Reading 28:Managing Institutional Investor Portfolios- LO

only, employees, offering, benefit, current

LOS a, (Part 1): Contrast a defined-benefit plan to a defined-contribution plan, from the perspectives of both the employee and employer.

Q1. 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) 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.

B) 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.

C) One shortcoming of the defined contribution plan from the perspective of Palmer Steel is that it is more costly to administer.

Q2. 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 duration of 8 years.

B) income-producing assets with a nominal return of 8% and a portfolio with a maturity of 20 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.

Q3. 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) Palmer Steel has volatile operating earnings.

C) The plan has a surplus.

Q4. 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) Liquidity needs are low because of the low correlation between the fund assets and the firm's operating income.

C) Taxes are not a major issue for the fund because earnings are tax-exempt.

Q5. Which of the following statements regarding defined benefit and defined contribution pension plans is FALSE?

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.

Q6. Which of the following is a constraint to defined benefit pension funds that does NOT apply to most endowments?

A) Defined liquidity needs.

B) Tax considerations.

C) Contribution requirements to an employee's account.

Q7. From the perspective of the employer, which of the following statements is TRUE? A defined:

A) benefit plan can be underfunded; a defined contribution plan is less risky.