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LOS f: Formulate an investment policy statement for a defined-contribution plan. ffice ffice" />
Q1. Gina Manley, CFA, is a pension fund manager for Brooke and Associates. She manages the pension fund accounts for several small and medium-sized firms.
Company owner Herb Brooke has tasked Manley with reviewing the firm’s asset-allocation policy. In the past, Brooke and Associates included large-company international stocks and large-company domestic stocks as part of the same asset class because they have similar risk and return properties, even though they have a low (0.4) correlation with each other. Venture capital was included as part of the small-company stock asset class because it has a high correlation (above 0.7) with small-company stocks, even though the risk of venture capital investments is far greater than the risk of small company stocks.
As part of her portfolio management duties, Manley has recently taken over two pension accounts from other fund managers. The first account is the Crandall Company pension account. In reviewing the investment policy for Crandall, she finds a statement that "the fund shall not directly use equity futures, nor shall it hire any outside money manager that uses equity futures as part of its investment strategy in managing the fund’s assets."
The second new account Manley has recently acquired is the Cooper Company pension fund. The fund currently has a 70% allocation in equities, including 10% in Cooper stock, with the rest in bonds. The plan is currently underfunded. Manley believes the fund’s equity portfolio, including the Cooper stock, will provide an annualized return of 8% over the next five years. The fund’s long-term, investment-grade bonds should provide a 4% return.
Manley is also working with a new client, Chapman Inc., to set up a new pension fund. Manley’s discussions so far have been directly with the owner, David Chapman. Manley has laid out for Chapman the advantages and disadvantages of defined-benefit plans and defined-contribution plans. She tells Chapman about the following characteristics of defined-contribution plans:
- The employee makes regular contributions to the fund.
- Benefits are based on formulas relating to employee earnings or length of service.
- The employee bears all of the investment risk.
- The employer has no financial obligation beyond making contributions.
Chapman is comfortable with Brooke and Associates, likes Manley’s work, and he decides to set up a defined benefit plan instead of a defined contribution plan. In the process of gathering data, Manley discovers the following information about Chapman Inc.:
- The company is five years old.
- Most of Chapman’s employees graduated from college less than 10 years ago.
- Stock options represent a significant portion of most employees’ compensation.
- The median annual salary of Chapman employees is $65,000.
David Chapman and two of his vice presidents plan to retire within the next two years.
Which of the following is least likely to be an investment constraint for the Chapman pension fund?
A) Liquidity.
B) Taxes.
C) Investment horizon.
Correct answer is B)
Given the tax-deferred status of pension funds, taxes are usually not an important issue. Liquidity constraints depend on the age of the work force, and must be given consideration. A pension fund’s investment horizon also depends on the age of the work force and whether or not the firm is a going concern. While the work force is mostly young, the firm does have some older workers, and thus cannot ignore liquidity and time horizons.
Q2. Regarding the Cooper Company pension plan, Manley’s best course of action is to:
A) increase the allocation to equities because risk diminishes over time.
B) lower the fund’s equity allocation by selling the Cooper stock.
C) lower the fund’s equity allocation, but not sell the Cooper stock, as such a large sale would drive the price down.
Correct answer is B)
Manley’s fiduciary duty is to the beneficiaries of the plan, not the company. While holding the Cooper stock may benefit the shareholders, it is unlikely to benefit the employees. The company stock provides an undiversified position that is correlated with the employees’ human capital and should be sold. An equity allocation of 70% would be considered high for most pension plans (the average is around 50%), so while diversifying the bond holdings may be a good move, maintaining the equity weighting is not. Some thought could be given to the fact that the plan is underfunded, and that the plan needs growth. In this situation, the plan also needs to protect the existing assets from too much risk so that the underfunding situation is not exacerbated. In this case, reducing the equity weight to an average level and increasing contributions would be the best course of action.
Q3. Which of the following is the best justification for Crandall Company’s futures policy?
A) The use of futures is inconsistent with the Prudent Expert Rule of ERISA.
B) Futures are used mainly for speculative purposes.
C) Futures are used to manage short-term risks, and the fund should be concerned with long-term risks.
Correct answer is C)
Most futures transactions are used to manage short-term risks and those transactions might not impact long-term risks. Futures are often used to hedge equity holdings, and nothing in the Prudent Expert Rule would prohibit their use under the proper circumstances. The fund’s bond holdings are irrelevant, as long as there are equity holdings for which futures could be used to hedge risk.
Q4. Which of Manley's statements regarding defined-contribution plans is least accurate?
A) Benefits are based on formulas relating to employee earnings or length of service.
B) The employee makes regular contributions to the fund.
C) The employer has no financial obligation beyond making contributions to the plan.
Correct answer is A)
In a defined-contribution plan, the employee typically makes regular contributions to a fund that the company matches according to some formula, such as a percentage of current pay. The employee bears all of the investment risk in a defined contribution plan, and the employer has no financial obligation beyond making regular contributions on behalf of qualifying employees.
Q5. Regarding its asset classes, Brooke and Associates’ best course of action is to:
A) separate international stocks as a unique asset class, but leave venture capital in the small-company stock class.
B) separate venture capital as a unique asset class, but leave international stocks in the large-company stock class.
C) separate both venture capital and international stocks as unique asset classes.
Correct answer is C)
It is easier to optimize portfolios using asset classes with different risk characteristics and low correlation with other asset classes. None of the answers are wrong, but separating international stocks and venture capital into their own classes allows for the most precise optimization.
Q6. Which of the following represents the most appropriate asset allocation for Chapman’s pension fund?
A) 60% large-cap stocks, 30% small-cap stocks, 10% foreign stocks.
B) 40% large-cap stocks, 30% high-yield bonds, 20% investment-grade bonds, 10% real estate.
C) 40% investment-grade bonds, 30% small-cap stocks, 20% large-cap stocks, 10% venture capital.
Correct answer is C)
No matter how young the work force, an all-equity investment mix is inappropriate for a pension fund, which is always going to have at least a slight need for liquidity (particularly when the chairman and his lieutenants retire), and must be managed in such a way as to reduce risk. However, the youth of Chapman’s work force suggests a 70% weighting in bonds is too conservative. The mix of large-cap stocks and investment-grade and high-yield bonds is attractive, but most of Chapman’s employees are both young and well-paid, suggesting they have a high risk tolerance as well as low liquidity demands. The best option is the mix of investment-grade bonds, small-cap and large-cap stocks, and venture capital, the portfolio that probably offers the highest total return. There is nothing wrong with taking some risks in a pension plan, as long as those risks are well considered and suitable given the characteristics of the work force.
Q7. Which of the following statements are correct regarding a participant-directed defined contribution plan?
Statement 1: The plan should be responsible for establishing and revising the interest rate for plan loans to participants.
Statement 2: The plan should provide criteria for manager/fund selection, termination and replacement.
Statement 1 Statement 2
A) Incorrect Incorrect
B) Correct Correct
C) Incorrect Correct
Correct answer is B)
Instead of stating objectives and constraints (as in defined benefit plans), the purpose of a participant-directed defined contribution investment policy statement is to provide a governing document that describes the investment strategies and alternatives available to plan participants.
Q8. Which of the following statements about defined contribution investment policy statements (IPS) is FALSE?
A) Plan sponsors should provide education about investing plan funds.
B) Procedures are established to insure that a myriad of individual investor objectives and constraints can be handled.
C) IPS for defined benefit and defined contribution plans are similar in nature.
Correct answer is C)
Defined contribution plans call for quite a different IPS than do defined benefit plans.
Q9. Which of the following would be included in an investment policy statement (IPS) for a defined contribution plan?
A) Risk objectives.
B) Time horizon.
C) A description of the investment alternatives available to plan participants.
Correct answer is C)
In a defined contribution plan, the plan sponsor does not establish objectives and constraints but rather the plan participants set their own risk and return objectives.
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发表于 2009-3-4 16:31
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