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Portfolio Management and Wealth Planning【Reading 15】

The funding status of an ongoing defined benefit plan is usually computed by the plan’s:
A)
accumulated benefit obligation (ABO).
B)
total future liability (TFL).
C)
projected benefit obligation (PBO).



Funding status is the relationship between present value of pension assets and present value of pension liabilities. Determining over- or under-funded status for an ongoing defined benefit plan is usually computed using the plan’s projected benefit obligation (PBO). Defined contribution plans do not have a funded status.

Which of the following statements about participant-directed defined contribution plans is CORRECT?
A)
The plan must offer a sufficient number of investment vehicles for suitable portfolio construction.
B)
Defined contribution plans are not subject to ERISA.
C)
Defined contribution plans are structured similar to foundations.



For participant-directed defined contribution plans, each employee has his/her own account; hence, the structure is not similar to foundations. Defined contribution plans are subject to ERISA.

TOP

From the perspective of the employer, which of the following statements is most accurate? A defined:
A)
contribution plan can be underfunded; a defined benefit plan is more risky.
B)
benefit plan can be underfunded; a defined contribution plan is less risky.
C)
benefit plan can be underfunded; a defined contribution plan is more risky.



A defined benefit plan is underfunded when the present value of the liabilities exceeds the present value of the plan’s assets. A defined contribution plan cannot become underfunded, and is, therefore, considered to be less risky from the standpoint of the employer.

TOP

Which of the following statements regarding defined benefit and defined contribution pension plans is least accurate?
A)
The liability to a defined contribution plan sponsor is the current plan contribution requirement.
B)
The risk and return of defined benefit pension fund investments is borne by the plan participants.
C)
Promised benefits under a defined benefit plan are paid to plan participants at retirement and represent a liability to the plan sponsor.



As long as a pension sponsor is solvent, the performance of the fund’s investments has no impact on the benefits promised to the employees covered by the plan. The risk and return characteristics of the assets of a defined benefit pension fund are borne by the plan sponsor.

TOP

A number of years ago Palmer Steel Company began offering a defined contribution pension plan only to new employees, while retaining a defined benefit plan for current employees. As a result the firm must now administer two pension plans: a defined contribution plan for its 2,500 current employees and a defined benefit plan for 1,000 older employees, almost all of whom are now retired. The firm expects to fund pension payments to retired employees out of the defined benefit plan for the next 20 years.
Recent operating problems in the volatile steel industry have resulted in several years of losses and layoffs at Palmer Steel, as well as a weak company balance sheet. The assets in the defined benefit plan have a moderate degree of correlation with the firm's operating income. The fund currently has a 10% surplus. Inflation is expected to average 3% per year for the foreseeable future.
The required real rate of return in the defined benefit plan based on actuarial assumptions is 5%. The duration of the fund's liabilities is 8 years.Because the firm is in the position of having to administer two types of pension plans, Todd Thoms, the CFO, is reviewing the relevant management issues in preparation for a presentation to the Board of Directors. Which of the following issues is framed properly from the perspective of both Palmer Steel and its employees?
A)
One shortcoming of the defined contribution plan from the employees' perspective is that the long-term rate of return is highly uncertain, and depends on investment choices made by employees.
B)
Palmer Steel should diversify the assets of BOTH plans so that the correlation between those assets and the operating cash flow of the firm itself is low, in order to improve the probability of BOTH funds meeting their respective obligations.
C)
One shortcoming of the defined contribution plan from the perspective of Palmer Steel is that it is more costly to administer.



Defined benefit pension plans tend to be more costly for the company to administer. The company bears the investment risk in a defined benefit plan, and employees bear the investment risk in a defined contribution plan. The correlation between plan assets and company cash flow is an important consideration for a defined benefit plan but not a defined contribution plan. With a defined benefit plan, the firm faces the potential risk that in slow economic conditions, the investment performance of the fund will be reduced, increasing the firm's funding obligation to keep the plan fully funded, at the same time as the firm's operating cash flow is reduced.

Choose the answer that best completes the return objective for the defined benefit plan. The return objective is to generate total returns sufficient to meet projected pension liabilities while protecting against inflation. The effective maturity of the pension liabilities and the volatility of the firm's earnings require an emphasis on:
A)
income-producing assets with a nominal return of 8% and a portfolio with a maturity of 20 years.
B)
income-producing assets with a nominal return of 8% and a portfolio with a duration of 8 years.
C)
long-term capital gains to minimize taxes and a nominal after-tax return of 8% and a portfolio with a duration of 8 years.



The return requirement is the real return required on the plan assets plus the expected inflation rate, 5% + 3% = 8%. Because of the short-term nature of the liabilities, the portfolio should be managed to match the duration of the liabilities (8 years), not the expected final maturity of the last payment (20 years). Taxes are not a consideration in a pension plan.

Which of the following factors is NOT consistent with a low risk tolerance for the defined benefit fund?
A)
Palmer Steel has a weak balance sheet.
B)
The plan has a surplus.
C)
Palmer Steel has volatile operating earnings.



Over-funded pension plans can be somewhat more risk tolerant, all else equal, because the over-funding is a cushion against short-term fluctuations in investment returns. Both of the other choices are consistent with a lower risk tolerance.

Which of the following constraints is appropriate to include in the defined benefit plan's Investment Policy Statement?
A)
The fund is constrained to operate under the regulations of ERISA, which require the fund be managed solely in the interest of the plan sponsors and beneficiaries, using the standard of the Prudent Man Rule.
B)
Taxes are not a major issue for the fund because earnings are tax-exempt.
C)
Liquidity needs are low because of the low correlation between the fund assets and the firm's operating income.



The short-term pension liabilities require significant liquidity. ERISA requires the standard of the Prudent Expert Rule, rather than the more restrictive Prudent Man Rule, and that the fund is managed in the sole interests of the plan beneficiaries, not the plan sponsors.

TOP

Which of the following is a characteristic of a defined-benefit pension plan?
A)
Contributions to the plan are typically a percentage of plan participants current pay.
B)
Defined benefit plans are less expensive to administer and young employees like the portable nature of their contributions.
C)
Plan sponsors bear all investment risk. They are liable for shortages and have a claim against excess returns.



Retirement benefits from a defined benefit plan are based on a "defined benefit" formula. This is what the company owes the plan’s participants, regardless of the performance of the pension funds assets, and if the fund’s returns fall short of the pension obligations, the plan sponsor is liable for the difference. Defined benefit plans are costlier and riskier than defined contribution plans. Thus, defined contribution plans are the preferred pension plan for most employers. Also, since plan contributions are transferable to other plans, defined contribution plans are attractive to many young employees.

TOP

A defined benefit plan differs from a defined contribution plan in that the:
A)
benefit paid by the sponsor is defined by contributions made to the plan.
B)
risk/return tradeoffs of plan assets accrue to the plan sponsor.
C)
risk/return tradeoffs of plan assets accrue to the participant.



All investment decisions are made by the plan sponsor, and all risk/return tradeoffs accrue to the sponsor. The benefits paid by a defined benefit plan are determined by a specified benefit formula, not by what was contributed to the plan.

TOP

A defined contribution plan differs from a defined benefit plan in that the:
A)
investment decisions are made by the plan sponsor.
B)
risk/return tradeoffs of plan assets accrue to the plan sponsor.
C)
risk/return tradeoffs of plan assets accrue to the participant.



All investment decisions of defined contribution assets are made by the participant, which dictates to whom plan asset risk/return tradeoffs accrue—the participant. The benefit paid is determined by the value of the investment assets at retirement. The only requirement of the plan sponsor is the stated contribution made to the participant’s account.

TOP

Which of the following is a characteristic of a defined-contribution pension plan?
A)
Investment risk of plan assets is shifted to the individual.
B)
Up to a maximum limit, the Pension Benefit Guaranty Corp (PBGC) insures plan contributions.
C)
Benefits are based on specific formulas relating to employee earnings or length of service.



For defined contribution plans, investment risk is borne by the pension beneficiary. The plan sponsor, and frequently the plan participant, make “defined contributions” to the plan. The pension benefit to the participant is based on the pension fund’s investment performance.

TOP

The funded status/surplus of a defined benefit plan impacts the risk tolerance of investment activities and is best described as:
A)
larger pension surpluses indicate lower risk tolerance.
B)
there is no relationship between surplus in risk tolerance in a defined benefit plan.
C)
larger pension surpluses indicate higher risk tolerance.



A larger pension surplus indicates higher risk tolerance. Although willingness to take risk may be low, ability to take risk exists. Under-funded plans, however, may be willing to take high risk to make up pension shortfalls, but less ability to take risk exists due to an existing deficit between pension assets and liabilities.

TOP

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