This question looks a bit odd to me, just wanted to make sure that the explaination is logical as it focused on the 5 year rather than the total of 25 years, please comments Thanks World Wide Telecom (WWT), a troubled internet service provider recently filed Chapter 11 bankruptcy after seven unsuccessful years of operations. It was a plan sponsor in WWT Pension Plan for the benefit of its employees. The following information was available at the time of its bankruptcy filing: Employees: 500 Plan assets: $15 million Plan liabilities: $19 million Average age of workforce: 30 1% of plan assets are being paid out to retirees and no more participants are expected to retire over the next five years. Due to the company’s financial condition, the plan was under-funded. The duration of the plan liabilities is 25 years. Inflation is expected to be approximately 1% over the next five years. The bankruptcy trustee appointed Eric Geecu, CFA, as the portfolio manager overseeing the WWT Pension Plan to develop guidelines for its investment policy statement and the ultimate distribution of the proceeds of the plan upon fully funded status. Geecu believes that fully funded status could be achieved within the next five years, assuming the plan earns an expected rate of return in excess of its plan liabilities. The plan liabilities are expected to increase at the rate of inflation. In developing an investment policy statement (IPS) for WWT Pension Plan, which constraints should Geecu consider? A) A long time horizon, unique circumstances associated with the Chapter 11 bankruptcy, with no current taxes to be considered for the pension plan. B) A short time horizon, low liquidity needs, with assets managed according to the “prudent expert” rule. C) The pension plan is governed under ERISA, unique circumstances that the plan cannot provide any funds to meet the plan’s underfunded status, and a long time horizon. Your answer: C was incorrect. The correct answer was B) A short time horizon, low liquidity needs, with assets managed according to the “prudent expert” rule. Time horizon – The time horizon for this plan is short. Since the plan sponsor, WWT, is currently in bankruptcy and would not be considered a going concern, it cannot provide any funds to minimize the plan deficit. Since there is only a 5-year time horizon for the plan coupled with the uncertainty on the disposition of available funds in five years, the primary goal of this plan is on capital preservation with a secondary focus on income and a third goal of some growth over the time horizon. Five years is a short time frame to achieve these goals. Any IPS developed must consider capital preservation first and then consider a total return approach to preserve the plan from the effects of inflation. Liquidity – The liquidity needs of this portfolio are low primarily because only 1% of the plan assets are currently being paid out and no more employees are expected to retire over the next five years. The average age of the workforce is 30 and young and will not require any distributions until the expected termination upon its fully funded status. Therefore, the plan only has to provide for its current retirees at a rate of 1% per year. Laws and regulations – This pension plan is governed by ERISA and must adhere to the prudent expert rule. As such, diversification is necessary to minimize the risk of large losses to the plan and capital preservation. Taxes – There are none to be considered for the pension plan. However, upon the distribution of the plan assets after five years, there could be a tax impact on the plan participants. Tax counsel is advised here for the plan and its participants to also do some tax planning for the ultimate distribution of the proceeds of the plan in five years. Unique circumstances – WWT, the plan sponsor, is in a Chapter 11 bankruptcy filing and, therefore, cannot provide any funds to meet the plan’s underfunded status. The plan must also consider the administration of the distribution of the proceeds of the plan after five years to its plan participants. Should the underfunded status remain (assuming a higher than expected level of benefits are paid out to retirees or the expected rate of return does not meet the level of the plan liabilities) special policies and procedures may need to be considered at the time of the distribution of the plan assets. -------------------------------------------------------------------------------- In developing an IPS for WWT Pension Plan, what must Geecu consider with respect to the return objective and risk tolerance for the plan? A) Return requirement = 7.33%, risk tolerance = low to average. B) Return requirement = 7.89%, risk tolerance = moderate to high. C) Return requirement = 6.84%, risk tolerance = low or below average. Your answer: A was incorrect. The correct answer was C) Return requirement = 6.84%, risk tolerance = low or below average. Return requirement – The plan must consider the preservation of capital as its primary objective over the 5-year time horizon. The plan should focus on a goal of obtaining an expected rate of return of 6.84% to eliminate the plan deficit of $4 million (plan asset of $15 million less plan liabilities of $19 million) and preserve the plan from the effects of inflation. PV= -15 FV=19 N=5 PMT=0 CPT I/Y = 4.84% Rate of return to achieve fully funded status = 4.84% Plus: benefits paid out to retirees = 1.00% Plus: expected inflation rate = 1.00% Equals the return requirement = 6.84% Since the bankruptcy court has mandated that the plan liabilities will be held constant at $19 million, the plan assets could be invested at a required rate to achieve fully funded status in five years. Thus, the computation to achieve the rate of return is: (Future Value ¸ Present Value) (1/term) or using a financial calculator =4.84%. The result of this calculation is 4.84 percent. Additionally, we must also include the benefits currently paid out to retirees of 1 percent plus the expected inflation rate of 1 percent to arrive at the return requirement of 6.84 percent. This return requirement allows the plan to close the plan deficit while also providing retirement benefits to its retirees and preserving the capital from the effects of inflation. Risk Tolerance – The risk tolerance for the pension plan is low or below average. The primary objective of the plan is to preserve the plan assets and protect it from the effects of inflation with the ultimate goal of achieving a fully funded status in five years. Given the short time horizon of five years and its current underfunded status and the inability of its plan sponsor to commit any fund to the plan (due to bankruptcy), the plan cannot be subjected to any unexpected levels of market risk. Furthermore, it is currently paying out benefits to retirees, so it must have the liquidity to provide such benefits.