CFA 2018 level 3 schweser practice exam CFA 2018 level 3 question bank schweser 175 questions for institutional investors 06 portfolio management for institutional investors

When formulating an investment policy statement for a defined benefit pension plan, legal and regulatory factors, in addition to unique circumstances, must be considered.. Explanation Th

Portfolio Management for Institutional Investors Test ID: 7426254

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

to absorb losses and hence accept more risk

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 do defined benefit plans

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

Description Fixed income segment Surplus segment Fixed income segment Surplus segment

III Relatively high Very low Relatively high Relatively high

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

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

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 ofretired lives dictates a lower than average ability to take risk Hence, risk tolerance should be low to moderate Assets should bechosen 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 do 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 fixed-income 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 #8 of 175 Question ID: 465323

Which of the following defined benefit pension plan segments generates the greatest liability noise? The greatest source of

liability noise is that from:

Which of the following types of foundations do NOT have a spending requirement?

Question #10 of 175 Question ID: 465311

Which of the following statements most accurately describes assetliability management for the specified institution?

✗ A) Managers of foundations typically attempt to match the duration of assets and

liabilities

✓ B) Risk tolerance for an endowment is determined by the spending rate and its

importance to the operating budget of the recipient

✗ C) Asset allocation for pension funds is generally unaffected by regulatory constraints

Explanation

Managers of pension funds typically attempt to match the duration of assets and liabilities Asset allocation for foundations must accommodate a five percent spending rate so the fund may maintain its taxexempt status Asset allocation for pension funds is generally affected by regulatory constraints, such as restrictions on private and speculative debt

Question #11 of 175 Question ID: 465270

Which of the following statements best compares the legal and regulatory constraints when managing a pension plan versus

managing an endowment fund?

✗ A) State pension laws generally supersede Federal pension laws regarding pension plans whereas

endowment funds are primarily regulated at the Federal level.

✗ B) Endowment funds are managed according to the "prudent expert" rule while benefit plans are

managed under the "prudent investor" rule.

✓ C) Pension plans are managed according to the Employee Retirement Income Security Act while

endowment funds are governed by the Uniform Management Institutional Funds Act.

Endowment plans are held to a standard known as the "prudent investor" rule, which states that fiduciaries must adhere to

fundamental duties of loyalty, impartiality and prudence as well as maintain overall portfolio risk at a reasonable level and provide for the reasonable diversification of investments Fiduciaries must also act with prudence in deciding whether and how to delegate authority to experts and in selecting and supervising agents

Questions #1215 of 175

Ed Simon, CFA, has been assigned the arduous task of assessing the slight nuances concerning the investment objectives and constraints for foundations and endowments Simon's supervisor has requested a full report on these differences and how they affect the

investment policy statements.

Question #12 of 175 Question ID: 465264

Simon thought it best to first look at differences in return objectives between foundations and endowments Which of the following

best indicates differences between the return objectives of foundations and of endowments?

✓ A) Foundation return objectives depend on the time horizon of the foundation, whereas

endowment return objectives are to provide a permanent base of funding.

✗ B) Foundation return objectives are to provide a permanent base of funding whereas endowment

return objectives depend on the time horizon of the endowment.

✗ C) Endowment returns usually are dictated by a ruleofthumb of "5.3% + inflation," whereas

foundation return objectives are dictated by spending rules.

Explanation

Foundations may be finitelived entities, but endowments are created to provide a permanent base of funding

Question #13 of 175 Question ID: 465265

Simon next turned his attention to the differences in risk objectives between foundation and endowment investment policy

statements Which of the following best describes the main difference between foundation and endowment risk objectives?

✓ A) Foundation risk tolerance is dependent on the time horizon of the foundation, whereas

endowment risk tolerance is dependent on the importance of the endowment fund in the

sponsor's overall budget picture.

✗ B) Endowment risk tolerance is not dictated by the relationship between the current income

requirement and maintenance of purchasing power, whereas this is a crucial factor for

foundations.

✗ C) Foundation risk tolerance is dependent on the importance of foundation funds in the sponsor's

overall budget picture, while endowment risk tolerance is dependent on the time horizon of the

endowment.

Explanation

Risk tolerance of foundations is critically linked to any time horizon structure while endowment risk tolerance is dependent on the importance of endowment funds in a sponsor's overall budget picture

Question #14 of 175 Question ID: 465266

Foundations and endowments often have differential liquidity constraints Simon found which of the following to be a difference between the liquidity constraints of a foundation and an endowment?

✓ A) Private foundations are required to have a minimum spending rate whereas

endowments rarely have minimum spending rates.

✗ B) Endowments are required to have a minimum spending rate whereas private foundations rarely

have minimum spending rates.

✗ C) An endowment's spending rule will have less of an effect on liquidity requirements than a

foundation's liquidity requirement due to a minimum spending rate.

Private foundations are required to pay out at least 5% of assets on an annual basis Endowments do not have minimum spending requirements

Question #15 of 175 Question ID: 465267

Simon discovered tax laws seem to differentially impact foundations and endowments Which of the following most accurately depicts

the differential tax treatment between foundations and endowments?

✗ A) Operating foundation investment income is taxable, whereas endowment investment income is

not.

✗ B) Endowment investment income is taxable, whereas private foundation investment income is not.

✓ C) Private foundation investment income is taxable, whereas endowment investment income is

not.

Explanation

Private foundation investment income is taxable, whereas other foundations and endowments are not

Question #16 of 175 Question ID: 465317

The following statements concern differences between the investment policy statement for an institution and that for an individual Which of these statements is least accurate? The institutional investment policy statement:

✓ A) has four main stepsplanning, estimation, execution, and feedbackwhile the individual

investment policy statement has three.

✗ B) may have asset structure and liquidity requirements that are driven by the institution's liability

Question #17 of 175 Question ID: 465303

Which of the following CORRECTLY describes the primary source of invested funds to meet funding requirements for an endowment fund and an investment company?

Endowment Fund Investment Company

Question #18 of 175 Question ID: 465324

A defined benefit pension plan decides to index their benefits to inflation Meanwhile, the labor force has increased in

productivity and profits have soared Which of the following best describes the changes to their liabilitymimicking portfolio?

The liabilitymimicking portfolio should have:

✗ A) more equities and more nominal bonds

✓ B) more equities and more real return bonds

✗ C) fewer equities and more real return bonds

Explanation

If the pension plan decides to index their benefits to inflation, more real return (inflationindexed) bonds should be added to hedge the benefits If the labor force becomes more productive, wages will increase due to this real growth This real growth is related to economic growth and is best hedged by equities

Question #19 of 175 Question ID: 465223

The return objectives for a life insurance company can be broken into two segments, the fixedincome and the surplus segments

Which return objectives are mostly associated with each segment, respectively?

✗ A) Yield maximization and spread management.

✗ B) Spread management and maximizing yield.

✓ C) Spread management and capital gains.

Explanation

The return objectives for a life insurance company have mainly been associated with earning a competitive return that helps increase the spread between assets and liabilities The surplus portfolio, however, has growth in the surplus as its main return objective, which will happen via capital gains.

Question #20 of 175 Question ID: 465192Which of the following would be included in an investment policy statement (IPS) for a defined contribution plan?

World Wide Telecom (WWT), a troubled internet service provider recently filed Chapter 11 bankruptcy after seven

unsuccessful years of operations It was a plan sponsor in WWT Pension Plan for the benefit of its employees The following information was available at the time of its bankruptcy filing:

Employees: 500

Plan assets: $15 million Plan

liabilities: $19 million Average

age of workforce: 30

1% of plan assets are being paid out to retirees and no more participants are expected to retire over the next five years Due to the company's financial condition, the plan was underfunded

The duration of the plan liabilities is 25 years

Inflation is expected to be approximately 1% over the next five years

The bankruptcy trustee appointed Eric Geecu, CFA, as the portfolio manager overseeing the WWT Pension Plan to develop guidelines for its investment policy statement and the ultimate distribution of the proceeds of the plan upon fully funded status Geecu believes that fully funded status could be achieved within the next five years, assuming the plan earns an expected rate

of return in excess of its plan liabilities The plan liabilities are expected to increase at the rate of inflation

In developing an investment policy statement (IPS) for WWT Pension Plan, which constraints should Geecu consider?

✓ A) A short time horizon, low liquidity needs, with assets managed according to the "prudent

expert" rule.

✗ B) A long time horizon, unique circumstances associated with the Chapter 11 bankruptcy, with no

current taxes to be considered for the pension plan.

✗ C) The pension plan is governed under ERISA, unique circumstances that the plan cannot

provide any funds to meet the plan's underfunded status, and a long time horizon.

Explanation

Time horizon The time horizon for this plan is short Since the plan sponsor, WWT, is currently in bankruptcy and would not be considered a going concern, it cannot provide any funds to minimize the plan deficit Since there is only a 5year time horizon forthe plan coupled with the uncertainty on the disposition of available funds in five years, the primary goal of this plan

is on capital preservation with a secondary focus on income and a third goal of some growth over the time horizon Five years

is a short time frame to achieve these goals Any IPS developed must consider capital preservation first and then consider a total return approach to preserve the plan from the effects of inflation

Liquidity The liquidity needs of this portfolio are low primarily because only 1% of the plan assets are currently being paid out and no more employees are expected to retire over the next five years The average age of the workforce is 30 and young and will not require any distributions until the expected termination upon its fully funded status Therefore, the plan only has to provide for its current retirees at a rate of 1% per year

Laws and regulations This pension plan is governed by ERISA and must adhere to the prudent expert rule As such,

diversification is necessary to minimize the risk of large losses to the plan and capital preservation

Taxes There are none to be considered for the pension plan However, upon the distribution of the plan assets after five years, there could be a tax impact on the plan participants Tax counsel is advised here for the plan and its participants to also do some tax planning for the ultimate distribution of the proceeds of the plan in five years

Unique circumstances WWT, the plan sponsor, is in a Chapter 11 bankruptcy filing and, therefore, cannot provide any funds to meet the plan's underfunded status The plan must also consider the administration of the distribution of the proceeds of the plan after five years to its plan participants Should the underfunded status remain (assuming a higher than expected level of benefits are paid out to retirees or the expected rate of return does not meet the level of the plan liabilities) special policies and procedures may need to be considered at the time of the distribution of the plan assets

Question #22 of 175 Question ID: 465301