Level III CFA Exam: essay question #3 2009

Question three on the 2009 Level III exam was worth 24 points, or almost 7% of the total exam points available. Combined with question #4, another on institutional portfolio management worth 11 points, the material on institutional pm was worth close to a tenth of the exam.
This post will complete the series of six blog posts, reviewing the last three years’ individual and institutional essay questions. Please download the exams and guideline answers from the CFA Institute and go over these questions again before June. The first two questions, always individual and institutional portfolio management, are usually worth around 15% of your total score and you WILL NOT PASS without good points here.
Question #3 in 2009 was a defined benefit pension vignette about Wirth-Moore company and the Foundation-for-the-Future (FF) foundation. As always, I skimmed through the questions before reading the vignette.

  1. The first question asks for a return objective and REQUIRES calculations. Pay attention whether a question says, “show your calculations,” or not. Return objectives for institutionals are usually pretty easy and come from a few items straight from the vignette. The standard form is: (required distributions or return)*(appropriate inflation rate)*(management expenses). Adding the three numbers will get you points but the multiplicative approach is technically accurate.

Don’t forget to throw in a few qualitative statements as well, usually something like preserving real value of the portfolio. Also, be sure to use the appropriate inflation rate or that which is most directly related to spending. The traditional example is healthcare or educational inflation being higher than general consumer inflation.

  1. We’ve covered ability and willingness to tolerate risk quite a bit in other posts. Ability is usually tied to some quantitative measure like how high is spending relative to total portfolio assets? Willingness for risk almost always comes out of qualitative statements made in the vignette or by the participants like desiring a high return or previous experience with loss.

Foundations usually have a greater ability for risk because they are not contractually obligated to make payments as are banks/insurance/pensions, nor does the charitable cause depend on them for spending needs like endowments.

  1. Liquidity needs for an institution are all contributions minus spending needs for the year. Since foundations have a certain percentage they must spend to avoid taxes, this is usually the spending needs plus management fees.

Time horizons for institutionals are almost always single stage, long-term if they are to remain a going concern. Look for clues in the vignette for whether the company will stay in business or may close.

  1. The smoothing rules are fairly important but you really only need to know a few things. Understand how to calculate the geometric and the rolling three-year rules.  Understand the order in which each is when it comes to volatility of spending (single-year most volatile) and that using a smoothing rule increases the institution’s tolerance for risk because of the lowered volatility.
  2. Part E is a little harder here only because you have to get all your info from the vignette rather than using a few rules-of-thumb concepts. Look to the quantitative information for quick clues (i.e. the five-year lockup on funds and the $2.5 million minimum).

After reading through the questions, you are ready to read the case and make notes when something looks relevant or important. For pensions, you always want to look for the proportion of active to retired lives and whether the payments are inflation-adjusted. Fewer active workers will mean lower risk tolerance and adjusting payments for inflation will mean you need some equities or TIPS in the portfolio to hedge price increases. The financial health of the company and cyclical correlation between company/pension assets is usually important as well.
***Watch for contradictory or changing information in the follow-up questions. I got a question last week on one of the individual pm essay questions. The guideline answer did not make sense from data provided initially in the case. What the candidate did not see was the information update just before the question. Notice that on many of the questions, there is a small paragraph of additional information (i.e. just before questions D and E on page 16 of the exam). Use this information for the question, even if some of it contradicts or changes data previously written in the vignette.
For the rest of the level III posts until June, we’ll cover a few of the other essay questions from the last three years’ exams. Let me know if there is any particular question you are having trouble with and I’ll try to cover it.
Thanks and happy studyin’
Joseph Hogue, CFA

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