Managing Institutional Investor Portfolios －LO hybrid, employee, balance

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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 g: Discuss hybrid pension plans (e.g.,cash balance plans) and employee stock ownership plans.

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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 years 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) Beerys statement is correct; Harbals statement is correct.

B) Beerys statement is correct; Harbals statement is incorrect.

C) Beerys statement is incorrect; Harbals statement is incorrect.

D) Beerys statement is incorrect; Harbals statement is correct.

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Answer and Explanation

An ESOP is a type of defined-contribution plan that allows employees to purchase company stock, sometimes at a discount to the market price. Beerys statement is correct. Occasionally, an ESOP will purchase a large block of the firms 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. Harbals statement is incorrect. The account balance shown on a cash balance plans statement to a beneficiary is calculated on paper only based on a participants 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) Investment risk in an ESOP is held by plan beneficiaries.

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

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

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Answer and Explanation

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 HALs board of directors about cash balance plans, Mark Davidson, HALs Vice President of Human Resources puts together a memo that includes two statements regarding cash balance plans.

Statement 1:	The amount credited to a participants 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) incorrect with respect to Statement 1, but correct with respect to Statement 2.

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

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

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

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Answer and Explanation

Statement 1 is correct. In a typical cash balance plan, a participants account is credited each year with a pay credit and interest credit. The pay credit is typically based on the beneficiarys 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 plans investments do not affect the benefit amounts promised to participants.