2016 CFAI MOCK PM Q59

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olivia_x

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Hi guys, I have a question about question 59 in PM CFAI MOCK paper (MCQ).
I choose B because it includes equities and real rate bonds as the payments are indexed to inflation to active employees. But i am not sure why choice B include “Nominal bond”.
The answer says “For the accrued benefit liability, the market-related exposure is the trm structure of interest rates and, accordingly, the appropriate liability-mimicking assets are nominal bonds.”
However, this seems conflict with Scheweser notes, quoted below:
“The obligations for past service are analyzed like those for inactive participants and matched with real rate and nominal bonds based on whether or not the past service benefits are linked to inflation.”
In the case it mentioned indexed to inflation to active emplyees only - does it not apply active employees past and future services?
I am a bit confused.Could someone please advise me?
Thanks in advance!
 
I’m a little tired from studying, but i’m not understanding the question you are trying to ask.
Are you just asking what’s the relationship between nominal bonds and active participants?
 
I, too, don’t really understand the question you’re asking, though I remember doing this question just today morning, so let me know if I’m confusing you further.

For past service, since the liabilities relating to these are known, we can use real rate bonds. However, for future service, we’re not sure of the liabilities arising due to this, and therefore we go with nominal bonds. Equities are there, if I’m not mistaken, to provide some alpha so that the plan sponsor can reduce his obligation to contribute to the plan.

Hope this helped.
 
Thiru Cumaran wrote:
I, too, don’t really understand the question you’re asking, though I remember doing this question just today morning, so let me know if I’m confusing you further.

For past service, since the liabilities relating to these are known, we can use real rate bonds. However, for future service, we’re not sure of the liabilities arising due to this, and therefore we go with nominal bonds. Equities are there, if I’m not mistaken, to provide some alpha so that the plan sponsor can reduce his obligation to contribute to the plan.

Hope this helped.
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I think you have it the other way round.
 
Thanks guys, sorry for not being clear enough -
I highlighted my question in italic, bold and also here “ i am not sure why choice B include “Nominal bond”.
2016 PM mock question 59, option B - I dont understand why Nominal bonds should be included as the benchmark (i understand why Real rates bond and equities).
 
I made the same mistake you did, and have not found any of the existing answers satisfactory. The CFAI answer states almost verbatim that an inflation-indexed liability should be hedged using nominal bonds.

Thiru Cumaran wrote:For past service, since the liabilities relating to these are known, we can use real rate bonds.
Click to expand...

The question answer explicitly states that nominal bonds are needed to offset the inflation-linked accrued benefit.

Thiru Cumaran wrote:However, for future service, we’re not sure of the liabilities arising due to this, and therefore we go with nominal bonds.
Click to expand...

Future services are the sum of wage inflation (real bonds) and real wage growth (~real gdp, approximated using equity).

As MrSmart posted, your explanation is almost a perfect contradiction to the CFAI answer key.
 
“For the accrued benefit liability, the market-related exposure is the trm structure of interest rates and, accordingly, the appropriate liability-mimicking assets are nominal bonds”
They should have added “and real bonds”.
Otherwise, both accrued and future obligations have term structure risk. If the accrued benefits are not 100% indexed to inflation, then you still need a portion of fixed bonds.
 
Accrued benefits are set once earned- they do not get indexed to inflation until distributions start - that’s why you use nominal bonds to offset the accrued benefits.
 
verse214 wrote:
Accrued benefits are set once earned- they do not get indexed to inflation until distributions start - that’s why you use nominal bonds to offset the accrued benefits.
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Not always.
And certainly not in that example.
 
Reading a bit more into the Schweser Study Session 6, LOS 14.b:
“Active participants are those currently working for the firm. The obligations to these employees can be separated into that owed for past service and that owed for future service. The obligations for past service are analyzed like those for inactive participants and matched with real rate and nominal bonds based on whether or not the past service benefits are linked to inflation. The retirement payments owed to inactive participants and the payments for past service to active participants constitute accrued benefits.” (emphasis mine)

Active participant benefits are made up of BOTH past service and future service. And nominal and real rate bonds are matched to obligations for past service, which is one part (of two total: past and future) of the active participants’ benefits. Future service would be matched to equities, real rate bonds and possibly nominal bonds (if wage increases are not 100% indexed to inflation).
 
NR2004 wrote:
Reading a bit more into the Schweser Study Session 6, LOS 14.b:
“Active participants are those currently working for the firm. The obligations to these employees can be separated into that owed for past service and that owed for future service. The obligations for past service are analyzed like those for inactive participants and matched with real rate and nominal bonds based on whether or not the past service benefits are linked to inflation. The retirement payments owed to inactive participants and the payments for past service to active participants constitute accrued benefits.” (emphasis mine)

Active participant benefits are made up of BOTH past service and future service. And nominal and real rate bonds are matched to obligations for past service, which is one part (of two total: past and future) of the active participants’ benefits. Future service would be matched to equities, real rate bonds and possibly nominal bonds (if wage increases are not 100% indexed to inflation).
Click to expand...
Exactly, that’s what I was reading. I was confused because i thought that the past service of active emplyees should also be linked to inflation. Unless the brief table in the case only meant that future benefits are linked to inflation…
I hope CFAI can be more serious and consistent onwards…really so many inconsitency…
 
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