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Which of the following statements are correct regarding a participant-directed defined contribution plan?

Statement 1: The plan should be responsible for establishing and revising the interest rate for plan loans to participants.
Statement 2: The plan should provide criteria for manager/fund selection, termination and replacement.

Statement 1

Statement 2

A) Correct Correct

B) Incorrect Incorrect

C) Incorrect Correct

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Instead of stating objectives and constraints (as in defined benefit plans), the purpose of a participant-directed defined contribution investment policy statement is to provide a governing document that describes the investment strategies and alternatives available to plan participants. Some defined contribution plans allow plan participants to take out loans against the amount they contributed.

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Gina Manley, CFA, is a pension fund manager for Brooke and Associates. She manages the pension fund accounts for several small and medium-sized firms.
Company owner Herb Brooke has tasked Manley with reviewing the firm’s asset-allocation policy. In the past, Brooke and Associates included large-company international stocks and large-company domestic stocks as part of the same asset class because they have similar risk and return properties, even though they have a low (0.4) correlation with each other. Venture capital was included as part of the small-company stock asset class because it has a high correlation (above 0.7) with small-company stocks, even though the risk of venture capital investments is far greater than the risk of small company stocks.
As part of her portfolio management duties, Manley has recently taken over two pension accounts from other fund managers. The first account is the Crandall Company pension account. In reviewing the investment policy for Crandall, she finds a statement that "the fund shall not directly use equity futures, nor shall it hire any outside money manager that uses equity futures as part of its investment strategy in managing the fund’s assets."
The second new account Manley has recently acquired is the Cooper Company pension fund. The fund currently has a 70% allocation in equities, including 10% in Cooper stock, with the rest in bonds. The plan is currently underfunded. Manley believes the fund’s equity portfolio, including the Cooper stock, will provide an annualized return of 8% over the next five years. The fund’s long-term, investment-grade bonds should provide a 4% return.
Manley is also working with a new client, Chapman Inc., to set up a new pension fund. Manley’s discussions so far have been directly with the owner, David Chapman. Manley has laid out for Chapman the advantages and disadvantages of defined-benefit plans and defined-contribution plans. She tells Chapman about the following characteristics of defined-contribution plans:

• The employee makes regular contributions to the fund.
• Benefits are based on formulas relating to employee earnings or length of service.
• The employee bears all of the investment risk.
• The employer has no financial obligation beyond making contributions.

Chapman is comfortable with Brooke and Associates, likes Manley’s work, and he decides to set up a defined benefit plan instead of a defined contribution plan. In the process of gathering data, Manley discovers the following information about Chapman Inc.:

• The company is five years old.
• Most of Chapman’s employees graduated from college less than 10 years ago.
• Stock options represent a significant portion of most employees’ compensation.
• The median annual salary of Chapman employees is $65,000.

David Chapman and two of his vice presidents plan to retire within the next two years.Which of the following is least likely to be an investment constraint for the Chapman pension fund?

A) Liquidity.

B) Taxes.

C) Investment horizon.

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Given the tax-deferred status of pension funds, taxes are usually not an important issue. Liquidity constraints depend on the age of the work force, and must be given consideration. A pension fund’s investment horizon also depends on the age of the work force and whether or not the firm is a going concern. While the work force is mostly young, the firm does have some older workers, and thus cannot ignore liquidity and time horizons. (Study Session 5, LOS 15.b)

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Regarding the Cooper Company pension plan, Manley’s best course of action is to:

A) lower the fund’s equity allocation by selling the Cooper stock.

B) increase the allocation to equities because risk diminishes over time.

C) lower the fund’s equity allocation, but not sell the Cooper stock, as such a large sale would drive the price down.

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Manley’s fiduciary duty is to the beneficiaries of the plan, not the company. While holding the Cooper stock may benefit the shareholders, it is unlikely to benefit the employees. The company stock provides an undiversified position that is correlated with the employees’ human capital and should be sold. An equity allocation of 70% would be considered high for most pension plans (the average is around 50%), so while diversifying the bond holdings may be a good move, maintaining the equity weighting is not. Some thought could be given to the fact that the plan is underfunded, and that the plan needs growth. In this situation, the plan also needs to protect the existing assets from too much risk so that the underfunding situation is not exacerbated. In this case, reducing the equity weight to an average level and increasing contributions would be the best course of action. (Study Session 5, LOS 15.f)

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Which of the following is the best justification for Crandall Company’s futures policy?

A) Futures are used to manage short-term risks, and the fund should be concerned with long-term risks.

B) The use of futures is inconsistent with the Prudent Expert Rule of ERISA.

C) Futures are used mainly for speculative purposes.

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Most futures transactions are used to manage short-term risks and those transactions might not impact long-term risks. Futures are often used to hedge equity holdings, and nothing in the Prudent Expert Rule would prohibit their use under the proper circumstances. The fund’s bond holdings are irrelevant, as long as there are equity holdings for which futures could be used to hedge risk. (Study Session 5, LOS 15.l)

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Which of Manley's statements regarding defined-contribution plans is least accurate?

A) The employee makes regular contributions to the fund.

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

C) The employer has no financial obligation beyond making contributions to the plan.

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In a defined-contribution plan, the employee typically makes regular contributions to a fund that the company matches according to some formula, such as a percentage of current pay. The employee bears all of the investment risk in a defined contribution plan, and the employer has no financial obligation beyond making regular contributions on behalf of qualifying employees. (Study Session 5, LOS 15.a)

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Regarding its asset classes, Brooke and Associates’ best course of action is to:

A) separate international stocks as a unique asset class, but leave venture capital in the small-company stock class.

B) separate venture capital as a unique asset class, but leave international stocks in the large-company stock class.

C) separate both venture capital and international stocks as unique asset classes.

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It is easier to optimize portfolios using asset classes with different risk characteristics and low correlation with other asset classes. None of the answers are wrong, but separating international stocks and venture capital into their own classes allows for the most precise optimization. (Study Session 5, LOS 15.f)

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Which of the following represents the most appropriate asset allocation for Chapman’s pension fund?

A) 60% large-cap stocks, 30% small-cap stocks, 10% foreign stocks.

B) 40% investment-grade bonds, 30% small-cap stocks, 20% large-cap stocks, 10% venture capital.

C) 40% large-cap stocks, 30% high-yield bonds, 20% investment-grade bonds, 10% real estate.

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No matter how young the work force, an all-equity investment mix is inappropriate for a pension fund, which is always going to have at least a slight need for liquidity (particularly when the chairman and his lieutenants retire), and must be managed in such a way as to reduce risk. However, the youth of Chapman’s work force suggests a 70% weighting in bonds is too conservative. The mix of large-cap stocks and investment-grade and high-yield bonds is attractive, but most of Chapman’s employees are both young and well-paid, suggesting they have a high risk tolerance as well as low liquidity demands. The best option is the mix of investment-grade bonds, small-cap and large-cap stocks, and venture capital, the portfolio that probably offers the highest total return. There is nothing wrong with taking some risks in a pension plan, as long as those risks are well considered and suitable given the characteristics of the work force. (Study Session 5, LOS 15.f)

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Jim Findlay is the Founder and CEO of Impact Products. Findlay takes great pride in having his firm be on the leading edge of providing benefits to employees. Every year, Findlay sits down with his two senior executives, Jeff Beery and Tom Harbal to discuss various employee benefit plans. This year’s focus is on employee stock ownership plans (ESOPs) and cash balance plans. With regard to ESOPs, Beery states, “In addition to the benefits to employees, an ESOP would be a useful way for you as owner of the company, Mr. Findlay, to liquidate a large block of your Impact Product holdings.” After further discussion, they move on to discussing cash balance plans. Harbal reports, “Unlike regular pension plans, cash balance plans can never be under funded because the cash balance reflects the actual amount put away for employees.” With regard to their statements about ESOPs and cash balance plans:

A) Beery’s statement is correct; Harbal’s statement is correct.

B) Beery’s statement is correct; Harbal’s statement is incorrect.

C) Beery’s statement is incorrect; Harbal’s statement is incorrect.

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An ESOP is a type of defined-contribution plan that allows employees to purchase company stock, sometimes at a discount to the market price. Beery’s statement is correct. Occasionally, an ESOP will purchase a large block of the firm’s stock directly from a large stockholder (such as an owner who wants to liquidate a holding). The stock is then purchased at regular intervals by plan beneficiaries. Harbal’s statement is incorrect. The account balance shown on a cash balance plan’s statement to a beneficiary is calculated on paper only based on a participant’s credits. It is possible for a company not to fund its obligation, resulting in an underfunded cash balance plan.

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Which of the following is NOT a characteristic of employee stock ownership plans (ESOP)?

A) ESOPs typically allow employees to purchase company stock at a discount from the current market price.

B) The regulation of ESOPs can vary widely across countries.

C) An ESOP is typically funded by a company issuing new stock specifically to fund the ESOP.

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ESOPs are typically funded with existing shares that are either repurchased by the company in the open market, or directly from a large shareholder. The other characteristics listed correctly describe features of ESOPs.

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HAL Corporation is considering shifting their current defined-benefit pension plan to a cash balance plan. In an effort to educate HAL’s board of directors about cash balance plans, Mark Davidson, HAL’s Vice President of Human Resources puts together a memo that includes two statements regarding cash balance plans.

Statement 1:	The amount credited to a participant’s account in a cash balance plan is a function of salary, length of employment, and a benchmark interest rate.
Statement 2:	Converting our defined-benefit pension plan to a cash balance plan would effective shift investment risk from us as the employer to the employee.

With regard to the statements in the memo, Davidson is:

A) correct with respect to Statement 1, but incorrect with respect to Statement 2.

B) correct with respect to Statement 1 and Statement 2.

C) incorrect with respect to Statement 1, but correct with respect to Statement 2.

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Statement 1 is correct. In a typical cash balance plan, a participant’s account is credited each year with a pay credit and interest credit. The pay credit is typically based on the beneficiary’s salary, age, and/or length of employment, while the interest credit is based up on a benchmark such as U.S. Treasuries. Statement 2 is incorrect. The sponsor of a cash balance plan (employer) bears all investment risk since increases and decreases of a plan’s investments do not affect the benefit amounts promised to participants.

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Which of the following statements regarding foundations is most accurate?

A) An operating foundation is generally funded by the organization it is intended to support.

B) Independent foundations receive their funds from an individual, family, or group.

C) Grants from company-sponsored foundations must be made without regard to the sponsoring company’s business interest.

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Company executives usually dominate the board of trustees for a company-sponsored foundation, which may use grants to further corporate interest. A fund owned and funded by the organization it is intended to support is called an endowment, not a foundation.

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Which of the following types of foundations do NOT have a spending requirement?

A) Independent.

B) Operating.

C) Community.

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Independent (or private) and company-sponsored foundations must spend five percent of their assets annually toward non-operating expenses to maintain their tax-exempt status. Operating foundations must use 85% of interest and dividend income to conduct the institution’s own program.

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Which of the following statements regarding foundations is CORRECT?

A) An operating foundation is generally funded to support a variety of social causes over time.

B) Independent foundations provide grants to charities, educational institutions, and social organizations.

C) A community foundation is dedicated solely to support a specific organization or some on-going research initiative.

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An operating foundation is funded solely to support a specific organization or some on-going research initiative. A community foundation typically funds social, educational, or religious initiatives.

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Manuel Insman, CFA, has just been assigned responsibilities for insurance industry clients at Frontgate, a research and portfolio management boutique. Insman’s first concern is to identify insurance industry investment characteristics. The main purpose of this activity is to formulate a turn-key investment policy statement (IPS) that will increase the efficiency of managing client assets. By doing so, Insman hopes to add value not only to his employer, but to the firm’s investment clientele. To better understand the nuances of the insurance industry, Insman attends a one-day seminar at a local university with Saul Stetson, another portfolio manager. The seminar instructor feels that it is best to separate life insurance from property and casualty (P&C) insurance companies because of their differing investment objectives and constraints. Therefore, the morning session is devoted strictly to the life insurance industry.  
The instructor begins by reviewing how the life insurance industry has changed over the years and briefly discusses a variety of new products. He points out that changes in the industry have resulted in the classification of investment activities into segments having different return objectives. He stresses that although life insurance products have a tremendous variety of features, his research indicates that return objectives are often segmented as follows:

• Minimum Return
• Enhanced Margin Return
• Surplus Return

Insman also learns that life insurance companies are often perceived to be quasi-trust funds, and hence, require attention to objectives and constraints that are not typically found in other investment policy statements. Insman makes a list of specific factors often used to determine life insurance risk objectives or liquidity requirements:

• Cash flow volatility
• Effects of disintermediation
• Reinvestment risk
• Asset-liability mismatches
• Credit risk
• Portfolio manager style characteristics
• Asset marketability
• Liability marketability

The afternoon session of the seminar is devoted to non-life—primarily P&C—companies. The instructor explains the underwriting cycle, as well as key investment policy considerations.
Insman has a hard time keeping up with all of the information the instructor is conveying, and thinks his notes on P&C liabilities might be incorrect. To check, he asks his colleague Stetson to help him clarify the differences between P&C liabilities and those of life insurance companies.
Stetson says “I believe P&C liabilities are unknown in timing and amount, whereas life insurance company liabilities are unknown in timing but known in amount.”
Insman replies “Are you sure? I thought the instructor said that P&C liabilities are unknown in timing but known in amount, whereas life insurance companies are known in amount and timing.”
Insman continues, “Well what about the underwriting cycle? It’s approximately five to seven years and tends to follow the general business cycle doesn’t it?”
Stetson declares otherwise. “I agree that the underwriting cycle is five to seven years long but it runs counter to the business cycle.”Which of the following best characterizes enhanced margin return?

A) A net interest spread above the returns needed to fund liabilities; thus making it possible to offer competitive premiums.

B) The excess rate of return derived from using enhanced indexing portfolio management strategies.

C) Enhanced returns from equity-oriented investments designed to increase the surplus segment.

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Enhanced margin: The rate associated with efforts to earn competitive returns on assets funding well-defined liabilities. Spread management techniques are used. If done successfully, a return in excess of a policy’s crediting rate can be earned, giving life insurance companies a competitive edge in setting policy premiums and adding new business.  
Surplus return: The difference between total assets and total liabilities is surplus. The primary objective of surplus management is to generate growth, which is key to expanding insurance volume.
Minimum return: The mandated return applied to assets earmarked to meet death benefits. The minimum rate of return is a statutory rate (normally actuarially determined) that will ensure funding so that reserves are sufficient to meet mortality predictions. (Study Session 5, LOS 15.i)

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Insman wants to subdivide the list of factors impacting life insurance risk tolerance and liquidity. Which of the following set of factors best encompasses the most important risk considerations?

A) Cash flow volatility, reinvestment risk, and credit risk.

B) Credit risk, asset-liability mismatches, and portfolio manager style characteristics.

C) Cash flow volatility, disintermediation effects, and asset marketability risk.

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Cash flow volatility, reinvestment risk, credit risk, and asset valuation fluctuations are generally considered to be the most important risk factors to be evaluated when determining the risk objectives of a life insurance company. Liquidity is directly affected by the possibility of disintermediation, asset-liability mismatches, and asset marketability risk. The style characteristics of a portfolio manager are considered after risk objectives are determined, not during the formulation of the risk objectives. (Study Session 5, LOS 15.i)

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When life insurance companies assess liquidity requirements, they do NOT typically address:

A) the effects of disintermediation.

B) asset-liability mismatches.

C) risks associated with liability marketability.

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Life insurance companies are required to pay an increasing amount of attention to disintermediation and asset-liability mismatches. Both of these factors impact the liquidity of asset portfolio investments. (Study Session 5, LOS 15.i)

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Which of the following best describes the accuracy of Insman’s and Stetson’s statements about P&C versus life insurance liabilities?

A) Insman is correct; Stetson is incorrect.

B) Insman is incorrect; Stetson is incorrect.

C) Insman is incorrect; Stetson is correct.

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P&C liabilities are unknown in timing and amount. Life insurance companies know the amount of the liability (the death benefit), but not the timing. (Study Session 5, LOS 15.i)

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Which of the following best describes the accuracy of Insman’s and Stetson’s statements about the P&C underwriting cycle?

A) Insman is incorrect; Stetson is correct.

B) Insman is correct; Stetson is incorrect.

C) Insman is incorrect; Stetson is incorrect.

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Evidence indicates the P&C underwriting cycle lasts three to five years and tends to follow general business cycles. (Study Session 5, LOS 15.i)

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The unique characteristics of P&C liability structure will have the greatest effect on which of the following constraints?

A) Time horizon and liquidity.

B) Time horizon and taxes.

C) The regulatory environment and unique considerations.

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The uncertainty associated with P&C liability structure has the greatest impact on the liquidity and time horizon constraints. (Study Session 5, LOS 15.i)

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The time horizon of a non-life insurance company differs from that of a pension fund in that a nonlife insurance company’s time horizon:

A) is dependent on the uncertainties of policies sold, whereas the time horizon of a pension fund is a direct consequence of the business cycle.

B) is quite long due to the uncertainty of the liability structure associated with policies sold, whereas a pension fund's time horizon will be much shorter due to the finite life of employees.

C) may be quite short and will depend upon the characteristics of policies sold, whereas a pension fund's time horizon may be much longer, depending on workforce characteristics.

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Due to the uncertainty associated with the characteristics of policies sold and when claims will be paid, the time horizon of a nonlife insurance company will necessarily be short. A pension fund, however, will have a time horizon typically longer than that of a nonlife insurance company. The pension fund’s time horizon will be directly related to the plan sponsor’s workforce characteristics.