Level III Essay Review: 2010 Question #3

Question #3 is portfolio management for a defined benefit pension plan, an institutional investor that often makes its way onto the essay section of the level 3 exam. In 2010 it was worth 24 points, or about 6.7% of your total exam points. Download the exam and guideline answers from the CFA Institute to follow along with the discussion.
Reading through the questions quickly, you see that you need info for:

  • Factors that affect ability to take risk, including the directional affect
  • Determining appropriateness of pension portfolios for different companies

These are both IPS-type questions so we’ll review the material for pensions first,
Return- This is usually an actuarial assumption given in the vignette, a return that depends on the funding status and contributions to the plan. It may be affected if the company wants to increase/decrease future contributions. Whether the plan is indexed for inflation or not is important as well. Remember, bonds do not protect investors for inflation so will need equity exposure if the plan is not indexed for inflation.
Risk Tolerance- Key here are things to look for that affect tolerance (below would decrease tolerance)
– older workforce or low ratio of active/retired lives
– pension funding shortfall- this does not mean taking on more risk to make up for the shortfall!
– financial health of company is not good- high debt on balance sheet, low liquidity ratios, poor income trends all mean the company can take less risk in pension accounting
– high correlation of business with pension assets- If pension and business are both under pressure at the same time, then there is little change the company can bail out the plan. Similarly, if the company is in a new industry then business risk is higher and free cash flow presumably lower so lower risk tolerance
– Any early retirement or lump sum offers may speed up payment estimates
Time Horizon- This usually depends on the active/retired ratio and is multi-stage.
Unique Circumstances- As with individual portfolio management, usually determined directly in the vignette.
Tax Considerations- Pension plans are tax-exempt
Legal and Regulatory- regulated by ERISA or depending on country of jurisdiction. Plan assets must be invested for the benefit of the participants and according to entire portfolio, not just based on individual assets
Liquidity- This depends on sponsor contributions (and ability to contribute), any plan features like early retirement or lump sum, and the estimated expense based on active/retired ratio
For part A, the info in the vignette that jumps out at me is: profitable, outlook for profitability is positive, pension surplus, growing ratio of inactive to active (inactive is equivalent to retired).
*Remember- you can markup/underline the exam all you want but make sure your answers are in the designated places, either template or on the answer booklet.
Detail your answers with data from the vignette so the grader knows that you understand the concept, not just “pension has a surplus so higher risk tolerance.” Instead something like, “Pension surplus of $95 million enables plan to face some negative returns without risk of liability coverage.” The guideline answers show five possible choices. On the test, pick the three most obvious/easy answers and then move on. You will not get extra points by trying to explain the most detailed concepts. Answer the question and move on!
For part B, the info in the vignette (in addition to what you read in A) that should jump out is:
CarbX- unprofitable, pension deficit, plan frozen, high ratio of active/inactive, not inflation indexed
DataComp- growing and profitable, global sales, plan surplus, no inactive, inflation indexed
For Apex, we see that there is no inflation protection through equities so buy equities and sell nominal bonds (real rate bonds protect for inflation so we would not want to sell these)
For CarbX, since there is no need for inflation protection and the plan is closed we only need to satisfy accrued liabilities and can do so through (relatively safer) nominal bonds
For DataComp- There are no current inactive members and the plan has a surplus so we are looking at a higher risk tolerance and focus on growth, buy equity and sell nominal bonds
Don’t forget to be working on the other essay questions provided by the Institute. There is no reason you shouldn’t be able to rock out the morning section and be that much closer to your charter. Work the past essay exams and pay attention to the guideline answers. This is exactly what the graders are going to be looking for in June.
We’ll start on the 2009 essay questions next week. Let me know if there are any topics you want to see covered. Happy studyin’
Joseph Hogue, CFA

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