Managing Institutional Investor Portfolios －LO management, investing, assets

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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 e: Evaluate the risk management considerations in investing pension plan assets.

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Brown Textiles has constructed its pension plan investment policy so that its pension assets have a high correlation with pension plan liabilities and a zero correlation with the firms operations. Which of the following is the most likely impact of following such an investment policy?

A) The firm will have a high probability of making pension payments when its ability to fund those payments is low.

B) The firm will have a low probability of making pension payments when its ability to fund those payments is high.

C) A positive long-run impact on firm valuation, and a more stable pension surplus.

D) The firm will have a high probability of making pension payments when its ability to fund those payments is high.

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Answer and Explanation

If pension plan assets are highly correlated with liabilities, but have a zero correlation with firm operations, this would ensure that pension plan assets increase in value at the same time liabilities increase, while the funding status of the plan will be unaffected by the firms ability or inability to make contributions. In the long run, the effect on firm valuation and the firms constituents will be positive due to decreased volatility in fund surplus and the firms earnings. Note that a high correlation between the firms operations and its pension assets means the firm would have a low probability of making pension payments when its ability to fund those payments is high, and a high probability of making pension payments when its ability to fund those payments is low.

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The pension plan at Ferrell Manufacturing currently has a surplus. Ferrells management team wants to maintain the level of the surplus and keep it as stable as possible. In order to accomplish their goal, how should they position the correlation of the pension plans assets with the pension liabilities and the firms operations respectively?

Correlation of Assets with Liabilities

Correlation of Assets with Firm Operations

A) High Low

B) High High

C) Low Low

D) Low High

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Answer and Explanation

In order to have a more stable pension plan surplus, the firm should construct plan liabilities and assets in such a way that changes in pension plan asset valuations are highly correlated with pension plan liabilities, but uncorrelated (low correlation) with the firms core operations. This would ensure that pension fund assets increase in value at the same time liabilities do, keeping funding status unaffected by the firms ability or inability to make contributions.

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Genentron is a small biotechnology firm that is developing new therapies and drugs for different types of cancer. Genentron has a number of benefits for its employees, including a defined benefit pension plan. The plan is overseen by Rolf Pyle and Shannon DeGroot, both senior executives with Genentron. Most of Genentrons employees are younger, so Pyle and DeGroot have invested the pension plans investment portfolio aggressively. Currently, the pension portfolio allocation is 30 percent in the Russell 1000 Growth Index and 70 percent in the Commodore Health Care Fund. Pyle and DeGroot are discussing the allocation of the plan at the most recent meeting. Pyle states, If the health care industry leads the market again this year, it is unlikely that our pension expense will have much impact on our strong earnings, and we will be able to share more of those earnings with our shareholders. DeGroot replies, The allocation of our pension assets should ensure that Genentron will not have to make large pension contributions even if profitability is low.

With regard to their statements about Genetrons pension plan:

A) Pyles statement is correct; DeGroots statement is incorrect.

B) Pyles statement is incorrect; DeGroots statement is incorrect.

C) Pyles statement is incorrect; DeGroots statement is correct.

D) Pyles statement is correct; DeGroots statement is correct.

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Answer and Explanation

With 70 percent of Genentrons pension assets allocated to a health care fund, the correlation between the firms pension assets and profits is likely to be strong. Pyles statement is correct if the health care industry has strong performance, both Genetrons profits and the performance of the pension plan are likely to be high. When a firm is generating high profits simultaneously with high returns, the probability of the firm having to make a pension contribution is low, and if a contribution is made, the amount is likely to be small.

DeGroots statement is incorrect. Since the correlation between Genentrons operations and its pension portfolio is high, if the firms profitability is low, the firm has a higher probability of making a large pension contribution. To avoid the problem of having to make a large contribution at a time when the ability to make contributions is low, companies should seek to have a low correlation between pension assets and firm operations.