Reading 22: Allocating Shareholder Capital to Pension Plans class, framework, different, maintain

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CFA Institute Area 3-5, 7, 12, 14-18: Portfolio Management
Session 5: Portfolio Management for Institutional Investors
Reading 22: Allocating Shareholder Capital to Pension Plans
LOS c: Explain, in an expanded balance sheet framework, the effects of different pension asset allocations on total asset betas, the equity capital needed to maintain equity beta at a desired level, and the debt/equity ratio.

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When the pension asset allocation changes which of the following is least likely to occur?

A) As the percentage of pension assets invested in equities increases the overall risk of the firm increases.

B) The higher the investment in bonds in the pension assets the more debt the firm will need to issue to maintain the same overall level of risk in the firms capital structure.

C) The equity beta will change while the total value of firm assets remains constant.

D) The total value of liabilities and equity stays the same even though the amount of equity capital changes.

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Answer and Explanation

The firms equity beta remains the same as the asset allocation in the pension assets changes but the total asset beta, equity capital, debt financing, and debt-to-equity ratio will all change. As the percentage of pension assets invested in equities increases the total asset beta will increase and to maintain the same equity beta the level of risk in the firms capital structure must decrease, thus the firm must issue more equity and reduce the amount of debt financing hence the debt-to-equity ratio will decrease.

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A firm increases the risk of its pension assets by investing those assets in a higher percentage of equities. The amount of equity capital needed to maintain the same equity beta and the resulting debt/equity ratio respectively would:

Equity Capital

Debt/Equity

A) Decrease Decrease

B) Increase Increase

C) Increase Decrease

D) Decrease Increase

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Answer and Explanation

A higher percentage of the pension assets invested in equities will increase the risk of the pension assets resulting in a higher total asset beta. To maintain the same equity beta there must be a decrease in risk in the capital structure of the firm. To accomplish this the amount of equity issued must increase along with a decrease in debt financing thus the debt/equity ratio will decrease.

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If a company changes its allocation of pension assets to be invested more heavily in bonds while maintaining the same equity beta, what is the likely effect on the:

Total asset beta?

Debt/equity ratio?

A) Increase Decrease

B) Increase Increase

C) Decrease Increase

D) Decrease Decrease

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Answer and Explanation

As the pension assets are invested more heavily in bonds the pension asset risk will decrease causing the total asset beta to decrease. To keep the equity holders and creditors satisfied that the overall risk of the firm has not changed there must be a corresponding increase in debt financing thus the debt/equity ratio will increase.

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To maintain the same equity beta after decreasing the percentage of pension assets invested in equities a firm would need to:

A) decrease the amount of risk in its capital structure by using less equity capital.

B) decrease the amount of risk in its capital structure by using less debt financing.

C) increase the amount of risk in its capital structure by using more debt financing.

D) increase the amount of risk in its capital structure by using more equity capital.

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Answer and Explanation

Decreasing the percentage of pension assets invested in equities will decrease the risk of the pension assets decreasing the overall total asset beta. To maintain the same equity beta there must be an increase in risk in the overall capital structure of the firm which would be accomplished by using more debt financing and decreasing the amount of equity capital.