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Evaluating Two Pension Plans on CFA Level 3 via their IPS Constraints



A defined benefits plan is built using asset-liability matching (ALM) in a way that pension assets are highly correlated to the pension liabilities. In other words, the key risk a pension fund tries to mitigate is shortfall risk relative to the projected benefit obligation or PBO. 

These legally binding obligations mean a defined benefit pension plan has below average risk tolerance.

But the above is table stakes.

Pension risk is also almost always tested in a compare and contrast way.

On the CFA Level 3 exam you will need to look at one pension plan vs another, and use their respective workforce characteristics, risk factors, and plan features to decide which one has more or less ability to take risk. We covered this concept and the workforce characteristics extensively here. This post will outline the pension plan constraints and how they fold into this common level 3 question. 

Note that this post is part of a four part series of posts on pension plans:

Four Part Pension Series

This is "foundational" Institutional IPS material (pun intended). 

What you need to know about the Five IPS Constraints of a Defined Benefit Pension Plan

As with all CFA Level 3 IPS problems, the five constraints (TTLLU) are vital. Let's run through them from a pension perspective.

Pension Plan Time Horizon

Defined benefit pension plans have an infinite time horizon (long-term single stage).

The only exception is if the passage specifies that they're set to terminate in the shorter term, so be mindful of this type of (uncommon) trick question. Where time horizon becomes more interesting is in how it is directly related to the workforce itself. You can almost think of a DB pension plan as having two categories based on retired and active employees. The time horizon of those that are retired is equal to their life expectancy. For the active (still working) employees their time horizon is two-part and is considered their time until retirement. We'll see this concept extensively in the ALM matching material in terms of how we balance the different profiles/risks of these two types of employees from an investment perspective. Finally, if you are asked to describe the time horizon you always want to include the duration of liabilities (if given) as a description. Do NOT focus on the duration of a pension plan's assets in answer questions about it's time horizon. This is irrelevant data that might be included in a table in order to throw you off.

Again, remember that on the CFA L3 exam a lot of the DB pension plan material could focus on comparing two different pension plans. So if you want to understand which has a greater ability to take risk based on time horizon you want to look at two key facts: the average age of the employees and the percentage of active lives to retired lives is really important.

The higher the active-to-retired lives ratio or the younger the average age of the employees the longer the plan's time horizon and the longer the time horizon, the greater the ability to take risk.

DB Pension Plan Time Horizon CFA  
Pension Plan Taxes

Most pension funds are tax exempt. There might be something in the passage that you might have call out but it's not a major consideration.

DB Plan Liquidity Needs 

From a constraints perspective, liquidity is vital and often tested. From a calculation perspective it should be fairly straightforward. A DB plan receives inflows from the plan sponsor. And the company disperses those benefits to the retirees. The annual liquidity requirement is the net cash outflow between those two that's needed to meet any retirement benefits. 

The extent of retirement benefits needed is itself impacted by a variety of factors. 
 
The first factor is the number of retired lives. We just covered this in a risk context, but the more folks in the plan that are retired, the more people are taking advantage of plan benefits and the greater the liquidity requirements. This reduces the ability of the plan to take risk (as the duration of liabilities is shorter). Other factors to pay attention to include things related to plan features, most notably lump sum distributions and early retirement options.

Lump sum distributions increase liquidity needs because you have to have more cash on hand for someone that elects to take their total benefits all at once. The same thing is true if the plan has a feature that allows folks to take early retirement.  

Defined Benefit Pension Plan Liquidity Constraint - CFA L3 IPS

Legal Constraints for Pension Plans

Legal constraints, like taxes, are not commonly tested. You should know that pensions are subject to ERISA, the Employee Retirement Income Security Act. If you see that on the CFA level 3 exam just remember to mark that down and you're be good to go.

Unique Constraints for Pension Plans

As with the individual IPS constraints, unique is a catch all again. Anything that sets a plan apart from other plans would be included here. This could be self-imposed constraints like unusual retirement options, the fact that the plan is closing to new participants, or prohibitions on what to invest in. One constraint that is more likely with foundations/endowments (but is possible here) is the size of the investment staff. If you have a small staff or the staff isn't well-positioned to investigate or evaluate certain asset classes that could be a constraint that goes into unique. 

How the CFA Level 3 exam tests Pension Plan Constraints

Pension plans are probably the most tested institution on the CFA Level 3 exam.

We've talked about how pension plans have below average risk tolerance due to the legally binding nature of their liabilities. That means they have to construct a portfolio that's really cognizant of that trade-off and most usually default to an ALM framework that selects assets that have higher correlation to plan liabilities. We cover the nature of these assets elsewhere, but the overall risk tolerance is also related to the IPS constraints facing the DB plan. 
 
With pension plans in particular, you should be hyper aware of the liquidity and time horizon constraints as these tend to be the most tested:

 

Pension Plan Time Horizon and Liquidity - CFA