Return Objective of a Pension

CFA Level III
#1

An answer to a mock says:

’The R.O is for the plan to achieve a NOMINAL return that is sufficient to fund the liabilities on an inflation adjusted basis. Therefore it is the discount rate of 8% + Inflation of 1.5% = 9.5%.

I am confused as I have never seen a return with inflation included. The passage does not seem to explicity suggest they are after a nominal return. Is this answer correct?

I always thought the answer was always just the discount rate, and inflation was included within that number.

Can someone please confirm?

#2

Are the pension payments indexed to inflation?

#3

Hi S2000,

I have misread - it was not inflation of 1.5% that was added.

There is a sentence which says:

In an effort to restore the plan’s surplus, the trustees wish to pursue a return 150bps above the actuary discount rate.

Presumably this is what was added. I think its a strange question and confusing - as usually when we are in underfunded we do not take on more risk to increase the funded status of the plan.

#4

It would have been nicer if their excess return target were a number slightly different from inflation.

#5

S2000, if the board ask for an excess return target above discount rate would that become the Return requirement?

#6

Yes.

#7

I was under the impression that the return requirement was just the discount rate of the liabilities; and if they wanted anything in excess of that, that would be the return objective?

#8

So, if the plan is underfunded the objective is . . . to remain underfunded?

#9

Okay, makes sense. So if the plan is underfunded the return REQUIREMENT would be higher than the discount rate of liabilities; and they will likely tell us a return that they need to bring it up to fully funded, which we add to the discount rate?

I got confused above, as Rex said typically when a plan is underfunded they don’t take on more risk,