's return objective should be to generate high levels of return to cover the plan shortfall through aggressive growth investment vehicles.

B) The current under-funded status of the pension plan should have no bearing on the risk tolerance or return objectives of the plan's investment policy statement. Pension plans should pursue as high a return as possible in order to minimize contributions and/or increase benefits.

C) Due to the current under-funded status, relatively older workforce age, and high retired-lives proportion, Ace's pension plan willingness to take risk should be high. Ability to take risk in this scenario takes second place to the firm's willingness to close the funding gap and lower pension contributions. The plan's return objective, therefore, should be to achieve as high a return as possible by investing in aggressive growth-oriented investments.

D) Due to the current under-funded status, relatively older workforce age, and high retired-lives proportion, Ace's pension plan risk tolerance profile is low to moderate. The plan's return objective should be to meet the pension benefit payment requirements of the high level of the current retired-lives proportion of participants and those soon approaching retirement. Matching plan assets with plan liabilities is a must.

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Answer and Explanation

Although Aces willingness to take risk may be high, the current under-funded status, older workforce age, and high proportion of retired lives dictates a lower than average ability to take risk. Hence, risk tolerance should be low to moderate. Assets should be chosen that deliver returns that match liability payments of current retirees and those about to enter retirement.

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Which of the following scenarios will result in the lowest volatility in the surplus of a defined benefit pension plan, while at the same time keeping funding status independent of the plan sponsors ability to make pension contributions? A:

A) low correlation between pension fund assets and pension fund liabilities, and a low correlation between pension fund assets and the pension sponsor's operating performance.

B) high correlation between pension fund assets and pension fund liabilities, and a high correlation between pension fund assets and the pension sponsor's operating performance.

C) high correlation between pension fund assets and pension fund liabilities, and a low correlation between pension fund assets and the pension sponsor's operating performance.

D) low correlation between pension fund assets and pension fund liabilities, and a high correlation between pension fund assets and the pension sponsor's operating performance.

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Answer and Explanation

The likelihood of a neutral impact on a firms earnings is increased when changes in the value of pension assets are highly correlated with pension liabilities but uncorrelated with the firms operating performance. This ensures that funding the surplus is constant and independent of the pension sponsors ability or inability to make contributions to the plan.

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The potential effect of a pension plan policy that positively impacts a plan surplus is a:

A) high discount rate, low plan feature flexibility, and low liquidity requirements.

B) low discount rate, high retired-lives portion, and high liquidity.

C) high discount rate, plenty of plan feature flexibility, and high liquidity requirements.

D) high discount rate, high retired-lives portion, and plenty of plan feature flexibility.

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Answer and Explanation

Pension plan surplus may be positively impacted by using a high discount rate to determine the present value of liabilities, generating a pension plan that has no flexibility (e.g., no early retirement provisions), and having a pension plan with low liquidity requirements.

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Which of the following could dictate that a pension fund take on less risk?

A) A declining debt/equity ratio.

B) Younger workforce.

C) The firm's declining growth rate.

D) Pension surplus.

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Answer and Explanation

The question obviously refers to defined benefit plans. If the firm is experiencing declining sales growth, then this speaks negatively about the financial status of the company. The sponsors financial status and profitability affect how much risk the plan can take. All other selections are positives for the plan.

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Pension fund risk tolerance decreases with:

A) no provisions for plan flexibility.

B) low plan sponsor leverage.

C) high plan asset and plan sponsor operating characteristic correlation.

D) low retired lives portion.

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Answer and Explanation

Pension fund risk tolerance decreases when plan assets and plan sponsor operating characteristics have high correlation. The ability for the plan sponsor to make contributions is decreased at the most inopportune time when plan assets and operating characteristics are highly correlated. Hence, risk tolerance decreases in a highly correlated environment. All other answers work to increase pension fund risk tolerance.

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Pension fund risk tolerance increases according to:

A) greater plan sponsor leverage.

B) high plan asset and plan sponsor operating characteristic correlation.

C) high flexibility in plan features.

D) less plan sponsor leverage.

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Answer and Explanation

Pension fund risk tolerance increases when the plan sponsor has lower leverage. The higher the correlation between plan assets and sponsor activities, as well as high flexibility in plan features (e.g., early retirement options), work to decrease the risk tolerance of a pension plan.

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Pension fund risk tolerance is increased by a young workforce and:

A) high retired-lives proportion.

B) high plan sponsor leverage.

C) low retired-lives proportion.

D) low plan surplus.

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Answer and Explanation

Pension fund risk tolerance is increased by having a young workforce and a small proportion of retired lives. All other combinations with a young workforce will tend to decrease risk tolerance.