QUESTION 13, INCLUDING GUIDELINE ANSWER, 1996 CFA LEVEL III EXAMINA...

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: