LEVELIIIQuestion:Topic:Minutes:1PortfolioManagement–Individual26Questions1and2relatetoPatriciaandAlexanderTracy.Atotalof35minutesisallocatedtothesequestions.Candidatesshouldanswerthesequestionsintheorderpresented.QUESTION1HASFOURPARTS(A,B,C,D)FORATOTALOF26MINUTES.PatriciaandAlexanderTracy,bothage59,areresidentsofCanada.Theyhavetwinsonswhowillenterafour-yearuniversityprograminoneyear.Patriciaisalong-timeemployeeofatelecommunicationscompany.Alexanderisaself-employedsalesconsultant.Alexander’sannualincomeisnowsteadyafteryearsofextremehighsandlows.TheTracyshavebuiltaninvestmentportfoliothroughsavinginAlexander’shighincomeyears.TheTracys’currentannualincomeisequaltotheirtotalexpenses;asaresult,theycannotaddtosavingscurrently.Theyexpectthatboththeirexpensesandincomewillgrowattheinflationrate.Allmedicalcosts,nowandinthefuture,arefullycoveredthroughgovernmentprograms.TheTracysworryaboutwhethertheyhavesavedenoughforretirement,andwhethertheywillbeabletomaintaintherealvalueoftheirportfolio.Inflationisexpectedtoaverage4%fortheforeseeablefuture.TheTracyshaveapproachedDarrenBriscoetohelpthemanalyzetheirinvestmentstrategyandretirementchoices.TheTracysdisagreeabouttheappropriateinvestmentstrategy.Patriciaprefersnotlosingmoneyovermakingahighreturn.Thisispartlyaresultofcontinuingregretforalossexperiencedinanequitymutualfundseveralyearsago.Alexander’shistoryofmakingfrequentchangesintheirportfoliogreatlyannoyedPatricia.ShethinksAlexanderfocusedonlyonpotentialreturnandpaidlittleattentiontorisk.TheTracyscurrentlyhavealltheirassetsininflation-indexed,short-termbondsthatareexpectedtocontinuetoearnareturnthatwouldmatchtheinflationrateaftertaxes.Afterretirement,theyarewillingtoconsiderchangingtheirinvestmentstrategyifnecessarytomaintaintheirlifestyle.TheTracysareeligibletoretirenextyearatage60.Iftheydo,Patriciawillreceiveannualpaymentsfromhercompany’sdefined-benefitpensionplanandbothPatriciaandAlexanderwillreceivepaymentsfromtheCanadiangovernmentpensionplan.Alexanderdoesnotparticipateinanycompanyorindividualretirementplan.BriscoehascompiledfinancialdataandmarketexpectationsfortheTracys’retirement,showninExhibit1.Currently,BriscoeestimatesthattheTracys’investmentportfoliowillgrowto1,100,000Canadiandollars(CAD)bytheirretirementdatenextyear.LEVELIIIQuestion:Topic:Minutes:1PortfolioManagement–Individual26Exhibit1FinancialDataandMarketExpectationsPatriciaandAlexanderTracyExpectedannualexpensesAnnualpensionincome(after-tax)Patricia’scompanyplanCombinedgovernmentpensionTotalannualpensionincomeExpectedannualinflationExpectedannualafter-taxportfolioreturnRetirementatAge60(2010)CAD125,000CAD40,000CAD40,000CAD80,0004%4%PensionincomefrombothPatricia’scompanyplanandthegovernmentpensionplanisfullyindexedforinflation.Briscoeexpectsataxrateof20%toapplytotheTracys’withdrawalsfromtheinvestmentaccount.TheTracysexpecttoearnnoemploymentincomeafterretirement.TheTracys’residenceisnotconsideredpartoftheirinvestableassets.TheTracyshavetheoptiontodelayretirementuntilage65.TheTracysintendtoretiretogether,whetheritisin2010atage60orin2015atage65.BriscoedeterminesthatiftheTracysretireatage60,theirrisktoleranceisbelowaverage.Iftheyretireatage60,theyplantopayofftheirmortgageandassociatedtaxesbywithdrawingCAD100,000fromtheirportfoliouponretirement.AnotherconsiderationfortheTracysrelatestofundinguniversityexpensesfortheirsons.IftheTracysretireatage60,eachsonwillreceiveascholarshipavailabletoretireefamiliesfromPatricia’scompanythatwillcoveralluniversitycosts.IftheTracysretireatage65,allpensionincomewouldincreaseandwouldalmostmeettheirannualspendingneeds.Iftheyretireatage65,theTracyswouldpayalluniversityexpensesfromtheirinvestmentportfoliothroughanarrangementwiththeuniversity.Thearrangement,coveringbothsons,wouldrequiretheTracystomakeasinglepaymentofCAD200,000atage60LevelIIIGuidelineAnswersMorningSession-of68LEVELIIIQuestion:Topic:Minutes:1PortfolioManagement–Individual26A.i.PreparethereturnobjectivesportionoftheTracys’investmentpolicystatement(IPS)thatwillapplyiftheyretireatage60.ii.Calculatethepre-taxnominalrateofreturnthatisrequiredfortheTracys’firstyearofretirementiftheyretireatage60.Showyourcalculations.(12minutes)B.IndicatespecificfactorsfortheTracys,foreachofthefollowing,whichsupportBriscoe’sconclusionthattheTracys’risktoleranceisbelowaverage:i.ii.Abilitytotakerisk.Indicatetwofactors.Willingnesstotakerisk.Indicateonefactor.(6minutes)C.Preparethecurrent(2009)liquidityconstraintfortheTracys’IPS:i.ii.iftheyretireatage60.iftheyretireatage65.(4minutes)D.Preparethecurrent(2009)timehorizonconstraintfortheTracys’IPS:i.ii.iftheyretireatage60.iftheyretireatage65.(4minutes)2009LevelIIIGuidelineAnswersMorningSession-of68LEVELIIIQuestion:Topic:Minutes:1PortfolioManagement–Individual26ReadingReferences:8.“FrameDependence:TheSecondTheme,”Ch,BeyondGreedandFear:UnderstandingBehavioralFinanceandthePsychologyofInvesting,HershShefrin(OxfordUniversitySchoolPress,2002)“ManagingIndividualInvestorPortfolios,”ManagingInvestmentPortfolios:ADynamicProcess,3rdedition,JamesW.Bronson,MatthewH.Scanlan,andJanR.Squires(CFAInstitute,2007)14.Purpose:Totestthecandidate’s:(1)understandingoftheinvestmentpolicystatementforanindividualinvestor,(2)abilitytoassesspertinentfactorsforaninvestor’sabilitytoassumerisk,(3)abilitytocalculateaninvestor’srequiredreturn,and(4)understandingofaninvestor’sotherconstraintfactors.LOS2009–III-3-8-a,“FrameDependence:TheSecondTheme”Thecandidateshouldbeableto:a)explainhowlossaversioncanresultininvestors’willingnesstoholdontodeterioratinginvestmentpositions;LOS2009–III-4-14-a,f,j,k,l,“ManagingIndividualInvestorPortfolios”Thecandidateshouldbeableto:a)discusshowsourceofwealth,measureofwealth,andstageoflifeaffectindividualinvestors’risktolerance;compareandcontrastriskattitudesanddecision-makingstylesacrossdistinctinvestorpersonalitytypes,includingcautious,methodical,spontaneous,andindividualisticinvestors;explainhowtosetriskandreturnobjectivesforindividualinvestorsanddiscusstheimpactthatabilityandwillingnesstotakeriskhaveontolerance;identifyandexplaineachofthemajorconstraintcategoriesincludedinanindividualinvestor’sinvestmentpolicystatement;formulateandjustifyaninvestmentpolicystatementforanindividualinvestor;f)j)k)l)2009LevelIIIGuidelineAnswersMorningSession-of68LEVELIIIQuestion:Topic:Minutes:1PortfolioManagement–Individual26GuidelineAnswer:PARTAi.ReturnObjectiveStatementTheTracys’returnobjectiveistoprovidesufficientafter-taxcashflowinretirementtomeetannuallivingexpensesinexcessofpensionandotherretirementincome.GiventheTracys’concernaboutinflationerodingtheirpurchasingpower,theportfolioshouldalsorealizeareturnhighenoughtomaintainthereal(inflationadjusted)valueoftheirassetbase.ii.ReturnCalculationsare:CashFlowsInflowsRetireNextYearatAge60Patricia’scompanypensionCADCombinedgovernmentpensionTotalInflowsOutflowsEstimatedexpensesAfter-taxnetincomeneededPretaxnetincomeneeded(using20%taxrate)InvestableAssetsEstimatedinvestmentportfolioinoneyearMortgagepayoffInvestmentportfoliouponretirementRequiredReturnCalculationPretaxincomeneeddividedbyinvestableassetsPlusexpectedinflation40,00040,00080,000125,000(45,000)(56,250)1,100,000(100,000)1,000,0005%4%RequiredPretaxNominalReturn(arithmetic)RequiredPretaxNominalReturn(geometric)[(1×1)–1==9%]OR[(1×1)–1=9%]9%9%2009LevelIIIGuidelineAnswersMorningSession-of68
