Angus Walker, CFA, is reviewing the defined benefit pension plan of Acme Industries. Based in...

Angus Walker, CFA, is reviewing the defined benefit pension plan of Acme Industries. Based in London, Acme has operations in North America, Japan, and several European countries. Next month, the retirement age for full benefits under the plan will be lowered from age 60 to age 55. The median age of Acme’s workforce is 49 years. Walker is responsible for the pension plan’s investment policy and strategic asset allocation decisions. The goals of the plan include achieving a minimum expected return of 8.4% with expected standard deviation no greater than 16.0%.

Walker is evaluating the current asset allocation (Table 26A) and selected financial information for the company (Table 26B). There is an ongoing debate within Acme Industries about the pension plan’s investment policy statement (IPS). Two investment policy statements under consideration are shown in Table 26C.

International Equities (MSCI World, excluding U.K.)	10%
U.K. bonds	42
U.K. small capitalization equities	13
U.K. large capitalization equities	30
Cash	5

 

Acme Industries total assets	£16,000
Pension plan data:
Plan assets	6,040
Plan liabilities	9,850

 

	IPS X	IPS Y
Return	Plan’s objective is to outperform the	Plan’s objective is to match the
requirement	relevant benchmark return by a	relevant benchmark return.
	substantial margin.
Risk	Plan has a high risk tolerance because	Plan has a low risk tolerance because
tolerance	of the long-term nature of the plan and	of its limited ability to assume
	its liabilities.	substantial risk.
Time	Plan has a very long time horizon	Plan has a shorter time horizon than in
horizon	because of the plan’s infinite life.	the past because of plan demographics.
Liquidity	Plan needs moderate level of liquidity	Plan has minimal liquidity needs.
	to fund monthly benefit payments.

 

	Current	Graham	Michael
U.K. large capitalization equities	30	20	40
U.K. small capitalization equities	13	8	20
International equities (MSCI World ex-U.K.)	10	10	18
U.K. bonds	42	52	17
Cash	5	10	5
Total	100	100	100
Expected portfolio return (%)	9.1	8.2	10.6
Expected portfolio volatility (standard deviation in %)	16.1	12.8	21.1

a. Determine, for each of the following components, whether IPS X or IPS Y has the appropriate language for the pension plan of Acme Industries. Justify each response with one reason.

i. Return requirement

ii. Risk tolerance

iii. Time horizon

iv. Liquidity

Note: Some components of IPS X may be appropriate, while other components of IPS Y may be appropriate.

b. To assist Walker, Acme has hired two pension consultants, Lucy Graham and Robert Michael. Graham believes that the pension fund must be invested to reflect a low risk tolerance, but Michael believes the pension fund must be invested to achieve the highest possible returns. The fund’s current asset allocation and the allocations recommended by Graham and Michael are shown in Table 26D.

Select which of the three asset allocations in Table 26D is most appropriate for Acme’s pension plan. Explain how your selection meets each of the following objectives or constraints for the plan:

i. Return requirement

ii. Risk tolerance

iii. Liquidity