Return requirement – The plan must consider the preservation of capital as its primary objective over the 5-year time horizon. The plan should focus on a goal of obtaining an expected rate of return of 6.84% to eliminate the plan deficit of $4 million (plan asset of $15 million less plan liabilities of $19 million) and preserve the plan from the effects of inflation.
- PV= -15 FV=19 N=5 PMT=0 CPT I/Y = 4.84%
- Rate of return to achieve fully funded status = 4.84%
- Plus: benefits paid out to retirees = 1.00%
- Plus: expected inflation rate = 1.00%
- Equals the return requirement = 6.84%
Since the bankruptcy court has mandated that the plan liabilities will be held constant at $19 million, the plan assets could be invested at a required rate to achieve fully funded status in five years. Thus, the computation to achieve the rate of return is: (Future Value ¸ Present Value) (1/term) or using a financial calculator =4.84%. The result of this calculation is 4.84 percent. Additionally, we must also include the benefits currently paid out to retirees of 1 percent plus the expected inflation rate of 1 percent to arrive at the return requirement of 6.84 percent.
This return requirement allows the plan to close the plan deficit while also providing retirement benefits to its retirees and preserving the capital from the effects of inflation.
Risk Tolerance – The risk tolerance for the pension plan is low or below average. The primary objective of the plan is to preserve the plan assets and protect it from the effects of inflation with the ultimate goal of achieving a fully funded status in five years. Given the short time horizon of five years and its current underfunded status and the inability of its plan sponsor to commit any fund to the plan (due to bankruptcy), the plan cannot be subjected to any unexpected levels of market risk. Furthermore, it is currently paying out benefits to retirees, so it must have the liquidity to provide such benefits.
