Please advise…
I would think no equity, since it is used to match future real wage growth and with a frozen plan there are no future benefits to account for. Should be just nominal & inflation-linked bonds.
DING DING DING
There’s not enough info to answer.
If it’s underfunded, it’ll need equity, or other risky assets, if the company doesn’t want to make further contributions. Or no equity/risky assets if the company will continue to make contributions to the plan. Just b/c it’s frozen doesn’t mean its funded status is irrelevant.
If it’s fully funded, you can just immunize the liabilities with appropriate debt securities and manage it from there. No equity needed if you manage immunization appropriately.
Curriculum:
For frozen pension plans, the liability attributable to future benefits is zero and therefore doesn’t need to be considered. That is, for frozen plans the accrued benefit liability is the ultimate liability of the plan and has market exposures that are best mimicked by a combination of nominal and index-linked bonds.
So, no more new participants. Only accrued benefits, either to reitrees or deferrds, payments will grow only by inflation if indexed. No need to have equities.
That’s only true if the plan is fully funded when it’s frozen.
There’s difference between (i) freezing a pension plan and (ii) the funded status of a pension plan. Two totally different things. Most DB plans are underfunded for what it’s worth.
As you stated, if you freeze it, future liabilities will no longer accrue. You still have liabilities that have already been earned by plan participants, however. The value of plan assets (funded status) needs to be considered before making asset allocation decisions.
If your plan is 50% funded when you freeze it, immunizing plan liabilities is inadequate.
okay, I think that’s another issue.
If the pension plan is underfunded and the sponsor doesn’t want to make contribution any more. Should the portfolio manager start to increase portfolio risk? What’s CFA’s approach?
Willingness to take risk: High
Ability to take risk: Low
Overall => ?
unfortunately, the institute does not reward original thinking. You have to go by the curriculum. That is the thing that stresses me out.
ok, curriculum, fyi.
An underfunded plan may increase the plan sponsor’s willingness to take risk in an attempt to make the plan fully funded; however, all else equal, an underfunded plan has less ability to take risk because a funding shortfall already exists. Consequently, an underfunded plan must de-emphasize its willingness to take risk.
Yeah, these IPS questions are tough but I don’t think this is creative thinking. The oringal point was there wasn’t enough info to determine whether equities were needed in the plan. The funded status of the plan is really important to know – immunizing an underfunded plan isn’t a good strategy. That info would have to be provided on an actual exam.
This is the type of question that’d show up in the AM and they’d give us plenty of info on the plan sponsor. Not just, “The plan is frozen. Determine the appropriate asset allocation”.
This is a side note, but the average DB plan is ~80% funded of all S&P 500 companies.
Tommy- think about this from a legal perspective. If it’s a publicly-traded company with an underfunded pension plan that has been frozen, do you think that company has the “right or choice” to play catch-up by investing in Equities? Or to take it a step further, in “riskier” Alternative assets?
It’s a good question. I’m not an expert on regulation, but in the US these DB plans are regulated by ERISA. I don’t think it’s really the company’s choice in cases when the plan is severely underfunded. I think there are required contributions in these situations, but they aren’t huge. Not sure how ERISA figures into asset allocations of DB plans, but I think they have a seat at the table in some cases.
There’s a US public newspaper company, McClatchy, that had a very large DB plan that was underfunded at a time when the newspaper business went to heck (it still sucks). They had to sell their headquarters in 2010 (primo real estate in Miami) to their DB plan, and they are now leasing it back from their DB plan. I’m pretty sure ERISA required them to make a significant contribution to their plan due to its underfunded status, and that the real estate asset was how they made the contribution. The plan was frozen, btw.
I think ERISA tells them what they can and can’t do (or invest in?) in some situations, but I’m not an expert on this stuff. This is beyond the scope of the exam, but you ask a good question.
I just think if a candidate said to immunize an underfunded pension plan on the exam, you wouldn’t get points, unless you backed it up by the company making required contributions to bring the plan back to a fully funded status at some point.
^Your last paragraph sums it up.
Thanks for the input. For future benefit, both “future service to be rendered” and “future wages to be earned” are 0 if pension forzen?
^Yes. Employees will obviously be paid in cash for their labor, but they will no longer earn additional benefits from the plan when it’s frozen.
Thank you!
2010 CFA AM
CarbX Corp is an unprofitable U.S.-based producer of automobile engine components. Its defined benefit pension plan has been in deficit for 10 years. A recent agreement between the company and the participants of the CarbX pension plan resulted in the plan being frozen in exchange for CarbX making a one-time payment to fully fund the plan. The plan has a high ratio of inactive to active participants and plan benefits are not inflation indexed.
Carbx now holds 90% nominal bond, 10% equity.
Should Carbx sell all the equity and hold 100% nominal bond?
It will always need at least 10% equity unless it is frozen AND most of the participants are close to retirement.
most of the participants are close to retirement? Why?
The CFA probably won’t be ambiguous on the exam and will probably state the situation but I would bet if it is frozen it’s only new workers who it’s frozen for and that the plan will still have to pay benefits on the future wages earned by workers. I’m pretty sure that’s why they cited the high ratio of inactive to active ratio