Managing Institutional Investor Portfolios －LO advantages

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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 a, (Part 2): Discuss the advantages and disadvantages of a defined-benefit plan and a defined-contributuion plan.

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Which of the following is a characteristic of a defined-contribution pension plan?

A) Investment risk of plan assets is shifted to the individual.

B) Benefits are based on specific formulas relating to employee earnings or length of service.

C) Up to a maximum limit, the Pension Benefit Guaranty Corp (PBGC) insures plan contributions.

D) If the plan sponsor is no longer a going concern (in termination) then plan participants have first claim against the assets of the pension fund.

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Answer and Explanation

For defined contribution plans, investment risk is borne by the pension beneficiary. The plan sponsor, and frequently the plan participant, make defined contributions to the plan. The pension benefit to the participant is based on the pension funds investment performance.

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Which of the following is a characteristic of a defined-benefit pension plan?

A) Contributions to the plan are typically a percentage of plan participants current pay.

B) The use of defined benefit plans has grown in recent years due to the relaxation of ERISA standards.

C) Defined benefit plans are less expensive to administer and young employees like the portable nature of their contributions.

D) Plan sponsors bear all investment risk. They are liable for shortages and have a claim against excess returns.

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Answer and Explanation

Retirement benefits from a defined benefit plan are based on a "defined benefit" formula. This is what the company owes the plans participants, regardless of the performance of the pension funds assets, and if the funds returns fall short of the pension obligations, the plan sponsor is liable for the difference. Defined benefit plans are costlier and riskier than defined contribution plans. Thus, defined contribution plans are the preferred pension plan for most employers. Also, since plan contributions are transferable to other plans, defined contribution plans are attractive to many young employees.

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A defined benefit plan differs from a defined contribution plan in that the:

A) risk/return tradeoffs of plan assets accrue to the plan sponsor.

B) risk/return tradeoffs of plan assets accrue to the participant.

C) investment decisions are made by the participant.

D) benefit paid by the sponsor is defined by contributions made to the plan.

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Answer and Explanation

All investment decisions are made by the plan sponsor, and all risk/return tradeoffs accrue to the sponsor. The benefits paid by a defined benefit plan are determined by a specified benefit formula, not by what was contributed to the plan.

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A defined contribution plan differs from a defined benefit plan in that the:

A) risk/return tradeoffs of plan assets accrue to the plan sponsor.

B) investment decisions are made by the plan sponsor.

C) benefit is defined by a benefit formula.

D) risk/return tradeoffs of plan assets accrue to the participant.

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Answer and Explanation

All investment decisions of defined contribution assets are made by the participant, which dictates to whom plan asset risk/return tradeoffs accruethe participant. The benefit paid is determined by the value of the investment assets at retirement. The only requirement of the plan sponsor is the stated contribution made to the participants account.