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Which of the following is NOT a characteristic of employee stock ownership plans (ESOP)?

A) ESOPs typically allow employees to purchase company stock at a discount from the current market price.

B) The regulation of ESOPs can vary widely across countries.

C) An ESOP is typically funded by a company issuing new stock specifically to fund the ESOP.

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ESOPs are typically funded with existing shares that are either repurchased by the company in the open market, or directly from a large shareholder. The other characteristics listed correctly describe features of ESOPs.

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Jim Findlay is the Founder and CEO of Impact Products. Findlay takes great pride in having his firm be on the leading edge of providing benefits to employees. Every year, Findlay sits down with his two senior executives, Jeff Beery and Tom Harbal to discuss various employee benefit plans. This year’s focus is on employee stock ownership plans (ESOPs) and cash balance plans. With regard to ESOPs, Beery states, “In addition to the benefits to employees, an ESOP would be a useful way for you as owner of the company, Mr. Findlay, to liquidate a large block of your Impact Product holdings.” After further discussion, they move on to discussing cash balance plans. Harbal reports, “Unlike regular pension plans, cash balance plans can never be under funded because the cash balance reflects the actual amount put away for employees.” With regard to their statements about ESOPs and cash balance plans:

A) Beery’s statement is correct; Harbal’s statement is correct.

B) Beery’s statement is correct; Harbal’s statement is incorrect.

C) Beery’s statement is incorrect; Harbal’s statement is incorrect.

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An ESOP is a type of defined-contribution plan that allows employees to purchase company stock, sometimes at a discount to the market price. Beery’s statement is correct. Occasionally, an ESOP will purchase a large block of the firm’s stock directly from a large stockholder (such as an owner who wants to liquidate a holding). The stock is then purchased at regular intervals by plan beneficiaries. Harbal’s statement is incorrect. The account balance shown on a cash balance plan’s statement to a beneficiary is calculated on paper only based on a participant’s credits. It is possible for a company not to fund its obligation, resulting in an underfunded cash balance plan.

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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.

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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. (Study Session 5, LOS 15.b)

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Regarding the Cooper Company pension plan, Manley’s best course of action is to:

A) lower the fund’s equity allocation by selling the Cooper stock.

B) increase the allocation to equities because risk diminishes over time.

C) lower the fund’s equity allocation, but not sell the Cooper stock, as such a large sale would drive the price down.

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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. (Study Session 5, LOS 15.f)

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Which of the following is the best justification for Crandall Company’s futures policy?

A) Futures are used to manage short-term risks, and the fund should be concerned with long-term risks.

B) The use of futures is inconsistent with the Prudent Expert Rule of ERISA.

C) Futures are used mainly for speculative purposes.

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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. (Study Session 5, LOS 15.l)

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Which of Manley's statements regarding defined-contribution plans is least accurate?

A) The employee makes regular contributions to the fund.

B) Benefits are based on formulas relating to employee earnings or length of service.

C) The employer has no financial obligation beyond making contributions to the plan.

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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. (Study Session 5, LOS 15.a)

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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.

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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. (Study Session 5, LOS 15.f)

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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% investment-grade bonds, 30% small-cap stocks, 20% large-cap stocks, 10% venture capital.

C) 40% large-cap stocks, 30% high-yield bonds, 20% investment-grade bonds, 10% real estate.

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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. (Study Session 5, LOS 15.f)

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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) Correct Correct

B) Incorrect Incorrect

C) Incorrect Correct

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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. Some defined contribution plans allow plan participants to take out loans against the amount they contributed.

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Which of the following statements about defined contribution investment policy statements (IPS) is least accurate?

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.

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Defined contribution plans call for quite a different IPS than do defined benefit plans.

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Which of the following would be included in an investment policy statement (IPS) for a defined contribution plan?

A) A description of the investment alternatives available to plan participants.

B) Risk objectives.

C) Time horizon.

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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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Brown Textiles has constructed its pension plan investment policy so that its pension assets have a high correlation with pension plan liabilities and a zero correlation with the firm’s operations. Which of the following is the most likely impact of following such an investment policy?

A) The firm will have a high probability of making pension payments when its ability to fund those payments is high.

B) A positive long-run impact on firm valuation, and a more stable pension surplus.

C) The firm will have a high probability of making pension payments when its ability to fund those payments is low.

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If pension plan assets are highly correlated with liabilities, but have a zero correlation with firm operations, this would ensure that pension plan assets increase in value at the same time liabilities increase, while the funding status of the plan will be unaffected by the firm’s ability or inability to make contributions. In the long run, the effect on firm valuation and the firm’s constituents will be positive due to decreased volatility in fund surplus and the firm’s earnings. Note that a high correlation between the firm’s operations and its pension assets means the firm would have a low probability of making pension payments when its ability to fund those payments is high, and a high probability of making pension payments when its ability to fund those payments is low.

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The pension plan at Ferrell Manufacturing currently has a surplus. Ferrell’s management team wants to maintain the level of the surplus and keep it as stable as possible. In order to accomplish their goal, how should they position the correlation of the pension plan’s assets with the pension liabilities and the firm’s operations respectively?

Correlation of Assets with Liabilities

Correlation of Assets with Firm Operations

A) Low Low

B) High Low

C) High High

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In order to have a more stable pension plan surplus, the firm should construct plan liabilities and assets in such a way that changes in pension plan asset valuations are highly correlated with pension plan liabilities, but uncorrelated (low correlation) with the firm’s core operations. This would ensure that pension fund assets increase in value at the same time liabilities do, keeping funding status unaffected by the firm’s ability or inability to make contributions.

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Genentron is a small biotechnology firm that is developing new therapies and drugs for different types of cancer. Genentron has a number of benefits for its employees, including a defined benefit pension plan. The plan is overseen by Rolf Pyle and Shannon DeGroot, both senior executives with Genentron. Most of Genentron’s employees are younger, so Pyle and DeGroot have invested the pension plan’s investment portfolio aggressively. Currently, the pension portfolio allocation is 30% in the Russell 1000 Growth Index and 70% in the Commodore Health Care Fund. Pyle and DeGroot are discussing the allocation of the plan at the most recent meeting. Pyle states, “If the health care industry leads the market again this year, it is unlikely that our pension expense will have much impact on our strong earnings, and we will be able to share more of those earnings with our shareholders.” DeGroot replies, “The allocation of our pension assets should ensure that Genentron will not have to make large pension contributions even if profitability is low.”

With regard to their statements about Genetron’s pension plan:

A) Pyle’s statement is correct; DeGroot’s statement is correct.

B) Pyle’s statement is correct; DeGroot’s statement is incorrect.

C) Pyle’s statement is incorrect; DeGroot’s statement is incorrect.

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With 70% of Genentron’s pension assets allocated to a health care fund, the correlation between the firm’s pension assets and profits is likely to be strong. Pyle’s statement is correct – if the health care industry has strong performance, both Genetron’s profits and the performance of the pension plan are likely to be high. When a firm is generating high profits simultaneously with high returns, the probability of the firm having to make a pension contribution is low, and if a contribution is made, the amount is likely to be small.

DeGroot’s statement is incorrect. Since the correlation between Genentron’s operations and its pension portfolio is high, if the firm’s profitability is low, the firm has a higher probability of making a large pension contribution. To avoid the problem of having to make a large contribution at a time when the ability to make contributions is low, companies should seek to have a low correlation between pension assets and firm operations.

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When formulating an investment policy statement for a defined benefit pension plan, legal and regulatory factors, in addition to unique circumstances, must be considered. In this regard, which of the following statements is least accurate?

A) In the United States, the provisions of the Employee Retirement Income Security Act (ERISA) must be adhered to regardless of any state or local laws and regulations that govern pension investment activity.

B) The basic tenet of the Employee Retirement Income Security Act (ERISA) is that pension plans be managed with equal regard for the interests of plan sponsors and plan beneficiaries.

C) Due to either ethical or political objections, a pension plan may disallow investments in certain types of traditional or alternative asset classes.

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The fundamental standard of care required by ERISA is that pension fund assets must be invested for the sole benefit of plan participants and not that of plan sponsors.