2019 CFA level 3 qbank reading 15 managing institutional investor portfolios answers

10/11/2018 Learning Management System Question #1 of 164 Which of the following statements best describes the tax constraints existing for endowments and life insurance companies? A) Both entities are taxable B) Endowments are tax free entities, whereas life insurance companies are taxable C) Endowments are taxable entities, whereas life insurance companies are tax free entities .in Explanation en tre Endowments are tax free entities but life insurance companies are taxable (Study Session 7, Module 15.2, LOS 15.j) Related Material bo ok c SchweserNotes - Book Ed Simon, CFA, works for Mountaintop Consultants, a middle-market investment advisory rm catering to institutional clients Simon's supervisor has recently given him the task of revising m the rm's basic investment policy statements (IPS) for foundations and endowments Simon knows that there are many similarities between foundations and endowments, but that there o are also some important di erences that mandate development of two separate "boilerplate" w w documents that can then be customized for individual accounts Simon has come up with a template that includes sections for each client's background, risk w and return objectives, constraints, strategic asset allocation, and performance monitoring To highlight the di erences between the objectives and constraints of foundations and endowments, Simon has prepared Exhibit A below: Exhibit A: Foundations vs Endowments - Objectives & Constraints Foundations Endowments Return Risk Tolerance Varies: Low to High Varies: Low to High Time Horizon In nite In nite https://www.kaplanlearn.com/education/dashboard/index/66a9ea0d62bb71ab495925615029a3fd/practice/qbank/24038518/quiz/83416097/print 1/117 Learning Management System Tax Generally taxexempt Legal & Regulatory Uniform Management of Institutional Funds Act (most U.S states) Uniform Management of Institutional Funds Act (most U.S states) Liquidity & Income Spending limited by law to 5% annually; liquidity for grants No legal spending requirements but need stable income source Entityspeci c; may be social investing concerns bo ok c Entityspeci c; may Unique Constraints be social investing concerns en tre Generally tax-exempt in 10/11/2018 Simon understands that there are four major classi cations of foundations To clarify some of the di erences, he consults his co-worker Gus Grainger, who has a number of foundation m clients Grainger tells Simon "It's easy – just remember that independent, company-sponsored, o and operating foundations are subject to some type of minimum spending requirement and w w may be subject to taxation, whereas community foundations are not." Simon ponders Grainger's statement and responds: "I thought that independent, private, and family foundations have minimum spending rules I will research this further and get back to w you." Question #2 of 164 Simon wants to complete the return objectives section of Exhibit A Which of the following best indicates di erences between the return objectives of foundations and of endowments? A) Endowment returns usually are dictated by a rule-of-thumb of "5.3% + in ation," whereas foundation return objectives are dictated by spending rules https://www.kaplanlearn.com/education/dashboard/index/66a9ea0d62bb71ab495925615029a3fd/practice/qbank/24038518/quiz/83416097/print 2/117 10/11/2018 Learning Management System B) Foundation return objectives are closely linked to the time horizon of the foundation, whereas endowment return objectives are to provide a permanent b f f di C) Foundation return objectives are to provide a permanent base of funding whereas endowment return objectives depend on the time horizon of the endowment Explanation Foundations may be in nite-lived entities, but endowments are generally created to provide a permanent base of funding (Study Session 7, Module 15.2, LOS 15.i) Related Material en tre in SchweserNotes - Book Question #3 of 164 bo ok c Following completion of the return objectives, Simon proofs the remaining sections of Exhibit A For foundations, which of the remaining sections are NOT correct? A) Tax, liquidity & income B) Risk tolerance, liquidity & income, legal & regulatory .o Explanation m C) Risk tolerance, time horizon, legal & regulatory w w w Private foundation investment income is taxable, whereas community foundations and endowments are not Private foundations are required to pay out at least 5% of assets on an annual basis Endowments not have minimum spending requirements Foundations may also be able to decrease grant-making activity if investment returns have declined, in contrast to most endowments that need stable, in ation-protected income, and su cient liquidity to fund the ongoing operations of a speci c entity The risk tolerance of endowments is generally lower than foundations due to short-term budgetary needs (income and liquidity) of the sponsored organization, but can vary due to other factors such as the risk tolerance of the trustees/investment committee, the size of the principal, long-term return goals, etc Foundation risk tolerance is critically linked to time horizon, but is also in uenced by the risk tolerance of the board, principal size, etc However, foundations are often more aggressive than endowments (Study Session 7, Module 15.2, LOS 15.i) Related Material SchweserNotes - Book https://www.kaplanlearn.com/education/dashboard/index/66a9ea0d62bb71ab495925615029a3fd/practice/qbank/24038518/quiz/83416097/print 3/117 10/11/2018 Learning Management System Question #4 of 164 Which of the following best describes the time horizon constraint of foundations and endowments? A) Foundations may have an in nite life, whereas endowments always have nite lives B) Foundations may have a nite life, whereas endowments typically have in nite lives .in C) Endowments and foundations generally both have in nite lives en tre Explanation Foundations and endowments are generally established for in nite time horizons There are some foundations that are required to spend down their assets in which case they would have a nite time horizon bo ok c (Study Session 7, Module 15.2, LOS 15.i) Related Material m SchweserNotes - Book o Question #5 of 164 w w A publicly-sponsored organization that makes grants for charitable, religious, social or educational purposes is a (an): w A) private or family foundation B) endowment C) community foundation Explanation Community foundations are publicly-sponsored entities with boards consisting of community representatives Community foundations have no annual spending requirements Other types of foundations may also be organized to fund charitable, social educational or religious purposes, but are not public-sponsored or operated Endowments are not generally grantmaking entities (Study Session 7, Module 15.2, LOS 15.i) Related Material https://www.kaplanlearn.com/education/dashboard/index/66a9ea0d62bb71ab495925615029a3fd/practice/qbank/24038518/quiz/83416097/print 4/117 10/11/2018 Learning Management System SchweserNotes - Book Question #6 of 164 Which of the following most accurately depicts the tax treatment of a private foundation and an endowment? A) Endowment investment income is taxable, whereas private foundation investment income is not .in B) Private foundation investment income is taxable, whereas endowment investment en tre income is not C) Operating foundation investment income is taxable, whereas endowment investment income is not Explanation bo ok c Private foundation investment income is taxable, whereas the income of other foundations and endowments is generally not taxable (Study Session 7, Module 15.2, LOS 15.i) Related Material w w o m SchweserNotes - Book Question #7 of 164 w With respect to Grainger's and Simon's statements concerning the spending policies of the di erent types of foundations: A) Grainger is incorrect; Simon is correct B) Grainger is correct; Simon is correct C) Grainger is correct; Simon is incorrect Explanation https://www.kaplanlearn.com/education/dashboard/index/66a9ea0d62bb71ab495925615029a3fd/practice/qbank/24038518/quiz/83416097/print 5/117 10/11/2018 Learning Management System Both Grainger and Simon are correct Independent (private and family foundations are independent foundations), operating, and company-sponsored foundations are subject to minimum spending requirements of some kind Community foundations are not Although Simon did not mention operating and company-sponsored foundations, his statement is still correct (Study Session 7, Module 15.2, LOS 15.i) Related Material SchweserNotes - Book Ed Simon, CFA, has been assigned the arduous task of assessing the slight nuances concerning in the investment objectives and constraints for foundations and endowments Simon's supervisor has requested a full report on these di erences and how they a ect the investment en tre policy statements Question #8 of 164 bo ok c Simon thought it best to rst look at di erences in return objectives between foundations and endowments Which of the following best indicates di erences between the return objectives of foundations and of endowments? A) Foundation return objectives are to provide a permanent base of funding whereas m endowment return objectives depend on the time horizon of the endowment .o B) Endowment returns usually are dictated by a rule-of-thumb of "5.3% + in ation," w w whereas foundation return objectives are dictated by spending rules C) Foundation return objectives depend on the time horizon of the foundation, w whereas endowment return objectives are to provide a permanent base of funding Explanation Foundations may be nite-lived entities, but endowments are created to provide a permanent base of funding (Study Session 7, Module 15.2, LOS 15.i) Related Material SchweserNotes - Book Question #9 of 164 https://www.kaplanlearn.com/education/dashboard/index/66a9ea0d62bb71ab495925615029a3fd/practice/qbank/24038518/quiz/83416097/print 6/117 10/11/2018 Learning Management System Simon next turned his attention to the di erences in risk objectives between foundation and endowment investment policy statements Which of the following best describes the main di erence between foundation and endowment risk objectives? A) Foundation risk tolerance is dependent on the time horizon of the foundation, whereas endowment risk tolerance is dependent on the importance of the d f di h ll b d i B) Endowment risk tolerance is not dictated by the relationship between the current income requirement and maintenance of purchasing power, whereas this is a i lf f f d i C) Foundation risk tolerance is dependent on the importance of foundation funds in the sponsor's overall budget picture, while endowment risk tolerance is dependent h i f h d in i en tre h Explanation Risk tolerance of foundations is critically linked to any time horizon structure while endowment risk tolerance is dependent on the importance of endowment funds in a sponsor's overall budget picture (Study Session 7, Module 15.2, LOS 15.i) bo ok c Related Material m SchweserNotes - Book o Question #10 of 164 w w Foundations and endowments often have di erential liquidity constraints Simon found which of the following to be a di erence between the liquidity constraints of a foundation and an w endowment? A) Private foundations are required to have a minimum spending rate whereas endowments rarely have minimum spending rates B) Endowments are required to have a minimum spending rate whereas private foundations rarely have minimum spending rates C) An endowment's spending rule will have less of an e ect on liquidity requirements than a foundation's liquidity requirement due to a minimum spending rate Explanation Private foundations are required to pay out at least 5% of assets on an annual basis Endowments not have minimum spending requirements (Study Session 7, Module 15.2, LOS 15.i) https://www.kaplanlearn.com/education/dashboard/index/66a9ea0d62bb71ab495925615029a3fd/practice/qbank/24038518/quiz/83416097/print 7/117 10/11/2018 Learning Management System Related Material SchweserNotes - Book Question #11 of 164 Simon discovered tax laws seem to di erentially impact foundations and endowments Which of the following most accurately depicts the di erential tax treatment between foundations and endowments? in A) Endowment investment income is taxable, whereas private foundation investment income is not en tre B) Operating foundation investment income is taxable, whereas endowment investment income is not C) Private foundation investment income is taxable, whereas endowment investment bo ok c income is not Explanation Private foundation investment income is taxable, whereas other foundations and endowments are not Related Material w w o SchweserNotes - Book m (Study Session 7, Module 15.2, LOS 15.i) w Question #12 of 164 Which of the following types of foundations NOT have a spending requirement? A) Community B) Independent C) Operating Explanation https://www.kaplanlearn.com/education/dashboard/index/66a9ea0d62bb71ab495925615029a3fd/practice/qbank/24038518/quiz/83416097/print 8/117 10/11/2018 Learning Management System Independent (or private) and company-sponsored foundations must spend ve percent of their assets annually toward non-operating expenses to maintain their tax-exempt status Operating foundations must use 85% of interest and dividend income to conduct the institution's own program (Study Session 7, Module 15.2, LOS 15.h) Related Material SchweserNotes - Book in Question #13 of 164 en tre Which of the following is a characteristic of a de ned-bene t pension plan? A) Plan sponsors bear all investment risk They are liable for shortages and have a claim against excess returns B) De ned bene t plans are less expensive to administer and young employees like bo ok c the portable nature of their contributions C) Contributions to the plan are typically a percentage of plan participants current pay Explanation w w o m Retirement bene ts from a de ned bene t plan are based on a "de ned bene t" formula This is what the company owes the plan's participants, regardless of the performance of the pension funds assets, and if the fund's returns fall short of the pension obligations, the plan sponsor is liable for the di erence De ned bene t plans are costlier and riskier than de ned contribution plans Thus, de ned contribution plans are the preferred pension plan for most employers Also, since plan contributions are transferable to other plans, de ned contribution plans are attractive to many young employees w (Study Session 7, Module 15.1, LOS 15.a) Related Material SchweserNotes - Book Question #14 of 164 https://www.kaplanlearn.com/education/dashboard/index/66a9ea0d62bb71ab495925615029a3fd/practice/qbank/24038518/quiz/83416097/print 9/117 10/11/2018 Learning Management System Genentron is a small biotechnology rm that is developing new therapies and drugs for di erent types of cancer Genentron has a number of bene ts for its employees, including a de ned bene t 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 pension contributions even if pro tability is low." en tre With regard to their statements about Genetron's pension plan: in allocation of our pension assets should ensure that Genentron will not have to make large A) Pyle’s statement is incorrect; DeGroot’s statement is incorrect B) Pyle’s statement is correct; DeGroot’s statement is incorrect bo ok c C) Pyle’s statement is correct; DeGroot’s statement is correct Explanation o m With 70% of Genentron's pension assets allocated to a health care fund, the correlation between the rm's pension assets and pro ts is likely to be strong Pyle's statement is correct – if the health care industry has strong performance, both Genetron's pro ts and the performance of the pension plan are likely to be high When a rm is generating high pro ts simultaneously with high returns, the probability of the rm having to make a pension contribution is low, and if a contribution is made, the amount is likely to be small w w w DeGroot's statement is incorrect Since the correlation between Genentron's operations and its pension portfolio is high, if the rm's pro tability is low, the rm 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 rm operations (Study Session 7, Module 15.1, LOS 15.e) Related Material SchweserNotes - Book Question #15 of 164 https://www.kaplanlearn.com/education/dashboard/index/66a9ea0d62bb71ab495925615029a3fd/practice/qbank/24038518/quiz/83416097/print 10/117 10/11/2018 Learning Management System Related Material SchweserNotes - Book Question #147 of 164 Which of the following statements concerning the risks in the xed-income portfolio is most accurate? A) Credit risk is relatively less important, because the emphasis should be on Treasury in bonds and AAA corporate bonds to be consistent with the low risk tolerance of the en tre f li B) Reinvestment risk is relatively less important, because the rate-sensitive nature of the company's policies signi cantly reduces this risk C) Interest rate risk is relatively less important, because the allocation to high-yielding equities in the surplus portfolio o sets the interest rate risk in the xed-income bo ok c f li Explanation m Reinvestment risk, the "risk of reinvesting coupon income or principal at a rate less than the original coupon," becomes less important when an insurance company switches over to variable rate products Proper management of credit risk and interest rate risk, however, is still essential Related Material o (Study Session 7, Module 15.3, LOS 15.i) w w w SchweserNotes - Book Question #148 of 164 Which of the following statements least accurately describe the evolution in the investment policies of insurance companies like Lakeland in the past 15-20 years? A) A more volatile interest rate environment has forced companies to create new, rate-sensitive insurance products to prevent disintermediation B) The time horizon has gotten longer as the average life span of policyholders has increased with improvements in health care https://www.kaplanlearn.com/education/dashboard/index/66a9ea0d62bb71ab495925615029a3fd/practice/qbank/24038518/quiz/83416097/print 103/117 10/11/2018 Learning Management System C) Life insurance companies have segmented their investment portfolios along product lines with di erent time horizons, liquidity constraints, and return bj i Explanation This statement is not accurate; the time horizon for life insurance companies has gotten shorter as the duration of the insurance products they o er has decreased (Study Session 7, Module 15.3, LOS 15.i) Related Material in SchweserNotes - Book en tre Question #149 of 164 From the perspective of the employer, which of the following statements is most accurate? A de ned: bo ok c A) bene t plan can be underfunded; a de ned contribution plan is more risky B) contribution plan can be underfunded; a de ned bene t plan is more risky C) bene t plan can be underfunded; a de ned contribution plan is less risky m Explanation o A de ned bene t plan is underfunded when the present value of the liabilities exceeds the present value of the plan's assets A de ned contribution plan cannot become underfunded, and is, therefore, considered to be less risky from the standpoint of the employer w w (Study Session 7, Module 15.1, LOS 15.a) Related Material w SchweserNotes - Book Question #150 of 164 Pension fund risk tolerance increases according to: A) high exibility in plan features B) greater plan sponsor leverage C) less plan sponsor leverage https://www.kaplanlearn.com/education/dashboard/index/66a9ea0d62bb71ab495925615029a3fd/practice/qbank/24038518/quiz/83416097/print 104/117 10/11/2018 Learning Management System Explanation Pension fund risk tolerance increases when the plan sponsor has lower leverage The higher the correlation between sponsor activities, as well as high exibility in plan features (e.g., early retirement options), work to decrease the risk tolerance of a pension plan (Study Session 7, Module 15.1, LOS 15.c) Related Material SchweserNotes - Book in Question #151 of 164 A) high proportion of retired lives B) high proportion of active lives bo ok c C) low proportion of retired lives en tre The liquidity requirement of a pension plan is directly related to and increased by a: Explanation Pension plan liquidity requirements are increased by the proportion of participants currently receiving bene ts Hence, a high proportion of retired lives, those currently receiving bene ts, indicates a larger liquidity requirement .o Related Material m (Study Session 7, Module 15.1, LOS 15.b) w w w SchweserNotes - Book Question #152 of 164 Which of the following statements regarding foundations is CORRECT? A) Independent foundations provide grants to charities, educational institutions, and social organizations B) An operating foundation is generally funded to support a variety of social causes over time C) A community foundation is dedicated solely to support a speci c organization or some on-going research initiative https://www.kaplanlearn.com/education/dashboard/index/66a9ea0d62bb71ab495925615029a3fd/practice/qbank/24038518/quiz/83416097/print 105/117 10/11/2018 Learning Management System Explanation An operating foundation is funded solely to support a speci c organization or some on-going research initiative A community foundation typically funds social, educational, or religious initiatives (Study Session 7, Module 15.2, LOS 15.h) Related Material SchweserNotes - Book Ranjana Clarkson, CFA, has just been hired by First National American (FNA), a small in Midwestern U.S bank Clarkson, originally from India, is married to a career military o cer; hence she must relocate every few years Despite this and her lack of banking experience, Jason en tre Anderman her supervisor, was impressed with Clarkson and is delighted to hire someone with her credentials and experience Clarkson is dent that she can make the transition to banking, but knows she needs to learn a lot more about the speci cs of the industry, particularly with regard to how their securities portfolios are managed bo ok c As part of her review process, Clarkson begins to assemble a notebook with pertinent information Her progress so far is detailed below: Objectives and Constraints m Manage risk relative to liabilities Earn a positive interest spread o Contain liquid assets w w Short to intermediate term time horizon Highly regulated legal environment w Taxable Management Approaches Approach Description Barbell Strategy Invest amounts on both the short and long ends of the maturity spectrum Bullet Strategy Concentrates the maturities of the bonds in the portfolio around a single point on the yield curve Clarkson believes that the Federal Reserve will be increasing interest rates regularly over the next two years in an attempt to slow an overheating economy This will result in increasing https://www.kaplanlearn.com/education/dashboard/index/66a9ea0d62bb71ab495925615029a3fd/practice/qbank/24038518/quiz/83416097/print 106/117 10/11/2018 Learning Management System rates at the short end of the yield curve Because the curve is already quite steep Clarkson predicts no change in intermediate and long term rates She is considering how the bank should position itself to prepare for that scenario Question #153 of 164 The highest priority use of a bank's funds is for: A) reserve requirements B) making loans .in C) investing in securities en tre Explanation Banks must meet required reserve amounts or their activities will be curtailed by regulators This is a legal requirement Generally they then make loans and any residual funds go to the securities portfolio bo ok c (Study Session 7, Module 15.4, LOS 15.i) Related Material m SchweserNotes - Book o Question #154 of 164 w w Of the items shown in Figure of Clarkson's notebook which is the most important objective for a bank's securities portfolio? w A) Item B) Item C) Item Explanation The primary objective of the securities portfolio is to manage risk relative to liabilities through an ALM framework They adjust the duration in the securities portfolio in order to manage the overall duration of total assets versus duration of liabilities Next they use the securities portfolio to provide liquidity Then to the extent possible they use the securities to contribute to earning a positive interest rate spread which is the di erence between the bank's cost of funds and the interest earned on loans and other investments They also consider any possible diversi cation of credit risk (Study Session 7, Module 15.4, LOS 15.i) https://www.kaplanlearn.com/education/dashboard/index/66a9ea0d62bb71ab495925615029a3fd/practice/qbank/24038518/quiz/83416097/print 107/117 10/11/2018 Learning Management System Related Material SchweserNotes - Book Question #155 of 164 Clarkson views the securities portfolio as an allocation across three duration points: short, intermediate, and long term with durations of 2, 4, and years respectively To position the bank's security portfolio to earn maximum return over a six month period, Clarkson should use in a: A) Equal weight investments throughout the three duration points en tre B) bullet strategy of only short-term securities C) barbell approach of intermediate and long-term securities Explanation bo ok c With no change in intermediate- and long-term rates, the barbell will experience no price decline and in a steep curve it will have the highest initial yield This will produce the best return The other two portfolios include short-term (duration of 2) securities With an increase in short-term rates over the next months, there will be at least some price decline and the initial yield will be lower This makes the other two choices less attractive from a return perspective .o Related Material m (Study Session 7, Module 15.4, LOS 15.i) w w w SchweserNotes - Book Question #156 of 164 A nonlife insurance company is facing the end of its underwriting cycle What should the rm with respect to the duration of its xed-income portfolio and the liquidity constraints in its policy statement? The duration of the nonlife insurance company's xed-income portfolio should be: A) lengthened in expectation of decreasing claims, and the investment policy statement should re ect the possibility of a decreasing claims environment in its li idi i d h d fi d ii l https://www.kaplanlearn.com/education/dashboard/index/66a9ea0d62bb71ab495925615029a3fd/practice/qbank/24038518/quiz/83416097/print 108/117 10/11/2018 Learning Management System B) lowered in expectation of decreasing claims, and the investment policy statement should re ect the possibility of a decreasing claims environment in its liquidity i d h d fi d ii l C) shortened in expectation of increasing claims, and the investment policy statement should re ect the possibility of an increasing claims environment in its liquidity i Explanation d h d fi d ii l in Nonlife insurance companies experience a noted underwriting cycle that generates low claim submissions at the beginning of the cycle and high claim submissions at the end of the cycle The investment policy statement should re ect this changing underwriting cycle reality, which would impact a greater liquidity constraint towards the end of the cycle Bond portfolio durations should be lowered, if they have not been already, to meet the impending increased claims submissions en tre (Study Session 7, Module 15.3, LOS 15.n) Related Material Question #157 of 164 bo ok c SchweserNotes - Book One di erence between the asset liability management techniques between a life and nonlife m insurance company is liability: o A) payment amounts are known for the life insurance company w w B) payment amounts are not known for the life insurance company C) payment amounts are known for the nonlife insurance company w Explanation The liability payment amounts for the life insurance company are known, whereas they are not known for the nonlife insurance company (Study Session 7, Module 15.5, LOS 15.m) Related Material SchweserNotes - Book Question #158 of 164 https://www.kaplanlearn.com/education/dashboard/index/66a9ea0d62bb71ab495925615029a3fd/practice/qbank/24038518/quiz/83416097/print 109/117 10/11/2018 Learning Management System Which of the following CORRECTLY describes the primary source of invested funds to meet funding requirements for an endowment fund and an investment company? Endowment Fund Investment Company A) Own assets Own assets B) Assets pooled from investors Own assets C) Assets pooled from Assets pooled from investors investors in Explanation (Study Session 7, Module 15.5, LOS 15.l) bo ok c Related Material en tre The primary di erence between investment companies and other institutional investors such as an endowment fund is the source and use of their invested funds The endowment fund will invest its own assets to meet various funding requirements while the investment company will collect funds from investors to meet the needs of the investors m SchweserNotes - Book o Question #159 of 164 The time horizon of a non-life insurance company di ers from that of a pension fund in that a w w nonlife insurance company's time horizon: A) may be quite short and will depend upon the characteristics of policies sold, w whereas a pension fund's time horizon may be much longer, depending on kf h i i B) is quite long due to the uncertainty of the liability structure associated with policies sold, whereas a pension fund's time horizon will be much shorter due to the nite lif f l C) is dependent on the uncertainties of policies sold, whereas the time horizon of a pension fund is a direct consequence of the business cycle Explanation https://www.kaplanlearn.com/education/dashboard/index/66a9ea0d62bb71ab495925615029a3fd/practice/qbank/24038518/quiz/83416097/print 110/117 10/11/2018 Learning Management System Due to the uncertainty associated with the characteristics of policies sold and when claims will be paid, the time horizon of a nonlife insurance company will necessarily be short A pension fund, however, will have a time horizon typically longer than that of a nonlife insurance company The pension fund's time horizon will be directly related to the plan sponsor's workforce characteristics (Study Session 7, Module 15.3, LOS 15.i) Related Material SchweserNotes - Book in Question #160 of 164 en tre A portfolio manager at an endowment fund expects in ation to increase over the intermediate to long term How should the return objective of the investment policy statement re ect these expectations? A) A total return objective should be pursued so that spending requirements are met, bo ok c while at the same time purchasing power of fund assets is maintained B) An exclusive income oriented approach should be adopted so that spending requirements can be met in the impending in ationary environment C) An exclusive capital gain oriented approach should be followed so that purchasing d Explanation o d m power is preserved, while at the same time spending requirements must be w w An endowment fund should adopt a total return objective, especially in an impending in ationary environment In this way, not only are current spending requirements met, but the ability to meet future spending requirements is also increased w (Study Session 7, Module 15.2, LOS 15.n) Related Material SchweserNotes - Book World Wide Telecom (WWT), a troubled internet service provider recently led Chapter 11 bankruptcy after seven unsuccessful years of operations It was a plan sponsor in WWT Pension Plan for the bene t of its employees The following information was available at the time of its bankruptcy ling: Employees: 500 https://www.kaplanlearn.com/education/dashboard/index/66a9ea0d62bb71ab495925615029a3fd/practice/qbank/24038518/quiz/83416097/print 111/117 10/11/2018 Learning Management System Plan assets: $15 million Plan liabilities: $19 million Average age of workforce: 30 1% of plan assets are being paid out to retirees and no more participants are expected to retire over the next ve years Due to the company's nancial condition, the plan was under-funded The duration of the plan liabilities is 25 years In ation is expected to be approximately 1% over the next ve years The bankruptcy trustee appointed Eric Geecu, CFA, as the portfolio manager overseeing the WWT Pension Plan to develop guidelines for its investment policy statement and the ultimate in distribution of the proceeds of the plan upon fully funded status Geecu believes that fully funded status could be achieved within the next ve years, assuming the plan earns an en tre expected rate of return in excess of its plan liabilities The plan liabilities are expected to Question #161 of 164 bo ok c increase at the rate of in ation In developing an investment policy statement (IPS) for WWT Pension Plan, which constraints should Geecu consider? m A) The pension plan is governed under ERISA, unique circumstances that the plan cannot provide any funds to meet the plan's underfunded status, and a long time o h i B) A short time horizon, low liquidity needs, with assets managed according to the w w "prudent expert" rule C) A long time horizon, unique circumstances associated with the Chapter 11 w bankruptcy, with no current taxes to be considered for the pension plan Explanation https://www.kaplanlearn.com/education/dashboard/index/66a9ea0d62bb71ab495925615029a3fd/practice/qbank/24038518/quiz/83416097/print 112/117 10/11/2018 Learning Management System Time horizon – The time horizon for this plan is short Since the plan sponsor, WWT, is currently in bankruptcy and would not be considered a going concern, it cannot provide any funds to minimize the plan de cit Since there is only a 5-year time horizon for the plan coupled with the uncertainty on the disposition of available funds in ve years, the primary goal of this plan is on capital preservation with a secondary focus on income and a third goal of some growth over the time horizon Five years is a short time frame to achieve these goals Any IPS developed must consider capital preservation rst and then consider a total return approach to preserve the plan from the e ects of in ation Liquidity – The liquidity needs of this portfolio are low primarily because only 1% of the plan assets are currently being paid out and no more employees are expected to retire over the next ve years The average age of the workforce is 30 and young and will not require any distributions until the expected termination upon its fully funded status Therefore, the plan only has to provide for its current retirees at a rate of 1% per year en tre in Laws and regulations – This pension plan is governed by ERISA and must adhere to the prudent expert rule As such, diversi cation is necessary to minimize the risk of large losses to the plan and capital preservation Taxes – There are none to be considered for the pension plan However, upon the distribution of the plan assets after ve years, there could be a tax impact on the plan participants Tax counsel is advised here for the plan and its participants to also some tax planning for the ultimate distribution of the proceeds of the plan in ve years m bo ok c Unique circumstances – WWT, the plan sponsor, is in a Chapter 11 bankruptcy ling and, therefore, cannot provide any funds to meet the plan's underfunded status The plan must also consider the administration of the distribution of the proceeds of the plan after ve years to its plan participants Should the underfunded status remain (assuming a higher than expected level of bene ts are paid out to retirees or the expected rate of return does not meet the level of the plan liabilities) special policies and procedures may need to be considered at the time of the distribution of the plan assets w w Related Material o (Study Session 7, Module 15.2, LOS 15.k) w SchweserNotes - Book Question #162 of 164 In developing an IPS for WWT Pension Plan, what must Geecu consider with respect to the return objective and risk tolerance for the plan? A) Return requirement = 7.33%, risk tolerance = low to average B) Return requirement = 7.89%, risk tolerance = moderate to high C) Return requirement = 6.84%, risk tolerance = low or below average Explanation https://www.kaplanlearn.com/education/dashboard/index/66a9ea0d62bb71ab495925615029a3fd/practice/qbank/24038518/quiz/83416097/print 113/117 10/11/2018 Learning Management System Return requirement – The plan must consider the preservation of capital as its primary objective over the 5-year time horizon The plan should focus on a goal of obtaining an expected rate of return of 6.84% to eliminate the plan de cit of $4 million (plan asset of $15 million less plan liabilities of $19 million) and preserve the plan from the e ects of in ation PV= -15 FV=19 N=5 PMT=0 CPT I/Y = 4.84% Rate of return to achieve fully funded status = 4.84% Plus: bene ts paid out to retirees = 1.00% Plus: expected in ation rate = 1.00% Equals the return requirement = 6.84% en tre in Since the bankruptcy court has mandated that the plan liabilities will be held constant at $19 million, the plan assets could be invested at a required rate to achieve fully funded status in ve years Thus, the computation to achieve the rate of return is: (Future Value ¸ Present Value) (1/term) or using a nancial calculator =4.84% The result of this calculation is 4.84 percent Additionally, we must also include the bene ts currently paid out to retirees of percent plus the expected in ation rate of percent to arrive at the return requirement of 6.84 percent This return requirement allows the plan to close the plan de cit while also providing retirement bene ts to its retirees and preserving the capital from the e ects of in ation bo ok c Risk Tolerance – The risk tolerance for the pension plan is low or below average The primary objective of the plan is to preserve the plan assets and protect it from the e ects of in ation with the ultimate goal of achieving a fully funded status in ve years Given the short time horizon of ve years and its current underfunded status and the inability of its plan sponsor to commit any fund to the plan (due to bankruptcy), the plan cannot be subjected to any unexpected levels of market risk Furthermore, it is currently paying out bene ts to retirees, so it must have the liquidity to provide such bene ts m (Study Session 7, Module 15.2, LOS 15.k) o Related Material w w w SchweserNotes - Book Question #163 of 164 https://www.kaplanlearn.com/education/dashboard/index/66a9ea0d62bb71ab495925615029a3fd/practice/qbank/24038518/quiz/83416097/print 114/117 10/11/2018 Learning Management System Based on the information presented in the case above and the IPS, which of the following Portfolio B Portfolio C U.S Treasury Bills 1% 5% 5% 5% U.S Treasury 10-Year Bonds 5% 5% 25% 10% U.S Corp 5-Year Bonds 5% 20% 35% 35% U.S Corp 10-Year Bonds 8% 5% 25% 10% U.S Stocks - S&P 500 9% 25% 5% 15% U.S Stocks - Small Cap 12% 15% 0% 5% U.S Stocks – Mid Cap 10% 20% 5% 10% 12% 5% 0% 10% 8.35% 6.00% 7.25% 1.67% 2.50% 2.10% 0.35 0.40 0.38 Real Estate Investment Trusts Yield w w Sharpe Ratio o m Total Return in Portfolio A bo ok c Expected Return en tre portfolios would be the most appropriate for WWT: A) Portfolio B w B) Portfolio A C) Portfolio C Explanation https://www.kaplanlearn.com/education/dashboard/index/66a9ea0d62bb71ab495925615029a3fd/practice/qbank/24038518/quiz/83416097/print 115/117 10/11/2018 Learning Management System Portfolio C is the most appropriate portfolio for the WWT Pension Plan First of all, it exceeds the return requirement of 6.84% by 41 basis points It is the most diversi ed of the portfolio selections, thus providing a means of meeting the primary objective of preserving capital along with in ation protection for the plan assets (30% in stocks, 55% in bonds, 15% in REITs and 5% in T-bills) There is a moderate allocation of REITs to provide in ation protection and diversi cation bene ts while also providing higher yields than bonds This allocation also provides plenty of liquidity to meet the bene t requirements for its retirees There is also a larger concentration of corporate bonds in the 5-year time horizon in order to meet the termination requirements of the plan Its Sharpe ratio is at the mid-point of all the portfolio selections o ering a moderate level of excess returns for its risk level .in Portfolio A is inappropriate because of the higher concentration in stocks (60%) and low concentration in bonds (30%) Given the low risk tolerance and the short time horizon, this portfolio would be subject to high levels of market risk because of its high stock allocation Since the primary goal is capital preservation, the high exposure to stocks makes this portfolio selection risky because of the lack of diversity bo ok c en tre Portfolio B is inappropriate because of the extraordinary high concentration in bonds (85%) There is a very high concentration in long-term, 10-year bonds (50%) making this portfolio selection particularly sensitive to in ation risk This selection also does not meet the return requirement of the pension plan Even though it does have the highest Sharpe ratio, the combination of an inadequate return requirement, lack of in ation risk protections, and lack of diversity can in uence the plan's ability to reach its desired goal of fully funded status (Study Session 7, Module 15.1, LOS 15.k) Related Material o m SchweserNotes - Book w w Question #164 of 164 Which of the following would be included in an investment policy statement (IPS) for a de ned w contribution plan? A) A description of the investment alternatives available to plan participants B) Risk objectives C) Time horizon Explanation In a de ned contribution plan, the plan sponsor does not establish objectives and constraints but rather the plan participants set their own risk and return objectives (Study Session 7, Module 15.1, LOS 15.f) Related Material SchweserNotes - Book https://www.kaplanlearn.com/education/dashboard/index/66a9ea0d62bb71ab495925615029a3fd/practice/qbank/24038518/quiz/83416097/print 116/117 Learning Management System w w w o m bo ok c en tre in 10/11/2018 https://www.kaplanlearn.com/education/dashboard/index/66a9ea0d62bb71ab495925615029a3fd/practice/qbank/24038518/quiz/83416097/print 117/117 ... Module 15. 2, LOS 15. i) Related Material SchweserNotes - Book https://www.kaplanlearn.com/education/dashboard/index/66a9ea0d62bb71ab495925 6150 29a3fd/practice /qbank/ 24 038 518/quiz/ 834 16097/print 3/ 117... 7, Module 15 .3, LOS 15. j) Related Material SchweserNotes - Book https://www.kaplanlearn.com/education/dashboard/index/66a9ea0d62bb71ab495925 6150 29a3fd/practice /qbank/ 24 038 518/quiz/ 834 16097/print... Module 15. 2, LOS 15. i) Related Material SchweserNotes - Book https://www.kaplanlearn.com/education/dashboard/index/66a9ea0d62bb71ab495925 6150 29a3fd/practice /qbank/ 24 038 518/quiz/ 834 16097/print 30 /117