CAIA - 04 - Pension Fund Portfolio Management

Question 1

What are the advantages of a pension plan?

1. Employee ___
2. Reduced ___ ___
3. ___ - ___
4. ___ of ___

Answer 1

What are the advantages of a pension plan?

1. Employee retention
2. Reduced personal savings
3. Tax-deferred
4. Economies of scale

Question 2

There are 3 types of pension plans:

1. ___ ___
2. Governmental ___ ___
3. ___ ___

Answer 2

There are 3 types of pension plans:

1. Defined Benefit
2. Governmental Social Security
3. Defined Contribution

Question 3

A ___ ___ plan is similar to a traditional DB plan in that assets remain in a single investment pool, but shares the characteristics of a DC plan in that the benefits are maintained in individual record-keeping accounts that show the accrued benefit and facilitate portability.

Answer 3

A cash balance plan is similar to a traditional DB plan in that assets remain in a single investment pool, but shares the characteristics of a DC plan in that the benefits are maintained in individual record-keeping accounts that show the accrued benefit and facilitate portability.

Question 4

A DB plan’s risk can be measured three ways:

1. Asset-___
2. Asset-___
3. ___ asset-___

Answer 4

A DB plan’s risk can be measured three ways:

1. Asset-focused
2. Asset-liability
3. Integrated asset-liability

Question 5

Under ___-___ risk management, the risk of a DB plan is measured in terms of the volatility of its assets.

Answer 5

Under asset-focused risk management, the risk of a DB plan is measured in terms of the volatility of its assets.

Question 6

Under ___-___risk management, the DB Plan’s risk is measured in terms of the volatility of its surplus.

Answer 6

Under asset-liability risk management, the DB Plan’s risk is measured in terms of the volatility of its surplus.

Question 7

In an ____ ____ -____ risk management approach, the Plan’s funding status and the sponsor’s operations are integrated and it is preferred that the surplus be negatively correlated with the sponsor’s profitability.

Answer 7

In an integrated asset-liability risk management approach, the Plan’s funding status and the sponsor’s operations are integrated and it is preferred that the surplus be negatively correlated with the sponsor’s profitability.

Question 8

There are 4 key factors that affect the value of a plan’s liabilities:

1. ___ ___
2. ___
3. ___ ___
4. ___ ___

Answer 8

There are 4 key factors that affect the value of a plan’s liabilities:

1. Interest rates

2. Inflation

3. Retirement cycle

4. Mortality rate

Question 9

___ ___ are the most important factor that affect liability values

Answer 9

Interest rates are the most important factor that affect liability values

Question 10

The value of liabilities are (positively/negatively) correlated with inflation.

Answer 10

The value of liabilities are positively correlated with inflation.

Question 11

The value of liabilities is ___ correlated with the number of future retirees.

Answer 11

The value of liabilities is positively correlated with the number of future retirees.

Question 12

The value of liabilities is (positively/negatively) correlated with mortality rate.

Answer 12

The value of liabilities is negatively correlated with mortality rate.

Question 13

5 factors impact the risk tolerance of plan sponsors:

1. ___ status
2. Fund ___
3. Expected future ___ relative to employer ___ ___
4. Employer’s ___ ___
5. Employees’ ___

Answer 13

5 factors impact the risk tolerance of plan sponsors:

1. Funding status
2. Fund size
3. Expected future contributions relative to employer cash flow
4. Employer’s financial position
5. Employees’ characteristics

Question 14

Plan sponsors with underfunded DB plans with large deficits tend to have (more/less) risk tolerance

Answer 14

Plan sponsors with underfunded DB plans with large deficits tend to have less risk tolerance

Question 15

Sponsors with large plan liablities relative to the size of their assets have (high/low) risk tolerance

Answer 15

Sponsors with large plan liablities relative to the size of their assets have high risk tolerance

Question 16

Sponsors with large expected future free cash flows compared to projections needed to cover obligations have (higher/lower) risk tolerance.

Answer 16

Sponsors with large expected future free cash flows compared to projections needed to cover obligations have higher risk tolerance.

Question 17

Sponsors with younger employees tend to have a (higher/lower) risk tolerance

Answer 17

Sponsors with younger employees tend to have a higher risk tolerance

Question 18

Some DB plans use a simple strategic asset allocation approach that divides the portfolio into two buckets: a ___ bucket and a ___ bucket.

Answer 18

Some DB plans use a simple strategic asset allocation approach that divides the portfolio into two buckets: a hedging bucket and a growth bucket.

Question 19

The ___ bucket is constructed to simulate the liabilities growth and aims to reduce the volatility of the fund’s surplus

Answer 19

The hedging bucket is constructed to simulate the liabilities growth and aims to reduce the volatility of the fund’s surplus

Question 20

In the asset-liablity framework, the hedging bucket can be constructed in 3 ways:

1. ___ matching approach
2. ___ ___ matching approach
3. ___ approach

Answer 20

In the asset-liablity framework, the hedging bucket can be constructed in 3 ways:

1. Duration matching approach
2. Cash flow matching approach
3. Overlay approach

Question 21

In the ___ matching approach, the hedging bucket is constructed so that its duration matches the liabilities. It must be monitored and ___ since changes in the ___ ___ and ___ ___ affect duration.

Answer 21

In the duration matching approach, the hedging bucket is constructed so that its duration matches the liabilities. It must be monitored and rebalanced since changes in the yield curve and credit spreads affect duration.

Question 22

In the ___ ___ matching approach, the hedging bucket is constructed such that its expected future cash inflows match its expected liability cash outflows. This involves constructing a portfolio of ___ ___ bonds that mature on the dates the future payments are needed in amounts equal to those payments.

Answer 22

In the cash flow matching approach, the hedging bucket is constructed such that its expected future cash inflows match its expected liability cash outflows. This involves constructing a portfolio of zero coupon bonds that mature on the dates the future payments are needed in amounts equal to those payments.

Question 23

In the ___ approach, the hedging bucket is constructed using derivatives. The use of derivatives may result in ___ positions, which increases the ___ of the portfolio.

Answer 23

In the overlay approach, the hedging bucket is constructed using derivatives. The use of derivatives may result in leveraged positions, which increases the risk of the portfolio.

Question 24

The ___ bucket is composed of investments that are expected to outperform the plan’s liabilities, thus reducing the sponsor’s future contributions to the fund. The allocation size depends on the sponsor’s propensity to assume ___ risk.

Answer 24

The growth bucket is composed of investments that are expected to outperform the plan’s liabilities, thus reducing the sponsor’s future contributions to the fund. The allocation size depends on the sponsor’s propensity to assume surplus risk.

Question 25

An employee's benefit relative to final salary is referred to as the employee's ___ \_\_\_-\_\_\_ratio.

Answer 25

An employee's benefit relative to final salary is referred to as the employee's **retirement income**-**replacement** ratio.

Question 26

A key characteristic of DB plans is that they (are/are not) portable.

Answer 26

A key characteristic of DB plans is that they **are** **not** portable.

Question 27

Pension liabilities can be categorized as two types: 1. ___ benefit obligation 2. \_\_\_benefit obligation

Answer 27

Pension liabilities can be categorized as two types: 1. **Accumulated** benefit obligation 2. **Projected** benefit obligation

Question 28

What is the equation for calculating change in projected benefit obligations (PBOs) (aka Liabilities)

Answer 28

Question 29

A pension plan's ___ \_\_\_ is the amount of its assets compared to its PBO or ABO

Answer 29

A pension plan's **funded status** is the amount of its assets compared to its PBO or ABO

Question 30

Overfunded plans have a ___ \_\_\_

Answer 30

Overfunded plans have a **pension surplus**

Question 31

Plans should aim to be about \_\_\_% funded.

Answer 31

Plans should aim to be about **100**% funded.

Question 32

Overfunded plans may attract employees who want to earn ___ \_\_\_ or corporate merger partners who want to ___ the pension fund and keep the ___ \_\_\_ .

Answer 32

Overfunded plans may attract employees who want to earn **larger benefits** or corporate merger partners who want to **dismantle** the pension fund and keep the **surplus value**.

Question 33

Underfunded plans may require larger ___ \_\_\_and attract ___ \_\_\_.

Answer 33

Underfunded plans may require larger **employer contributions** and attract **regulatory scrutiny**.

Question 34

A plan's ___ \_\_\_ is its economic exposure to the spread between its assets and liabilities.

Answer 34

A plan's **surplus risk** is its economic exposure to the spread between its assets and liabilities.

Question 35

Surplus risk may be measured as the ___ of the difference between \_\_\_values and the ___ \_\_\_value.

Answer 35

Surplus risk may be measured as the **volatility** of the difference between **asset** values and the **liabilities present** value.

Question 36

Surplus risk is higher when assets and liabilities are ___ correlated.

Answer 36

Surplus risk is higher when assets and liabilities are **negatively** correlated.

Question 37

Balance sheets of companies (do/do not) reflect their surplus risk.

Answer 37

Balance sheets of companies **do** reflect their surplus risk.

Question 38

A number of factors have contributed to decreased use of DB pension plans. 1. \_\_\_ 2. \_\_\_changes 3. \_\_\_risk 4. Lack of \_\_\_

Answer 38

A number of factors have contributed to decreased use of DB pension plans. 1. **Unaffordability** 2. **Regulatory** changes 3. **Equity** risk 4. Lack of **portability**

Question 39

The U.S. Pension Protection Act of 2006 requires that corporate employers disclose the plan's ___ \_\_\_to plan participants and requires employer contributions to match the funding status. Underfunded plans must increase the contributions such that the plan is fully funded within \_\_\_years.

Answer 39

The U.S. Pension Protection Act of 2006 requires that corporate employers disclose the plan's **funded status** to plan participants and requires employer contributions to match the funding status. Underfunded plans must increase the contributions such that the plan is fully funded within **seven** years.

Question 40

According to Merton (2006), companies with large pension deficits may have ___ multiples of earnings and book value, exhibit higher stock price \_\_\_, and have higher \_\_\_.

Answer 40

According to Merton (2006), companies with large pension deficits may have **lower** multiples of earnings and book value, exhibit higher stock price **volatility**, and have higher **betas**.

Question 41

In ___ plans, employees scheduled to receive DB pension plans do not accrue additional years of service in the plan.

Answer 41

In **frozen** plans, employees scheduled to receive DB pension plans do not accrue additional years of service in the plan.

Question 42

Employers that choose to stop offering DB plans have a number of options: they can establish a \_\_\_-\_\_\_structure in which newly hired employees are offered a ___ \_\_\_ pension plan, or they can \_\_\_or \_\_\_the plan.

Answer 42

Employers that choose to stop offering DB plans have a number of options: they can establish a **two**-**tier** structure in which newly hired employees are offered a **less generous** pension plan, or they can **freeze** or **terminate** the plan.

Question 43

A ___ plan is no longer operated by the employer, so the employer no longer controls the assets. When the plan is \_\_\_the assets are either paid to employees in ___ \_\_\_or used to buy \_\_\_to cover future retiree benefits.

Answer 43

A **terminated** plan is no longer operated by the employer, so the employer no longer controls the assets. When the plan is **terminated** the assets are either paid to employees in **lump sums** or used to buy **annuities** to cover future retiree benefits.

Question 44

Pension plan sponsors have two conflicting goals when designing the asset allocation: 1. To earn a ___ \_\_\_on pension assets 2. To minimize the plan's level of ___ \_\_\_

Answer 44

Pension plan sponsors have two conflicting goals when designing the asset allocation: 1. To earn a **high return** on pension assets 2. To minimize the plan's level of **surplus** **risk**

Question 45

\_\_\_-\_\_\_ \_\_\_reduces surplus risk by constructing a portfolio of assets with returns that are highly correlated with the change in the plan's liabilities.

Answer 45

**Liability**-**driven investing** reduces surplus risk by constructing a portfolio of assets with returns that are highly correlated with the change in the plan's liabilities.

Question 46

There are different ways to immunize a pension fund's liabilities. 1. Use a ___ bond portfolio with a \_\_\_that matches that of the pension's liabilities. 2. Use ___ \_\_\_, such as \_\_\_that receive long-duration bond returns or \_\_\_that increase in value as interest rates \_\_\_.

Answer 46

There are different ways to immunize a pension fund's liabilities. 1. Use a **corporate** bond portfolio with a **duration** that matches that of the pension's liabilities. 2. Use **derivative overlays**, such as **swaps** that receive long-duration bond returns or **swaptions** that increase in value as interest rates **decrease**.

Question 47

Plans offering benefits with large COLA adjustments need large allocations to \_\_\_-\_\_\_ \_\_\_in order to reduce surplus risk

Answer 47

Plans offering benefits with large COLA adjustments need large allocations to **inflation**-**protected bonds** in order to reduce surplus risk

Question 48

Instead of using low return-yielding inflation-protected bonds, portfolios can be protected against inflation using ___ \_\_\_.

Answer 48

Instead of using low return-yielding inflation-protected bonds, portfolios can be protected against inflation using **real** **assets**.

Question 49

In contrast to DB plans that do not cap benefits, social security plans cap earnings. This results in a ___ \_\_\_ , in which retirees with lower career-average incomes receive relatively higher benefits as a percentage of salary than higher-income retirees.

Answer 49

In contrast to DB plans that do not cap benefits, social security plans cap earnings. This results in a **progressive system**, in which retirees with lower career-average incomes receive relatively higher benefits as a percentage of salary than higher-income retirees.

Question 50

A ___ \_\_\_plan is a retirement plan in which employers make a specific contribution on behalf of each covered employee and employees also contribute to the plan.

Answer 50

A **defined contribution** plan is a retirement plan in which employers make a specific contribution on behalf of each covered employee and employees also contribute to the plan.

Question 51

DC Plans differ from DB plan in a number of ways: 1. They are \_\_\_ 2. \_\_\_risk is borne by the employees 3. ___ \_\_\_are made by the employees

Answer 51

DC Plans differ from DB plan in a number of ways: 1. They are **portable** 2. **Longevity** risk is borne by the employees 3. **Investment decisions** are made by the employees

Question 52

Some employees are offered a ___ \_\_\_ by the employer, enabling them to invest in a broader range of investment options. However, they typically only benefit financially \_\_\_employees.

Answer 52

Some employees are offered a **brokerage window** by the employer, enabling them to invest in a broader range of investment options. However, they typically only benefit financially **sophisticated** employees.

Question 53

When participants in a DC plan do not rebalance, it results in a ___ asset allocation.

Answer 53

When participants in a DC plan do not rebalance, it results in a **drifting** asset allocation.

Question 54

There are 2 key phases related to retirement: 1. ___ phase 2. \_\_\_phase

Answer 54

There are 2 key phases related to retirement: 1. **Accumulation** phase 2. **Decumulation** phase

Question 55

DC Plan participants are exposed to 3 chief risks: 1. ___ risk 2. \_\_\_risk 3. \_\_\_risk

Answer 55

DC Plan participants are exposed to 3 chief risks: 1. **Longevity** risk 2. **Market** risk 3. **Inflation** risk

Question 56

What is the equation for estimating longevity risk (economic life in years)

Answer 56

Question 57

There are two broad types of annuities: 1. ___ annuity 2. \_\_\_annuity

Answer 57

There are two broad types of annuities: 1. **Immediate** annuity 2. **Deferred** annuity

Question 58

In an ___ annuity, the investor makes a lump-sum payment to an insurance company in exchange for a series of guaranteed cash flows scheduled to start within the first year.

Answer 58

In an **immediate** annuity, the investor makes a lump-sum payment to an insurance company in exchange for a series of guaranteed cash flows scheduled to start within the first year.

Question 59

With a ___ annuity, an investor makes a lump-sum payment to an insurance company in exchange for a series of guaranteed cash flows scheduled to start at a future date.

Answer 59

With a **deferred** annuity, an investor makes a lump-sum payment to an insurance company in exchange for a series of guaranteed cash flows scheduled to start at a future date.

Question 60

Deferred annuities are sometimes referred to as ___ \_\_\_.

Answer 60

Deferred annuities are sometimes referred to as **longevity insurance**.

Question 61

An ___ annuity is one where the payment does not grow over time.

Answer 61

An **ordinary** annuity is one where the payment does not grow over time.

Question 62

A ___ annuity is one where payments will grow over time.

Answer 62

A **growth** annuity is one where payments will grow over time.

Question 63

What's the equation for present value of a growth annuity?

Answer 63

Question 64

What is the equation for the present value of an ordinary annuity?

Answer 64

Question 65

The cost of a growth annuity is (more/less) than that of a fixed annuity.

Answer 65

The cost of a growth annuity is **more** than that of a fixed annuity.

Question 66

The cost of a deferred annuity is (more/less) than that of an immediate annuity.

Answer 66

The cost of a deferred annuity is **less** than that of an immediate annuity.

Question 67

When interest rates decrease, the cost of an annuity (increases/decreases).

Answer 67

When interest rates decrease, the cost of an annuity **increases**.

Question 68

When the payment period increases, the cost of an annuity (increases/decreases).

Answer 68

When the payment period increases, the cost of an annuity **increases**.