andytrader

The discount rate used to determine the present value of pension liabilities is the fund’s:

A) contribution return.

B) required return.

C) desired return.

---

The discount rate used to determine present value of pension liabilities is that rate which discounts pension benefits, and hence, dictates the rate of return on pension assets that must be met to fund pension benefits. A fund’s desired return, however, may be higher and could relate to the amount of contributions a firm makes to the plan and/or the amount of benefits a plan wishes to offer participants.

andytrader

The liquidity requirement of a pension plan is directly related to and increased by a:

A) high proportion of retired lives.

B) high proportion of active lives.

C) low proportion of retired lives.

---

Pension plan liquidity requirements are increased by the proportion of participants currently receiving benefits. Hence, a high proportion of retired lives, those currently receiving benefits, indicates a larger liquidity requirement.

andytrader

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

A) The firm's declining growth rate.

B) A declining debt/equity ratio.

C) Pension surplus.

---

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 sponsor’s financial status and profitability affect how much risk the plan can take. Both of the other selections are positives for the plan.

andytrader

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

A) high plan sponsor leverage.

B) high retired-lives proportion.

C) low retired-lives proportion.

---

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

andytrader

Pension fund risk tolerance increases according to:

A) greater plan sponsor leverage.

B) high flexibility in plan features.

C) less plan sponsor leverage.

---

Pension fund risk tolerance increases when the plan sponsor has lower leverage. The higher the correlation between 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.

andytrader

Pension fund risk tolerance increases with:

A) provisions for early retirement or lump-sum payouts.

B) a low retired lives portion.

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

---

A low number of retired lives usually indicates an increased ability to take risk. Both of the other answers work to decrease pension fund risk tolerance. 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. Plans that offer early retirement or lump-sum payments essentially decrease the time horizon of the retirement liability and increase the liquidity requirements of the plan, so the ability to tolerate risk is decreased.

andytrader

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

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

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

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

---

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.

andytrader

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 sponsor’s ability to make pension contributions? A:

A) 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.

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) 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.

---

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

andytrader

Ace Manufacturing’s 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 Ace’s current workforce is 53, and the retired-lives proportion of pension plan participants is 62%. Which of the following statements most appropriately fits in Ace’s 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 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.

---

Although Ace’s 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.

andytrader

A defined benefit plan should:

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

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

C) review investment performance on a yearly basis.

---

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