Reading 28:Managing Institutional Investor Portfolios- LO

status, common, features, currently

LOS c: Evaluate pension fund risk tolerance when risk is considered from the perspective of the (1) plan surplus, (2) sponsor financial status and profitability, (3) sponsor and pension fund common risk exposures, (4) plan features, and (5) workforce characteristics.

Q1. Ace Manufacturing’s pension plan is currently under-funded by $15,000,000. Earnings for Ace have been under pressure for the past five years, and although the downward trend seems to have been slowed, prospects for earnings growth are not promising. The average age of Ace’s current workforce is 53, and the retired-lives proportion of pension plan participants is 62%. Which of the following statements most appropriately fits in Ace’s investment policy statement for its pension plan?

A) Due to the current under-funded status, relatively older workforce age, and high retired-lives proportion, Ace's pension plan risk tolerance profile needs to be moderate to high. The plan's return objective should be to generate high levels of return to cover the plan shortfall through aggressive growth investment vehicles.

B) The current under-funded status of the pension plan should have no bearing on the risk tolerance or return objectives of the plan's investment policy statement. Pension plans should pursue as high a return as possible in order to minimize contributions and/or increase benefits.

C) Due to the current under-funded status, relatively older workforce age, and high retired-lives proportion, Ace's pension plan risk tolerance profile is low to moderate. The plan's return objective should be to meet the pension benefit payment requirements of the high level of the current retired-lives proportion of participants and those soon approaching retirement. Matching plan assets with plan liabilities is a must.

Q2. Grace Manufacturing is a medium-sized industrial company whose stock returns are highly correlated with the Dow Jones Industrial Average. The company administers and manages in-house a defined-benefit pension plan for its employees. The average age of the work force is only 30 years, and only 5% of the plan beneficiaries are currently retired. Recent strong operating results have enabled Grace to over-fund the plan by 15%. Based on actuarial assumptions, the required real rate of return on the fund is 6%.

Because of the recent downturn in domestic markets, particularly in the high-tech industry, as well as turmoil and uncertainty in international markets, the company has restricted investment in the fund to a small number of large, moderate-yield domestic industrial stocks with proven dividend track records, AAA corporate and U.S. Treasury bonds, as well as Treasury Bills.

Current Asset Allocation
Portfolio	Allocation	Expected Return	Volatility
Equally weighted portfolio of 25 large U.S. industrial companies	25%	9%	18%
AAA Corporate Bond Portfolio	20%	7%	8%
Treasury Bonds (8-year duration)	30%	6%	7%
Treasury Bills	25%	4%	0%

This conservative stance is reflected in the risk tolerance objective of the fund's Investment Policy Statement (IPS).

Investment Policy Statement
Return Objective	The fund's return objective is to achieve total returns of 10%, sufficient to fund the required real rate of 6% plus the expected inflation rate of 4%.
Risk Tolerance	The risk tolerance of the company is below average. The plan must guarantee the safety of the plan assets to insure income will be available to fund retirees' pension payments in the future.
Liquidity Constraint	The fund's liquidity requirements are low because of the long time horizon and relatively young workforce.

The company has asked Elaine Sargent, CFA, for advice in revising the IPS and reviewing the current asset allocation for potential inclusion of one or more of the following portfolios:

Portfolios	Expected Return	Volatility	Correlation with DJIA
Portfolio A	7%	10%	0.5
Portfolio B	11%	15%	0.7
Portfolio C	14%	22%	0.3
Dow Jones Industrial Average (DSIA) Index Fund	10%	18%	1.0

Which of the following changes to the fund's IPS should Sargent recommend?

A) The risk tolerance for the fund should be much higher because of the long-term nature of the obligations and the need to preserve capital through equity investment to guard against inflation eroding the value of the assets.

B) The fund's liquidity constraint should be rewritten to reflect moderate liquidity requirements consistent with the fund's low risk tolerance.

C) A return objective of 10% is not consistent with a below average risk tolerance. Therefore, the fund should target a lower return objective in order to be consistent with the low risk tolerance.

Q3. Sargent should recommend that the allocation to the equally weighted equity portfolio be:

A) decreased significantly because it is most likely highly correlated with the firm's operating cash flows.

B) decreased significantly because it is not consistent with the fund's return objective.

C) increased significantly because it has favorable risk-return characteristics relative to the other funds.

Q4. Sargent should recommend which of the following allocations?

A) AAA Corporate Bonds Treasury Bills

increase increase

B) AAA Corporate Bonds Treasury Bills

increase decrease

C) AAA Corporate Bonds Treasury Bills

decrease decrease

Q5. Which of the following scenarios will result in the lowest volatility in the surplus of a defined benefit pension plan, while at the same time keeping funding status independent of the plan sponsor’s ability to make pension contributions? A:

A) high correlation between pension fund assets and pension fund liabilities, and a high correlation between pension fund assets and the pension sponsor's operating performance.

B) low correlation between pension fund assets and pension fund liabilities, and a low correlation between pension fund assets and the pension sponsor's operating performance.

C) high correlation between pension fund assets and pension fund liabilities, and a low correlation between pension fund assets and the pension sponsor's operating performance.

Q6. The potential effect of a pension plan policy that positively impacts a plan surplus is a:

A) low discount rate, high retired-lives portion, and high liquidity.

B) high discount rate, low plan feature flexibility, and low liquidity requirements.

C) high discount rate, plenty of plan feature flexibility, and high liquidity requirements.

Q7. Pension fund risk tolerance decreases with:

A) no provisions for plan flexibility.

B) high plan asset and plan sponsor operating characteristic correlation.

C) low retired lives portion.

Q8. Pension fund risk tolerance increases according to:

A) less plan sponsor leverage.

B) greater plan sponsor leverage.

C) high flexibility in plan features.