Managing Institutional Investor Portfolios －LO investment, policy

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

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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) Workforce characteristics.

C) Sponsor financial status.

D) Plan features.

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Answer and Explanation

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

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The Smithersons 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 Foundations investment policy statement?

A) 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 percent spending requirement should be discouraged.

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

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.

D) All family foundations must have low risk tolerance to maintain perpetual purchasing power. Asset returns beyond the risk-free rates is discouraged.

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Answer and Explanation

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

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

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

B) The return should be 5 percent of the plan's assets plus the expected inflation rate.

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

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

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Answer and Explanation

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 plans funding status and contributions dictated by accrued benefits.

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A defined benefit plan should:

A) not ever be overly concerned with respect to liquidity.

B) review investment performance on a yearly basis.

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

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

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Answer and Explanation

As a tax-exempt investor, there should be no preference over income or capital gains. Liquidity is a concern if there are retired lives in the plan. Investment performance should be reviewed quarterly, and the IPS reviewed at least annually. The IPS should be the first step in the process.

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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) 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.

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

C) Even though hedge funds and derivatives offer attractive returns, smaller firms may not be able to invest in them because these firms cannot exercise the appropriate level of due diligence that these investments require.

D) 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.

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Answer and Explanation

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.

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

A) Plan B.

B) Plan A.

C) Plan C.

D) Plan D.

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Answer and Explanation

Currently, there is no surplus or deficit. So, if Waldrops plan assets can exactly match its liability stream, the firm will be able to meet pension liabilities. Pegging returns relative to a benchmark will not guarantee that liabilities will be met.

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

A) Plan B.

B) Plan A.

C) Plan D.

D) Plan C.

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Answer and Explanation

If Waldrop were to take on either extremely high or low risk strategies, the potential to not meet plan liabilities is great. Too much risk could mean loss of principal and too little risk could mean that plan assets would be inadequate because of inflation.

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

A) Plan B.

B) Plan D.

C) Plan C.

D) Plan A.

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Answer and Explanation

With only 5 percent of participants retired and the median age of 40, the firm has a fairly long time horizon. Although the theoretical time horizon for an ongoing plan is infinite, there are current retirees to consider.

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Based on the information provided above, which policy statement has the appropriate language for Waldrops investment policy statement (IPS) with respect to liquidity?

A) Plan B.

B) Plan C.

C) Plan D.

D) Plan A.

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Answer and Explanation

Because only 5 percent of participants require monthly benefit payments, liquidity needs are minimal.

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

A) Plan A.

B) Plan B.

C) Plan C.

D) Plan D.

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Answer and Explanation

High employee turnover (60 percent of current employees with firm less than 5 years) means the probability of eventually paying out benefits is reduced. Firm stability is important as it relates to financial performance of the firm. The fact that the firm almost went bankrupt 50 years ago is not relevant today, as it has been viable sincesomething most firms cant claim.

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Waldrops plan allocation to Treasury bills should be:

A) higher.

B) the same.

C) lower.

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

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Answer and Explanation

Liquidity needs of the plan are very low with only 5 percent of participants retired. This level of safety is unwarranted. Assets should be redeployed into higher return assets than Treasury bills.

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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) The plan must adhere to Employee Retirement Income Security Act (ERISA).

D) Adequate liquidity must be maintained to meet liabilities.

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Answer and Explanation

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.