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? Plan Age of Ratio of active to Sponsor's Sponsor's workforce retired participants debt ratio profitability A young high high low B young high low high C older high low high ✗ A) Plan C ✓ B) Plan B ✗ 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? ✗ A) Procedures are established to insure that a myriad of individual investor objectives and constraints can be handled ✓ B) IPS for defined benefit and defined contribution plans are similar in nature ✗ C) Plan sponsors should provide education about investing plan funds Explanation Defined contribution plans call for quite a different IPS than 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 nonlife insurance companies? Liquidity Requirements for Insurance Companies Life Insurance Companies Nonlife 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 ✓ A) Description I ✗ B) Description III ✗ 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 Assetliability mismatch, disintermediation, and asset marketability risk all contribute to the relatively high liquidity requirement For nonlife 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: ✗ A) construct an investment policy statement (IPS) after a manager has been chosen for the plan ✓ B) invest plan assets without distinction between the tax consequences of returns generated from income and returns generated from capital gains ✗ C) review investment performance on a yearly basis Explanation As a taxexempt 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? ✗ 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 ✗ B) Due to either ethical or political objections, a pension plan may disallow investments in certain types of traditional or alternative asset classes ✓ 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 underfunded 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 retiredlives 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? ✗ A) Due to the current underfunded status, relatively older workforce age, and high retired lives 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 ✓ B) Due to the current underfunded status, relatively older workforce age, and high retiredlives 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 retiredlives proportion of participants and those soon approaching retirement Matching plan assets with plan liabilities is a must ✗ C) The current underfunded 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 underfunded 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 with respect to the duration of its fixed income portfolio and the liquidity constraints in its policy statement? The duration of the nonlife insurance company's fixedincome portfolio should be: ✗ 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 ✓ 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 ✗ 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 #163 of 175 Question ID: 465315 The ending of a general business cycle may indicate the last rounds of increased firm profitability With the prospects of lower profits on the horizons, a pension fund plan sponsor may wish to take which of the following actions? Shift pension assets into those that have a: ✗ A) low correlation with pension liabilities and high correlation with the firm's operations ✗ B) low correlation with pension liabilities and low correlation with the firm's operations ✓ C) high correlation with pension liabilities and low correlation with the firm's operations Explanation Pension assets that are highly correlated with pension liabilities and have a low correlation with the firm's operations will have a greater probability of meeting pension fund obligations and lowering contributions in the event contributions are required during the upcoming business cycle downturn Question #164 of 175 Question ID: 465146 Which of the following is a characteristic of a definedcontribution pension plan? ✓ A) Investment risk of plan assets is shifted to the individual ✗ B) Benefits are based on specific formulas relating to employee earnings or length of service ✗ C) Up to a maximum limit, the Pension Benefit Guaranty Corp (PBGC) insures plan contributions Explanation For defined contribution plans, investment risk is borne by the pension beneficiary The plan sponsor, and frequently the plan participant, make "defined contributions" to the plan The pension benefit to the participant is based on the pension fund's investment performance Question #165 of 175 Question ID: 465143 Which of the following is a characteristic of a definedbenefit pension plan? ✓ A) Plan sponsors bear all investment risk They are liable for shortages and have a claim against excess returns ✗ B) Defined benefit plans are less expensive to administer and young employees like the portable nature of their contributions ✗ C) Contributions to the plan are typically a percentage of plan participants current pay Explanation Retirement benefits from a defined benefit plan are based on a "defined benefit" 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 difference Defined benefit plans are costlier and riskier than defined contribution plans Thus, defined contribution plans are the preferred pension plan for most employers Also, since plan contributions are transferable to other plans, defined contribution plans are attractive to many young employees Question #166 of 175 Question ID: 465276 The liquidity requirements of a pension fund differ from the liquidity requirements of a life insurance company in that the liquidity requirements of a pension fund: ✗ A) will be dictated by state statutes, whereas the liquidity requirements of a life insurance company will be dictated by federal statute ✓ B) will be a direct function of the age of employees and the retiredlives portion of participants, whereas the liquidity requirements of a life insurance company will be a function of the liability requirements of products sold ✗ C) and the liquidity requirements of an 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 differential products sold to policy holders Question #167 of 175 Question ID: 465135 Which of the following statements about participantdirected defined contribution plans is CORRECT? ✓ A) The plan must offer a sufficient number of investment vehicles for suitable portfolio construction ✗ B) Defined contribution plans are structured similar to foundations ✗ C) Defined contribution plans are not subject to ERISA Explanation For participantdirected defined contribution plans, each employee has his/her own account; hence, the structure is not similar to foundations Defined contribution plans are subject to ERISA Question #168 of 175 Question ID: 465305 Connie King prepared a memo for her supervisor that listed the similarities and differences between the investment objectives of a life insurance company versus the investment objective of a commodity pool The memo contained the following statements: Statement 1: Both life insurance companies and commodity pools are taxable entities Statement 2: Life insurance companies invest in order to meet various funding requirements while commodity pools invest according to objectives advertised to investors Statement 3: The source of invested assets for both life insurance companies and commodity pools are assets pooled from investors King's memo is: ✗ A) correct with respect to Statement 2, but incorrect with respect to Statements and ✓ B) correct with respect to Statements and 2, but incorrect with respect to Statement ✗ C) correct with respect to Statements 1, 2, and Explanation King is correct with respect to Statement Both commodity pools and life insurance companies are taxable entities The primary difference between commodity pools, and other institutional investors (like life insurance companies) is the source and use of their invested funds King is correct with respect to Statement in that the use of funds for the two types of investors is different Life insurance companies invest in order to meet various funding requirements while commodity pools invest according to objectives advertised to investors King is incorrect with respect to Statement 3, however The source of invested funds for a life insurance company is its own assets (likely gathered from premium payments) while the source of funds for a commodity pool is assets pooled from investors Question #169 of 175 Question ID: 465222 The time horizon of a nonlife insurance company differs from that of a pension fund in that a nonlife insurance company's time horizon: ✗ A) is quite long due to the uncertainty of the liability structure associated with policies sold, whereas a pension fund's time horizon will be much shorter due to the finite life of employees ✓ B) may be quite short and will depend upon the characteristics of policies sold, whereas a pension fund's time horizon may be much longer, depending on workforce characteristics ✗ C) is dependent on the uncertainties of policies sold, whereas the time horizon of a pension fund is a direct consequence of the business cycle Explanation Due to the uncertainty associated with the characteristics of policies sold and when claims will be paid, the time horizon of a nonlife insurance company will necessarily be short A pension fund, however, will have a time horizon typically longer than that of a nonlife insurance company The pension fund's time horizon will be directly related to the plan sponsor's workforce characteristics Questions #170173 of 175 Lakeland Life Insurance Company is a U.S based underwriter of life insurance policies doing business in 23 states In the past 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 fixedincome portfolio and a surplus portfolio The fixed income portfolio is invested primarily in longterm corporate and U.S Treasury bonds The surplus portfolio is currently invested in the common and preferred stock of large, wellknown 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 Lakeland management has decided to widen the target margin between investment returns and liability costs from 1.5% to 2.0% The current allocation and expected return on the two portfolios is outlined below Current Asset Allocations Asset Class Treasury bills FixedIncome Portfolio Surplus Portfolio 10% 10% Intermediate term Treasury bonds 15% 0% Intermediate term Corporate bonds 5% 0% Longterm Treasury bonds 50% 0% Longterm Corporate bonds 20% 0% Large company common stock 0% 60% Large company preferred stock 0% 30% 100% 100% Total Expected Returns Current (dividend) yield 5.0% 3.0% Total return 7.0% 10.0% Question #170 of 175 Question ID: 465246 Which of the following changes if any should Lakeland make given the capital market expectations to more closely match the firm's liabilities with the fixedincome portfolio? ✗ A) Maintain the current asset allocation, because the total expected return is sufficient to provide the 2% spread over required return on liabilities ✗ B) Increase the allocation to longterm treasury and corporate bonds, and reduce the allocation to shortterm treasury and corporate bonds, because the yield curve is typically upward sloping ✓ C) Increase the allocation to intermediate term corporate bonds, and reduce the allocation to intermediate term treasury bonds and longterm treasury and corporate bonds, because corporate bonds earn a default premium over Treasury bond yields Explanation The fixedincome portfolio should include treasury bills, Treasury bonds and corporate bonds to provide the liquidity and income necessary to durationmatch the liabilities The emphasis should be on intermediate term bonds, rather than longterm bonds, to more easily match the duration of the liabilities An increased emphasis on corporate bonds is required to widen the spread between the earnings on assets and the cost of liabilities Equities are not appropriate for this portfolio Question #171 of 175 Which of the following changes should Lakeland make to the surplus portfolio? ✓ A) Liquidate the preferred stock and substantially reduce the allocation to large company equities Diversify by investing in other longterm growth vehicles, such as midcap and smallcap equities, REITS, venture capital, and international equities, in addition to a small allocation to bonds ✗ B) Increase the allocation to intermediate and longterm corporate and Treasury bonds, and reduce the allocation to equities, in order to reduce the risk exposure of the portfolio in light of the expected increase in rate volatility during the next 12 months Question ID: 465247 ✗ C) Increase the allocation to venture capital and international equities by reducing the exposure to large company common stock, in order to increase the longterm growth potential of the portfolio while maintaining a sufficient income stream from preferred stock Explanation The surplus portfolio should emphasize longterm capital gains, as opposed to income, while maintaining a sufficient level of diversification, which favors a large allocation in equities The current allocation, however, is restricted to lowgrowth "blue chips," as well as preferred stock, and is not well diversified The income from preferred shares is not needed in this portfolio State law typically limits an insurance company's investment in equities to a fixed percent of total assets across all portfolios As long as the total equity allocation in the surplus portfolio is less than the mandated maximum, Lakeland is free to allocate to equities in the surplus portfolio to meet longterm goals Question #172 of 175 Question ID: 465248 Which of the following statements concerning the risks in the fixedincome portfolio is most accurate? ✗ A) Credit risk is relatively less important, because the emphasis should be on Treasury bonds and AAA corporate bonds to be consistent with the low risk tolerance of the portfolio ✗ B) Interest rate risk is relatively less important, because the allocation to highyielding equities in the surplus portfolio offsets the interest rate risk in the fixedincome portfolio ✓ C) Reinvestment risk is relatively less important, because the ratesensitive nature of the company's policies significantly reduces this risk Explanation Reinvestment risk, the "risk of reinvesting coupon income or principal at a rate less than the original coupon," becomes less important when an insurance company switches over to variable rate products Proper management of credit risk and interest rate risk, however, is still essential Question #173 of 175 Question ID: 465249 Which of the following statements least accurately describe the evolution in the investment policies of insurance companies like Lakeland in the past 1520 years? ✗ A) Life insurance companies have segmented their investment portfolios along product lines with different time horizons, liquidity constraints, and return objectives ✗ B) A more volatile interest rate environment has forced companies to create new, rate sensitive insurance products to prevent disintermediation ✓ C) The time horizon has gotten longer as the average life span of policyholders has increased with improvements in health care Explanation This statement is not accurate; the time horizon for life insurance companies has gotten shorter as the duration of the insurance products they offer has decreased Question #174 of 175 Question ID: 465320 Which of the following is NOT a characteristic of the liabilitymimicking portfolio for a pension? The process of creating the liabilitymimicking portfolio: ✓ A) uses cash as the riskfree investment ✗ B) creates a benchmark portfolio that has a high correlation with the liabilities ✗ C) decomposes the liability into its various exposures Explanation Cash is used as the riskfree investment in the assetonly approach In a liabilityrelative approach, the riskfree investment is the liabilitymimicking portfolio This portfolio has a high correlation with the liabilities The pension fund manager constructs this portfolio by decomposing the liability into its various exposures Question #175 of 175 Question ID: 465145 A defined contribution plan differs from a defined benefit plan in that the: ✓ A) risk/return tradeoffs of plan assets accrue to the participant ✗ B) investment decisions are made by the plan sponsor ✗ C) risk/return tradeoffs of plan assets accrue to the plan sponsor Explanation All investment decisions of defined contribution assets are made by the participant, which dictates to whom plan asset risk/return tradeoffs accruethe participant The benefit 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 ... of plan sponsors Question #6 of 175 Question ID: 46 5175 Ace Manufacturing's pension plan is currently underfunded by $15,000,000 Earnings for Ace have been under pressure for the past five years,... 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: 46 532 3 Which of the following... conduct the institution's own program Question #10 of 175 Question ID: 46 531 1 Which of the following statements most accurately describes assetliability management for the specified institution? ✗