Schweser QBank 2017 portfolio management and wealth planning 06 portfolio management for institutional investors

Portfolio Management for Institutional Investors

Test ID: 7426254

Question #1 of 175

Question ID: 465147

Which of the following defined benefit pension plans has the greatest ability to accept risk?

Age of

Ratio of active to Sponsor's Sponsor's

Plan
workforce retired participants debt ratio profitability
A

young

high

high

low

B

young

high

low

high

C

older

high

low

high

ᅞ A) Plan C.
ᅚ B) Plan B.
ᅞ C) Plan A.
Explanation
The younger the workforce, the longer until pension liabilities are due and the greater the ability of a plan to accept risk. This is especially
true when the ratio of active to retired participants is high. Profitable plan sponsors with low debt ratios have a greater ability to absorb
losses and hence accept more risk.

Question #2 of 175

Question ID: 465193

Which of the following statements about defined contribution investment policy statements (IPS) is least accurate?

ᅞ A) Procedures are established to insure that a myriad of individual investor objectives and

constraints can be handled.

ᅚ B) IPS for defined benefit and defined contribution plans are similar in nature.
ᅞ C) Plan sponsors should provide education about investing plan funds.
Explanation
Defined contribution plans call for quite a different IPS than do defined benefit plans.

Question #3 of 175

Question ID: 465269

Which of the descriptions in the table below most accurately describes the liquidity requirements for life and non-life insurance
companies?

Liquidity Requirements for Insurance Companies


Life Insurance Companies

Non-life insurance Companies

Description Fixed income segment Surplus segment Fixed income segment Surplus segment
I

Relatively high

Very low

Relatively high

Very low

II

Relatively low

Moderate

Relatively low

Very low

III

Relatively high

Very low

Relatively high

Relatively high

ᅚ A) Description I.
ᅞ B) Description III.
ᅞ C) Description II.
Explanation
The surplus portfolio components of insurance companies' portfolios have very low liquidity requirements. These portfolios are managed to
generate high returns and generate greater surplus through portfolio growth. Low liquidity equity investments, including venture capital, are
used to accomplish this goal.
The fixed income segment of life insurance company portfolios has a relatively high liquidity requirement. Asset-liability mismatch,

disintermediation, and asset marketability risk all contribute to the relatively high liquidity requirement.
For non-life insurance companies, the fixed income segment of their portfolios has a relatively high liquidity requirement due to the
uncertainty of claims.

Question #4 of 175

Question ID: 465176

A defined benefit plan should:

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

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

ᅞ C) review investment performance on a yearly basis.
Explanation
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.

Question #5 of 175

Question ID: 465188

When formulating an investment policy statement for a defined benefit pension plan, legal and regulatory factors, in addition to unique
circumstances, must be considered. In this regard, which of the following statements is least accurate?


ᅞ A) In the United States, the provisions of the Employee Retirement Income Security Act

(ERISA) must be adhered to regardless of any state or local laws and regulations that
govern pension investment activity.

ᅞ B) Due to either ethical or political objections, a pension plan may disallow investments in certain
types of traditional or alternative asset classes.

ᅚ C) The basic tenet of the Employee Retirement Income Security Act (ERISA) is that pension
plans be managed with equal regard for the interests of plan sponsors and plan beneficiaries.

Explanation
The fundamental standard of care required by ERISA is that pension fund assets must be invested for the sole benefit of plan participants
and not that of plan sponsors.

Question #6 of 175

Question ID: 465175

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?

ᅞ A) Due to the current under-funded status, relatively older workforce age, and high retiredlives 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.

ᅚ B) 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.

ᅞ C) 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.

Explanation
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.

Question #7 of 175

Question ID: 465314

A nonlife insurance company is facing the end of its underwriting cycle. What should the firm do with respect to the duration of its fixedincome portfolio and the liquidity constraints in its policy statement? The duration of the nonlife insurance company's fixed-income
portfolio should be:


ᅞ A) lengthened in expectation of decreasing claims, and the investment policy statement
should reflect the possibility of a decreasing claims environment in its liquidity
constraint towards the end of its underwriting cycle.

ᅚ B) shortened in expectation of increasing claims, and the investment policy statement should
reflect the possibility of an increasing claims environment in its liquidity constraint towards the
end of its underwriting cycle.

ᅞ C) lowered in expectation of decreasing claims, and the investment policy statement should
reflect the possibility of a decreasing claims environment in its liquidity constraint towards the
end of its underwriting cycle.

Explanation
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 reflect 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.

Question #8 of 175

Question ID: 465323

Which of the following defined benefit pension plan segments generates the greatest liability noise? The greatest source of
liability noise is that from:
ᅞ A) inactive participants.
ᅞ B) deferreds.
ᅚ C) active participants.
Explanation
Pensions are subject to non-market exposures referred to as liability noise. Inactive participants can be divided into retirees
and deferreds. The liability noise from either of these groups is less than that from active participants.

Question #9 of 175

Question ID: 465206

Which of the following types of foundations do NOT have a spending requirement?
ᅞ A) Operating.
ᅚ B) Community.
ᅞ C) Independent.
Explanation
Independent (or private) and company-sponsored foundations must spend five percent of their assets annually toward nonoperating expenses to maintain their tax-exempt status. Operating foundations must use 85% of interest and dividend income

to conduct the institution's own program.


Question #10 of 175

Question ID: 465311

Which of the following statements most accurately describes asset-liability management for the specified institution?
ᅞ A) Managers of foundations typically attempt to match the duration of assets and
liabilities.
ᅚ B) Risk tolerance for an endowment is determined by the spending rate and its
importance to the operating budget of the recipient.
ᅞ C) Asset allocation for pension funds is generally unaffected by regulatory constraints.
Explanation
Managers of pension funds typically attempt to match the duration of assets and liabilities. Asset allocation for foundations
must accommodate a five percent spending rate so the fund may maintain its tax-exempt status. Asset allocation for pension
funds is generally affected by regulatory constraints, such as restrictions on private and speculative debt.

Question #11 of 175

Question ID: 465270

Which of the following statements best compares the legal and regulatory constraints when managing a pension plan versus managing an
endowment fund?

ᅞ A) State pension laws generally supersede Federal pension laws regarding pension plans
whereas endowment funds are primarily regulated at the Federal level.

ᅞ B) Endowment funds are managed according to the "prudent expert" rule while benefit plans are
managed under the "prudent investor" rule.

ᅚ C) Pension plans are managed according to the Employee Retirement Income Security Act while
endowment funds are governed by the Uniform Management Institutional Funds Act.

Explanation
With respect to the legal and regulatory constraints, pension plans are regulated by the Employee Retirement Income Security Act
(ERISA) while endowment funds are governed by the Uniform Management Institutional Funds Act (UMIFA).
Pension plans are held to a higher standard known as the "prudent expert" rule which states that ERISA fiduciaries must discharge their
duties..." with care, skill, prudence, and diligence under circumstances then prevailing that a prudent person acting in like capacity and
familiar with such matters would use in the conduct of an enterprise of like character and aims." By diversifying the investments of the
plan we minimize the risk of large losses.
Endowment plans are held to a standard known as the "prudent investor" rule, which states that fiduciaries must adhere to fundamental
duties of loyalty, impartiality and prudence as well as maintain overall portfolio risk at a reasonable level and provide for the reasonable
diversification of investments. Fiduciaries must also act with prudence in deciding whether and how to delegate authority to experts and
in selecting and supervising agents.

Questions #12-15 of 175
Ed Simon, CFA, has been assigned the arduous task of assessing the slight nuances concerning the investment objectives and
constraints for foundations and endowments. Simon's supervisor has requested a full report on these differences and how they affect the


investment policy statements.

Question #12 of 175

Question ID: 465264

Simon thought it best to first look at differences in return objectives between foundations and endowments. Which of the following best
indicates differences between the return objectives of foundations and of endowments?

ᅚ A) Foundation return objectives depend on the time horizon of the foundation, whereas
endowment return objectives are to provide a permanent base of funding.

ᅞ B) Foundation return objectives are to provide a permanent base of funding whereas endowment
return objectives depend on the time horizon of the endowment.

ᅞ C) Endowment returns usually are dictated by a rule-of-thumb of "5.3% + inflation," whereas
foundation return objectives are dictated by spending rules.

Explanation
Foundations may be finite-lived entities, but endowments are created to provide a permanent base of funding.

Question #13 of 175

Question ID: 465265

Simon next turned his attention to the differences in risk objectives between foundation and endowment investment policy statements.
Which of the following best describes the main difference between foundation and endowment risk objectives?

ᅚ A) Foundation risk tolerance is dependent on the time horizon of the foundation, whereas
endowment risk tolerance is dependent on the importance of the endowment fund in
the sponsor's overall budget picture.

ᅞ B) Endowment risk tolerance is not dictated by the relationship between the current income
requirement and maintenance of purchasing power, whereas this is a crucial factor for
foundations.

ᅞ 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 on the time horizon of the
endowment.

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.

Question #14 of 175

Question ID: 465266

Foundations and endowments often have differential liquidity constraints. Simon found which of the following to be a difference between
the liquidity constraints of a foundation and an endowment?

ᅚ A) Private foundations are required to have a minimum spending rate whereas
endowments rarely have minimum spending rates.

ᅞ B) Endowments are required to have a minimum spending rate whereas private foundations rarely
have minimum spending rates.

ᅞ C) An endowment's spending rule will have less of an effect 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 do not have minimum spending
requirements.

Question #15 of 175

Question ID: 465267

Simon discovered tax laws seem to differentially impact foundations and endowments. Which of the following most accurately depicts the
differential tax treatment between foundations and endowments?

ᅞ A) Operating foundation investment income is taxable, whereas endowment investment
income is not.

ᅞ B) Endowment investment income is taxable, whereas private foundation investment income is
not.

ᅚ C) Private foundation investment income is taxable, whereas endowment investment income is
not.

Explanation
Private foundation investment income is taxable, whereas other foundations and endowments are not.

Question #16 of 175

Question ID: 465317

The following statements concern differences between the investment policy statement for an institution and that for an individual. Which
of these statements is least accurate? The institutional investment policy statement:

ᅚ A) has four main steps--planning, estimation, execution, and feedback--while the
individual investment policy statement has three.

ᅞ B) may have asset structure and liquidity requirements that are driven by the institution's liability
structure.

ᅞ C) is likely to give more prominence to legal constraints.
Explanation

Both individual and institutional policy statements should have three main steps: planning, execution, and feedback. The institutional
statement is more likely to include legal and regulatory constraints, and may have the asset structure and liquidity requirements driven by
the institution's liability structure.

Question #17 of 175

Question ID: 465303

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


ᅚ A)

Own assets

ᅞ B) Assets pooled from
investors
ᅞ C) Own assets

Assets pooled from
investors
Assets pooled from
investors
Own assets

Explanation
The primary difference 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.

Question #18 of 175

Question ID: 465324

A defined benefit pension plan decides to index their benefits to inflation. Meanwhile, the labor force has increased in
productivity and profits have soared. Which of the following best describes the changes to their liability-mimicking portfolio?
The liability-mimicking portfolio should have:
ᅞ A) more equities and more nominal bonds.
ᅚ B) more equities and more real return bonds.
ᅞ C) fewer equities and more real return bonds.
Explanation
If the pension plan decides to index their benefits to inflation, more real return (inflation-indexed) bonds should be added to
hedge the benefits. If the labor force becomes more productive, wages will increase due to this real growth. This real growth is
related to economic growth and is best hedged by equities.

Question #19 of 175

Question ID: 465223

The return objectives for a life insurance company can be broken into two segments, the fixed-income and the surplus segments. Which
return objectives are mostly associated with each segment, respectively?

ᅞ A) Yield maximization and spread management.
ᅞ B) Spread management and maximizing yield.
ᅚ C) Spread management and capital gains.

Explanation
The return objectives for a life insurance company have mainly been associated with earning a competitive return that helps increase the
spread between assets and liabilities. The surplus portfolio, however, has growth in the surplus as its main return objective, which will
happen via capital gains.


Question #20 of 175

Question ID: 465192

Which of the following would be included in an investment policy statement (IPS) for a defined contribution plan?

ᅞ A) Time horizon.
ᅞ B) Risk objectives.
ᅚ C) A description of the investment alternatives available to plan participants.
Explanation
In a defined contribution plan, the plan sponsor does not establish objectives and constraints but rather the plan participants set their own
risk and return objectives.

Questions #21-23 of 175
World Wide Telecom (WWT), a troubled internet service provider recently filed Chapter 11 bankruptcy after seven
unsuccessful years of operations. It was a plan sponsor in WWT Pension Plan for the benefit of its employees. The following
information was available at the time of its bankruptcy filing:
Employees: 500
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 five years.
Due to the company's financial condition, the plan was under-funded.
The duration of the plan liabilities is 25 years.

Inflation is expected to be approximately 1% over the next five 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 distribution of the proceeds of the plan upon fully funded status.
Geecu believes that fully funded status could be achieved within the next five years, assuming the plan earns an expected rate
of return in excess of its plan liabilities. The plan liabilities are expected to increase at the rate of inflation.

Question #21 of 175

Question ID: 465300

In developing an investment policy statement (IPS) for WWT Pension Plan, which constraints should Geecu consider?

ᅚ A) A short time horizon, low liquidity needs, with assets managed according to the
"prudent expert" rule.

ᅞ B) A long time horizon, unique circumstances associated with the Chapter 11 bankruptcy, with
no current taxes to be considered for the pension plan.

ᅞ C) 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 horizon.

Explanation
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 deficit. Since there is only a 5-year time
horizon for the plan coupled with the uncertainty on the disposition of available funds in five 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 first and then consider a
total return approach to preserve the plan from the effects of inflation.

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 five 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.
Laws and regulations - This pension plan is governed by ERISA and must adhere to the prudent expert rule. As such,
diversification 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 five
years, there could be a tax impact on the plan participants. Tax counsel is advised here for the plan and its participants to also
do some tax planning for the ultimate distribution of the proceeds of the plan in five years.
Unique circumstances - WWT, the plan sponsor, is in a Chapter 11 bankruptcy filing 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 five years to its plan participants. Should the underfunded status remain (assuming a higher than expected
level of benefits 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.

Question #22 of 175

Question ID: 465301

In developing an IPS for WWT Pension Plan, what must Geecu consider with respect to the return objective and risk tolerance for the
plan?

ᅚ A) Return requirement = 6.84%, risk tolerance = low or below average.
ᅞ B) Return requirement = 7.33%, risk tolerance = low to average.
ᅞ C) Return requirement = 7.89%, risk tolerance = moderate to high.
Explanation
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 deficit of $4 million (plan
asset of $15 million less plan liabilities of $19 million) and preserve the plan from the effects of inflation.
PV= -15 FV=19 N=5 PMT=0 CPT I/Y = 4.84%

Rate of return to achieve fully funded status = 4.84%
Plus: benefits paid out to retirees = 1.00%
Plus: expected inflation rate = 1.00%
Equals the return requirement = 6.84%
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 five years. Thus, the computation to achieve the rate of return is:
(Future Value ¸ Present Value) (1/term) or using a financial calculator =4.84%. The result of this calculation is 4.84 percent.
Additionally, we must also include the benefits currently paid out to retirees of 1 percent plus the expected inflation rate of 1
percent to arrive at the return requirement of 6.84 percent.
This return requirement allows the plan to close the plan deficit while also providing retirement benefits to its retirees and
preserving the capital from the effects of inflation.
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 effects of inflation with the ultimate goal of achieving a fully funded status in
five years. Given the short time horizon of five 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 benefits to retirees, so it must have the liquidity to provide such benefits.

Question #23 of 175

Question ID: 465302

Based on the information presented in the case above and the IPS, which of the following portfolios would be the most
appropriate for WWT:

Expected Return Portfolio A 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%

Real Estate Investment Trusts 12%

5%

0%

10%

Total Return

8.35%

6.00%

7.25%

Yield

1.67%

2.50%

2.10%

Sharpe Ratio

0.35

0.40

0.38

ᅞ A) Portfolio B.
ᅚ B) Portfolio C.
ᅞ C) Portfolio A.
Explanation
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 diversified of the portfolio selections, thus providing a means of meeting the primary objective of preserving
capital along with inflation 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 inflation protection and diversification benefits while also providing higher yields than bonds. This
allocation also provides plenty of liquidity to meet the benefit 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 offering a moderate level of excess returns for its risk level.
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.
Portfolio B is inappropriate because of the extraordinary high concentration in bonds (85%). There is a very high concentration in longterm, 10-year bonds (50%) making this portfolio selection particularly sensitive to inflation 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 inflation risk protections, and lack of diversity can influence the plan's ability to reach its desired goal of fully funded
status.

Question #24 of 175

Question ID: 465307

One difference between the asset liability management techniques between a life and nonlife insurance company is liability:

ᅞ A) payment amounts are not known for the life insurance company.
ᅞ B) payment amounts are known for the nonlife insurance company.
ᅚ C) payment amounts are known for the life insurance company.
Explanation
The liability payment amounts for the life insurance company are known, whereas they are not known for the nonlife insurance company.

Question #25 of 175

Question ID: 465166

Pension fund risk tolerance is increased by a young workforce and:

ᅞ A) high retired-lives proportion.
ᅚ B) low retired-lives proportion.
ᅞ C) high plan sponsor leverage.
Explanation
Pension fund risk tolerance is increased by having a young workforce and a small proportion of retired lives. Both of the other
combinations with a young workforce will tend to decrease risk tolerance.

Question #26 of 175

Question ID: 465318

Which of the following statements regarding the focus of a liability-mimicking versus an asset-only portfolio of pension plans is
CORRECT? The liability-mimicking portfolio will have a:

ᅞ A) low correlation with the liabilities and the asset-only approach will focus on
investments with a low correlation to assets.
ᅞ B) high correlation with the liabilities and the asset-only approach will focus on
investments with a high correlation to assets.
ᅚ C) high correlation with the liabilities and the asset-only approach will focus on
investments with a low correlation to assets.


Explanation
In the liability-relative approach, the portfolio will be chosen for its ability to mimic the liability (i.e., the portfolio will have a high
correlation with the liability). In the asset-only approach, the focus is instead on investments with a low correlation to assets.

Question #27 of 175

Question ID: 465194

Which of the following statements are correct regarding a participant-directed defined contribution plan?

Statement 1: The plan should be responsible for establishing and revising the interest rate for plan loans to
participants.
Statement 2: The plan should provide criteria for manager/fund selection, termination and replacement.
Statement 1

Statement 2

ᅚ A) Correct

Correct

ᅞ B) Incorrect

Incorrect

ᅞ C) Incorrect

Correct

Explanation
Instead of stating objectives and constraints (as in defined benefit plans), the purpose of a participant-directed defined
contribution investment policy statement is to provide a governing document that describes the investment strategies and
alternatives available to plan participants. Some defined contribution plans allow plan participants to take out loans against the
amount they contributed.

Questions #28-33 of 175
Bob Monarch, CFA, has been managing portfolios for individuals for about 10 years. It started out as a second job, but about 5
years ago he left his full-time position to manage the portfolios as his sole occupation. His clients are largely retired or persons
near retirement who would be considered to be conservative investors.
In the last two years, Monarch has been sending out resumes to institutional investment firms of various types in the hopes of
becoming a full-time manager of a single fund. Recently, he has been invited to two interviews for the position of portfolio
manager. The first interview he schedules is with an investment company for a position as manager of their mid-cap growth
equity mutual fund.
Monarch's second interview will be with Starling College (Starling) for the position of endowment manager. The endowment
fund has been highly correlated with the S&P 500 in growth and income, but with a beta of about 0.6. The endowment follows
a "socially conscious" investment policy. The current spending rate is set at 3% annually, the minimum needed to support
Starling's operating budget. This is unlikely to change. To provide for real growth of the principal, the fund's moderately
aggressive return target is also unlikely to be altered.
Both the mutual fund and the endowment have assets in the tens-of-millions of dollars, and each is offering a roughly
equivalent salary and benefits package. Consequently, Monarch feels he would be happy with either position. As he prepares
for his interviews, he compares the portfolio management approach he currently employs to what would be appropriate in
either of the two prospective positions. He creates the following template and begins to summarize his thoughts:

Current Clients vs. Investment Co. & Endowment Fund
Investment Company

Endowment Fund

Higher

Higher

Return Objective
Risk Objective
Time Horizon
Taxes
Liquidity
Legal & Regulatory

Unique Constraints Focus on Single Asset Class Socially Conscious

After work that evening, Monarch calls Antonia Linn, a friend who is an emerging markets debt analyst for a large investment
bank. He wants her advice on the two positions he is considering, and hopes she can give him some helpful interviewing tips.
During the course of their discussion, Linn asks Monarch to distinguish between endowments and foundations. They disagree
on the issues of taxation and the allowable functions foundations and endowments may undertake.
Monarch states that "while both are tax-exempt entities, endowments are generally organized to provide ongoing budgetary
support for the operations of a specific entity, such as a university or some other charity. Foundations are typically formed for
grant-making purposes, but can also be created to provide perpetual support for a specific charitable organization."
Linn responds: "Well, I know that's not my field, but as I understand it, foundations are taxable while endowments are not. In
addition, I think that foundations can make grants, but can't be set up to provide permanent support. You'd better be sure to
know the distinctions before your interviews."

Question #28 of 175

Question ID: 485049

Compared to the risk tolerance of Monarch's current clients, the risk tolerance of the investment company and endowment
fund would be:

Investment Co.

Endowment
Fund

ᅞ A) less

more

ᅚ B) more

more

ᅞ C) more

less

Explanation
Both the endowment and investment company would have longer horizons and, thus, would be able to tolerate more risk than
would Monarch's current clients. Institutions can generally tolerate more risk than individuals, and this is especially true give
that Monarch's current clients are retired or near retirement. (Study Session 6, LOS 14.i)

Question #29 of 175

Question ID: 485050

Compared to the average time horizon of his current clients, the time horizon of the investment company and endowment fund
will be:


Investment Co.

Endowment
Fund

ᅚ A) longer

longer

ᅞ B) shorter

longer

ᅞ C) shorter

shorter

Explanation
Both the endowment and investment company would have longer horizons than Monarch's current clients. Institutions
generally have longer horizons than individuals, and this is especially true given that Monarch's clients are retired or near
retirement. (Study Session 6, LOS 14.i)

Question #30 of 175

Question ID: 485051

Which of these situations (the investment company or the endowment fund), would have the fewest tax considerations?
ᅞ A) The investment company.
ᅞ B) There is no clear answer.
ᅚ C) The endowment fund.
Explanation
An endowment fund does not have to consider taxes. Although, an investment company manager is judged primarily on the
total pretax return, the public is paying increasing attention to the tax implications of funds with high turnover rates. (Study
Session 6, LOS 14.i)

Question #31 of 175

Question ID: 485052

Which of these situations (the investment company or the endowment), would require the most attention to generating a
positive alpha?
ᅚ A) The investment company.
ᅞ B) The endowment.
ᅞ C) There is no clear answer.
Explanation
Alpha is a standard criterion for measuring the success of an investment company. Although alpha could be used to measure
Monarch's success as the endowment manager, the endowment has other criteria such as loss aversion and social
consciousness. Thus, alpha would not be the primary focus. (Study Session 6, LOS 14.l)

Question #32 of 175
With respect to the statements made by Monarch and Linn comparing foundations and endowments:
ᅚ A) Monarch is incorrect about taxes and correct about functions; Linn is correct

about taxes and incorrect about functions.
ᅞ B) Monarch is incorrect about taxes and incorrect about functions; Linn is correct about
taxes and correct about functions.

Question ID: 485053


ᅞ C) Monarch is correct about taxes and correct about functions; Linn is incorrect about
taxes and incorrect about functions.
Explanation
Foundations are subject to excise taxes between1-2% on net investment income. Any unrelated business income is exposed
to regular corporate tax rates. In addition to grant-making, foundations can be primary sources of ongoing funding for
charitable programs. (Study Session 6, LOS 14.i)

Question #33 of 175

Question ID: 485054

Monarch thinks he might be questioned about the predictive power of an investment manager's past performance. Which of
the following factors is least likely to help when projecting how well a manager will do in the future is:
ᅞ A) what time frame was used to measure performance.
ᅚ B) the manager's nominal return.
ᅞ C) whether the performance was evaluated relative to a style benchmark.
Explanation
The nominal return itself provides limited information for gauging a manager's future success. Risk-adjusted returns and
returns relative to a style or index benchmark are more useful. Other important factors to consider are the investment process,
who the investment decision-makers are, the time frame, the presence of dependable staff, the size of the portfolio, and the
consistency of the performance. (Study Session 12, LOS 24.u)

Question #34 of 175

Question ID: 465205

Which of the following statements regarding foundations is most accurate?
ᅞ A) Grants from company-sponsored foundations must be made without regard to
the sponsoring company's business interest.
ᅚ B) Independent foundations receive their funds from an individual, family, or group.
ᅞ C) An operating foundation is generally funded by the organization it is intended to
support.
Explanation
Company executives usually dominate the board of trustees for a company-sponsored foundation, which may use grants to
further corporate interest. A fund owned and funded by the organization it is intended to support is called an endowment, not a
foundation.

Question #35 of 175
The liquidity requirement of a pension plan is directly related to and increased by a:

ᅞ A) low proportion of retired lives.
ᅚ B) high proportion of retired lives.

Question ID: 465150


ᅞ C) high proportion of active lives.
Explanation
Pension plan liquidity requirements are increased by the proportion of participants currently receiving benefits. Hence, a high proportion of
retired lives, those currently receiving benefits, indicates a larger liquidity requirement.

Question #36 of 175

Question ID: 465304

Dr. Jack Wolfe, a finance professor with the University of Tulsa asked his students to identify differences between a pension
fund and a growth mutual fund. Kelly Musch, a student in Wolfe's class, turned in a paper with two statements:
Statement The pension fund is likely to have more flexibility to significantly change its asset allocation.
1:
Statement The pension fund could invest in the mutual fund, but the mutual fund could not invest in the
2:

pension fund.

When grading Musch's paper, Dr. Wolfe should:

ᅞ A) disagree with Statement 1, but agree with Statement 2.
ᅞ B) disagree with Statement 1 and Statement 2.
ᅚ C) agree with Statement 1 and Statement 2.
Explanation
When grading the paper, Dr. Wolfe should agree with both of Musch's statements. Musch has indirectly hit on the two key
differences between a mutual fund (investment company) and other types of institutional investors such as pension funds. The
pension plan uses its own assets to meet various funding requirements while the mutual fund invests money pooled from
investors based on advertised objectives and constraints. It would be relatively easy for the pension fund to have a meeting
and decide to adjust its asset allocation, while the growth mutual fund, which advertises its objectives in a prospectus would
likely have to change the prospectus that governed the objective of the fund and possibly hold a shareholder proxy vote.
Statement 2 is also correct. The mutual fund invests funds on behalf of other investors, while the pension fund is part of a
company. Since the pension is an investor itself, the pension fund could invest in the mutual fund, but the mutual fund could
not invest in the pension.

Question #37 of 175

Question ID: 465308

One difference between the asset liability management techniques between a life and nonlife insurance company is liability payment:

ᅞ A) amounts are known for the nonlife insurance company.
ᅚ B) amounts are unknown for the nonlife insurance company.
ᅞ C) timing is known with certainty for the nonlife insurance company.
Explanation
Liability payment amounts are unknown for the nonlife insurance company.


Question #38 of 175

Question ID: 465202

Jim Findlay is the Founder and CEO of Impact Products. Findlay takes great pride in having his firm be on the leading edge of
providing benefits to employees. Every year, Findlay sits down with his two senior executives, Jeff Beery and Tom Harbal to
discuss various employee benefit plans. This year's focus is on employee stock ownership plans (ESOPs) and cash balance
plans. With regard to ESOPs, Beery states, "In addition to the benefits to employees, an ESOP would be a useful way for you
as owner of the company, Mr. Findlay, to liquidate a large block of your Impact Product holdings." After further discussion, they
move on to discussing cash balance plans. Harbal reports, "Unlike regular pension plans, cash balance plans can never be
under funded because the cash balance reflects the actual amount put away for employees." With regard to their statements
about ESOPs and cash balance plans:
ᅞ A) Beery's statement is correct; Harbal's statement is correct.
ᅞ B) Beery's statement is incorrect; Harbal's statement is incorrect.
ᅚ C) Beery's statement is correct; Harbal's statement is incorrect.
Explanation
An ESOP is a type of defined-contribution plan that allows employees to purchase company stock, sometimes at a discount to
the market price. Beery's statement is correct. Occasionally, an ESOP will purchase a large block of the firm's stock directly
from a large stockholder (such as an owner who wants to liquidate a holding). The stock is then purchased at regular intervals
by plan beneficiaries. Harbal's statement is incorrect. The account balance shown on a cash balance plan's statement to a

beneficiary is calculated on paper only based on a participant's credits. It is possible for a company not to fund its obligation,
resulting in an underfunded cash balance plan.

Questions #39-44 of 175
Raul Garcia, CFA, works for Enterprise Insurance Company (hereafter referred to as the "Enterprise"). Enterprise offers a
number of products including whole, term, universal, and variable life policies. The retail line is Enterprise 's mainstay; the firm
does only a small amount of group life business and corporate-owned life insurance to fund executive deferred compensation
plans. Most of the policies Enterprise issues are for face amounts less than $10 million, although they do occasionally
participate in underwriting large policies for the high net worth market. To limit risk, a reinsurance syndicate is used for policies
in excess of $25 million. Enterprise has always received the highest rating from A. M. Best and Moodys.
Garcia has been asked to review the data in Tables A and B below. He knows that Enterprise uses a traditional approach for
managing its Policy-Holder Reserves (PHR) portfolio. He also realizes that the interest rate yield curve is becoming steeper.
Short-term interest rates have been trending downward while long-term rates have been increasing. Furthermore, the stock
market appears to be in a bull phase that will last into the foreseeable future.

Table A
Changes in Assets and Liabilities (data in millions)
Prior Year-End Current Year-End
Total assets
Duration of PHR
Liabilities
Duration of liabilities

$320

$380

6 years

7 years

$280

$320

5 years

4 years


Table B
Proposed Portfolios for Enterprise 's Surplus
Asset Class

Portfolio I Portfolio II Portfolio III Portfolio IV

AAA Bonds

80%

50%

5%

10%

Junk Bonds

0%

10%

10%

10%

Small Stocks

0%

20%

10%

10%

Large Stocks

10%

10%

65%

0%

Global Stocks

10%

10%

10%

70%

After reviewing the data, Garcia meets with his supervisor Chad Burns to chat about his concerns and to clear up some of his
questions. During the course of their conversation the topic of disintermediation comes up. Garcia says, "As I understand it,
disintermediation is the occurrence of large numbers of policy loans and surrenders when interest rates are low. The low-rate
policy loans cause liquidity needs to increase."
Burns replies, "I believe that disintermediation is exacerbated when assets decline at a greater rate than liabilities during high
interest rate periods. Let's check on this issue and get together again later today."

Question #39 of 175

Question ID: 485056

The change in Enterprise's surplus as shown in Table A is a:
ᅞ A) negative sign because it means that the firm has mismatched its liabilities and
assets.
ᅚ B) positive sign because it means the firm can take more risk to generate a higher return.
ᅞ C) positive sign because it means the firm has more liquidity.
Explanation
A large surplus is a good thing for an insurance company. Even if it was achieved using risky methods, once it is there, it is
positive for the firm. The firm can assume more risk with a larger surplus, and this may lead to higher return and a reduction in
the overall risk of the firm. (Study Session 6, LOS 14.i)

Question #40 of 175

Question ID: 485057

The change in the relative durations of the PHR and Enterprise's liabilities is a:
ᅚ A) negative sign because risk has increased.
ᅞ B) positive sign because it means the firm is benefiting from yield curve changes and the
stock market.
ᅞ C) negative sign because it means the firm is not benefiting from yield curve changes
and the stock market.
Explanation
Enterprise's goal should be to match the durations of the PHR and liabilities. The increased divergence of the durations means
that Enterprise has higher interest rate risk. (Study Session 6, LOS 14.i)


Question #41 of 175

Question ID: 485058

Enterprise is considering increasing its allocation to short-term, low-grade corporate bonds. Which of the following concerns
will this address? What potential problem might arise from the increase in this asset class?
Concern

Potential Problem

ᅞ A) The change in

Regulatory

surplus

restrictions

ᅚ B) The durations of PHR
and liabilities
ᅞ C) The durations of PHR
and liabilities

Regulatory
restrictions

Reinvestment risk

Explanation
The duration of policy-holder reserves (PHR) has increased, while the duration of the liabilities has deceased. The investment
in short-term bonds would help address this concern by lowering the duration of the PHR to better match that of the liabilities.
Regulations may prevent Enterprise from investing in low-grade bonds if the bonds introduce too much default risk into the
portfolio. Although investing in low-grade, high-yield bonds could enhance surplus returns, additional surplus growth should
not be a primary concern at this time. Reinvestment risk is a concern of life insurance companies but the main concern
Enterprise has at the moment regarding a decrease in interest rates and a shorter duration of liabilities compared to their
assets is disintermediation and not reinvestment risk. (Study Session 6, LOS 14.i)

Question #42 of 175

Question ID: 485059

Based on the information above, rank the following items from most important to least important for Enterprise to address:
changes in the surplus, relative durations of the PHR and liabilities, and the yield curve.
ᅞ A) Surplus, yield curve, relative durations.
ᅞ B) Surplus, relative durations, yield curve.
ᅚ C) Relative durations, surplus, yield curve.
Explanation
Matching the durations of the PHR and liabilities should be the primary focus of Enterprise at this time. (Study Session 6, LOS

14.i)

Question #43 of 175

Question ID: 485060

Which of the following portfolio selections from Table B would be the most appropriate and the least appropriate, respectively,
for managing Enterprise's surplus?
ᅚ A) Portfolio III is most appropriate; Portfolio I is least appropriate.
ᅞ B) Portfolio II is most appropriate; Portfolio III is least appropriate.
ᅞ C) Portfolio I is most appropriate; Portfolio IV is least appropriate.
Explanation
Portfolio III is the best choice. Enterprise can be aggressive with its surplus and diversify away some of its interest rate risk.


Portfolios I and II have a high level of interest rate risk. Portfolio IV is aggressive, but it has more interest rate risk than III.
Furthermore, Portfolio IV's large position in global stocks would introduce excessive exchange rate and asset class risk.
Portfolio I is the least appropriate. The traditional method for covering forecasted liabilities is to employ a portfolio of highgrade bonds. Assuming that Enterprise is using a traditional portfolio of bonds to cover its liabilities, then Enterprise should not
invest heavily in high-grade bonds in its surplus. (Study Session 6, LOS 14.i)

Question #44 of 175

Question ID: 485061

Which of the following best evaluates the accuracy of Garcia's and Burn's statements about disintermediation?
ᅚ A) Garcia is incorrect; Burns is correct.
ᅞ B) Garcia is correct; Burns is incorrect.
ᅞ C) Garcia is incorrect; Burns is incorrect.
Explanation
Disintermediation occurs in high interest rate environments, prompting large numbers of policy loans or surrenders.

Policyholders take proceeds from lower-rate policy loans or their surrender values and reinvest at more favorable rates.
During high-rate environments liability durations decrease dramatically and liquidity needs rise. To the extent that assets
decline at a greater rate than liabilities in an increasing interest rate environment, disintermediation will be exacerbated. (Study
Session 6, LOS 14.i)

Questions #45-50 of 175
Helen Smith, CFA, has been assigned the portfolio management responsibilities for her firm's first institutional investor, Branch
Industries Defined Benefit Pension Plan (hereafter referred to as the "Plan"). To date, Smith's firm has managed money only
for high net worth individuals. In addition to her portfolio management duties, Smith has been delegated the task of formulating
the investment policy statement (IPS) for the Plan.
Branch Industries manufactures tiny transformers and circuitry used in small electrical appliances, and components for cars
and trucks. Silver is a small, but critical, input to the production process, and Branch uses a reliable supplier. Branch's sales
have grown steadily for the past three years despite a rather tepid economic recovery fostered by modest tax cuts and
aggressive expansion of the money supply. It appears likely that Federal Reserve policy will remain accommodative, with
continued low interest rates. Therefore Branch's five-year sales forecast is very optimistic. Branch's profit margins are
projected to be in line with its competitors, but the firm is carrying significantly more debt in its capital structure than
comparable companies.
Smith has determined the following about the Plan:
The average employee age is 45.5 years, and the active-to-retired participant ratio is high.
The Plan should be considered ongoing, and it has a moderate surplus.
Employees are eligible for retirement at age 62. There are no provisions for lump-sum distributions or early retirement.
The discount rate for the projected benefit obligation (PBO) is 10%.
The expected return on plan assets is 10 percent.
Smith decides she needs to review the terminology, accounting, and other factors affecting the Plan's funding status. Below is
her brief synopsis of relevant terms:

Exhibit A: Pension Terminology


Definition

PBO

Present value of future benefits earned to date. Assumes plan termination.

ABO

Present value of projected future benefits. Assumes ongoing plan.

Net Pension Cost

Income statement expense to be recognized for a specific year.

Funded (Surplus) Status Market value of plan assets less the present value of future liabilities.

Smith recalls that the Pension Committee wishes to minimize the volatility of future contributions. They also expressed concern
that the discount rate and expected return on plan assets might need modification. She decides to explore these issues further
before finishing the IPS or developing an asset allocation recommendation for the portfolio.

Question #45 of 175

Question ID: 485001

Which of the following best explains two constraints that differ between individuals and pension funds and the way they differ?
ᅚ A) Legal and tax considerations: pensions must follow the Employee Retirement
Income Security Act (ERISA) whereas individuals can usually invest as they
please; pensions are tax-exempt investors whereas individuals pay taxes.
ᅞ B) Legal and time horizon considerations: pensions must follow the Employee Retirement
Income Security Act (ERISA) whereas individuals can usually invest as they please;
pensions have finite lives whereas individuals do not.
ᅞ C) Liquidity and time horizon considerations: pensions always have a greater need for

liquidity than individual investors; pensions have infinite lives whereas individuals do
not.
Explanation
Pensions must operate under a plethora of regulatory burdens, such as ERISA. Individual investors normally are not subject to
onerous legal considerations concerning their investment decisions. Pension funds are tax exempt, but most individuals must
pay taxes. (Study Session 6, LOS 14.b)

Question #46 of 175

Question ID: 485002

Regarding the pension terminology in Exhibit A, the definition of:
ᅞ A) ABO is correct; PBO is correct; funded status is incorrect.
ᅞ B) ABO is incorrect; PBO is correct; funded status is correct.
ᅚ C) ABO is incorrect; PBO is incorrect; funded status is correct.
Explanation
A plan's ABO dictates what is owed to participants in a terminating plan. The pension benefit obligation (PBO) is the obligation
required of a pension plan for a company considered a going concern. Funded status is the relationship between the present
(market) value of plan assets and the present value of plan liabilities. (Study Session 6, LOS 14.a)

Question #47 of 175
Future pension contributions required will be directly affected by:

Question ID: 485003


ᅚ A) the expected return on existing plan assets and and pension expense
requirements.
ᅞ B) the expected return on existing plan assets and pension default expectations.
ᅞ C) prior expected return estimates and pension expense requirements.

Explanation
A pension plan's contribution level can be impacted by the expected return on plan assets. The contribution amount can be
greatly reduced or eliminated altogether by setting high enough return expectations. Pension expenses must be recognized on
a sponsor's income statement and, hence, must be considered in the overall return objective. Interestingly, negative pension
expense, or pension income, can also be recognized. (Study Session 6, LOS 14.b)

Question #48 of 175

Question ID: 485004

Considering the characteristics of Branch Industries and the Plan, which of the following statements best describes the ability
of the pension plan to take risk?
ᅚ A) Average ability to take risk.
ᅞ B) Below average ability to take risk.
ᅞ C) Above-average ability to take risk.
Explanation
Overall, the data Smith has gathered so far indicate an average tolerance for risk. The plan surplus indicates that the present
value of plan liabilities is more than covered by the present value of plan assets. Pension plans with restrictive plan features,
such as no early retirement or lump-sum distribution provisions increases the duration of the liabilities which, in turn, allows for
a higher risk tolerance. The workforce is young; a high active to retired lives ratio indicates a large portion of the workforce is
still working while only a small portion of beneficiaries is receiving plan benefit payments. All of these factors indicate an
above-average ability to take risk. However, if the Pension Committee were to decrease the discount rate, the PBO would rise
and the surplus could disappear. Also, a spike in commodity prices (silver required and only one supplier) and/or the cyclicality
of the auto industry could adversely affect Branch's sales and profit margins. Hence, Branch's ability to make contributions if
the economy slumps, could be compromised. In addition, Branch is more heavily leveraged than its competitors. This could
also impact its ability to make timely contributions in an economic downturn. These factors imply less ability to take risk,
especially in light of the Pension Committee's expressed desire to control the volatility of contributions. (Study Session 6, LOS
14.c)

Question #49 of 175

Question ID: 485005

Which of the following factors should NOT affect a pension plan's ability and/or willingness to take risk?
ᅞ A) Workforce characteristics.
ᅚ B) Portfolio manager's investment style.
ᅞ C) Plan surplus.
Explanation
The investment style of a portfolio manager has no affect on a plan's ability and willingness to take risk. Portfolio managers are
chosen after risk considerations are determined. To varying degrees, both of the other factors will have a direct affect on a
plan's ability and willingness to take risk. (Study Session 6, LOS 14.c)


Question #50 of 175

Question ID: 485006

To maximize the sponsor's ability to make pension contributions and meet the Pension Committee's desire to manage
contribution volatility, Smith should give the most consideration to the correlation between the sponsor's:
ᅞ A) operating profitability and Plan termination potential.
ᅞ B) net income and the Plan's ABO.
ᅚ C) operating profitability and Plan asset returns.
Explanation
The correlation between the sponsor's operating profitability and plan asset returns comes directly to bear on the firm's
required contributions and its ability to make them. When operating profitability and plan asset returns are high, the probability
of having to make greater than average contributions is low, but at a time when the sponsor is most able to make a
contribution. Alternatively, when operating profitability and plan asset returns are low, the probability of having to make
contributions is high, but at a time when the sponsor may have difficulty making a contribution. Minimizing the correlation
between the sponsor's operating profitability and plan asset returns will maximize the probability that the sponsor will be able
to make contributions when required to do so. (Study Session 6, LOS 14.c)

Questions #51-54 of 175
Lakeland Life Insurance Company is a U.S. based underwriter of life insurance policies doing business in 23 states. In the past
5 years the company has completely revamped its product offerings, going from a focus on whole life policies to floating rate
referred variable and universal life policies. The average duration of the company's insurance liabilities is eight years.
Lakeland targets a 1.5% spread on investment assets over liabilities. The current expected nominal actuarial return is 5%
(based on current capital market conditions), but management expects the rate environment to get more volatile in the coming
months.
The company has segmented its investments into two portfolios: a fixed-income portfolio and a surplus portfolio. The fixedincome portfolio is invested primarily in long-term corporate and U.S. Treasury bonds. The surplus portfolio is currently
invested in the common and preferred stock of large, well-known U.S companies. The surplus portfolio has a dividend yield of
3%. Management expects equity markets to earn 12% per year in the long term.

Question #51 of 175

Question ID: 465241

The appropriate return objective for the fixed-income portfolio is to earn a return:
ᅚ A) sufficient to provide a spread of 1.5% over the promised rate on the company's
variable rate insurance products while maintaining an average duration of 8
years, in order to fund liabilities.
ᅞ B) of 6.5% while maintaining an average duration of 8 years in order to fund insurance
liabilities.
ᅞ C) of 18.5% sufficient to fund long-term expansion in insurance volume and fund
insurance liabilities through a total return approach.
Explanation
The company has segmented its investment portfolio; the purpose of the fixed-income segment is to fund insurance liabilities.
The return objective should focus on providing the target spread over policy costs, which float with changes in interest rates.


Therefore, while the current target is 6.5% based on current economic conditions, this target rate will change as conditions

change; 6.5% is not the appropriate long-term return objective. A reasonable objective for the surplus fund is to earn a return
"of 12% sufficient to fund long-term expansion in insurance volume by investing in growth-oriented securities, primarily equity."
A total return approach is not appropriate for the fixed-income or the surplus portfolio.

Question #52 of 175

Question ID: 465242

The appropriate risk tolerance for the surplus portfolio:

ᅞ A) is lower than that of the fixed-income portfolio, to guard against loss of principal and
maintain a constant income stream, in order to maintain public confidence in the
company's ability, in its role as a fiduciary, to fund policyholder liabilities.

ᅚ B) is higher than that of the fixed-income portfolio, because the funds should be used to support
long-term growth in insurance volume.

ᅞ C) is the same as that of the fixed-income portfolio. While the portfolios are nominally separated
for regulatory purposes, they should actually be managed as a single portfolio, because funds
from each can be used to meet both goals of long-term growth and current funding of
liabilities.

Explanation
A lower risk tolerance is appropriate for the fixed-income portfolio, on the other hand, to "guard against loss of principal and maintain a
constant income stream, in order to maintain public confidence in the company's ability, in its role as a fiduciary, to fund policyholder
liabilities." Interest rate volatility over the short-term is not a primary concern of the surplus portfolio. The portfolios are "nominally
separated," but not "for regulatory purposes;" each should have its own investment policy statement.

Question #53 of 175

Question ID: 465243

The appropriate time horizon constraint for the surplus portfolio:

ᅞ A) is shorter than that of the fixed-income portfolio, because policies such as universal
and variable life have shorter effective maturities than traditional life insurance
products.

ᅚ B) is longer than that of the fixed-income portfolio, because the purpose of the surplus portfolio is
to support long-term growth in new lines of business.

ᅞ C) is the same as that of the fixed-income portfolio. While the portfolios are nominally separated
for regulatory purposes, they should actually be managed as a single portfolio, because funds
from each can be used to meet both goals of long-term growth and current funding of
liabilities.

Explanation
While it's true that "...universal and variable life have shorter effective maturities than traditional life insurance products...", this does not
mean the time horizon of the surplus portfolio (which is not related to the duration of the liabilities), should be shorter than the time horizon
of the fixed-income portfolio (which must be matched to the duration of the liabilities). The maturity of the securities in the portfolio
depends on the appropriate time horizon, not the other way around. Finally, the portfolios are "nominally separated", but not "for regulatory
purposes"; each should have its own investment policy statement.