Reading 16: Life-Cycle Investing－LOS d protect, discuss, annuity, against, investment

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CFA Institute Area 3-5, 7, 12, 14-18: Portfolio Management
Session 4: Private Wealth Management
Reading 16: Life-Cycle Investing
LOS d: Critique the use of an annuity to protect against the risk of outliving one's assets and discuss alternative investment strategies for addressing this risk.

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Once an individual reaches the retirement stage of life, the main concern is:

A) reallocating financial assets to adopt a more conservative profile.

B) paring back expenditures so that they can be met without impairing principal.

C) establishing a drawdown rate that will not result in their outliving their assets.

D) safety of principal, with investment income being secondary.

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Answer and Explanation

When an individual reaches the retirement stage, the primary issue is to establish a drawdown rate (i.e., an income distribution plan) that will not result in their outliving their assets.

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A financial asset that is specifically designed to address the problem of outliving ones assets is called:

A) a life annuity.

B) life insurance.

C) a hybrid bond.

D) a guaranteed investment contract.

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Answer and Explanation

Life annuities are designed to pay income to the owner as long as the owner is alive. Therefore, unless the insurance company issuing the annuity fails and is unable to make the payments as promised, the annuitant cannot outlive their income.

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Relative to a drawdown plan that is based upon an individuals life expectancy, if an individual only spends the real returns on their financial assets, their income will be:

A) larger, and the remaining estate will also be larger.

B) larger, but the remaining estate will be smaller.

C) smaller, and the remaining estate will be smaller.

D) smaller, but the remaining estate will be larger.

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Answer and Explanation

If an investor only spends the real returns on assets held, their income will be smaller than a plan based upon life expectancy. This is because a plan based upon life expectancy will also result in a drawdown of principal. However, since only the real returns are spent, the remaining estate will be larger than any plan that also draws down principal.