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

4. Question 13, including Guideline Answer, 1996 CFA Level III Examination (AIMR) Purpose: To test the candidate’s: 1) understanding of the investment policy implications for a pension plan when the pension plan is underfunded, and 2) ability to develop an appropriate investment policy statement and asset allocation for a pension plan. LOS: The candidate should be able to “Determination of Portfolio Policies: Institutional Investors” (Study Session 10) a) contrast a defined-benefit and a defined-contribution plan from the perspective of both the employee and employer; b) appraise and contrast the factors that affect the investment policies of pension funds, endowment funds, insurance companies, and commercial banks; c) differentiate among the return objectives, risk tolerances, constraints, regulatory environment, and unique circumstances of endowment funds, pension funds, insurance companies, and commercial banks. “Pension Investing and Corporate Risk Management” (Study Session 10) a) appraise the investment policy implications, especially for risk management, of the relationship between the financial condition of a corporate pension fund and the corporation itself; b) evaluate the potential effects of a corporate pension fund investment policy on plan surplus, the corporation’s valuation, and the corporation’s constituents; c) appraise the pension fund investment policy when risk is considered from the perspective of the (1) asset value, (2) plan surplus, or (3) financial position of the corporation. Cases in Portfolio Management (Study Session 10) a) formulate the overall portfolio management process leading to an investment policy statement and an asset allocation decision for an institutional investor, including developing objectives and constraints and analyzing capital market expectations; Question 13, including Guideline Answer (Study Session 10) b) criticize an existing investment policy statement and its associated asset allocation; c) create a formal investment policy statement for an institutional investor; d) recommend and justify a general asset allocation that would be appropriate for an institutional investor.

Guideline Answer:

A. Determine whether IPS X or IPS Y has Component Justify with one reason appropriate language (Circle One) Because the Plan is currently underfunded, the Return primary objective should be to make the pension fund financially stronger. The risk Requirement IPS Y inherent in attempting to maximize total returns would be inappropriate. Because of the fund’s underfunded status, the Plan has a limited risk tolerance; should the Risk Tolerance IPS Y fund have a substantial loss, payments to beneficiaries could be jeopardized. Although going concern pension plans usually have a long time horizon, the Acme plan has a Time Horizon IPS Y shorter time horizon because of the reduced retirement age and the relatively high median age of the workforce. Because of the early retirement feature starting next month and the age of the workforce (which indicates an increasing number of Liquidity IPS X retirees in the near future), the Plan needs a moderate level of liquidity to fund monthly benefit payments. B. The current portfolio is the most appropriate choice for the pension plan’s asset allocation. The current portfolio offers: i. an expected return that exceeds the Plan’s return requirement; ii. an expected standard deviation that only slightly exceeds the Plan’s target; and iii. a level of liquidity that should be sufficient for future needs. The higher expected return will help the Plan’s underfunded status somewhat, and the change in the fund’s risk profile will be minimal if any. The portfolio has significant allocations to U.K. bonds (42 percent) and large-cap equities (13 percent), in addition to cash (5 percent). The availability of these highly liquid assets should be sufficient, particularly in view of the stable income flows from these investments, to fund monthly benefit payments when the early retirement feature takes effect next month. The Graham portfolio offers: i. an expected return that is slightly below the Plan’s requirement; ii. an expected standard deviation that is substantially below the Plan’s target; and iii. a level of liquidity that should be more than sufficient for future needs. The portfolio’s expected return is unacceptable given the Plan’s underfunded status. The Michael portfolio offers: i. an expected return that is substantially above the Plan’s requirement; ii. an expected standard deviation that far exceeds the Plan’s target; and The portfolio’s level of risk is unacceptable given the Plan’s underfunded status.

LEVEL III, QUESTION 2

Topic: Portfolio Management Minutes: 9 Reading References: