Reading 26: Asset Allocation LOS m～ Q12-13

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Q12. Shad Reed is on the Board of Trustees for the Wesley Ridge World Hunger Organization. The primary role of the organization is to oversee a large endowment fund that was originally established in 1995 as the Wesley Ridge U.S. Hunger Fund to provide food to low income children in the United States. Recently, the original donor for the endowment has died and provided the fund another $200 million in his will and broadened the scope of the fund to provide food for hungry children all over the world. With the new addition, the endowment’s assets are currently valued at $600 million. When the fund was originally established, the spending rate was 5%; however, with the broader scope, the payout has increased to 6%. Also, since funds are going to be distributed to other countries, the board has determined that approximately 25% of the foundation’s annual payout will be in the foreign currencies of other countries. The fund’s investment policy statement which has been revised by the board is shown below:

Return Objective	Accounting for inflation of 2.5% and the new spending rate of 6%, the return requirement for the plan is 8.5%. A total return approach is appropriate.
Risk Tolerance	Above average, although risk tolerance has declined due to higher spending needs.
Liquidity	The endowment has minimal operating expenditures – liquidity requirements are low.
Time Horizon	Long-term
Legal/Regulatory	N/A
Taxes	N/A
Unique Considerations	N/A

The board has consulted with an investment advisor to discuss changes to the endowment’s current asset allocation which is shown below:

Asset Class	Allocation (%)	Expected Return	Expected Standard Deviation
Cash	2%	3.0%	2%
Intermediate-term U.S. Treasury bonds	28%	5.5%	7%
Foreign Government Bonds	8%	6.5%	10%
U.S. equities	50%	9.5%	18%
International equities	7%	11.0%	23%
Venture Capital	5%	19.0%	38%

Which of the following sets of recommendations would be most appropriate for the endowment fund?

A) Increase the allocation to cash, decrease the allocation to U.S. equities, decrease the allocation to international equities, and increase the allocation to venture capital.

B) Decrease the allocation to U.S. Equities, decrease the allocation to international equities, increase the allocation to foreign government bonds, and increase the allocation to intermediate-term U.S. Treasury bonds.

C) Increase the allocation to foreign government bonds, increase the allocation to international equities, keep the allocation to cash the same, and keep the allocation to venture capital the same.

Q13. Todd Zattau is the chief financial officer for the Crandall Steel Company, a mature U.S. steel processing company. The company provides a traditional defined benefit pension plan to all of its employees. The plan covers 5,000 employees and the average age of workers who will eventually collect benefits is 52. Approximately 45% of the plan’s participants are now retired and are receiving benefits. Zattau has hired Kara Rittenhouse, a financial advisor to help him construct an IPS for the plan as well as recommend revisions to the plan’s current investment allocation.
Zattau’s progress on the IPS so far is shown below:

Return Objective	The discount rate applied to liabilities is 6.5%. Desired level of returns is 7.2%.
Risk Tolerance	?
Liquidity	?
Time Horizon	Company is a going concern, and new employees are still being added to the defined benefit plan, so the actual time horizon of the plan is infinite. However, the high percentage of retired participants and older workforce reduces the effective time horizon of the plan considerably.
Legal/Regulatory	Plan is subject to ERISA requirements.
Taxes	None
Unique Considerations	Plan is currently underfunded by 4%.

The current investment allocation for the plan is shown below:

Asset Class	Allocation (%)	Expected Return
Cash	3%	3.0%
Intermediate-term Treasury bonds	25%	5.0%
High quality corporate bonds	32%	5.5%
U.S. equities	10%	8.5%
International equities	10%	10.0%
Venture Capital	15%	19.0%

Based on the information provided, what is the risk tolerance for the Crandall Steel Pension plan, and what should Rittenhouse recommend for the plan’s allocation to cash and U.S. equities respectively?

Risk Tolerance Cash Allocation U.S. Equities Allocation

A) Below Average Higher Higher

B) Above Average Adequate Higher

C) Below Average Lower Lower