Food Processors Inc. (FPI) is a mature U.S. company reporting declining earnings and a weak…

Food Processors Inc. (FPI) is a mature U.S. company reporting declining earnings and

a weak balance sheet. Its ERISA-qualified defined benefit pension plan has total assets

of $750 million. However, the plan is underfunded by $200 million by U.S. standards,

a cause for concern by shareholders, management, and the board.

The average age of plan participants is 45 years. FPI’s annual contribution to the

plan and the earnings on its assets are sufficient to meet pension payments to present retirees.

The pension portfolio’s holdings are equally divided between large-capitalization

U.S. equities and high-quality, long-maturity U.S. corporate bonds. For actuarial purposes,

the assumed long-term rate of return on plan assets is 9% per year; the discount

rate applied to plan liabilities, all of which are U.S.-based, is 8%. As FPI’s treasurer,

you are responsible for oversight of the plan’s investments and managers and for liaison

with the board’s pension investment committee.

At the committee’s last meeting, its chairman observed that both U.S. stocks and

U.S. bonds had recorded total returns in excess of 12% per year over the past decade.

He then made a pointed comment: “Given this experience, we seem to be overly conservative

in using only a 9% future return assumption. Why don’t we raise the rate to

10%? This would be consistent with the recent record, would help our earnings, and

should make the stockholders feel a lot better.”

You have been directed to examine the situation and prepare a recommendation for

next week’s committee meeting. In this connection, your assistant has provided you

with the background information shown in Table 26H.

a. In response to the chairman’s observations and based solely on the data shown

in Table 26H, recommend and justify the long-term rate of return assumption

you believe is most appropriate for FPI’s plan. Prepare an asset allocation summing

to 100% and calculate the expected return on the portfolio resulting from that

allocation.