RPA2

Question 1

Describe the following types of investment risk: (a) purchasing power, (b) business,
(c) interest rate, (d) market and (e) specific

Answer 1

(a) Purchasing power risk reflects the relationship between the nominal rate of
return on an investment and the increase in the rate of inflation.

(b) Business risk involves the prospect of the corporation issuing the security
suffering a decline in earnings power that would adversely affect its ability to pay
interest, principal or dividends.

(c) Interest rate risk comprises the well-known inverse relationship between interest
rates and (long-term) bond prices. That is to say, when interest rates increase, the
value of long-term bonds falls.

(d) Market risk can be thought of as an individual stock’s reaction to a change in the
market. In general, most stock prices will increase if the stock market increases
appreciably and decrease if the market decreases appreciably; however, the price
of one stock may change half as fast as the market, on average, while another
may change twice as fast. This relationship is quantified by a measure known as
beta.

(e) Specific risk is risk that is intrinsic to a particular firm

Question 2

Describe (a) why the tax aspect of an investment is important for a pension fund
and (b) why an investment’s relative liquidity may be important to a pension plan’s
investment manager.

Answer 2

(a) The tax aspect of an investment is important because of the tax-exempt status of
the pension fund. Because investment income of qualified retirement plans is
tax-exempt, certain types of investments may not be as attractive to pension
funds as they would be for other types of investors.
(b) Liquidity refers to the ability to convert an investment into cash in a short time
period with little, if any, loss in principal. This may be an important attribute for
at least a portion of the pension plan assets in case the plan has to sustain a short
period of time when the plan sponsor is unable to make contributions (or
contributions are less than the amount of the benefit payments for the year) and,
at the same time, the securities markets are depressed. If the plan does not
possess an adequate degree of liquidity, the sponsor might have to sell securities
at an inopportune time, perhaps resulting in the realization of capital losses.

Question 3

What have historical studies demonstrated with respect to the risk-and-return
characteristics of the major classes of investments?

Answer 3

Published in 2016, an 89-year time series analysis of the major classes of investments
found, as expected, that the riskiest investments also generated the highest yields.
Common stocks provided the highest annual return, with small company stocks
having a compound annual growth rate of 12.0% and large company stocks having a
compound annual growth rate of 10.0%. However, investors purchasing common
stocks paid a price in terms of the volatility of their investment. Over the past several
decades, the large company stocks experienced one-year losses as high as 37.0% (in
2008). Long-term bonds issued by the government had a significantly lower return
(6.0%). U.S. Treasury bills were obviously the safest investment in terms of annual
volatility; however, they only generated a return of 3.4%.
These figures cannot be viewed in isolation, and it is important to consider how they
fared after the effects of inflation had been removed. During this period, the
compound inflation rate was 2.9%, an amount that should be subtracted from the
nominal rate of return to find the real rate of return produced by an investment.

Question 4

What types of questions should the investment manager’s guideline statement
cover?

Answer 4

(a) How much risk is the plan sponsor prepared to take to achieve a specific
benchmark rate of return?
(b) What is the time period for measurement of performance relative to objectives?
(c) What is the sponsor’s preference in terms of asset mix, especially as it relates to
stocks?
(d) What is the liability outlook for the plan, and what should the fund’s investment
strategy be in light of this outlook?
(e) What are the sponsor’s cash flow or liquidity requirements?
(f) How much discretion is the manager permitted regarding foreign investment,
private placements, options, financial futures, hedge funds and the like?

Question 5

The 4 steps involved in effective performance measurement and

Answer 5

Definition, Input, Processing, Output

Question 6

Describe: Definition, Input, Progressions, Output

Answer 6

Definition: Establishment of investment objectives and, to the extent
practical, a clearly formulated portfolio strategy
• Input: Availability of reliable and timely data. Incorrect and tardy data will
render the most sophisticated system ineffective.
• Processing: Use of appropriate statistical methods to produce relevant
measurements. The complex interaction of objectives, strategies and
managers’ tactics cannot be understood if inappropriate statistical methods
are used. A meaningful summary will make possible analysis of the
investment process at the necessary depth.
• Output: Analysis of the process and results presented in a useful format.
Presentation should relate realized performance to objectives and preestablished standards. Enough material should be available to understand and
analyze the process. Exhibits should be designed to highlight we

Question 7

4 caveats that must be kept in mind in choosing a performance
measurement system

Answer 7

There is a danger that a hastily chosen system, poorly related to real needs,
can rapidly degenerate into a mechanistic, pointless exercise.
• The system should fit the investment objectives—not the reverse.
• Measuring the process may alter it.
• To save time and cost, it is important that overmeasurement be avoided

Question 8

Internal rate of return

Answer 8

valuable in that it allows the sponsor to determine whether the investment is achieving the rate of return assumed for actuarial calculations; however, it is largely ineffective as a means of evaluating investment managers because it is contaminated by the effects of the timing of investments and withdrawals—a factor over which the investment manager presumably has no control

Question 9

Time-weighted value

Answer 9

computed by dividing the time interval under study into subintervals whose boundaries are the dates of cash flows into and out of the fund and by computing the internal rate of return for each subinterval. The time-weighted rate of return is the (geometric) average for the rates for these
subintervals, with each rate having a weight proportional to the length of time in its corresponding subinterval.

Question 10

Capital asset pricing model (CAPM)

Answer 10

uses standard statistical techniques
(simple linear regression) to analyze the relationship between the periodic returns
of the portfolio and those of the market (for example, the Standard & Poor’s 500)

Question 11

importance of the (a) alpha value and (b) beta value produced by the
capital asset pricing model

Answer 11

(a) The portfolio’s alpha value can be thought of as the amount of return produced by the portfolio, on average, independent of the return of the market. Generally alpha is viewed as the level of return contributed because of the skill of the investment manager that is managing the portfolio.

(b) The beta value is the slope of the line measured as the change in vertical
movement per unit of change in the horizontal movement. This represents the
average return on the portfolio per 1% return on the market. For example, if the
portfolio’s beta is 1.25, then a 2% increase (or decrease) in the market would be
expected to be associated with a 2.5% (1.25 3 2) increase (or decrease) in the
portfolio, on average.

Question 12

How is the risk-adjusted rate of return utilized in portfolio measurement?

Answer 12

The risk-adjusted rate of return can be used to measure risk-adjusted performance and to compare portfolios with different risk levels developed by actual portfolio
decisions.

Question 13

Various forms of money market instruments

Answer 13

US Treasury Bills/Notes
Federal Agency Issues
Certificates of Deposit
Commercial Paper
Money Market Mutual Funds

Question 14

Describe the various forms of money market instruments

Answer 14

(1) U.S. Treasury bills and notes. Treasury bills have maturities at issue ranging from
91 to 360 days, while Treasury notes have initial maturities ranging from one to
five years. There is almost no default risk on these investments. In other words,
the probability that either interest or principal payments will be skipped is nearly
zero.
(2) Federal agency issues. The Treasury is not the only federal agency to issue
marketable obligations. Other agencies issue short-term obligations that range in
maturity from one month to over ten years. These instruments typically
(3) Certificates of deposit. These certificates are issued by commercial banks and
have a fixed maturity, generally in the range of 90 days to one year. The ability to
sell a certificate of deposit prior to maturity usually depends on its
denomination. The default risk for these certificates depends on the issuing
bank, but it is usually quite small.
(4) Commercial paper. This is typically an unsecured short-term note of a large
corporation. This investment offers maturities that range up to 270 days, but the
marketability is somewhat limited if an early sale is required. The default risk
depends on the credit standing of the issuer, but commensurately higher yield is
available.
(5) Money market mutual funds. These funds invest in the money market
instruments described above. As a result, investors achieve a yield almost as high
as that paid by the direct investments themselves and, at the same time, benefit
from the diversification of any default risk over a much larger pool of
investments.

Question 15

Why are bonds used in pension plan portfolios?

Answer 15

The use of bonds in pension plan portfolios typically can be attributed to one of two reasons. First, if the sponsor realizes that (to a large extent) the pension plan’s obligations are fixed dollar obligations that will be paid out several years in the future, there may be a desire to purchase assets that will generate a cash flow similar to the benefit payments. Second, the investment manager may be willing to purchase assets with a longer maturity than the money market instruments described above.
This assumption of interest rate risk is presumably compensated for by a higher yield than that available from shorter maturities.

Question 16

6-Types of Common Stocks

Answer 16

Blue-Chip
Income
Growth
Defensive
Interest-sensitive
Cyclical

Question 17

Describe the 6-types of Common Stocks

Answer 17

(a) Blue-chip stocks. These are stocks issued by major companies with long and
unbroken records of earnings and dividend payments. They should appeal
primarily to pension plans seeking safety and stability.
(b) Growth stocks. These are stocks issued by companies whose sales, earnings and
share of the market are expanding faster than either the general economy or the
industry average. They represent a higher risk, but the prospects for capital
appreciation should produce a correspondingly higher total return. Because they
pay relatively small dividends, they may not be attractive to pension plans with
cash flow needs.
(c) Income stocks. These are stocks that pay higher-than-average dividend returns.
They have been attractive to pension plans that bought stock for current income.
(d) Cyclical stocks. These are stocks issued by companies whose earnings fluctuate
with the business cycle and are accentuated by it.
(e) Defensive stocks. These are stocks issued by recession-resistant companies.
These may be an important consideration for pension plans that cannot afford
major capital losses.
(f) Interest-sensitive stocks. These are stocks whose prices tend to drop when
interest rates rise, and vice versa.

Question 18

Explain the 6-reasons pension plans often choose mutual funds as investment
vehicles

Answer 18

:

(a) Greater liquidity through ease of entry and exit
(b) Greater degree of diversification
(c) Easier means of portfolio specialization
(d) Daily update of holdings through Internet listings
(e) Ease of meeting asset allocation or market timing goals
(f) Ease of checking past performance through published studies and indexes.

Question 19

What type of information should be elicited in a questionnaire sent to prospective
investment managers?

Answer 19

(a) Portfolio strategies and tactics
(b) Ownership as well as employee compensation
(c) Decision-making procedures
(d) List of current clients and specific people to contact for references
(e) Names of accounts lost as well as those gained in recent years
(f) Historic performance of each class of assets managed
(g) Explanation of exactly how the firm’s performance statistics have been
computed.

Question 20

Explain why a passive investment strategy may be attractive to a
pension plan sponsor

Answer 20

Proponents of the passive strategy argue that as the stock market becomes
increasingly efficient, it is more difficult for investment managers to consistently
outperform the market. If actively managed funds do indeed encounter difficulties
producing a gross rate of return superior to that of the market, it will obviously be
even more difficult to produce a superior return on a net basis (after the effects of
fees and transaction costs have been accounted for).

Question 21

Explain why some sponsors will use index funds as an investment for the core of
their portfolio and allow active management of the remaining amount of the assets.

Answer 21

This tactic possesses the advantage of freeing the investment managers from having
to deal with the core portfolio and, instead, allowing them to focus their time on
their specialty areas. Moreover, given a relative sense of security for the core
investment, investment managers are able to pursue a higher risk strategy on their
subset of the plan’s assets in hopes of above-average returns.

Question 22

Describe the basic objectives behind the use of dedication and immunization
techniques for pension plan portfolios.

Answer 22

Another form of passive investment of pension plan assets makes use of the bond
market and has been variously referred to as dedication, immunization and
contingent immunization. This technique attempts to construct a bond portfolio such
that its cash flow can be used to fund specific plan liabilities, such as to pay benefits
to a group of retirees.

Question 23

Describe the respective roles of employers and employees in the plan investment
provisions of a (DC) plan.

Answer 23

(a) Structuring appropriate investment programs
(b) Selecting suitable investment managers
(c) Monitoring investment performance
(d) Communicating critical investment provisions to employees.
In the typical plan, employees are responsible for deciding how to invest their
account balances. It is important to note that employees assume all of the risks
associated with investment performance.
Both employers and employees must have a sound understanding of basic investment
principles if they are to succeed in fulfilling their respective responsibilities.

Question 24

Describe the benefits of a successful investment program for (a) the employer and
(b) the employees

Answer 24

(a) For the employer, the benefits of a successful investment program include:
• Low-cost fees
• Ease of administration
• Flexibility to make needed changes in investment arrangements
• Improved recognition of the company as a source of valuable benefits.
(b) For employees, a well-executed investment program maximizes capital
accumulation through:
• Increased participation
• Improved returns
• Lower costs

Question 25

What factors have contributed to the shift toward enhanced investment
opportunities in DC plans?

Answer 25

(a) A growing public awareness of the role of DC plans in providing economic
security and of the importance of saving and investing wisely
(b) An increased recognition on the part of employers of the need to provide
flexibility of choice and investment education
(c) Improved and more efficient administrative capabilities
(d) The aggressive marketing efforts of the leading mutual funds

Question 26

Does a variety of investment choices in a well-structured DC plan ensure maximum
benefits for participants?

Answer 26

A variety of investment choices in a well-structured DC plan does not in and of itself
ensure that employees will utilize the plan to its full potential. Many plans with
ample investment choices underscore the need for educating employees to become
better investors.
Overall, billions of dollars in DC plan assets are still being invested very
conservatively and with little diversification. While this reflects the fact that
employees need to know more about investments and financial planning, it also
reflects the fact that many employers still have not focused on managing their plans
as effectively as possible.

Question 27

5 How has the Pension Protection Act of 2006 (PPA) provided protection to, and
advanced efforts to improve investment outcomes of, DC plan participants?

Answer 27

PPA has provided protection to, and advanced efforts to improve investment
outcomes of, DC plan participants through provisions that facilitate a plan sponsor’s
ability to provide investment advice, require investment diversification for DC plans
and permit fiduciary exemption associated with automatic plan enrollment.

Question 28

What major areas should an employer consider when evaluating the investment
provisions of a DC plan?

Answer 28

(1) Fiduciary responsibilities
(2) The role of employer stock
(3) Administrative issues.

Question 29

Does conformity with the Section 404(c) safe harbor provisions relieve an employer
of fiduciary responsibility for plan investments?

Answer 29

Compliance with the Section 404(c) safe harbor provisions does not relieve the
employer of the responsibility of ensuring that the investment options offered under
the plan are prudent and properly diversified and does not relieve the employer of
fiduciary responsibility for investments over which the employee has no control,
such as employer contributions that are automatically directed to one of the
investment options.
As noted in Learning Objective 5.5, PPA allows (does not mandate) plan sponsors to
offer investment advice services. If plan sponsors do offer such services to their
participants, they assume certain fiduciary responsibilities. They must prudently
select the advice provider and must monitor the services provided. Therefore,
fiduciary responsibilities relate both to the appointment of the investment advice
provider and the ongoing monitoring process of the investment advice provider. The
Department of Labor (DOL) has specified the criteria that should be followed when
appointing an investment advice provider and prescribed plan sponsors’
responsibilities for monitoring the advice provided.

Question 30

What are the potential disadvantages of using employer stock as an investment
option within a DC plan?

Answer 30

(a) Employer stock is a completely undiversified investment option and may be
inappropriate from a financial perspective.
(b) Employer contributions invested in company stock at the employer’s direction
are not eligible for the Section 404(c) safe harbor provisions.
(c) Plan sponsors that permit employee contributions to be invested in company
stock must comply with Securities and Exchange Commission (SEC) registration
and reporting requirements.
(d) Employee relations problems may surface if the value of the employer stock
declines.
(e) If significant balances are built up in the company stock fund, employees have
not only their livelihood but also a sizable block of their savings tied to the wellbeing of the company.
(f) Any investment in employer stock must be shown to satisfy the requirement that
plan assets be “expended for the exclusive benefit of employees” and must satisfy
the fiduciary requirement for prudence.
(g) If employer stock is offered as one of the investment options, the employer must
adhere to the PPA diversification requirements. The PPA rules do not apply to
employee stock ownership plans (ESOPs).

Question 31

Discuss administrative issues that need to be addressed in structuring the
investment provisions of a DC plan.

Answer 31

(a) Frequency of valuation. How often will plan assets and account balances be
valued for purposes of processing loans, distributions, withdrawals and
investment election changes?
(b) Frequency of change. How often will employees be permitted to change their
investment choices? The Section 404(c) safe harbor provisions require that
employees must be permitted to make changes at least quarterly, and more often
for more volatile investment options.
(c) Default provisions. Employers must provide some sort of default option in the
event an employee fails to make an investment election for contributions. PPA
has clarified standards for default options and exempted plan sponsors from
fiduciary liability when they abide by the act’s requirements.
(d) Negative elections. Instead of requiring an employee to elect to participate in a
DC plan, employees are deemed to have elected to defer a percentage of their
eligible compensation as a plan contribution unless they affirmatively elect a
different deferral amount or elect not to participate in the plan.
(e) Employee communications. Employee communication is a critical link in the
long-term success of DC plans. DOL now requires that the employer offer
participants sufficient information to enable them to make an intelligent choice
among the investment options available to them. PPA provides a new prohibited
transaction exemption allowing qualified fiduciary advisors to provide
personally developed professional investment advice to assist plan participants
in managing their retirement plan investments.