CHAPTER 29

PENSION PLAN MANAGEMENT

(Difficulty: E = Easy, M = Medium, and T = Tough)

Please see the preface for information on the AACSB letter indicators (F, M,
etc.) on the subject lines.

True-False

Easy:
Defined contribution plan FG Answer: b Diff: E
1. Under a defined contribution plan, employees agree to contribute some
percentage of their salaries, up to 20 percent, to the firm’s pension
fund.

a. True
b. False

Vesting FG Answer: a Diff: E

2. If employees have a right to receive pension benefits even if they leave
the company prior to retirement, their pension rights are said to be
vested.

a. True
b. False

Medium:
Contribution plans FG Answer: a Diff: M
3. From a pure cost standpoint, a firm with a defined contribution plan
would be more likely to hire older workers than a firm with a defined
benefit plan.

a. True
b. False

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or in part.
Chapter 29 - Page 1
Performance measurement FG Answer: a Diff: M
4. The performance measurement of stock portfolio managers must recognize
the risk inherent in the investment portfolio. One way to incorporate
risk into performance measurement is to examine the portfolio’s alpha,
which measures the vertical distance of the portfolio’s return above or
below the Security Market Line.

a. True
b. False

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or in part.

Chapter 29 - Page 2
Multiple Choice: Conceptual

Medium:
Pension plan terminology CG Answer: e Diff: M
5. Which of the following statements about pension plans if any, is
incorrect?

a. A defined contribution plan is, in effect, a savings plan that is

funded by employers, although many plans also permit additional
contributions by employees.
b. Under a defined benefit plan, the employer agrees to give retirees a
specifically defined benefit, such as $500 per month or 50 percent of
the employee’s final salary.
c. A portable pension plan is one that an employee can carry from one
employer to another.
d. An employer’s obligation is satisfied under a defined contribution
plan when it makes the required contributions to the plan. The risk
of inadequate investment returns is borne by the employee.
e. If assets exceed the present value of benefits, the pension plan is
fully funded.

Defined contribution plan CG Answer: c Diff: M

6. Which of the following statements about defined contribution plans is
incorrect?

a. A defined contribution plan places the risk of poor pension portfolio

performance on the employee.
b. In general, employees can choose the investment vehicle under a
defined contribution plan. Thus, highly risk-averse employees can
choose low-risk investments, while more risk-tolerant employees can
choose high-risk investments.
c. In a defined contribution plan, the employer must make larger-than-
average contributions to the pension plan when investment returns have
been below expectations.
d. Defined benefit plans are used more often by large corporations than
by small companies.
e. The PBGC insures a portion of pension benefits.

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or in part.
Chapter 29 - Page 3
Performance measurement CG Answer: e Diff: M
7. Which of the following statements about pension plan portfolio
performance is incorrect?

a. Pension fund sponsors must evaluate the performance of their portfolio

managers periodically as a basis for future asset allocations.
b. Alpha analysis, which relies on the Capital Asset Pricing Model,
considers the risk of the portfolio when measuring performance.
c. Peer comparison examines the relative performance of portfolio
managers with similar investment objectives.
d. A portfolio annual return of 12 percent from one investment advisor is
not necessarily better than a return of 10 percent from another
advisor.
e. In managing the retiree portfolio, fund managers often use
immunization techniques such as alpha analysis to eliminate, or at
least significantly reduce, the risk associated with changing interest
rates.

Multiple Choice: Problems

Medium:
Retirement benefits CG Answer: d Diff: M
8. The Apex Company has just hired Mr. Smith, who is age 25 and is expected
to retire at age 60. Mr. Smith’s current salary is $30,000 per year, but
his wages are expected to increase by 5 percent annually over the next 35
years. Apex has a defined benefit pension plan in which workers receive
2 percent of their final year’s wages for each year of employment.
Assume a world of certainty. Further, assume that all payments occur at
year-end. What is Mr. Smith’s expected annual retirement benefit,
rounded to the nearest thousands of dollars?

a. $ 35,000
b. $ 57,000
c. $ 89,000
d. $116,000
e. $132,000

© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole
or in part.

Chapter 29 - Page 4
Performance measurement CG Answer: b Diff: M
9. Midwest Investment Consultants (MIC) operates several stock investment
portfolios that are used by firms for investment of pension plan assets.
Last year, one portfolio had a realized return of 12.6 percent and a beta
coefficient of 1.15. The average T-bond rate was 7 percent and the
realized rate of return on the S&P 500 was 12 percent. What was the
portfolio’s alpha?

a. -0.75%
b. -0.15%
c. 0%
d. 0.15%
e. 0.75%

Pension fund mathematics CG Answer: c Diff: M

10. The Ritz Company has a 40-year-old employee that will retire at age 60
and live to age 75. The firm has promised a retirement income of $20,000
at the end of each year following retirement until death. The firm’s
pension fund is expected to earn 7 percent annually on its assets and the
firm uses 7% to discount pension benefits. What is Ritz’s annual pension
contribution to the nearest dollar for this employee? (Assume certainty
and end-of-year cash flows.)

a. $2,756
b. $3,642
c. $4,443
d. $4,967
e. $5,491

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or in part.
Chapter 29 - Page 5
 CHAPTER 29
ANSWERS AND SOLUTIONS

1. Defined contribution plan FG Answer: b Diff: E

2. Vesting FG Answer: a Diff: E

3. Contribution plans FG Answer: a Diff: M

4. Performance measurement FG Answer: a Diff: M

5. Pension plan terminology CG Answer: e Diff: M

If assets exceed the present value of benefits, the plan is overfunded.

6. Defined contribution plan CG Answer: c Diff: M

7. Performance measurement CG Answer: e Diff: M

Duration is the immunization technique used to either eliminate, or at

least significantly reduce, the risk associated with changing interest
rates.

8. Retirement benefits CG Answer: d Diff: M

Final year’s salary = $30,000(1.05)35 = $165,480.46.

Salary multiplier = 35(2%) = 70%.
Pension benefit = 0.70($165,480.46) = $115,836.32.

9. Performance measurement CG Answer: b Diff: M

Portfolio's required
rate of return = rRF + (rM – rRF)b
= 7% + (12% - 7%)1.15 = 7% + (5%)1.15 = 12.75%.

Alpha = 12.6% - 12.75% = -0.15%.

10. Pension fund mathematics CG Answer: c Diff: M

Find the PV (at retirement) of the 15-year pension payment:

$20,000(PVIFA7%, 15 years) = $182,158.28.

Find the annual payment needed to accumulate the above amount over 20
years:

Annual payment = $182,158.28/FVIFA7%, 20 years = $4,443.37.

© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole
or in part.

Chapter 29 - Page 6