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Portfolio Management and Wealth Planning【Reading 16】

Which of the following statements regarding the focus of a liability-mimicking versus an asset-only portfolio of pension plans is CORRECT? The liability-mimicking portfolio will have a:
A)
low correlation with the liabilities and the asset-only approach will focus on investments with a low correlation to assets.
B)
high correlation with the liabilities and the asset-only approach will focus on investments with a high correlation to assets.
C)
high correlation with the liabilities and the asset-only approach will focus on investments with a low correlation to assets.



In the liability-relative approach, the portfolio will be chosen for its ability to mimic the liability (i.e., the portfolio will have a high correlation with the liability). In the asset-only approach, the focus is instead on investments with a low correlation to assets.

Which of the following is NOT a characteristic of the liability-mimicking portfolio for a pension? The liability-mimicking portfolio:
A)
is independent of economic growth.
B)
has an exposure to interest rate changes.
C)
recognizes economic liability.



The liability-mimicking portfolio recognizes that the future liability is subject to market related risk, i.e., it is an economic liability. Market risk is that from interest rate risk, inflation risk, or from an exposure to economic growth.

TOP

Which of the following is NOT a characteristic of the liability-mimicking portfolio for a pension? The process of creating the liability-mimicking portfolio:
A)
creates a benchmark portfolio that has a high correlation with the liabilities.
B)
decomposes the liability into its various exposures.
C)
uses cash as the risk-free investment.



Cash is used as the risk-free investment in the asset-only approach. In a liability-relative approach, the risk-free investment is the liability-mimicking portfolio. This portfolio has a high correlation with the liabilities. The pension fund manager constructs this portfolio by decomposing the liability into its various exposures.

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Suppose a corporation has decided to close their defined-benefit pension plan to new employees and open a defined-contribution plan. All new employees will use the defined-contribution plan. All previous employees will have their benefits in the defined benefit plan held constant at its current level. Going forward, they will be entered into the defined-contribution plan. Which of the following assets would be most appropriate for the liability-mimicking portfolio?
A)
Real return bonds.
B)
Large-cap equities.
C)
Nominal bonds.



If the defined benefit pension plan is frozen at its current level, it will have no growth and not be indexed for inflation. Therefore, the most appropriate asset for the liability-mimicking portfolio is nominal bonds.

TOP

Which of the following pension plan segment obligations would not be hedged by the liability-relative portfolio? The segment exposure not hedged is that from:
A)
future participants.
B)
future wage growth.
C)
inactive participants.



The payments to inactive participants and the accruals to active participants for past service constitute accrued benefits will be hedged with nominal bonds if they are not indexed to inflation. A pension’s future obligations are those arising due to wages to be earned in the future, future service rendered, and future plan participants. The first component is typically hedged with equities, nominal, and real bonds. The latter two components are uncertain and not easily modeled or funded.

TOP

Which of the following defined benefit pension plan segments generates the greatest liability noise? The greatest source of liability noise is that from:
A)
deferreds.
B)
active participants.
C)
inactive participants.



Pensions are subject to non-market exposures referred to as liability noise. Inactive participants can be divided into retirees and deferreds. The liability noise from either of these groups is less than that from active participants.

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A defined benefit pension plan decides to index their benefits to inflation. Meanwhile, the labor force has increased in productivity and profits have soared. Which of the following best describes the changes to their liability-mimicking portfolio? The liability-mimicking portfolio should have:
A)
fewer equities and more real return bonds.
B)
more equities and more real return bonds.
C)
more equities and more nominal bonds.



If the pension plan decides to index their benefits to inflation, more real return (inflation-indexed) bonds should be added to hedge the benefits. If the labor force becomes more productive, wages will increase due to this real growth. This real growth is related to economic growth and is best hedged by equities.

TOP

Which of the following would NOT be typically included in the asset-only approach portfolio of a pension?
A)
Derivative contracts.
B)
Medium-duration bonds.
C)
Short-duration bonds.



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.

TOP

Which of the following would result in a pension plan investing more in equities?
A)
The retirement benefits are no longer indexed to inflation.
B)
The workforce is younger.
C)
The retirement benefits are indexed to inflation.



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.

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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 be costly.
B)
will have a high return.
C)
will have low risk.



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.

TOP

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