Reading 26: Linking Pension Liabilities to Assets－LOS c liability, designed, relative, discuss

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CFA Institute Area 3-5, 7, 12, 14-18: Portfolio Management
Session 7: Asset Allocation
Reading 26: Linking Pension Liabilities to Assets
LOS c: Compare pension portfolios built from a traditional asset-only perspective to portfolios designed relative to liabilities and discuss why corporations may choose not to fully implement the liability mimicking portfolio.

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Which of the following is NOT a characteristic of the liability-mimicking portfolio for a pension? The liability-mimicking portfolio:

A) will have low risk.

B) should be used as a benchmark.

C) will be costly.

D) will have a high return.

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Answer and Explanation

The liability-mimicking, low-risk portfolio will be costly. The future liability from future service rendered and future participants is uncertain and is not funded. An investment in the liability-mimicking portfolio would therefore require future cash payments by the sponsor to satisfy these obligations. By construction, the liability-mimicking portfolio will not provide a return in excess of the liabilities. For pension plans, the best use of the liability-mimicking portfolio would be as a benchmark.

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Which of the following would NOT be typically included in the asset-only approach portfolio of a pension?

A) Equities.

B) Short-duration bonds.

C) Medium-duration bonds.

D) Derivative contracts.

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Answer and Explanation

In the traditional asset-only approach, the portfolio is usually composed of 60%-70% equities with the rest in short and medium duration nominal bonds.

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Which of the following would result in a pension plan investing more in equities?

A) The workforce is younger.

B) The retirement benefits are indexed to inflation.

C) The pension plan was frozen.

D) The retirement benefits are no longer indexed to inflation.

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Answer and Explanation

If the workforce is younger, more will be allocated to equities. If there were more inflation indexing, inflation-indexed bonds would be emphasized. If there were less inflation indexing, nominal bonds would be emphasized. If the plan was frozen, there would be no future obligations and nominal bonds would dominate the portfolio.