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.

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Explanation

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Endowments are tax free entities but life insurance companies are taxable.
(Study Session 7, Module 15.2, LOS 15.j)
Related Material

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SchweserNotes - Book 2

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

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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

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are also some important di erences that mandate development of two separate "boilerplate"

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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

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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

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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

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Entityspeci c; may
Unique Constraints be social
investing
concerns

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Generally
tax-exempt

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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

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clients. Grainger tells Simon "It's easy – just remember that independent, company-sponsored,

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and operating foundations are subject to some type of minimum spending requirement and

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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

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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.

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B) Foundation return objectives are closely linked to the time horizon of the
foundation, whereas endowment return objectives are to provide a permanent
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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

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SchweserNotes - Book 2

Question #3 of 164

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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.

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Explanation

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C) Risk tolerance, time horizon, legal & regulatory.

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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 do 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 2

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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.

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C) Endowments and foundations generally both have in nite lives.

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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.

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(Study Session 7, Module 15.2, LOS 15.i)
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SchweserNotes - Book 2

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Question #5 of 164

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A publicly-sponsored organization that makes grants for charitable, religious, social or
educational purposes is a (an):

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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)
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SchweserNotes - Book 2

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.

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B) Private foundation investment income is taxable, whereas endowment investment

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income is not.

C) Operating foundation investment income is taxable, whereas endowment
investment income is not.
Explanation

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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)
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SchweserNotes - Book 2

Question #7 of 164

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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

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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 2

Ed Simon, CFA, has been assigned the arduous task of assessing the slight nuances concerning

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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

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policy statements.

Question #8 of 164

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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

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endowment return objectives depend on the time horizon of the endowment.

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B) Endowment returns usually are dictated by a rule-of-thumb of "5.3% + in ation,"

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whereas foundation return objectives are dictated by spending rules.
C) Foundation return objectives depend on the time horizon of the foundation,

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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 2

Question #9 of 164
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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
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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
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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
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f h

d

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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)

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Related Material

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SchweserNotes - Book 2

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Question #10 of 164

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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

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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 do not have minimum spending requirements.

(Study Session 7, Module 15.2, LOS 15.i)
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Related Material
SchweserNotes - Book 2

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?

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

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

C) Private foundation investment income is taxable, whereas endowment investment

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income is not.
Explanation

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

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SchweserNotes - Book 2

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(Study Session 7, Module 15.2, LOS 15.i)

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Question #12 of 164
Which of the following types of foundations do NOT have a spending requirement?

A) Community.
B) Independent.

C) Operating.
Explanation

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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 2

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Question #13 of 164

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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

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the portable nature of their contributions.

C) Contributions to the plan are typically a percentage of plan participants current pay.
Explanation

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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.

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(Study Session 7, Module 15.1, LOS 15.a)

Related Material
SchweserNotes - Book 2

Question #14 of 164

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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."

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With regard to their statements about Genetron's pension plan:

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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.

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C) Pyle’s statement is correct; DeGroot’s statement is correct.
Explanation

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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.

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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 2

Question #15 of 164

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The investment policy statement (IPS) of which of the following entities may include language
pertaining to net interest spread?

A) Insurance companies.
B) Endowments.
C) De ned bene t plans.
Explanation
Net interest spread is the di erence between interest earned and interest credited to
policyholders. Therefore, net interest spread may be talked about in the return objectives of
an insurance company's IPS.

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(Study Session 7, Module 15.3, LOS 15.k)
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Question #16 of 164

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SchweserNotes - Book 2

Which of the following statements concerning foundations and endowments is CORRECT?
Foundations are:

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A) grant-making institutions and may have variable time horizons; endowments are

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established to permanently fund some activity, and typically have minimum payout

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B) established to permanently fund some activity and have high degrees of risk
tolerance.

C) grant-making institutions and may have variable time horizons; endowments are

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established to permanently fund some activity, and typically have in nite lives.
Explanation
Foundations are grant-making institutions and may have short or long (in nite) lives.
Endowments are established to permanently fund some activity (e.g., provide scholarships)
and typically have in nite lives. Endowments typically do not have minimum payout
requirements. Both types of institutions typically have fairly high degrees of risk tolerance if
they are long-lived.
(Study Session 7, Module 15.2, LOS 15.i)
Related Material
SchweserNotes - Book 2

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Question #17 of 164
Dr. Jack Wolfe, a nance professor with the University of Tulsa asked his students to identify

di erences between a pension fund and a growth mutual fund. Kelly Musch, a student in
Wolfe's class, turned in a paper with two statements:

The pension fund is likely to have more exibility to
signi cantly change its asset allocation.

Statement
2:

The pension fund could invest in the mutual fund, but the
mutual fund could not invest in the pension fund.

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Statement
1:

A) disagree with Statement 1 and Statement 2.
B) agree with Statement 1 and Statement 2.

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

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C) disagree with Statement 1, but agree with Statement 2.

Explanation

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When grading the paper, Dr. Wolfe should agree with both of Musch's statements. Musch has
indirectly hit on the two key di erences 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.
(Study Session 7, Module 15.5, LOS 15.l)
Related Material
SchweserNotes - Book 2

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.

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In the last two years, Monarch has been sending out resumes to institutional investment rms
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 rst 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

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principal, the fund's moderately aggressive return target is also unlikely to be altered.

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Both the mutual fund and the endowment have assets in the tens-of-millions of dollars, and
each is o ering a roughly equivalent salary and bene ts 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

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of the two prospective positions. He creates the following template and begins to summarize
his thoughts:

Current Clients vs. Investment Co. & Endowment Fund

Risk Objective

Taxes

Higher

Higher

Focus on Single Asset
Class

Socially Conscious

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Time Horizon

Endowment Fund

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Return Objective

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Investment Company

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Liquidity

Legal & Regulatory
Unique Constraints

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.
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Monarch states that "while both are considered tax-exempt entities, endowments are generally
organized to provide ongoing budgetary support for the operations of a speci c 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 speci c charitable organization."
Linn responds: "Well, I know that's not my eld, 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."

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Question #18 of 164

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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

more

B) more

less

C) less

more

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A) more

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Explanation

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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 7, Module 15.2, LOS 15.i)

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Related Material

SchweserNotes - Book 2

Question #19 of 164
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

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A) longer

longer

B) shorter

shorter

C) shorter

longer

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 7, Module 15.2, LOS 15.i)
Related Material

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SchweserNotes - Book 2

Question #20 of 164

fewest tax considerations?

A) There is no clear answer.

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B) The endowment fund.

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Which of these situations (the investment company or the endowment fund), would have the

Explanation

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C) The investment company.

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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 7, Module 15.2, LOS 15.i)
Related Material
SchweserNotes - Book 2

Question #21 of 164
Which of these situations (the investment company or the endowment), would require the most
attention to generating a positive alpha?

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A) The investment company.

B) There is no clear answer.
C) The endowment.
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 7, Module 15.2, LOS 15.i)
Related Material

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SchweserNotes - Book 2

Question #22 of 164

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With respect to the statements made by Monarch and Linn comparing foundations and
endowments:

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

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

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about taxes and correct about functions.

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

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Explanation

Foundations and endowments are considered to be tax-exempt. Exceptions are that private
foundations in the U.S. are subject to a 1% tax on net-investment income and 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 7, Module 15.2, LOS 15.i)
Related Material
SchweserNotes - Book 2

Question #23 of 164
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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:

A) whether the performance was evaluated relative to a style benchmark.
B) what time frame was used to measure performance.
C) the manager’s nominal return.
Explanation

(Study Session 7, Module 15.2, LOS 15.i)
Related Material

Question #24 of 164

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SchweserNotes - Book 2

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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 sta , the size of the
portfolio, and the consistency of the performance.

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The pension plan at Ferrell Manufacturing currently has a surplus. Ferrell's management team

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wants to maintain the level of the surplus and keep it as stable as possible. In order to
accomplish their goal, how should they position the correlation of the pension plan's assets

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with the pension liabilities and the rm's operations respectively?

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Correlation of Assets with Correlation of Assets with
Liabilities
Firm Operations

A) High

Low

B) Low

Low

C) High

High

Explanation

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In order to have a more stable pension plan surplus, the rm should construct plan liabilities
and assets in such a way that changes in pension plan asset valuations are highly correlated
with pension plan liabilities, but uncorrelated (low correlation) with the rm's core
operations. This would ensure that pension fund assets increase in value at the same time
liabilities do, keeping funding status una ected by the rm's ability or inability to make
contributions.
(Study Session 7, Module 15.1, LOS 15.e)
Related Material

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SchweserNotes - Book 2

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Question #25 of 164

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

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.

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Statement
1:

Correct

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B) Correct

Incorrect

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A) Incorrect

Statement 2

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Statement 1

C) Incorrect

Correct

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Explanation

Instead of stating objectives and constraints (as in de ned bene t plans), the purpose of a
participant-directed de ned contribution investment policy statement is to provide a
governing document that describes the investment strategies and alternatives available to
plan participants. Some de ned contribution plans allow plan participants to take out loans
against the amount they contributed.
(Study Session 7, Module 15.1, LOS 15.f)
Related Material
SchweserNotes - Book 2

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Question #26 of 164
Which of the following entities could be subject to unrelated business income tax (UBIT)?

A) Only foundations.
B) Only endowments.
C) Endowments and foundations.
Explanation
UBIT must be paid by both endowments and foundations if income is produced that is not
substantially related to a foundations'/endowments' charitable purpose.

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(Study Session 7, Module 15.2, LOS 15.k)
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Question #27 of 164

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SchweserNotes - Book 2

A de ned bene t plan di ers from a de ned contribution plan in that the:

A) bene t paid by the sponsor is de ned by contributions made to the plan.

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B) risk/return tradeo s of plan assets accrue to the participant.

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Explanation

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C) risk/return tradeo s of plan assets accrue to the plan sponsor.

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All investment decisions are made by the plan sponsor, and all risk/return tradeo s accrue to
the sponsor. The bene ts paid by a de ned bene t plan are determined by a speci ed
bene t formula, not by what was contributed to the plan.
(Study Session 7, Module 15.1, LOS 15.a)
Related Material
SchweserNotes - Book 2

Question #28 of 164
Which of the following are characteristics of public foundations' and endowments' liquidity
needs, respectively?
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A) Varies; low.
B) Low; varies.
C) Moderate; moderate.
Explanation
A foundation determines what its spending needs are, which thereby causes liquidity to vary
for each foundation. Liquidity is low for endowments—usually only for emergencies and
spending.
(Study Session 7, Module 15.2, LOS 15.i)
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SchweserNotes - Book 2

Question #29 of 164

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Which of the following scenarios will result in the lowest volatility in the surplus of a de ned
bene t pension plan, while at the same time keeping funding status independent of the plan
sponsor's ability to make pension contributions? A:

A) high correlation between pension fund assets and pension fund liabilities, and a

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low correlation between pension fund assets and the pension sponsor's operating

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f
B) low correlation between pension fund assets and pension fund liabilities, and a low
correlation between pension fund assets and the pension sponsor's operating

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f
C) high correlation between pension fund assets and pension fund liabilities, and a
high correlation between pension fund assets and the pension sponsor's operating

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f

Explanation

The likelihood of a neutral impact on a rm's earnings is increased when changes in the value
of pension assets are highly correlated with pension liabilities but uncorrelated with the
rm's operating performance. This ensures that funding the surplus is constant and
independent of the pension sponsor's ability or inability to make contributions to the plan.
(Study Session 7, Module 15.1, LOS 15.c)
Related Material
SchweserNotes - Book 2

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Question #30 of 164
The potential e ect of a pension plan policy that positively impacts a plan surplus is a:

A) low discount rate, high retired-lives portion, and high liquidity.
B) high discount rate, low plan feature exibility, and low liquidity requirements.
C) high discount rate, plenty of plan feature exibility, and high liquidity requirements.
Explanation

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Pension plan surplus may be positively impacted by using a high discount rate to determine

the present value of liabilities, generating a pension plan that has no exibility (e.g., no early
retirement provisions), and having a pension plan with low liquidity requirements.
(Study Session 7, Module 15.1, LOS 15.c)

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Question #31 of 164

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SchweserNotes - Book 2

In setting a risk objective for a de ned bene t plan, which of the following should NOT be

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considered?

A) Workforce characteristics.

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B) Investment education expertise of employees.

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C) Sponsor nancial status.
Explanation

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Employees are not responsible for investment performance for de ned bene t plans.
However, the plan must concern itself with the workforce characteristics (ages), and sponsor
nancial status (is it capable of funding the plan now and in the future).
(Study Session 7, Module 15.1, LOS 15.d)
Related Material
SchweserNotes - Book 2

Question #32 of 164
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The funding status of an ongoing de ned bene t plan is usually computed by the plan's:

A) total future liability (TFL).
B) accumulated bene t obligation (ABO).
C) projected bene t obligation (PBO).
Explanation
Funding status is the relationship between present value of pension assets and present value

of pension liabilities. Determining over- or under-funded status for an ongoing de ned
bene t plan is usually computed using the plan's projected bene t obligation (PBO). De ned
contribution plans do not have a funded status.

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(Study Session 7, Module 15.1, LOS 15.a)
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Question #33 of 164

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SchweserNotes - Book 2

The liquidity requirements of a pension fund di er from the liquidity requirements of a life
insurance company in that the liquidity requirements of a pension fund:

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A) will be a direct function of the age of employees and the retired-lives portion of
participants, whereas the liquidity requirements of a life insurance company will be

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statute.

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B) and the liquidity requirements of an insurance company will be dictated by federal

C) will be dictated by state statutes, whereas the liquidity requirements of a life

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insurance company will be dictated by federal statute.
Explanation

Pension fund liquidity is often dictated by the age of employees and the retired-lives portion
of participants. Life insurance companies, on the other hand, will have liquidity requirements
that are generated by the di erential products sold to policy holders.
(Study Session 7, Module 15.3, LOS 15.j)
Related Material
SchweserNotes - Book 2

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Question #34 of 164
A de ned contribution plan di ers from a de ned bene t plan in that the:

A) investment decisions are made by the plan sponsor.
B) risk/return tradeo s of plan assets accrue to the plan sponsor.
C) risk/return tradeo s of plan assets accrue to the participant.
Explanation

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All investment decisions of de ned contribution assets are made by the participant, which
dictates to whom plan asset risk/return tradeo s accrue—the participant. The bene t paid is
determined by the value of the investment assets at retirement. The only requirement of the
plan sponsor is the stated contribution made to the participant's account.

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(Study Session 7, Module 15.1, LOS 15.a)
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SchweserNotes - Book 2

Grace Manufacturing is a medium-sized industrial company whose stock returns are highly
correlated with the Dow Jones Industrial Average. The company administers and manages inhouse a de ned-bene t pension plan for its employees. The average age of the work force is
only 30 years, and only 5% of the plan bene ciaries are currently retired. Recent strong

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operating results have enabled Grace to over-fund the plan by 15%. Based on actuarial

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assumptions, the required real rate of return on the fund is 6%.

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Because of the recent downturn in domestic markets, particularly in the high-tech industry, as
well as turmoil and uncertainty in international markets, the company has restricted
investment in the fund to a small number of large, moderate-yield domestic industrial stocks

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with proven dividend track records, AAA corporate and U.S. Treasury bonds, as well as Treasury
Bills.

Current Asset Allocation
Portfolio

Allocation

Expected
Return

Volatility

Equally weighted portfolio of 25 large
U.S. industrial companies

25%

9%

18%

AAA Corporate Bond Portfolio

20%

7%

8%

Treasury Bonds (8-year duration)

30%

6%

7%

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Treasury Bills

25%

4%

0%

This conservative stance is re ected in the risk tolerance objective of the fund's Investment
Policy Statement (IPS).

Investment Policy Statement
The fund's return objective is to achieve total returns of
10%, su cient to fund the required real rate of 6% plus the
expected in ation rate of 4%.

Risk
Tolerance

The risk tolerance of the company is below average. The

plan must guarantee the safety of the plan assets to insure
income will be available to fund retirees' pension
payments in the future.

Liquidity
Constraint

The fund's liquidity requirements are low because of the
long time horizon and relatively young workforce.

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Return
Objective

The company has asked Elaine Sargent, CFA, for advice in revising the IPS and reviewing the

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current asset allocation for potential inclusion of one or more of the following portfolios:

Portfolios
Portfolio A

Correlation with

DJIA

7%

10%

0.5

11%

15%

0.7

14%

22%

0.3

10%

18%

1.0

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Portfolio C

Volatility

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Portfolio B

Expected
Return

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Dow Jones Industrial
Average (DSIA) Index
Fund

Question #35 of 164
Which of the following changes to the fund's IPS should Sargent recommend?

A) A return objective of 10% is not consistent with a below average risk tolerance.
Therefore, the fund should target a lower return objective in order to be consistent
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B) The risk tolerance for the fund should be much higher because of the long-term
nature of the obligations and the need to preserve capital through equity
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C) The fund's liquidity constraint should be rewritten to re ect moderate liquidity
requirements consistent with the fund's low risk tolerance.
Explanation
The fund is able to take on more risk in search of higher returns than suggested in the
current IPS because of the long-term horizon and low liquidity constraints. The current
employees are relatively young, few retirees are making income demands on the fund, and
the plan is over-funded. Therefore the return objective and liquidity constraints are

appropriate; the risk tolerance should be rewritten to be consistent. An emphasis on safety
(presumably through low-risk bonds and treasury bills) will leave the fund exposed to
in ation risk in the long-term.
(Study Session 7, Module 15.1, LOS 15.c)

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Question #36 of 164

Sargent should recommend that the allocation to the equally weighted equity portfolio be:

A) decreased signi cantly because it is most likely highly correlated with the rm's
operating cash ows.

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B) decreased signi cantly because it is not consistent with the fund's return objective.

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C) increased signi cantly because it has favorable risk-return characteristics relative to

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the other funds.
Explanation

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With a de ned bene t plan, the rm faces the potential risk that in an economic downturn,
the investment performance of the fund is reduced, increasing the rm's funding obligation
to keep the plan fully funded, at the same time as the rm's operating cash ow is reduced.
In this case, the rm's stock returns are highly correlated with the Dow Jones Industrial
Average. An equally weighted fund of 25 large industrial stocks is probably also highly
correlated with the Dow. Therefore the allocation to this fund should be decreased
signi cantly. In fact, given that it is dominated by the DJIA index fund (lower return, same
volatility), Sargent could argue that it should be replaced completely. However, Portfolios B
and C are even better choices.
(Study Session 7, Module 15.1, LOS 15.c)
Related Material
SchweserNotes - Book 2

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