a. Did constructing this chart entail present value calculations or future value
ID: 1190519 • Letter: A
Question
a. Did constructing this chart entail present value calculations or future value calculations?
Answer: It entailed _______________________ calculations.
b. Set up the equations to show how to calculate what $100 billion would grow to over 10 years at the two rates shown. (You have to do this twice: once for the 6% and once for the 7.75% returns.)
c. Connecticut recently reported that it expects its pension funds to earn 8% or more per year. This is highly optimistic. What behaviors might their pension fund managers engage in in order to get these returns?
d. What are the costs if they fail?
e. What are the problems associated with setting a more realistic target?
Mind the Gap Over 10 years, a pension fund would earn $32 billion more on its initial $100 billion from a 7.75% annual return than a 6% return $220 billion llion 7 75% 200 180 160 140 120 6.00% 100 1 2 3 4 5 6 7 8 910 number of years Source: Pew Center on the StatesExplanation / Answer
(a) The chart is showing Future Value calculations.
(b)
Future Value = Present Value x (1 + r)N where r: Interest rate, N: Number of periods
(i) r = 6%
Future Value = $100 billion x (1.06)10
(ii) r = 7.75%
Future Value = $100 billion x (1.0775)10
(c)
In investment practice, higher risks lead to higher returns. Therefore, if the pension plan assets are invested in riskier portfolios, higher return is expected to be generated.
(d)
If they fail, the cost will be difference in the interest earned of the next best opportunity (7.75%):
Cost = $100 billion x (0.08 - 0.0775) = $0.25 billion = $250 million
(e)
The main problem in setting a more realistic target is the risk-return trade-off and corresponding certain of fetching the required return, if the plan assets are invested in a different fund.
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