2006 CFA AM - Pension vs. foundation

[June06]

Although 2006 has an amazing pass rate…but some questions still interesting/ tricky… Below Q6. What do you think?
Vrieland Foundation is an independent foundation with the objective to fund children’s music education programs. PM makes the following statements:

• “Vrieland, unlike a defined benefit pension plan, does not need to consider the correlation between plan sponsor financial performance and the performance of the portfolio.”
• “Like a defined benefit pension plan, the liquidity needs of Vrieland fluctuate over time.”
• “The primary objective of both Vrieland and a defined benefit pension plan is to exist in perpetuity, resulting in an infinite investment time horizon.”
  Determine whether you agree or disagree with each of the three statements made by PM. If you disagree, support your opinion with one reason related to portfolio management.

 

[dan5342]

Foudations need to consider:
1) their annual spending amount as a % of the childrens music educations operating budget to determine their importance to the program
2) whether there is a spending rule to help dampen the volatility of annual spending requirements
3) If donations and contributions are essential to the success of the foundation as these may not continue in the futre.
Therefore I would agree with bullet one.
Disagree with bullet point two. Foundations liquidity needs are relatively consistent over time. The main determinent is how their spending rate is calucluated and smoothing rules will help dampen the volatility of this spending rate.
Disagree with bullet point three. Defined benefit pension plans should base their time horizon on the aspects of the pension liability such as workforce characteristics (age, retirees vs. active) and any lump sum payments/benefits which will create immediate liquidity needs.
I did this as somewhat of my own mock practice question so any critiquing of my answers would be much appreciated!

 

[June06]

Good answer! I’m afraid I’m not qualified to grade it so I leave it to someone more familiar with this topic.

 

[June06]

CFAI Guideline answers fyi.
Point 1: Agree
Point 2: Agree
Point 3: Disagree
There are two portions of the statement for which the candidate may disagree.
Primary Objective:
The primary objective of Vrieland is not to exist, but rather to achieve its mission.
The primary objective of a defined benefit pension plan is not to exist in perpetuity, but rather to provide funding to meet pension liabilities.
Infinite Time Horizon
Some foundations can be established with limited time horizons, with the intent of being “spent down” over a predetermined period of time.
Pension funds however have a primary objective of meeting benefit obligations, therefore the time
horizon will be based on the expected life of the plan.
The expected life of the plan depends on:
1. whether the plan sponsor is a going concern or plan termination is expected, and
2. the age of the workforce and the proportion of active lives. The plan’s horizon will be longer if the workforce is young and the plan is open to new entrants.