andytrader

Which of the following statements would NOT be consistent with an investment policy statement (IPS) for a defined benefit plan?

A) No objectives and constraints are needed.

B) Tax consequences can be ignored.

C) Adequate liquidity must be maintained to meet liabilities.

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No objectives and constraints are needed for defined contribution plans in that each employee is responsible for his/her investing. They are very much needed for defined benefit plans.

andytrader

Which of the following return objectives is most appropriate for a defined benefit pension plan?

A) The return on plan assets should be 50 basis points greater than the actuarial rate applied to the plan's liabilities.

B) The return on plan assets should be equal to or greater than the plan's spending rate.

C) To earn an inflation-adjusted return that is adequate to fund plan liabilities.

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The ultimate goal of a pension plan is to have pension assets generate returns sufficient to cover pension liabilities on an inflation-adjusted basis. The specific return requirement will depend on the plan’s funding status and contributions dictated by accrued benefits.

andytrader

The Smitherson’s Family Foundation was created to fund causes dear to the family. An initial grant of $35,000,000 was established in the hopes of finding deserving projects to receive funding. The Foundation was established with a perpetual life, and one of its investment goals is to maintain the purchasing power of present assets. Which of the following represents a reasonable objective in the Foundation’s investment policy statement?

A) The perpetual life of the plan indicates a moderate to high risk tolerance. Return objectives are to meet the required 5% private foundation spending requirement in addition to covering inflation expectations. Evaluating investments from a total return perspective is warranted.

B) The perpetual life of the plan indicates a low to moderate risk stance. In order to preserve purchasing power, investment in the safest of all assets is critical. Investing in assets returning in excess of the required 5% spending requirement should be discouraged.

C) All family foundations must have high risk tolerance to maintain perpetual purchasing power. Return objectives should be commensurate with the risk stance and, therefore, achieving highest growth oriented returns is prescribed.

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The perpetual life of the Smitherson Family Foundation indicates a moderate to high risk tolerance. Return requirements are at least the regulatory-dictated 5% spending requirement plus inflation expectations. A total return investment objective is warranted.

andytrader

In setting a risk objective for a defined benefit plan, which of the following should NOT be considered?

A) Investment education expertise of employees.

B) Sponsor financial status.

C) Workforce characteristics.

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Employees are not responsible for investment performance for defined benefit plans. However, the plan must concern itself with the workforce characteristics (ages), and sponsor financial status (is it capable of funding the plan now and in the future).

andytrader

A defined benefit plan should:

A) construct an investment policy statement (IPS) after a manager has been chosen for the plan.

B) invest plan assets without distinction between the tax consequences of returns generated from income and returns generated from capital gains.

C) review investment performance on a yearly basis.

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As a tax-exempt investor, there should be no preference over income or capital gains. Investment performance should be reviewed quarterly, and the IPS reviewed at least annually. The IPS should be the first step in the process.

andytrader

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.

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Although Ace’s willingness to take risk may be high, the current under-funded status, older workforce age, and high proportion of retired lives dictates a lower than average ability to take risk. Hence, risk tolerance should be low to moderate. Assets should be chosen that deliver returns that match liability payments of current retirees and those about to enter retirement.

andytrader

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 low correlation between pension fund assets and the pension sponsor's operating performance.

B) 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.

C) 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.

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The likelihood of a neutral impact on a firm’s earnings is increased when changes in the value of pension assets are highly correlated with pension liabilities but uncorrelated with the firm’s operating performance. This ensures that funding the surplus is constant and independent of the pension sponsor’s ability or inability to make contributions to the plan.

andytrader

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, plenty of plan feature flexibility, and high liquidity requirements.

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

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Pension plan surplus may be positively impacted by using a high discount rate to determine the present value of liabilities, generating a pension plan that has no flexibility (e.g., no early retirement provisions), and having a pension plan with low liquidity requirements.

andytrader

Pension fund risk tolerance increases with:

A) provisions for early retirement or lump-sum payouts.

B) a low retired lives portion.

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

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A low number of retired lives usually indicates an increased ability to take risk. Both of the other answers work to decrease pension fund risk tolerance. Pension fund risk tolerance decreases when plan assets and plan sponsor operating characteristics have high correlation. The ability for the plan sponsor to make contributions is decreased at the most inopportune time when plan assets and operating characteristics are highly correlated. Hence, risk tolerance decreases in a highly correlated environment. Plans that offer early retirement or lump-sum payments essentially decrease the time horizon of the retirement liability and increase the liquidity requirements of the plan, so the ability to tolerate risk is decreased.

andytrader

Pension fund risk tolerance increases according to:

A) greater plan sponsor leverage.

B) high flexibility in plan features.

C) less plan sponsor leverage.

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Pension fund risk tolerance increases when the plan sponsor has lower leverage. The higher the correlation between sponsor activities, as well as high flexibility in plan features (e.g., early retirement options), work to decrease the risk tolerance of a pension plan.