3. Question 13, including Guideline Answer, 1996 CFA Level III Examination (AIMR)
Purpose:
To test the candidate’s ability to develop objectives and constraints for a defined benefit pension
fund and a college endowment fund.
LOS: The candidate should be able to
“Determination of Portfolio Policies: Institutional Investors” (Session 14)
• indicate the investment objectives, constraints, and policies of leading institutional investors;
• distinguish between defined-benefit and defined-contribution pension plans in terms of
characteristics, needs, and concerns;
• identify the return objectives and risk tolerances of endowment funds, including considerations
of spending rates and inflation rates.
Cases in Portfolio Management (Session 22)
• contrast the investment objectives and constraints of investors in several different economic
circumstances.
1996 CFA Level III Examination (Session 22)
• critique an existing investment policy statement and its associated asset allocation.
Guideline Answer:
A. Investment policy objectives for the Lindsay pension plan in the three areas are:
i. Return Objective
The return objective for this mature U.S. corporate pension plan is the sum of the plan’s
required real rate of return (5.5 percent) and the expected rate of inflation (2 percent) for a
total of 7.5 percent. An alternate approach would be to multiply, rather than add, the two
rates, which produces a return objective equal to 7.6 percent, as follows:
[(1 + .055) × (1 + .02)] – 1 = 0.076
ii. Risk Tolerance
The level of risk tolerance for the pension plan is quite low, well below average. The plan is
quite mature, as indicated by the high percentage (60 percent) of employees already retired
and receiving pension payments and by the relatively advanced average age of active
employees (45 years). In addition, the plan is currently fully funded.
iii. Time Horizon
The time horizon for the pension plan is substantially shorter than average. The horizon is
relatively short because payments must be made now (and into the future) to the 60 percent
of employees already retired and must be made in the near future to many of the active
employees because their average age is 45 years. This combination of circumstances
markedly reduces the time horizon as compared with most corporate pension plans and
reinforces the minimum risk, limited return objectives of the plan.
B. The nature of the three investment policy elements, and the impact of the change in spending
policy on each, is:
i. Return Objective
The return objective for the Mountaintop Fund will change to the sum of the new spending
policy (6 percent, up from 4 percent) and the annual college tuition inflation rate (3 percent)
for a total of 9 percent (up from 7 percent).
The level of risk tolerance for the Mountaintop Fund is high. A spending rate of 6 percent
and a tuition inflation rate of 3 percent is fairly common among U.S. university endowment
funds and a high level of risk tolerance is commonly assumed for such funds. The increased
spending rate, which raised the total return to 9 percent, would require the fund to increase
its risk tolerance. In addition, the new exposure to currency risk may alter the risk profile of
the fund.
The fund’s time horizon is very long term; there is no change in the fund’s time horizon as a
result of the change in the spending rate.
Level III: Question 13
Topic: Institutional Portfolio Management: Asset Allocation
Minutes: 30
Reading References:
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