RPIRM - EDGE

Question 1

Duties of the Trustee (9)

Answer 1

1. Duty of loyalty
2. Duty of care
3. Duty to diversify plan assets
4. Duty of impartiality
5. Duty to delegate
6. Duty to follow statutory constraints
7. Duty to make the property productive
8. Duty regarding co-trustees
9. Duty to act in accordance with the trust agreement

Question 2

US Safe Harbor for Shifting Responsibility for Investment Decisions to Plan Members (3)

Answer 2

1. Have at least 3 diversified investment options covering a broad range of investment options
2. Can transfer fund at least quarterly
3. Sufficient information upon which to make an informed decision (investment managers, description of funds, etc.)

Question 3

Disclosures that must be made upon the participants request (5)

Answer 3

1. Description of plan expenses
2. Prospectuses, financial statements and reports
3. List of asset and their value within the investment
4. Value of shares or units available to participants and past investment performance
5. Information concerning the value of shares or units in investment alternatives held by the beneficiary

Question 4

Points regarding 404(c) Protection (Responsibilities of the Fiduciary) (5)

Answer 4

1. Fiduciary remains liable for the prudent selection and management funds to be offered
2. Fiduciary remains liable for prudent investment and diversification of plan assets if plan does not offer member choices
3. Multi-fund plan fiduciary not complying with 404(c) responsible for the prudent investment of plan funds
4. Fiduciary responsible for prudent asset mix if changes allowed less often than quarterly
5. It is transactional

Question 5

Requirements for 404(c) Protection for Default Fund used with Automatic Enrollment (7)

Answer 5

1. Must be QDIA (Plan sponsor fiduciary responsible for selecting and monitoring QDIA)
2. Participant had opportunity to direct investments but did not do so
3. Must notify participants at least 30 days before initial investment and each subsequent plan year
4. Provide ERISA 404(c) fee and expense disclosures
5. Can transfer assets at least quarterly
6. QDIA fees same for everyone
7. Must offer at least 3 broad range investments

Question 6

QDIA Requirements (4)

Answer 6

1. Can’t be employer stock unless part of a mutual fund
2. Can transfer out within 90 days
3. Must be professionally managed by regulated firm or named fiduciary
4. Must be one of the following
   - TDF or Target life expectancy fund
   - Balanced fund
   - Actively managed account similar to 2 above
   - Preserve capital (120 days only)

Question 7

Role of the plan administrator includes: (3)

Answer 7

1. Managing the plan assets (following prudent principles)
2. Drafting an investment policy
3. Ensuring assets are managed according to the investment policy and legislation

Question 8

Fiduciaries must: (3)

Answer 8

1. Act in prudent manner
2. Manage/make decisions in the best interest of plan members
3. Exercise due diligence

Question 9

Due diligence means making decisions based on: (2)

Answer 9

1. Adequate information

2. Documenting decisions, motives and circumstances

Question 10

Steps that demonstrate a prudent investment strategy (4)

Answer 10

1. Developed
2. Adopted
3. Implemented
4. Monitored

Question 11

Prudent investment practices take into account (4)

Answer 11

1. Nature of plan liabilities
2. Timing of payments
3. Expected future experience
4. Demographics of plan members

Question 12

Prudent investment principles (5)

Answer 12

1. Prudent person rule
2. Prudent delegation
3. Define investment objectives
4. Develop an investment policy
5. Proper monitoring

Question 13

When delegating functions, plan administrator… (2)

Answer 13

1. Must do so prudently

2. Remains responsible for delegated activities (should review and monitor the delegates)

Question 14

Clearly defined investment objectives allows the risks associated with the objectives (2)

Answer 14

1. To be understood

2. To be actively managed

Question 15

Investment objectives should be consistent with the plan’s (4)

Answer 15

1. Retirement income objectives
2. Liabilities
3. Demographics
4. Ability to accommodate investment volatility

Question 16

Investment objectives should reflect (2)

Answer 16

1. Relevant legal provisions

2. Relevant investment principles regarding asset allocation, diversification and liquidity

Question 17

Investment policy/ SIP&P should (6)

Answer 17

1. Reflect plan’s investment objectives
2. Specify investment principles, strategic asset allocation, performance objectives, etc.
3. Life investment restrictions
4. Identify the asset allocation
5. Identify the plan’s expected returns
6. Address the nature and extent of anticipated risk

Question 18

When monitoring, administrator should (5)

Answer 18

1. Review investment objectives and risk tolerances
2. Ensure adequate investment procedures are in place
3. Review key investment decisions
4. Ensure service providers are monitored and measured
5. Review plan’s investment performance

Question 19

Purpose of pension governance (3)

Answer 19

1. Structure / process for effective administration
2. Ensure fiduciary compliance
3. Ensure participants receive benefits according to plan terms and understand their rights/responsibilities

Question 20

An effective pension governance system incorporates (3)

Answer 20

1. Framework for defining duties
2. All pension aspects (management, communication, funding)
3. Oversight to protect plan members

Question 21

Advantages of good governance (6)

Answer 21

1. Meet fiduciary requirements
2. Minimize risks and inefficiencies
3. Promote accurate and timely delivery of benefits
4. Consistent benefits administration
5. Provides control mechanisms to facilitate decision making, efficient practices, accountability and review
6. Facilitates positive plan performance

Question 22

Fiduciary must (5)

Answer 22

1. Treat members impartially
2. Act with care, skill and diligence of a prudent person
3. Interpret plan terms fairly
4. Prevent personal conflict of interest
5. Ensure members receive benefits

Question 23

Risk management governance framework should (6)

Answer 23

1. Identify risks
2. Assess / prioritize risks
3. Responsibilities for managing risk
4. Define acceptable risks
5. Design response to mitigate
6. Monitor

Question 24

Participant Communications Should (3)

Answer 24

1. Outline process for asking and raising questions
2. Communicate how important decisions are made
3. Information about plan’s risks, benefits, options and participants responsibilities

Question 25

Investment Behavior DC Sponsors are Likely to See Among the Norm (4)

Answer 25

1. Correlated equity allocation decisions 2. High utilization in hybrid allocations 3. Static asset allocations 4. Tax inefficiencies

Question 26

Investment Behavior DC Sponsors are Likely to See among the Minority (4)

Answer 26

1. Trade too much 2. Invest too much in company stock 3. Insufficiently diversified 4. Invest too much or not enough in equities

Question 27

Likely to see among the Norm Higher Equity Allocations Correlated with (12)

Answer 27

1. Positive stock market performance 2. Younger age 3. Higher education 4. Higher income 5. Longer investment horizons 6. Higher risk tolerance 7. Higher number of investment choices 8. Not participating in a DC plan 9. Good health 10. Married 11. Non-union 12. Male

Question 28

Theory to understand causes of irrational investment behavior is called

Answer 28

Prospect Theory (argues investors follow an investment process)

Question 29

Prospect Theory Investment Process

Answer 29

Phase 1 (Framing and Editing): Decision affected by the way the problem is presented and the investors habits and expectations Phase 2 (Evaluation): Decision affected by investor's risk aversion

Question 30

Party Responsible for Oversight of DC Plan Investments

Answer 30

- For DC, if ee has no control over how assets are invested, er has full responsibility - For DC, if ee has choices, er bears responsibility of selecting investment funds and making sure find line-up is diverse and competitive (can reduce fiduciary liability through 404(c))

Question 31

Items DC Sponsors should Provide Participants (3)

Answer 31

1. An investment framework 2. Guidance 3. A range of investment options

Question 32

To Increase Tax Inefficiency, DC Sponsors should Recommend Participants to... (2)

Answer 32

1. Invest bonds in pre-tax fund | 2. Invest equities in after-tax fund

Question 33

Reasons why DC Governance is more complicated than DB Governance (3)

Answer 33

1. DC plans are participant-directed 2. Participants have unique financial circumstances 3. Participants have different investment abilities

Question 34

DC Sponsors should Facilitate Best-Practice (3)

Answer 34

1. Skills 2. Resources 3. Processes

Question 35

Items DC Sponsors should Review (5)

Answer 35

1. Investment performance 2. Program's effectiveness reaching HR goals 3. Program's likelihood of reaching targeted replacement ratios 4. Asset allocations selected by participants 5. Program's legal compliance

Question 36

DC Governance should Address 3 common DC Structural flaws

Answer 36

1. Participant lack of investment skills 2. Providing a sub-optimal investment line-up 3. Not offering annuities

Question 37

Due to 3 common flaws, DC Fiduciaries should consider the following principles (4)

Answer 37

1. Participants' needs and circumstances 2. Correct framing on retirement adequacy 3. Protect participants from themselves 4. Provide simple but not simplistic solutions

Question 38

Items designed to address structural flaws 1 and 2 (5)

Answer 38

1. Fewer and lower cost investment options 2. Automatic enrollment 3. Auto-escalation contribution rates 4. Professionally managed target-date funds 5. Advice and financial education

Question 39

Key Attributes to a Successful DC Plan (9)

Answer 39

1. Empowerment within the scope of ability 2. Design-making support 3. Comprehensive risk profiling 4. Efficient investment building blocks 5. Offer options with protection 6. Right amount of fund choice 7. Cost controlled 8. Easy-to-understand reporting against objectives 9. Well-defined governance aligned with participant needs

Question 40

Building blocks DC Plan investment structure (3)

Answer 40

Tier 1 funds (Asset allocation funds): Professionally managed TDF and lifestyle funds Tier 2 funds (Core funds): Participant managed funds Tier 3 funds (Specialty funds): Participant managed

Question 41

Advantage of offering Tier 1 funds

Answer 41

Asset allocation decision is outsourced

Question 42

Disadvantage of offering Tier 1 funds

Answer 42

May not reflect participant's unique risk profile

Question 43

Advantages of offering Tier 2 funds (2)

Answer 43

1. Exposed to major asset classes | 2. Can develop desired risk / return profile

Question 44

Should only offer actively managed Tier 2 funds if (2)

Answer 44

1. Believe markets are inefficient | 2. Sponsor can select managers with skill

Question 45

Advantage of offering Tier 3 funds

Answer 45

Attractive to highly compensated and sophisticated participants

Question 46

Items fiduciaries should consider when offering / evaluating TDF (5)

Answer 46

1. Potential impact on decisions / strategy 2. Capacity constraints 3. Manager invested in fund? 4. Fund's principle strategies / objectives and risks 5. Fees

Question 47

Target-Date Glide Path Characteristics affecting Risk / Reward (4)

Answer 47

1. Initial and ultimate asset allocations 2. Slope (market-timing risk) 3. To vs. Through 4. Sub-asset classes (type, weight, active/passive)

Question 48

Glide Path Balances the Following Risks (2)

Answer 48

1. Longevity (higher equity allocation) | 2. Market (higher fixed income allocation)

Question 49

Comparing TDF performance (2)

Answer 49

1. Differentiate based on risk exposures | 2. Apply goals-based framework

Question 50

ERISA DC Fiduciaries responsible for (related to services)

Answer 50

Ensuring services DC plan receives are charged reasonable fees and that services are necessary

Question 51

Best-practice Considerations for ERISA DC Fiduciaries (4)

Answer 51

1. Develop inventory of fees paid by the plan 2. Benchmark fees 3. Review service agreements and contracts for appropriate scope and transparency 4. Assess record keeper services compared to other vendors

Question 52

Plan Fiduciary Responsibilities (2)

Answer 52

1. Act in best interest of participants (Prudence + Care) | 2. Monitor Delegates

Question 53

Services used to help with plan investments (2)

Answer 53

1. Investment management | 2. Investment consulting

Question 54

Role of an independent investment consultant (5)

Answer 54

1. Establish overall investment policies 2. Write investment policy statements 3. Benchmark investment results 4. Ensure all appropriate asset classes are represented 5. Ensure plan fiduciaries are discharging duties appropriately

Question 55

The investment management process (3 steps)

Answer 55

1. Develop SIPP 2. Implement 3. Monitor

Question 56

DB SIPP should address (6)

Answer 56

1. Investment objectives 2. Investment specifics 3. Manager selection/termination 4. Performance measurement (expected return, monitoring) 5. Risks (tolerance, management, measurement) 6. Governance

Question 57

Required Considerations when Setting the DB Investment Policy (3)

Answer 57

1. Liabilities 2. Funded Status 3. Factors affecting funding and solvency

Question 58

Member-Directed DC Plan's SIPP should Include / Address (7)

Answer 58

1. Investment Philosophy 2. Permitted asset classes 3. Default Investment options 4. Monitoring process 5. Manager selection / termination 6. Fees / expenses 7. Investment communications to participants

Question 59

Types of Risks Addressed in SIPP (3)

Answer 59

1. Asset based 2. Liability based 3. Asset-Liability-based

Question 60

Example of Liability-Based Risk

Answer 60

Longevity

Question 61

Example of Asset-Liability Risk

Answer 61

Solvency

Question 62

Example of Assets Risks (17)

Answer 62

1. Active management 2. Alternative asset 3. Asset concentration 4. Compliance 5. Counterparty 6. Country 7. Currency 8. Derivative 9. Index-tracking 10. Inflation 11. Interest rate 12. Investment style 13. Leverage 14. Liquidity 15. Market 16. Operational 17. Securities lending

Question 63

Examples of outcomes investment categories (4)

Answer 63

1. Absolute return 2. Yield-generating assets 3. Low volatility 4. Low correlation with rest of fund

Question 64

Examples of traditional investment categories (2)

Answer 64

1. Style | 2. Geography

Question 65

Sponsor's Fiduciary Responsibility: Ensure Investment Decisions Process (3)

Answer 65

1. Sound 2. Systematic 3. Informed

Question 66

Recommended first step in managers selection process is to consider (5)

Answer 66

1. Number of managers 2. Type (Specialty / Balanced) 3. Style 4. Primary approach (Fundamental / Quantitative) 5. Active / Passive management

Question 67

Factors affecting the manager selection (7)

Answer 67

1. Cost 2. Oversight resources 3. Diversification 4. Benchmark volatility 5. Varying expertise between managers 6. Ability to add value by switching asset classes 7. Market efficiency of different asset classes

Question 68

Desired attributes of the manager (8)

Answer 68

1. Expertise in a specific asset class 2. An established investment team 3. Minimum level of assets under management 4. No significant issues involving the overall organization 5. Low portfolio turnover 6. Above median performance over the past 5 years 7. Below median performance volatility over the past 5 years 8. Reasonable fees

Question 69

Plan size affects the following items (4)

Answer 69

1. Risk distribution 2. Manager selection 3. How funds will be invested (asset classes, type of account) 4. Economies of scale

Question 70

Plan size and its impact on risk (2 small, 2 large)

Answer 70

Small plans: 1. Less asset class diversification 2. Use of separate accounts leads toward active management concentration risk Large plans: 1. Lack of high-quality managers for needed asset classes 2. Balancing active management risk and avoiding low-quality managers

Question 71

Plan size and use of separate and commingled fund

Answer 71

Large plans: Separate accounts | Small plans: Commingled accounts

Question 72

Disadvantages of active management concentration (2)

Answer 72

1. Potentially lower returns | 2. Diverge from peer groups

Question 73

Advantages of separate accounts (5)

Answer 73

1. Access and fee scale to sophisticated managers 2. Can customize plan 3. Can customize tracking error targets 4. Specify risk parameters 5. Can develop performance statistics

Question 74

Disadvantages of customized accounts (2)

Answer 74

1. Require significant oversight | 2. Implementation risks

Question 75

Advantages of commingled accounts (5)

Answer 75

1. Many exist 2. Provide investment solutions 3. Can develop performance statistics 4. Facilitates cost-effective allocations 5. Access to high-quality managers

Question 76

Disadvantages of commingled accounts (2)

Answer 76

1. Active management risk if only one manager | 2. Must monitor the manager's performance, risk and style consistency

Question 77

Typical investment cost (4)

Answer 77

1. Investment management 2. Custodial 3. Transaction costs 4. Administration

Question 78

Small Plans and Costs

Answer 78

Need economies of scale through commingling

Question 79

Performance measurement should be carried out in the context of (3)

Answer 79

1. Plan's current value 2. Current and expected contribution levels 3. Anticipated liabilities or expenditure requirements

Question 80

Advantages of performance evaluation (3)

Answer 80

1. Enhances the effectiveness of a fund's investment policy 2. Identifies the program's strengths and weaknesses 3. Provides trustees evidence program is being conducted appropriately

Question 81

Types of Performance Evaluations (2)

Answer 81

1. Comparative performance | 2. Benchmark-based

Question 82

Properties of a valid benchmark (7)

Answer 82

1. Unambiguous 2. Investable 3. Measurable 4. Appropriate 5. Reflective of current investment options 6. Specified in advance 7. Owned

Question 83

Types of benchmark (7)

Answer 83

1. Absolute 2. Manager universe (median manager or fund) 3. Broad market indexes (TSX, S&P500) 4. Style indexes (small cap, large cap) 5. Factor-model-based benchmark 6. Returns-based benchmarks 7. Custom security-based benchmark

Question 84

Median of Manager Universe as Benchmark not Valid Because (4)

Answer 84

1. Can't be specified in advance 2. Not investable 3. Typically Ambiguous 4. Subject to survivor bias

Question 85

Steps to building custom security-based benchmarks (5)

Answer 85

1. Identify aspects of the manager's investment process 2. Select securities consistent with that process 3. Devise a weighting scheme for the benchmark securities, including cash position 4. Review preliminary benchmark and make modifications 5. Rebalance benchmark on a predetermined schedule

Question 86

Criteria used to test whether a benchmark is good or bad (6)

Answer 86

1. Should be minimal systematic biases relative to the account over time 2. Tracking error should be minimal 3. Account's exposure to systematic sources of risk should be similar to benchmark over time 4. Manager's account should have high coverage relative to benchmark 5. The benchmark's turnover should not be excessive 6. The manager should not be expected to hold largely positive active positions for actively managed long-only accounts

Question 87

Methods of measuring investment returns (3)

Answer 87

1. Money-weighted rate of return (IRR) 2. Time-weighted rate of return 3. Linked internal rate of return

Question 88

Advantage of IRR

Answer 88

Account only valued at the beginning and end of the evaluation period

Question 89

Disadvantages of IRR (2)

Answer 89

1. R can't be solved directly | 2. Sensitive to the size and timing of external cash flows while TWR is not

Question 90

Advantages of TWR (2)

Answer 90

1. Not sensitive to the size and timing of external cash flows 2. Accurately reflects how an investor would have fared over the period

Question 91

Disadvantage of TWR

Answer 91

Account valued every time an external cash flow occurs (more expensive and more error prone)

Question 92

TWR vs. MWR

Answer 92

MWR more appropriate if manager maintains control over the timing and amount of cash flows

Question 93

Stock's risk (definition)

Answer 93

Return variance and covariance with other stock returns in the portfolio

Question 94

Tracking error (definition)

Answer 94

Standard deviation of the difference between the portfolio's return and the benchmark

Question 95

Information ratio (definition)

Answer 95

Portfolio's average active return divided by its tracking error

Question 96

Sharpe ratio

Answer 96

Excess return of the portfolio divided by its volatility

Question 97

Efficient portfolio (definition)

Answer 97

Portfolio with the highest expected return for a target level of risk. Highest information ratio possible given the risk budget. All risks are compensated

Question 98

Active management in an EPM context

Answer 98

Overweighting attractive stocks and underweighting unattractive stocks relative to benchmark weights

Question 99

Four major steps in the EPM investment process

Answer 99

1. Forecasting returns, risks and transaction costs 2. Constructing efficient portfolios 3. Trading stocks efficiently 4. Evaluating results and updating the process

Question 100

Characteristics of a well-structured investment process (6)

Answer 100

1. Sound economic logic 2. Diverse information sources 3. Careful empirical analysis 4. Reliable forecasts 5. Effective implantation 6. Easy to explain

Question 101

EPM Approaches (2)

Answer 101

1. Traditional | 2. Quantitative

Question 102

Traditional Approach

Answer 102

Construct an in-depth stock-specific analysis (talk to senior management, study financial statements, conduct competitive analysis)

Question 103

Advantages of the traditional approach

Answer 103

More in depth knowledge than quantitative approach: - Cope with data errors - Cope with company's structural changes - Understand data sources - Incorporate qualitative factors

Question 104

Disadvantages of the traditional approach (5)

Answer 104

1. Relies heavily on analyst judgement 2. Costly 3. Difficult to evaluate 4. Typically relies on only the most distinctive factors 5. Fewer and larger bets taken

Question 105

Quantitative approach

Answer 105

Use statistical models to forecast each stock's return, risk and cost of trading

Question 106

Advantages of the quantitative approach (8)

Answer 106

1. Transparent 2. Minimizes subjective bias 3. Cost effective 4. Model can be tested historically 5. Can uncover opportunities more quickly and efficiently than traditional approach 6. Spreads risk over many companies 7. Every specified factor considered before reaching a conclusion 8. Model is stochastic

Question 107

Disadvantages of the quantitative approach (3)

Answer 107

1. Subject to specification errors 2. Overfitting 3. Model can be misleading

Question 108

Process for forecasting returns (quantitative approach) (4 steps)

Answer 108

1. Identify signals 2. Test the effectiveness of each signal 3. Determine signal weights 4. Blend output with market equilibrium

Question 109

Forecasting risk

Answer 109

- Consider the frequency of data to use - The more observations the better - Consider giving more weight to recent observations

Question 110

Methods of forecasting transaction costs (2)

Answer 110

1. Examine the complete record | 2. Use own trades to develop a model

Question 111

Transaction costs have two components (2)

Answer 111

1. Implicit costs | 2. Explicit costs

Question 112

Approach to constructing an efficient portfolio (2)

Answer 112

1. Rule-based system | 2. Portfolio optimization

Question 113

Rule-based system

Answer 113

- Rank stocks based on a few key risk factors | - Invests heavily in the highest-ranked stocks while keeping the portfolio's total weight close to the benchmark

Question 114

Advantage of rule-based system

Answer 114

Portfolio is neutral with respect to identified risk factors while overweighting attractive stocks and underweighting unattractive stocks

Question 115

Disadvantages of rule-based system (2)

Answer 115

1. Not very efficient | 2. Can't explicitly consider trading costs

Question 116

Advantages of the portfolio optimization approach (3)

Answer 116

1. Expected returns and risk/cost/constraints better balanced 2. Facilitates portfolio customization 3. Only requires use of forecasts

Question 117

Portfolio optimization caveat

Answer 117

Need to make sure model's inputs are reliable

Question 118

Evaluating results and updating the process

Answer 118

- Compare actual results against expected | - Determine sources of under and over performance

Question 119

Advantages of Alternative Investments (Private Equity or Hedge Fund) (3)

Answer 119

1. Lower volatility 2. Higher absolute and risk-adjusted returns 3. Varied correlations

Question 120

Risks Particularly Unique to Alternative Investments (9)

Answer 120

1. Market 2. Illiquidity 3. Valuation 4. Operational 5. Regulatory Obligations (Lack of) 6. Strategy Risk 7. Counterparty Risk 8. Sub-Advisor Risk 9. Unstable / Unreliable Vendor

Question 121

Common Characteristics of Illiquid Investments (Private Equity) (5)

Answer 121

1. Return Premium (3%+) 2. High dispersion of returns 3. Long time horizon before profits (10+ years) 4. Upfront commitment 5. Potential good fit for pensions

Question 122

Hedge Funds designed to look for (2)

Answer 122

1. Arbitrage opportunities | 2. Pricing Inefficiencies

Question 123

Characteristics of hedge funds (8)

Answer 123

1. Purest form of active management 2. Loosely Regulated 3. Lack of Transparency 4. Performance fees paid 5. Short lived 6. Illiquid 7. May experience capacity constraints 8. Unconstrained with regard to short selling, leverage, instruments, strategies

Question 124

Typical fund fee structure of hedge funds

Answer 124

Fixed management fee + Performance fee subject to high water mark

Question 125

Main advantage of hedge funds

Answer 125

Provide opportunity to both enhance expected returns and reduce risk

Question 126

Short selling (definition)

Answer 126

- Borrow then sell asset and repurchase it later | - Sell high and buy low (hedge against another asset, exploit relative price movements)

Question 127

Hedge fund strategies (4)

Answer 127

1. Relative value 2. Event driven 3. Equity long/short 4. Tactical trading

Question 128

Private Equity Investment (definition)

Answer 128

Any ownership interest not publicly traded, except for real estate

Question 129

Advantages of private equity (5)

Answer 129

1. Efficient market hypothesis does not apply (high returns) 2. Illiquid market may reduce purchase price 3. Long-term focus 4. Have more company control 5. Can decide when to exit investment

Question 130

Disadvantages of private equity (2)

Answer 130

1. Lack of transparency makes analysis difficult | 2. Market illiquid/difficult to sell

Question 131

Private equity investment strategies include (4)

Answer 131

1. Buying start-ups 2. Restructuring large company 3. Repositioning large company 4. Innovation

Question 132

Investment Characteristics of Infrastructure (4)

Answer 132

1. Defensive - less risk (higher barrier to entry, monopoly-like, less sensitive to business cycle, inflation protection) 2. Long operational life 3. High operating margins 4. Reliable long term cash flow

Question 133

Potential advantages of Infrastructure as a pension investment (3)

Answer 133

1. Enhanced diversification 2. Match liability profile with cash flows 3. Higher risk/return optimization

Question 134

Infrastructure's similarities/differences with other asset classes

Answer 134

Fixed income (Long-term predictable cashflow/Inflation hedge, low interest rate risk Real estate (Physical Asset/Barrier to entry, predictable cash flow) Private Equity (Management control/Longer time horizon) Equities (Equity ownership/Fewer securitization)

Question 135

Infrastructure risks (6)

Answer 135

1. Patronage / Demand 2. Regulatory 3. Contractual / Credit 4. Operational / Constrution 5. Financing / Inflation 6. Liquidity

Question 136

Essential Traits Needed for an Infrastructure Investment Team (6)

Answer 136

1. In-depth sector knowledge 2. Transaction capabilities 3. Operational experience 4. Access to Quality deal flow 5. Ability to select best opportunities 6. Apply strict governance

Question 137

Risks with emerging market investments (8)

Answer 137

1. Lack of reliable information 2. Currency risk 3. Poor legal infrastructure (may permit insider trading) 4. Political instability 5. Different accounting systems 6. Transaction costs 7. Shareholder rights 8. Ability to recover investment

Question 138

Major sources of fixed income risk (10)

Answer 138

1. Interest rate risk 2. Yield curve risk 3. Sector risk 4. Credit risk 5. Volatility risk 6. Prepayment risk 7. Currency risk 8. Security-Specific risk 9. Reinvestment risk 10. Liquidity risk

Question 139

Measurement typically used to measure interest rate risk exposure

Answer 139

Duration

Question 140

Ways to construct portfolios with the same duration but different exposures to yield curve risk (3)

Answer 140

1. Bulleted 2. Barbelled 3. Laddered

Question 141

Measurement typically used to measure yield curve risk exposure

Answer 141

Key-Rate Duration (Portfolio's duration that comes from cash flows in each part of the yield curve)

Question 142

Measurement typically used to measure sector risk exposure

Answer 142

Contribution to duration (MV weighted average duration of sector holdings x MV weight holdings in sector)

Question 143

Credit risk usually defined by...

Answer 143

Nationally recognized rating organization

Question 144

Volatility risk

Answer 144

Risk bond value impacted by how much interest rates move in either direction Arises when instrument has asymmetric payoffs

Question 145

Types of risk exposures that arise when investing in embedded options

Answer 145

1. Gamma exposure | 2. Vega risk

Question 146

Gamma exposure

Answer 146

- Market value impact from experiencing a change in interest rates - If you are long volatility then you gain from market movement - Convexity used to quantify gamma exposure

Question 147

Vega risk

Answer 147

- Risk due to a change in the market's expectation of future volatility of interest rates - Volatility duration is used to quantify vega risk

Question 148

Volatility duration

Answer 148

Percentage change in bond price due to a 1% change in expected future (or implied) volatility

Question 149

Prepayment risk

Answer 149

- Defined as the return volatility arising from the over or underestimation of actual prepayment rates - Prepayment duration used to quantify prepayment risk

Question 150

Prepayment duration

Answer 150

-Percentage change in price due to a 10% increase in projected prepayment rates

Question 151

Currency risk

Answer 151

Can mitigate/eliminate risk using currency hedging techniques such as currency forward contracts

Question 152

Active management strategies...

Answer 152

Change the risk exposure of the portfolio to maximize return given a level of risk or minimize risk given a level of return

Question 153

Most widely used active management fixed income strategies (6)

Answer 153

1. Duration timing 2. Yield Curve positioning 3. Sector allocation 4. Security selection 5. Country allocation 6. Currency allocation

Question 154

Combining active strategies using risk budgeting...

Answer 154

Need to allocate risk efficiently across investment idea and strategies

Question 155

Risk budgeting process/steps used to maximize return per budgeted level of risk (7)

Answer 155

1. Determine benchmark 2. Determine investment constraints 3. Determine permissible active strategies 4. Determine maximum tracking error allowed 5. Estimate information ratio 6. Determine the target excess return or tracking error 7. Determine the optimal amount of risk to each strategy

Question 156

Ready to determine appropriate allocation once you determine... (5)

Answer 156

1. What strategies can be used 2. How much could be allocated to each strategy 3. How good you are at generating returns in each strategy 4. How you expect them to move together 5. How much risk or return looking to achieve

Question 157

Successful investing (5)

Answer 157

1. Reposition risk to create return 2. Maximize return per unit of risk 3. Diversify 4. Avoid concentrated risks 5. Understand sources of risk

Question 158

Central them of MPT

Answer 158

Look at the expected return of each investment in relation to the impact that it has on the risk of the overall portfolio

Question 159

Risk and return estimates (characteristics)

Answer 159

1. Estimating expected returns problematic | 2. Estimating volatility is more complex but more easily quantified

Question 160

Implied views (other name)

Answer 160

Hurdle Rates

Question 161

Repositioning risk allocations...

Answer 161

1. Improves the portfolio's expected return | 2. Assets that reduce risk are less expensive on budget

Question 162

Traditional portfolio immunization strategy

Answer 162

Requires prior specification of expected excess return for all of the assets

Question 163

Alternative technique based on MPT to optimize a portfolio's return to risk ratio

Answer 163

- Analyse the risk margins to decide whether to sell/purchase asset - Portfolio optimal when expected excess return per marginal contribution is the same for all assets in the portfolio

Question 164

Advantages of the alternative technique (2)

Answer 164

1. Can calculate excess return on one asset and back out the implied views on all of the others 2. Analysis based on more risk statistics than expected return statistics

Question 165

Active vs management decision

Answer 165

Directed by belief about the EMH

Question 166

EMH

Answer 166

- Active manager can't outperform index - No arbitrage opportunities - Market reflects all information - Stock price movement is random - Stock prices unpredictable apart from a long-term trend

Question 167

EMH supported historically by (2)

Answer 167

1. Net of expenses, most active funds do not outperform index 2. Data does not support strong performance persistence

Question 168

Advantages of passive investing (4)

Answer 168

1. Low management fees 2. No active management risk 3. Low transaction costs 4. Returns close to benchmark

Question 169

Disadvantages of passive investing (3)

Answer 169

1. Most require high dollar minimums 2. No opportunity to reduce risk relative to benchmark 3. Return typically less than benchmark by the amount of management fees

Question 170

ERM steps of evaluating a pension plan's risk (5)

Answer 170

1. Identify the stakeholders 2. Identify risk 3. Quantify risk 4. Separate risk 5. Manage risk

Question 171

Things to consider when managing pension assets relative to the firm's economic strength (4)

Answer 171

1. Corporate risk in addition to pension risk must be considered 2. Must coordinate pension assets with corporate strength to minimize business interference 3. Must reflect liabilities to address surplus volatility 4. Must coordinate pension assets, liabilities and corporate strength to maximize firms expected life

Question 172

Risks to participant and shareholder by funding strategies (3 strategies)

Answer 172

1. Pay as you go: - P: Will company be around to pay benefit - S: Future shareholder must pay benefits 2. Balanced asset allocation: - P: Will the company be able to make up any future shortfall - S: Shortfall/Surplus addressed bu future shareholder 3. ALM asset allocation: - P: Risk is very small - S: Large up-front contribution and minimal possibility of surplus

Question 173

General framework to follow when determining an asset allocation (4 steps)

Answer 173

1. Identify stakeholders and their needs 2. Identify risks 3. Quantify risk 4. Separate and manage risk

Question 174

Three dimensions to risk management

Answer 174

1. Panning 2. Budgeting 3. Monitoring

Question 175

Risk management wants to (3)

Answer 175

1. Identify risk exposure 2. Measure risk exposures 3. Report risk exposures to senior management

Question 176

Measures of risk (2)

Answer 176

1. VaR | 2. Tracking error

Question 177

Risk plan should include/address the following items (6)

Answer 177

1. Set expected return and volatility goals 2. Define points of success and failure 3. Determine how risk capital will be used to meet objectives 4. Determine events that are disappointing vs life threatening 5. Identify critical dependencies 6. Involve senior leadership in the planning process

Question 178

Advantages of involving senior leadership in the risk plan (3)

Answer 178

1. Risk and return issues are addressed, understood and communicated 2. Can better describe context for risk and financial capital allocations 3. Better understand risks needed to generate profits

Question 179

Risk budget

Answer 179

- Amount of risk allocated toward a targeted tracking error - Budget carried out through the asset allocation - Each risk allocation should have a corresponding return expectation

Question 180

Ideal amount of risk

Answer 180

Within risk tolerance

Question 181

Advantages of risk monitoring (2)

Answer 181

1. Ensures transactions are authorized and within risk tolerance 2. Can distinguish material deviations from target that need to be addressed

Question 182

Recommended approach to managing risk

Answer 182

Create an independent risk management unit (RMU)

Question 183

Objectives of RMU (9)

Answer 183

1. Enable stakeholders to better understand and control risk 2. Develop a process to identify and address risks 3. Set and implement the risk agenda and initiatives 4. Identify/report unusual events to management 5. Start comprehensive risk-related discussions 6. Be a focal point where risk topics are identified and discussed 7. Ensure transactions are within risk tolerance 8. Develop risk measurement and performance attribution tools 9. Develop an inventory of risk data

Question 184

Objectives of performance management tools (4)

Answer 184

1. Compare manager against benchmark 2. Compare manager against peer group 3. Confirm whether returns compensate enough for the risk taken 4. Create process to identify superior managers

Question 185

Commonly used performance tools (5)

Answer 185

1. The Green zone approach 2. Attribution of returns 3. Sharpe and Information ratios 4. Alpha vs. Benchmark 5. Alpha vs. peer group

Question 186

Green zone tool

Answer 186

1. Identify excess returns statistically different from targeted excess returns 2. Compare actual tracking error against targeted tracking 3. Form policies for 1 and 2 4. Compile report with the results (Green is within defined expectation, yellow, red)

Question 187

Attribution of returns tool

Answer 187

- Measures the quality of returns | - Determines the sources of the return

Question 188

Sharpe ratio

Answer 188

- Portfolio's excess return / portfolio's standard deviation

Question 189

Information ratio

Answer 189

- Portfolio's excess return / Portfolio's tracking error

Question 190

Advantages of the Sharpe and Information ratio (3)

Answer 190

1. Can compare investment managers within the same peer group 2. Can test whether return compensated enough for risk taken 3. Can use at the portfolio level and individual sector/country level

Question 191

Disadvantages of the Sharpe and Information ratio (2)

Answer 191

1. May require data that is not available | 2. Results may not be relevant if use actual vs. forecasted risk

Question 192

Alpha vs. the Benchmark tool

Answer 192

- Regress portfolio's excess return against the benchmark's excess return - Tool's outputs (intercept + slope) - Apply confidence tests to regression outputs (to test if alpha is statistically significant)

Question 193

Advantages of the alpha vs. benchmark tool (4)

Answer 193

1. Can test whether excess return is skill or chance 2. Can distinguish between excess returns due to leverage vs. skill 3. Easy to calculate 4. Beta shows whether manager used underweighting or overweighting

Question 194

Disadvantages of the alpha vs. benchmark tool (1)

Answer 194

1. May not have enough data points to determine alpha's statistical significance

Question 195

Alpha vs. peer group tool

Answer 195

- Regress portfolio's excess return against the excess return of the manager's peer group

Question 196

Advantages and disadvantages of the alpha vs. peer group tool (4+3)

Answer 196

1. Can test whether excess return is skill or chance 2. Can distinguish between excess returns due to leverage vs. skill 3. Easy to calculate 4. Beta shows whether manager used underweighting or overweighting 1. May not have enough data points to determine alpha's statistical significance 2. Peer group subject to survivorship bias 3. Easier for peer group managers with small portfolios to produce excess returns

Question 197

Recommended framework: Three tenets

Answer 197

1. Objective analysis 2. Unbiased guidance 3. Well understood outcome

Question 198

Framework is applied in 5 key work steps

Answer 198

1. Define the objective 2. Define universe of alternative strategies 3. Analyze the alternatives 4. Implement 5. Monitor

Question 199

Advantages of having an established strategy/being proactive (3)

Answer 199

1. Can act on favorable market conditions 2. Implementation lead time 3. Increasing challenges

Question 200

Common De-risking strategies (4 types)

Answer 200

1. Plan design (Close, Freeze, Reduce benefits) 2. Financial (Addl contrib., lump sum, Borrow-to-fund) 3. Investment (LDI, Dynamic Asset allocation) 4. Insurance (Buy-in, Buy-out, Longevity insurance)

Question 201

Advantages of de-risking (5)

Answer 201

1. Minimized pension volatility (Balance-sheet + Contrib) 2. Secures benefits for participants 3. Increase financial flexbility 4. Increases shareholder value 5. Can focus on core business

Question 202

Risk defined from an asset-liability perspective can be defined as (3)

Answer 202

1. Contribution volatility 2. Funding surplus volatility 3. Probability of avoidance of a large decrease in funded status

Question 203

Problem with Asset Only Perspective

Answer 203

If plan assets outperformed policy benchmark al was well, even if funded status deteriorated

Question 204

LDI

Answer 204

- Maximize return while reducing interest rate risk - Strategy tailored to specific plan needs - Principal measure is the plan's funded status - Investment framework not restricted to just bonds

Question 205

Three key concepts of LDI management (3)

Answer 205

1. Liability duration must be hedged or partially hedged by the assets 2. Asset duration can come from either securities 3. Excess return comes at the cost of increased liability tracking

Question 206

LDI elements

Answer 206

- Marked-to-market liabilities are focus of investing - Appropriate benchmark is plan liabilities - Strategy coordinates assets and liabilities - Strategies are tailored to specific plan needs including interest rate sensitivity, plan design features, etc. - LDI seeks alpha and risk mitigation strategies custom tailored to the sponsor's objectives

Question 207

LDI Checklist (8)

Answer 207

1. Determine objectives 2. Determine pan liability duration 3. Determine desired fixed income allocation 4. Determine portfolio duration 5. Determine additional duration needed 6. Determined degree of comfort with derivatives 7. Determine appetite for active management 8. Monitor LDI strategy against liability benchmark

Question 208

Succesful LDI considerations (4)

Answer 208

1. What risks should be hedged 2. Degree of deviation from immunization 3. Portfolio's expected outcome 4. How will fiduciaries handle costs, leverage, monitoring, etc.

Question 209

Limitations of liability-driven investing (2)

Answer 209

1. Higher expected long-term return is sacrificed for lower risk 2. Availability of certain types of investments may be limited

Question 210

Myths About Liability-Driven Investing (10)

Answer 210

1. LDI always means reducing risk 2. IRR is uncompensated risk so reduce as much as possible 3. LDI can completely eliminate interest rate risk 4. Implement LDI if believe IR will rise 5. LDI reduces equity exposure which increases plan costs 6. Reducing equity exposure will reduce EROA so shouldn't reduce equity exposure 7. Getting a free LDI strategy from a fixed income manager is wise 8. IRR can be hedged by matching the timing of future benefit cash flows and fixed income exposure 9. A good fixed income manager means a good fixed income manager for a LDI strategy just by adding swaps 10. LDI isn't worth the trouble

Question 211

Should consider the following when determining risk tolerance (3)

Answer 211

1. Relative size of company's worldwide pensions to sponsor's size 2. Credit rating/strength of sponsor 3. Plan's funded status

Question 212

Process for developing an optimal portfolio in an asset-liability context (5)

Answer 212

1. Define risk tolerance/preferences 2. Create financial inputs 3. Generate stochastic scenarios 4. Analyze multiple asset allocations 5. Choose portfolio within risk tolerance with highest expected return

Question 213

Two ways to mitigate funded status volatility

Answer 213

1. Asset diversification | 2. Duration management

Question 214

Types of ALM strategies (2)

Answer 214

1. Dedication | 2. Immunization

Question 215

Ways to increase matching if liability duration longer than asset duration (4)

Answer 215

1. Add long-term bonds 2. Replace short-term bonds with long-term bonds 3. Increase inflation-linked assets 4. Use fixed income derivatives (Futures, Forwards, Swaps)

Question 216

Derivatives meet the needs of three groups of people

Answer 216

1. Those who wish to discover information 2. Those who wish to speculate 3. Those who wish to hedge

Question 217

Advantage of derivatives

Answer 217

Don't have to sell existing equity or bond positions to achieve desired duration

Question 218

Disadvantage of derivatives (2)

Answer 218

1. Need sufficient liquidity to fund initial and variation margin requirements 2. Introduces new sources of risk (counterparty, liquidity, valuation, etc.)

Question 219

Types of fixed income options include (3)

Answer 219

1. Call 2. Convertible bonds 3. Swaps

Question 220

Interest rate swap

Answer 220

- Periodic exchange of cash flows - Have a fixed leg and a floating leg - Settlement = Annual rate difference x Notional Principal x Fraction of the year - Swap duration = difference of duration of fixed rate bond and the duration of the floating-rate bond - Swap duration for fixed-rate receiver is positive - The same swap has a negative duration for the counterparty

Question 221

Swaption

Answer 221

- Have a right but not the obligation to enter an underlying swap - Pay an upfront premium - Can set the exercise date to be plan's next measurement date - A purchased receiver swaption provides provides protection against yield below strike level

Question 222

Choices swaption receiver has on exercise date

Answer 222

1. Out of the money : Let option expire | 2. In the money: Take delivery and become receiver of an above market swap OR close out swap and collect FV

Question 223

Swaption collar

Answer 223

- Plan buys one swaption and sells another (buy a fixed rate receiver, sell a floating rate payer) - Reduces or eliminates up-front expense - Receiver option increases in value if rates drop below strike level - Payer option decreases in value if rates increases above strike level

Question 224

Disadvantage of large fixed income allocation

Answer 224

Lower expected returns

Question 225

Advantage of swaps and swaptions (2)

Answer 225

1. Minimizes volatility without changing the asset allocation 2. May have higher return than large fixed income strategy

Question 226

Caveats regarding a risk management strategy involving interest rate derivatives (3)

Answer 226

1. Significant learning curve 2. Should consider underhedge vs. overhedge 3. Model risk

Question 227

Duration

Answer 227

- Modified duration if the first derivative of the bond with respect to a change in interest rate - Second derivative is convexity

Question 228

What drives the price component of a bond ?

Answer 228

Change in price = Change in yield X Duration X -1

Question 229

Convexity typically thought of as a percentage measure

Answer 229

Price gain from convexity = 0.5 X Convexity X Changei n DR

Question 230

Key Rate Duration

Answer 230

Duration at key points on yield curve

Question 231

Advantages of Key Rate Duration over Effective Duration (2)

Answer 231

1. Parallel shifts are rare | 2. Effective duration doesn't properly capture risk exposure

Question 232

Additional risk management tools (2)

Answer 232

1. Buy-out | 2. Buy-in

Question 233

Advantages of buy-out (2)

Answer 233

1. Exports all risks for covered obligation | 2. Reduces expense volatility

Question 234

Disadvantages of buy-out (2)

Answer 234

1. May be more expensive than immunization | 2. Triggers settlement accounting

Question 235

Advantages of buy-in (4)

Answer 235

1. Avoids settlement accounting 2. Exports most of the covered obligation's risks 3. Have buy-out option at no additional cost 4. Reduces expense volatility

Question 236

Disadvantages of buy-in (2)

Answer 236

1. May be more expensive than immunization | 2. Sponsor responsible for making payments

Question 237

Long position

Answer 237

Owning the asset

Question 238

Short position

Answer 238

Owing the asset

Question 239

When to take the long position

Answer 239

Expect asset value to increase

Question 240

When to take the short position

Answer 240

Expect asset value to decrease

Question 241

When to use put option vs. short strategy

Answer 241

Put: Unsure whether security will decrease Short: Confident security will decrease

Question 242

Advantage of Forwards

Answer 242

Customized

Question 243

Disadvantages of Forward (2)

Answer 243

1. Lack of liquidity | 2. Counterparty risk

Question 244

Advantages of Futures (3)

Answer 244

1. Liquid 2. Minimal counterparty risk 3. Can be used to increase/decrease duration

Question 245

Approaches used to preserve capital (3)

Answer 245

1. Cash equivalents 2. Sell index future 3. Put option

Question 246

Asset/strategies negatively correlated with equities (3)

Answer 246

1. Commodities 2. Short sales 3. Selling index futures

Question 247

Types of derivatives (2)

Answer 247

1. Exchange traded derivatives | 2. Non-standard over-the-counter derivatives

Question 248

Fiduciary prudence regarding investment derivative management

Answer 248

- Good documentation (reason for decisions, factors considered) - Minimize risk of large losses

Question 249

Derivative SIP&P/IPS documentation expectations (2)

Answer 249

1. Authorized derivative users | 2. List allowable categories, proportion of assets invested in derivatives, asset amount used for collateral

Question 250

Types of derivative risks (5)

Answer 250

1. Market 2. Liquidity 3. Basis 4. Counterparty 5. Operations and system

Question 251

Derivative risk management practices document expectations (9)

Answer 251

1. Uses and strategies 2. Investment objectives 3. Funds risk tolerance 4. Nature of plan's liabilities 5. Sponsor's funding policy 6. Plan's funded status 7. Sponsor's ability to fund the plan 8. List independent controls 9. Risk management considerations

Question 252

Non-standard OTC risk mitigation best practices (4)

Answer 252

1. Price via independent professional 2. Netting agreements 3. Initial and on-going credit rating 4. Start with standardized documentation

Question 253

Risk mitigation best practices expectations applicable for all derivatives types (9)

Answer 253

1. Quantify potential risks 2. Value derivative 3. Attain legal review 4. Require collateral 5. Have system to monitor and contain risks 6. Limit derivative exposure 7. Limit counterparty exposure 8. Limit derivative activities 9. Compensation policies that reduce risk-taking

Question 254

One approach for setting the plan's asset allocation

Answer 254

Dynamic investment policy - Liability-responsive approach - Glide path

Question 255

Glide path

Answer 255

1. Shifts asset allocation (risk-seeking to risk-protection, shifts when hit trigger) 2. Sponsor's risk tolerance affects the number of trigger points and the degree of shifting

Question 256

Most common approaches to increasing a plan's interest rate hedge ratio (2)

Answer 256

1. Increase fixed income duration | 2. Increase fixed income allocation

Question 257

Most common reason sponsors avoid long-duration fixed income allocations

Answer 257

- Expect rates will rise | - Glide path provides a balanced approach

Question 258

Reasons to establish a target asset duration policy ahead of time (4)

Answer 258

1. Lack of ability to support risk 2. Economic cost vs regret risk 3. Asymmetric risk/reward trade-off 4. Opportunity cost

Question 259

Advantages of a glide path (3)

Answer 259

1. Balanced approach (long-term objectives vs. short term concerns) 2. Predefined triggers 3. Avoids inaction

Question 260

Key Glide Path Design Considerations (4)

Answer 260

1. Clear end state 2. Appropriate trigger points 3. Appropriate monitor frequency 4. Formalized governance framework

Question 261

Most common glide path triggers (5)

Answer 261

1. Interest rate levels 2. Interest rate spreads 3. Funded status 4. Plan maturity 5. Time

Question 262

Items to consider when developing a dynamic asset allocation (4)

Answer 262

1. Evaluate risk/return trade-offs 2. Factors affecting risk/return trade-off 3. Account for risks within hedging strategies 4. One-way or two-way street

Question 263

Factors affecting risk/return trade-off (3)

Answer 263

1. Low funded status 2. Large benefit accruals 3. Frozen or low accrual plan with surplus

Question 264

Method of developing a dynamic asset allocation (5 steps)

Answer 264

1. Determine the current asset allocation policy as normal 2. Determine high-water mark 3. Define high-water mark allocation 4. Fill in the intermediate allocation 5. Define low-water mark

Question 265

Practical considerations regarding a dynamic asset allocation approach (8)

Answer 265

1. Will funded status estimates be readily available 2. Consider month-end shifts after trigger met 3. Integrate contributions with dynamic strategy 4. Consider special allowances regarding rebalancing policy 5. Size of trigger-point frequency and shifting 6. Governance process more complex than static approach 7. Define reporting procedures 8. Conduct formal reviews regularly

Question 266

Longevity risk

Answer 266

1. Can't be addressed by LDI alone | 2. Increases plan's liability and duration

Question 267

Demographic factors that affect longevity risk (6)

Answer 267

1. Number of participants 2. Age 3. Gender 4. Socio economic profile 5. Health profile 6. LS take-up rate

Question 268

Benefit factors that affect longevity risk (2)

Answer 268

1. COLAs | 2. LS option

Question 269

Significance of longevity risk measured in two stages:

Answer 269

1. Estimate likelihood and size of longevity increase | 2. Estimate item 1's impact on the pension liability

Question 270

Methods to manage longevity risk (7)

Answer 270

1. Buy-out 2. Buy-in 3. Lump sum 4. Longevity swap 5. Q-forward 6. Synthetic buy-in 7. Out-of-the-money longevity swap

Question 271

Characteristics of a q-forward

Answer 271

- Forward q's index, date set-up front and dollar amount set up-front - Plan pays dollar amount x forward q - Plan receives dollar amount x fixed q

Question 272

Characteristics of a synthetic buy-in

Answer 272

-Longevity swap combined with other hedges

Question 273

Ideal plan characteristics for a longevity swap (5)

Answer 273

1. Large plan 2. Large fixed income allocation 3. Strong funded status 4. Want to retain some risk 5. Preference to pay de-risking over time

Question 274

Types of longevity swaps (2)

Answer 274

1. Indemnity-based | 2. Index-based

Question 275

Longevity risk transfer

Answer 275

- Converts unknown payment stream into fixed payments - Indemnity-based: Actual experience reimbursed - Index-based: Reimbursement based on a change in mortality index

Question 276

Longevity contract risks (4)

Answer 276

1. Counterparty 2. Rollover 3. Basis 4. Legal

Question 277

Ways to reduce default risk (5)

Answer 277

1. Net approach 2. Collateral 3. Good documentation 4. Review regulatory regime/capital requirements 5. Review financial strength

Question 278

Best practice longevity contract considerations (7)

Answer 278

1. Quantify longevity risk exposure 2. Confirm contract is permitted by SIP&P and permitted by law 3. Minimal administrative complexity 4. Consider contract's duration 5. Lack of liquidity 6. Review risk exposures 7. Actuarial valuation implications

Question 279

Characteristics of an out-of-the-money longevity swap

Answer 279

Longevity swap with a threshold trigger and cap

Question 280

Advantage of buy-outs

Answer 280

Risk irrevocably transferred

Question 281

Disadvantages of buy-outs (3)

Answer 281

1. May trigger settlement accounting 2. Partial buy-out may reduce funded status for remaining population 3. Must fully fund obligation

Question 282

Buy-in best practices (3)

Answer 282

1. Confirm contract is permitted by SIP&P and permitted by law 2. Review default risk 3. Review contract terms

Question 283

Buy-in best practice review /considerations when contract issued by a foreign insurer (5)

Answer 283

1. Regulatory regime 2. Insurer's capital/solvency requirements 3. Coverage/guarantees if default 4. Contract's enforceability 5. Exchange rate risk

Question 284

Buy-in actuarial valuation considerations (4)

Answer 284

1. Value of contract = value of covered benefits 2. Calculate value under different scenarios (ongoing, solvency) 3. Reflect costs under different scenarios 4. Do not smooth value if AVA smoothed

Question 285

Advantages of Buy-Ins (3)

Answer 285

1. No settlement accounting 2. Funded status unaffected (other than cost of contract) 3. Contract can be converted to a buy-out

Question 286

Disadvantages of Buy-ins (2)

Answer 286

1. PBGC premiums still due | 2. Counterparty risk

Question 287

Advantages of Longevity Swaps/Insurance (6)

Answer 287

1. Can retain investment risk 2. Don't need to alter asset allocation 3. Fully funded plan not required 4. Pays de-risking over time / not all up-front 5. Divest unrewarded risk 6. Easier to manage LDI strategy

Question 288

Borrow-to-fund Strategy (5)

Answer 288

1. Facilitates immediate de-risking 2. Low borrowing rates 3. Interest cost offset by PBGC savings 4. Volatile deficit converted to fixed debt 5. Accelerates tax deductions

Question 289

Evaluating the cost of a risk transfer (3 steps)

Answer 289

1. Compare economic liability to insurer premium 2. Economic liability = accounting liability adjusted to reflect PBGC premium, expenses, etc. 3. Consider in-kind asset transfers

Question 290

Risk defined from an asset-only perspective

Answer 290

Volatility of the asset return

Question 291

Investment plan components (3)

Answer 291

1. Asset allocation 2. Risk budget 3. Update and monitor investment plan

Question 292

Asset allocation

Answer 292

- Determines overall risk level and long-run expected return - Determine bond/equity split - Determine allocation to alternative asset classes

Question 293

Other types of risk management investment strategies (2)

Answer 293

1. Alternative investments (Private equity, hedge funds, etc) 2. Alpha-only portfolio

Question 294

Risk management examples of alternative investment strategies (3)

Answer 294

1. Infrastructure assets and private equity match long-term liability characteristics 2. Can hedge inflationary benefit increases with commodities and many infrastructure assets 3. Alternative assets have a low correlation with stock and bonds

Question 295

Potential pitfalls and challenges of alternative investments (5)

Answer 295

1. Valuation and performance measurements difficult 2. Leveraging used 3. Short histories and a lack of robust data 4. High costs 5. Less control

Question 296

Risk management examples of alpha-only portfolios (2)

Answer 296

1. Can hire a skilled manager that invests in a market deemed to be too risky 2. Return correlation can be measured against other alpha and beta portfolios

Question 297

Change in asset allocation risk (4)

Answer 297

1. Drift 2. Undeployed cash 3. Currency deviations 4. Manager or benchmark transitions

Question 298

Ways to minimize allocation risk (2)

Answer 298

1. Rebalancing | 2. Completion manager

Question 299

Effectiveness of ALM strategy can be reduced by (2)

Answer 299

1. Payment amount uncertainty | 2. Timing of payment uncertainty

Question 300

Events that cause change in duration and method for keeping duration on track

Answer 300

1. Change in yield curve or passage of time | 2. Rebalancing required

Question 301

Pension put theory suggests investing in ... is optimal

Answer 301

Equities. Equities increase value of put.

Question 302

Tax arbitrage theory suggests investing in... is optimal

Answer 302

Matching bonds

Question 303

Labor-relations theory suggests investing in... is optimal

Answer 303

Equities (high return, used to fund or increase benefits)

Question 304

Accounting theory suggests investing in... is optimal

Answer 304

Equities. Reduces expense

Question 305

Pension Liability theory suggests investing in... is optimal

Answer 305

Depends on whether tying to hedge interest rate risk and /or future salary

Question 306

Pension put's value increases with (5)

Answer 306

1. Duration 2. Reduction in sponsor's credit rating 3. Asset liability mismatch 4. Reduced funded status 5. Plan contributions

Question 307

Plan contributions increase pension put because (3)

Answer 307

1. Pension assets are risky 2. Pension has long maturity 3. Plan members are passive

Question 308

Labor-relations explanations for typical high equity allocation (2)

Answer 308

1. Fiduciary concerns | 2. Surplus sharing/entitlement

Question 309

Pension liability theory

Answer 309

1. ABO is metric of interest (Matching bonds optimal) | 2. PBO is metric of interest (Include equities to provide long-term hedges)

Question 310

Inputs for ALM (3)

Answer 310

1. Asset assumptions 2. Liability assumptions 3. Financial assumptions

Question 311

Setting ALM assumptions (4)

Answer 311

1. Start with a historical analysis and combine with current economic conditions 2. Bond expected return needs to reflect capital appreciation due to change in rates 3. Equity risk premium approach typically used to set expected return for equities 4. Determine correlations matrix

Question 312

Efficient frontier

Answer 312

Portfolio's best risk/reward combination (highest yield for a given risk or lowest risk for a given yield)

Question 313

Risk and reward measures may consist of any variable including (Asset perspective (3), Asset-Liability perspective (6))

Answer 313

Asset perspective 1. Portfolio return 2. Real return 3. Wealth Asset-Liability perspective 1. Surplus 2. Funded ratio 3. Contributions 4. Expense 5. Benefits paid 6. Charges to balance sheet

Question 314

Efficient frontier methodology (2)

Answer 314

1. Single period | 2. Non-linear programming

Question 315

Reasons for using constraints in efficient frontiers include (4)

Answer 315

1. Liquidity issues 2. Fiduciary issues 3. Accuracy of estimates 4. Investment policy issues

Question 316

ALM- Monitoring the follow-up

Answer 316

- Every 3 to 5 years - Accelerates if changes in : - Plan benefit structure - Funded level - Risk tolerance - Economic conditions - Plan demographics - Results

Question 317

Traditional asset allocation vs ALM: Investment objective

Answer 317

Maximize return per unit of volatility vs Minimize cost per unit of volatility

Question 318

Traditional asset allocation vs ALM: Equity exposure

Answer 318

Subject to risk tolerance of trustees vs Virtually dictated by liabilities and funded status

Question 319

Traditional asset allocation vs ALM: Bond duration

Answer 319

Intermediate duration provides higher return per unit of volatility vs Long duration provides lowest cose per unit of volatility cost

Question 320

Traditional asset allocation vs ALM: Funding policy

Answer 320

Set through regulations and negotiated assumptions vs Integrated with investment policy to minimize risk adjusted PV of future contributions

Question 321

Traditional asset allocation vs ALM: Benefit policy

Answer 321

Maximize benefit per unit of cost on deterministic actuarial basis vs Maximize benefit per unit of risk adjusted cost

Question 322

Sources of public pension savings (ways to save taxpayers money) (7)

Answer 322

1. Better asset/liability matching 2. Extend the dollar duration of the fixed income portfolio 3. Amount of equity exposure 4. Rebalancing rules 5. Funding policy 6. Using a stochastic integrated approach 7. ALM enforces investment discipline

Question 323

Suggested reasons against shifting equities in public funds to bonds (5)

Answer 323

1. Government has no shareholders 2. Government pays no taxes 3. GASB not rushing toward a transparent economic accounting model 4. Taxpayers can move to avoid troubled pension fund whereas shareholders must find buyers 5. Indefinite lifetime of government plans

Question 324

Disadvantages of investing public pension plans in equities (5)

Answer 324

1. Subject to market risk 2. Lowers contribution for current tax payer but passes risk onto future generation 3. Current taxpayers subject to under-pricing risk 4. Surplus may not go back to taxpayer but used to enhance benefits 5. Higher governmental borrowing cost

Question 325

Obstacles to investing public plans exclusively in bonds (2)

Answer 325

1. Politicians prefer lower taxes now and passing risk to future generation 2. Lack of accounting transparency hides amount of risk being passed on

Question 326

How do public plans differ from private plans (5)

Answer 326

1. Less oversight 2. Diffuse governance 3. Budgeting process and accounting standards 4. Design issues 5. Higher public transparency

Question 327

Problem with government accounting

Answer 327

Liability uses EROA vs. market discount rate

Question 328

Public plans need to balance... (3)

Answer 328

1. Fulfilling promises to retirees 2. Maintaining reasonable pay and benefits for employees 3. Reasonable tax assessment

Question 329

Actions increasing stress on public plans (3)

Answer 329

1. Insufficient funding 2. Excessive benefit levels 3. Inappropriate benefit design

Question 330

Four common contributors of stress

Answer 330

1. Slippery slope of skipping contributions 2. Managing surplus 3. Asset-liability mismatch 4. Competing objectives of controlling authorities

Question 331

Three main financial levers can be used to control risk

Answer 331

1. Benefit levels 2. Contributions paid by employees and employers 3. Investment policy

Question 332

The risk management system should establish policies and mechanisms to support... (4)

Answer 332

1. Continuous funding 2. Education of administration and employees 3. Avoiding misaligned/mispriced plan provisions 4. Identifying stakeholder objectives that clash with system objectives

Question 333

Risk management framework (5 steps)

Answer 333

1. Identify participants/stakeholders 2. Define the objectives of the risk system 3. Define the sponsor's risk budget 4. Evaluate range of risk mitigation approaches 5. Maintain a feedback process

Question 334

When identifying participants/stakeholders, document... (2)

Answer 334

1. Where they conflict with each other | 2. Misalignment of principal and agent interests

Question 335

Public pension stakeholders (6)

Answer 335

1. Society/Taxpayers 2. Public employees 3. Unions 4. Public sector employers 5. Retirement system governing body 6. Elected officials

Question 336

Defining objectives of the system

Answer 336

May be difficult due to competing interests

Question 337

Considerations when defining system's objectives and risks to be managed (5)

Answer 337

1. Sustainability 2. Equitable costs for taxpayers 3. Appropriate funding 4. Benefit design 5. Governance that mitigates the competing objectives of stakeholders

Question 338

Risk budget steps (4)

Answer 338

1. Define the risk budget 2. Scenarios in which the budget might be exceeded 3. Risk mitigation strategies that can be used 4. Process and time horizon to implement strategy

Question 339

Example of systematic risk

Answer 339

Longevity risk affecting pool as a whole

Question 340

Example of tail risk

Answer 340

Lower tax revenue when contributions increase

Question 341

Risk mitigation techniques (5)

Answer 341

1. System discipline 2. Pricing discipline 3. Budgetary discipline 4. Traditional risk mitigation 5. Depending on regulatory backstop structure

Question 342

System discipline examples (2)

Answer 342

1. Tight control over surplus uses | 2. Risk-sharing plan provisions

Question 343

Pricing discipline examples (4)

Answer 343

1. Using market values 2. Stochastic measurements 3. Stress and specific scenario testing 4. Analyzing trade-offs if changes made

Question 344

Budget discipline examples (2)

Answer 344

1. Align revenue with costs | 2. Ensure cost variability can be supported by taxpayers

Question 345

Regulatory backstop if system fails

Answer 345

Increases taxes

Question 346

Items that distort the pension plan feedback loop (4)

Answer 346

1. Long time horizon 2. Dysfunctional control structure 3. Lack of effective regulatory standard 4. Economic and demographic cycles

Question 347

Funding dysfunction occurs when (4)

Answer 347

1. Employer not required to make needed contributions 2. Non-actuarial method used to determine contributions 3. Benefits not adjusted if contributions are insufficient 4. There are no surplus restrictions

Question 348

Approach taxpayers should consider implementing to manage risk (6)

Answer 348

1. Report liability on a market basis 2. Freeze future DB accruals 3. Invest existing DB assets in matching treasuries 4. Address remaining deficit 5. Provide DC accruals prospectively 6. Allow employees to participate in Social Security prospectively

Question 349

Federal government could incent reforms (2)

Answer 349

1. Encourage state-local govt to issue bonds to finance deficit 2. Provide subsidies with conditions (Freeze DB accruals, reduce ancillary benefits, require asset liability matching, etc.)

Question 350

Purpose of funding policy

Answer 350

Ensure benefits can be paid on on-going basis and on solvency basis

Question 351

Advantages of developing a funding policy (6)

Answer 351

1. Improves understanding and management of risks 2. More robust governance 3. Increased funding discipline 4. Increased transparency 5. Provide guidance to the actuary (selection of assumptions and cost methods) 6. Documents sponsor's objectives and how will meet them

Question 352

Factors that should be taken into account when developing a funding policy (9)

Answer 352

1. Benefit security 2. Stable and affordable contributions 3. Sponsor's financial situation and needs 4. Plan population demographics 5. Legal minimum funding requirements 6. Plan's funded status 7. Agreement between sponsor and participants 8. ITA maximum limits 9. Use of surplus requirements

Question 353

Best practice issues that should be considered when developing a funding policy (11)

Answer 353

1. Plan overview 2. Funding objectives 3. Key risks faced by the plan 4. Funding volatility factors and management of risk 5. Funding target ranges 6. Cost sharing mechanism 7. Utilization of funding excess 8. Actuarial methods and assumptions 9. Frequency of valuations 10. Monitoring 11. Communication policy

Question 354

Funding target ranges should describe desired (3)

Answer 354

1. Funding target 2. Contribution levels 3. Cost sharing

Question 355

Funding policy should be aligned with the (4)

Answer 355

1. Decision making process 2. Sponsor's objectives 3. Plan objectives 4. Investment policy

Question 356

Key risks that can affect benefit security and funding volatility (2)

Answer 356

1. Asset liability mismatch | 2. Plan population specifics

Question 357

Multi-employer pension plans funding policy should describe (5)

Answer 357

1. Approach used to set the benefit levels 2. Risks related to fixed contributions 3. Decision making roles of trustees, employers and union 4. How intergenerational equity will be addressed 5. Policy regarding benefit reductions (when adjusted, what is adjusted, etc.)

Question 358

Actuarial violation of corporate finance principles (4)

Answer 358

1. Intergenerational inequity 2. Underpricing pensions in compensation decisions 3. US GAAP biases investment decisions 4. Smoothing conceals risk

Question 359

How do financial economists and actuaries believe pensions should be valued?

Answer 359

Actuaries - Reflect equity risk premium - Use EROA - Smooth gains and losses - Level contributions Financial economists - Do not reflect equity risk premium (reflect gain when earned) - Risk-adjusted discount rate (matching bond portfolio) - Report ABO not PBO - Focus is market-based vs. level contributions

Question 360

Financial economists: reporting of pension surplus

Answer 360

Only report if invested in matching bonds

Question 361

Pension finance utilizes the following liability calculations (3)

Answer 361

1. Market liability 2. Solvency liability 3. Budget liability

Question 362

Differences between pension finance liability calculations explains the following

Answer 362

- Market liability - Solvency liability = Default risk | - Market liability - Budget liability = Expected equity risk premium

Question 363

Financial economics preference for corporate reporting (5)

Answer 363

1. Balance sheet = deficit 2. Expense = change in deficit 3. Charge against operating income = SC 4. Finance charge = IC - actual return on assets 5. OCI adjustment (demographics g/l, assumption changes, amendments)

Question 364

Additional arguments of financial economists (3)

Answer 364

1. Asset liability mismatch passes risk to someone other than sponsor 2. Budgeting model inadequate (does not ensure security when poorly funded 3. Cost of pension fund is independent of the way it is funded

Question 365

Additional arguments by actuaries regarding valuation models (2)

Answer 365

1. Financial economics limitations (no matching assets) | 2. Cash flow matching may not be optimal

Question 366

Two methods of calculating the market value of the liability per actuary's understanding of financial economics

Answer 366

1. Project the salary with the expected salary growth and discount the benefit with the expected return on the matching assets 2. Project the salary with the risk-adjusted salary growth and discount the benefit at the risk-free rate

Question 367

Ways of calculating risk-adjusted salary growth (2)

Answer 367

1. Calculated the expected value of salary growth using risk neutral probabilities 2. Use the following formula : k* = k+ p*j*(r-i)/s

Question 368

Law of one price

Answer 368

- Marked-to-market accounting based on the law of one price - Two financial instruments that generate identical cash flows and are both tradable in an efficient market must have the same price

Question 369

Typical approaches to managing pension (3)

Answer 369

1. Silo approach (not integrated into ERM) 2. Decisions focus on shareholder value 3. Key measures (improve operating earnings, reduce earnings volatility)

Question 370

Recommended approaches for corporations

Answer 370

Incorporate holistic balance sheet approach into risk management, strategic planning, decision making and financial metrics

Question 371

Empirical evidence of pension effects

Answer 371

1. Large plan size relative to business = greater stock price volatility/beta, greater cost of capital 2. Pension debt viewed as riskier than other debt 3. Plan freeze/close neutral on stock price 4. Credit rating impact : Buy-out = neutral, ALM = positive 5. Credit spreads impact (asymmetric effect, ALM de-risking not significant)

Question 372

Principles from financial economics regarding pensions (7)

Answer 372

1. Should not destroy shareholder value 2. Invest in matching bonds (tax arbitrage) 3. Use economic pension liability 4. Transparent accounting (no EROA/smoothing 5. Pension deficits are corporate debt 6. Surplus/deficit impacts are asymmetric on credit rating and stock value 7. Allocate/manage pension risks efficiently

Question 373

Economic pension liability reflects (4)

Answer 373

1. ABO 2. PBGC costs 4. Termination rate 5. Embedded options

Question 374

Pension deficits vs other corporate debt (2)

Answer 374

1. Borrowed from employees | 2. Not efficient (volatile, greater impact on credit rating, subject to PBGC premium)

Question 375

Observations of the holistic balance sheet (4)

Answer 375

1. Uses economic pension liability 2. Net pension obligation approach lacks transparency 3. Buyout removes assets and liabilities 4. Remove assets/liabilities for hedged pension liability

Question 376

Holistic balance sheet considers all sources of funding (3)

Answer 376

1. Plan assets 2. Sponsor support 3. Value of PBGC insurance

Question 377

Pensions can materially impact the following decisions (2)

Answer 377

1. Raise equity or debt capital (affected by size of deficit relative to company) 2. Issue fixed or floating rate debt (affected by plan's interest rate risk)

Question 378

Key corporate finance metrics affected by pensions (3)

Answer 378

1. Corporate leverage (debt to equity ratio) 2. Income/ cash flow adjustments made by rating agencies 3. WACC

Question 379

Corporate leverage ratios include (3)

Answer 379

1. Debt to equity ratio 2. Long term debt to equity ratio 3. Total assets to equity ratio

Question 380

Moody's credit rating adjustment (2)

Answer 380

1. Only SC included in pretax income 2. If the plan is underfunded - Implied interest =deficit x marginal borrowing rate - Implied interest subtracted from pretax income - Contributions in excess of SC reclassified

Question 381

Standard and Poor's credit rating adjustment

Answer 381

Items offset against core earnings: - SC - Interest cost not covered by the actual return

Question 382

Risk budgeting

Answer 382

Amount spent to mitigate risk

Question 383

Questions managers should ask (2)

Answer 383

1. How does pension risk reward the corporation? | 2. Which risks should be hedged / retained / transferred?

Question 384

Key goals of ERM

Answer 384

Determine how much risk should be taken and how

Question 385

ERM

Answer 385

1. Analyze the trade-off between risk and capital | 2. Allocate shareholder capital to different risks

Question 386

Risk budgeting approaches (5)

Answer 386

1. VaR 2. TVaR 3. Ruin probability 4. Sensitivity analysis 5. Maintain equity and debt betas

Question 387

Equity Capital (reserve)

Answer 387

1. Complete a risk budgeting approach | 2. Set aside reserve based on quantified risk

Question 388

Key concepts regarding capital

Answer 388

1. Uses - Grow income - Mitigate risk 2. Ways to raise capital - Debt - Issue shares

Question 389

Outside considerations that may explain corporate preference for equities (12)

Answer 389

1. Cost reduction 2. Professional advice 3. Legal issues (PPR) 4. Wider interests of shareholders 5. Signaling 6. Inertia 7. Strong historical equity growth disguises risk 8. Accounting methods reward equity allocation 9. Failure by analysts and investors to see through opaque accounting 10. Asset allocation risk not reflected in insurance premiums 11. Competitive reasons 12. Short-term risks are self-corrected in the actuarial process

Question 390

Inside considerations that may explain corporate preference for equities (5)

Answer 390

1. The role of corporate managers (incentive to increase their own wealth) 2. Direct interest of management in pension scheme (generating surplus) 3. Preference for rewarded risk 4. Scope for creative accounting 5. Better correlated with salaries

Question 391

Reasons why subjective judgments should be avoided (selecting discount rate that results in a lower liability than its economic value) (4)

Answer 391

1. People tend to overrate their ability to forecast asset prices and returns 2. Stakeholder may further their own interests at the expense of other stakeholders 3. Actuaries susceptible to client pressures 4. More open to criticism

Question 392

Financial economists : Reasons to shift asset allocation from equities to 100% duration matched bonds from the shareholders view (9)

Answer 392

1. Investor can invest equities in own portfolio 2. Benefit security 3. Reduce investment management fees 4. Reduce sponsor's financial risk 5. Tax arbitrage 6. Cost of pension fund independent of way it is funded 7. Reduces asymmetry risk 8. Reduces underpricing risk 9. Surplus asymmetric reward/risk

Question 393

Effect of financial economic assumptions on arbitrage amount (4)

Answer 393

1. Equity return assumption does not impact after-tax income 2. Arbitrage is proportional to bond return assumption 3. Arbitrage is proportional to individual tax rate spread 4. Arbitrage is proportional to (1-corporate tax rate)

Question 394

Arbitrage amount formula

Answer 394

Plan assets x Tax spread x bond return x (1 - corporate tax rate)

Question 395

What are advantages about borrowing money and then purchasing duration matched bonds if have a pension deficit? (6)

Answer 395

1. Leaves net liabilities unchanged and borrowing capacity undiminished 2. Can take tax deduction on principal immediately vs deferred on loan used to fund plan 3. Accelerate deductions on interest on loan vs. funding plan's interest cost later 4. Does not compete with borrowing to fund capital investment 5. Employees happier 6. Shareholders happier because full funding can create tax arbitrage

Question 396

Advantages of VBO accounting over PBO accounting (9)

Answer 396

1. Immunizes employees so don't bear brunt of plan design changes 2. Clarifies employment contract 3. Reduces dependency on ambiguous implicit contracts 4. Minimizes opportunities for gaming 5. Reduces the threat and cost of regulation 6. Provides transparency to investors 7. Gives management more plan design flexibility 8. Would illuminate total cost of plan amendments immediately to shareholders 9. Avoids moral hazards

Question 397

Types of contract risks faced by employees (3)

Answer 397

1. Demographics risk 2. Firm-specific risk 3. Moral hazard

Question 398

Principles behind contracts (2)

Answer 398

1. Increasing employment contract risk may be efficient up to a limit 2. Exposing employees to moral hazard is generally inefficient

Question 399

DB plan contract design from an employer and employee perspective (4)

Answer 399

1. Compensation is withheld 2. Trains employees to enhance future productivity 3. Motivates them to perform under the risk of losing value withheld 4. Rewards them at retirement

Question 400

What is one way to identify a frail plan design?

Answer 400

ABO significantly larger than VBO (Put's employees compensation at risk/creates a moral hazard) Employees will demand a higher pay in this situation

Question 401

Frail design features (5)

Answer 401

1. Subsidized early retirement with cliff eligibility 2. Revocable benefit promises 3. Past service benefits 4. Plan shutdown benefits 5. Cash balance conversions

Question 402

Benefit design features that reduce post-employment frailty (3)

Answer 402

1. Fund individual accounts 2. Modest class-year vesting 3. Full vesting at an age when retention is no longer a goal

Question 403

Moral hazard provides opportunity for exploitation which if acted on can... (4)

Answer 403

1. Diminish employee morale 2. Increase turnover 3. Cause recruiting difficulties 4. Lead to lawsuits

Question 404

Typical funding regulations for determining minimum contributions (3)

Answer 404

1. Formula based on funded status 2. Determined on plan-specific basis 3. Based pension asset's risk profile

Question 405

Current funding regulations are procyclical which have the following effects (3)

Answer 405

1. Contribution requirements inversely correlated with economic conditions 2. Affect investment strategies 3. Benefit changes correlated with economic conditions

Question 406

Disadvantages of procyclical funding regulations (3)

Answer 406

1. Increased pressure on sponsors when economic conditions are bad 2. Unstable contributions 3. DB plans discontinued

Question 407

Goals of counter-cyclical pension plan funding (3)

Answer 407

1. Long-term viability 2. Stability 3. Benefit security for participants

Question 408

Counter-cyclical approach : Funding regulations that want to achieve long-term viability, stability and security should (3)

Answer 408

1. Encourage additional contributions when sponsor' finances are strong (deficit reduction contributions, surplus build-up) 2. Maintain predictable costs and dampen volatility 3. Give sponsors more control over managing risks and costs

Question 409

Counter-cyclical approach : What type of funding regulations is better aligned with goals of funding regulations

Answer 409

Counter-cyclical

Question 410

Counter-cyclical funding policies should incorporate the following principles (8)

Answer 410

1. Avoid excessive reliance on market values 2. Funding targets that provide benefit security 3. Allow overfunding in good economic times 4. Limit contribution holidays and sponsor's access to surplus 5. Actuarial methods producing stable contribution patterns 6. Flexible rules that reflect funding volatility 7. Avoid over-regulation 8. Maintain stable regulatory environment

Question 411

Smoothing techniques as an alternative to market techniques include (3)

Answer 411

1. Average interest rate 2. Smoothed value of assets 3. Average funded ratio

Question 412

Caveats with smoothing (2)

Answer 412

1. Use consistent techniques for assets and liabilities | 2. Can mask plan that is in serious financial trouble

Question 413

Ways to develop funding targets that promote benefit security (2)

Answer 413

1. Increase funding target if exposed to asset liability mismatch 2. Target should reflect insurance schemes (conservative target if benefits not insured)

Question 414

Methods to allow overfunding in good economic times (3)

Answer 414

1. Maximum limit based multi-year period 2. Increase maximum surplus level before suspending contributions 3. Max based smoothing metric

Question 415

Ways to limit access to surplus (3)

Answer 415

1. Require additional benefits 2. Allow partial withdrawal above specified 3. Excise tax

Question 416

Ways to incorporate flexible rules that reflect funding volatility (3)

Answer 416

1. Allow longer amortizations if use market techniques 2. Allow letter of credit to secure deficits 3. Allow trustee to set prudent recovery period

Question 417

PBGC is designed to be self-financing through (4)

Answer 417

1. Premiums (fixed and variable) 2. Assets acquired by terminating plans 3. Investment returns 4. Bankruptcy recoveries

Question 418

Filing a claim with the PBGC (4 conditions)

Answer 418

1. Member guarantee is limited 2. Must be in severe financial distress 3. Plan must be underfunded 4. PBGC may terminate plan without employer consent

Question 419

Flaws in the pension insurance system (6)

Answer 419

1. Premiums set by congress 2. Premiums not properly priced 3. Funding requirements inadequate 4. Funded status not transparent 5. Subject to systematic risk 6. Low-risk sponsors subsidizing high-risk sponsors

Question 420

Reforms needed that... (6)

Answer 420

1. Implement risk-adjusted premiums 2. Tighten funding rules 3. Restrict investment policies 4. Allow PBGC to purchase reinsurance 5. Require regular and timely disclosures 6. Given pensions seniority over other creditors

Question 421

Should charge risk-adjusted premiums reflecting (3)

Answer 421

1. Probability firm will experience distress 2. Full extent of underfunding 3. Asset-liability mismatch

Question 422

Factors contributing to inadequate funding requirements (3)

Answer 422

1. Asset and liability smoothing 2. Extended amortization of plan amendments 3. Credit balances

Question 423

Approaches to reform (2)

Answer 423

1. Implement market incentives to existing system | 2. Mandate firms purchase insurance through private market

Question 424

Potential criticisms of privatization (3)

Answer 424

1. PBGC should be viewed as a social insurance program 2. Difficult to insure systematic risk in private market 3. Transition difficult for poorly funded plan

Question 425

DB funding regulations should aim for (3)

Answer 425

1. Benefit security 2. Acceptable costs to sponsors 3. Encouraging DB plans

Question 426

Purpose of pension regulations is to enhance (3)

Answer 426

1. Equity 2. Adequacy 3. Benefit security

Question 427

Three types of market risks pension regulations should address (3)

Answer 427

1. Information asymmetry 2. Externality 3. Monopoly

Question 428

Caveats of excessive regulations (2)

Answer 428

1. Discourage participation | 2. Reduce competitiveness

Question 429

Societal issues regarding trend from DB to DC (4)

Answer 429

1. Not saving enough 2. Poor investment choices 3. High management costs 4. Increasing cost of annuity purchase rates

Question 430

Examples of regulatory features that discourage DB plans (4)

Answer 430

1. Minimum benefit requirements 2. Investment guarantees 3. Mandatory indexation 4. Surplus restrictions

Question 431

Ways to regulate risky investments (2)

Answer 431

1. QAR | 2. PPR

Question 432

Current regulatory needs (2)

Answer 432

1. Address longevity risk | 2. Require counter cyclical funding

Question 433

Advantages of PPR vs QAR (2)

Answer 433

1. Can invest on the efficient frontier | 2. Does not restrict free market

Question 434

Disadvantages of QAR (3)

Answer 434

1. Not needed for diversification since PPR requires diversification 2. Restricts investment liquidity vs. investor's liquidity position 3. Plan's specific liability duration not reflected

Question 435

Regulatory enforcement of QAR vs PPR

Answer 435

QAR: confirm rues not broken PPR: assess validity of the investment approach

Question 436

Risk-based regulations to address funded status risk / asset-liability risk in DB plans (4)

Answer 436

1. VaR 2. Stress testing 3. Scenario testing 4. Score card

Question 437

Examples of risk-based funding regulations (2)

Answer 437

1. Adjust funding target | 2. Require stress tests

Question 438

Risk-based funding regulations should reflect (5)

Answer 438

1. Nature of plan risks 2. Extent benefits can be modified 3. Extent contributions can be raised 4. Sponsor's creditworthiness 5. Whether benefits are insured

Question 439

Stress test caveats (2)

Answer 439

1. Valid model outcomes needed for success | 2. Can lead to complacent risk management

Question 440

Risk scoring process (5 steps)

Answer 440

1. Complete detailed profile of fund 2. Identify management units 3. Assess risks 4. Assign a score 5. Score drives frequency of on-site inspections

Question 441

Caveats with an insurance-based regulatory approach (4)

Answer 441

1. Guarantor may default 2. Moral hazard 3. Conflicting regulations 4. May discourage participation

Question 442

Caveats with risk-based regulations (3)

Answer 442

1. Encourages short-term investment policies 2. Model risk / assumption risk 3. Herd outcomes

Question 443

Ways to regulate DC costs (3)

Answer 443

1. Direct 2. Central agency 3. Transparency

Question 444

Ways to regulate DC Risks / Outcomes includes restricting investments via (4)

Answer 444

1. QAR 2. Stress testing 3. Daily VaR ceilings 4. Risk scoring

Question 445

Caveats with DC investment regulations (3)

Answer 445

1. Greater low risk allocations can harm retirement outcome 2. Sell equities during market downturn 3. Subject to modeling error

Question 446

Ways to regulate longevity risk for DC Participants (4)

Answer 446

1. Require annuitization 2. Subsidize / fix price of annuities 3. Regulate broker commissions 4. Electronic quotation system

Question 447

Ways to regulate transparency and financial education for DC participants (5)

Answer 447

1. Auditor report 2. Benefit statements 3. Benefit risk simulators 4. Fee disclosure 5. Require financial education