5、Karl Schmit Case Scenario

Karl Schmit, an investment advisor with CHT Advisors, is meeting with a new client, Dr. Albert Amin, an orthopedic surgeon. They are discussing the imminent transfer of Amin’s account to CHT. Amin expects to retire one year from now at age 62. His investment portfolio is currently valued at $5 million and is divided equally among publicly traded equities, private equity, and real estate partnerships. For his lifetime, Amin will receive inflation-adjusted payments, currently $100,000 per year, of royalties from the sale of a patent on medical devices that he invented.

Upon retirement, Amin intends to establish a $1 million trust fund for the education of his grandchildren. Within the first year of his retirement, Amin and his wife expect to purchase for cash a second home in a resort area at an estimated cost of $500,000 and to pay off the $300,000 mortgage on their principal residence. Their annual living expenses in retirement are estimated to be $250,000 in 2007 dollars. Schmit has estimated that Amin will be subject to a 35% tax rate on all income and capital gains once he retires. Schmit has prepared Exhibit 1 to summarize Amin’s retirement funding requirements.

Exhibit 1

Dr. Amin’s Retirement Funding Requirements

Schmit has also calculated an annual spending rate for Amin of 5.78%. He defines the spending rate as Amin’s annual living expenses minus the after-tax royalty income that he will receive divided by the net assets available for investment after establishing the trust fund and completing the purchase of the second home and paying off the mortgage [$250,000 – 100,000 × (1.00 – 0.35)]/($5,000,000 – 1,800,000).

Amin tells Schmit that in retirement, he does not want to be exposed to wide variations in the market value of his portfolio. He is especially concerned about minimizing the damage from negative returns in any annual period. He also does not want to worry about not having enough money for living expenses after paying taxes and adjusting for inflation. Amin asks Schmit about CHT’s forecast of the investment returns for various asset classes, the rate of inflation, and tax rates. Schmit has summarized that data in Exhibit 2.

Exhibit 2

CHT’s Projected Investment, Inflation, and Tax Environment

  Expected Annual Rate of Inflation = 3.0%

Expected Tax Rate Range = 40% – 15%, depending on tax bracket

CHT does not prepare investment policy statements but instead offers clients four different portfolios. Each client is asked to select the portfolio that best reflects her/his risk tolerance and return objectives. Amin initially selects the portfolio that contains a conservative mix of bonds and stocks, because it will provide the most current income. Schmit suggests that Amin consider a slightly more aggressive portfolio in view of his age and life expectancy, which is at least 20 years based on his health and family history. Schmit has calculated an annual total required return objective of more than 13% for Amin based on his cash flow needs and the net assets available to be invested after the first year of his retirement. Schmit tells Amin that all relevant factors have been taken into consideration in his calculations.

The next day Amin tells a colleague, John Duncan, about his meeting with Schmit. During the course of the discussion, Duncan makes the following statement to Amin:

"You should insist that Schmit prepare an investment policy statement that will document your particular objectives and constraints. You should also insist that Schmit determine an appropriate strategic asset allocation.”

Amin makes a note to discuss an investment policy statement and asset allocation with Schmit at their next meeting.

Question 1

At the time of his retirement, which of the following best characterizes Amin's:

A. Answer A.

B. Answer B.

C. Answer C.

D. Answer D.

Question 2

One year after retirement, which of the following best characterizes Amin's liquidity risk on the:

A. Answer A.

B. Answer B.

C. Answer C.

D. Answer D.

Question 3

With respect to risk tolerance at the time of his retirement, which of the following best characterizes Amin's:

A. Answer A.

B. Answer B.

C. Answer C.

D. Answer D.

Question 4

Given Amin's concerns regarding negative returns, the most appropriate measure of risk for his portfolio is:

A. value at risk.

B. tracking risk.

C. standard deviation.

D. economic factor risk.

Question 5

Which of the following best characterizes Amin's:

A. Answer A.

B. Answer B.

C. Answer C.

D. Answer D.

Question 6

If Schmit follows Duncan's advice regarding an appropriate strategic asset allocation, the most appropriate factor to combine with Amin's investment policy statement is the:

A. investment strategy.

B. investor specifications.

C. capital market expectations.

D. maximal and minimal permissible asset class values.

Question 1

At the time of his retirement, which of the following best characterizes Amin's:

A. Answer A.

B. Answer B.

C. Answer C.

D. Answer D.

Correct answer = A

"The Portfolio Management Process and the Investment Policy Statement," John L. Maginn, Donald L. Tuttle, Dennis W. McLeavey, and Jerald E. Pinto
2008 Modular Level II, Vol. 6, pp. 506-508
Study Session 18-72-c
define investment objectives and constraints and explain and distinguish among the types of investment objectives and constraints
Amin's tax concerns are significant because he is in a relatively high tax bracket. His liquidity considerations are also significant. Within the next two years, he needs to: (a) liquidate $800,000 of investments to pay off the mortgage on his primary residence and purchase a second home, and (b) transfer $1 million in cash and/or liquid securities to fund the educational trust. The $1.8 million represents 36% of his current investment portfolio. 

Question 2

One year after retirement, which of the following best characterizes Amin's liquidity risk on the:

A. Answer A.

B. Answer B.

C. Answer C.

D. Answer D.

Correct answer = A

"The Portfolio Management Process and the Investment Policy Statement," John L. Maginn, Donald L. Tuttle, Dennis W. McLeavey, and Jerald E. Pinto
2008 Modular Level II, Vol. 6, pp. 506-507
Study Session 18-72-c
define investment objectives and constraints and explain and distinguish among the types of investment objectives and constraints
Liquidity risk on the asset side is significant because 2/3 of the assets (private equity and real estate) are illiquid. Liquidity risk regarding liquidity requirements is significant because his funding requirement for living expenses is nearly $300,000 pretax ($185,000 / 0.65). Amin has expressed significant concern regarding asset liquidity (price risk, i.e., wide swings in the market value of the portfolio). His liability liquidity, i.e., his spending rate to cover annual living expenses at 5.78% = [$250,000 - 100,000 x (1.00 - 0.35)] / $5,000,000 - 1,800,000)) on a pretax and pre-inflation total return basis of over 13%, is significant relative to the expected returns that CHT is forecasting. 

Question 3

With respect to risk tolerance at the time of his retirement, which of the following best characterizes Amin's:

A. Answer A.

B. Answer B.

C. Answer C.

D. Answer D.

Correct answer = C

"The Portfolio Management Process and the Investment Policy Statement," John L. Maginn, Donald L. Tuttle, Dennis W. McLeavey, and Jerald E. Pinto
2008 Modular Level II, Vol. 6, pp. 501-503, 507
Study Session 18-72-c, e
define investment objectives and constraints and explain and distinguish among the types of investment objectives and constraints;
explain how capital market expectations and the investment policy statement help influence the strategic asset allocation decision and discuss how an investor's investment time horizon may influence the investor's strategic asset allocation
Amin has an above-average ability to take risk based on his age and financial position, but has expressed a below-average willingness to take risk when he retires. His current portfolio demonstrates an above-average willingness to take risk prior to retirement. 

Question 4

Given Amin's concerns regarding negative returns, the most appropriate measure of risk for his portfolio is:

A. value at risk.

B. tracking risk.

C. standard deviation.

D. economic factor risk.

Correct answer = A

"The Portfolio Management Process and the Investment Policy Statement," John L. Maginn, Donald L. Tuttle, Dennis W. McLeavey, and Jerald E. Pinto
2008 Modular Level II, Vol. 6, p. 502
Study Session 18-72-c
define investment objectives and constraints and explain and distinguish among the types of investment objectives and constraints
Value at risk is a measure of downside risk. It can be used to measure the probability of negative returns over a specified time period. 

Question 5

Which of the following best characterizes Amin's:

A. Answer A.

B. Answer B.

C. Answer C.

D. Answer D.

Correct answer = C

"The Portfolio Management Process and the Investment Policy Statement," John L. Maginn, Donald L. Tuttle, Dennis W. McLeavey, and Jerald E. Pinto
2008 Modular Level II, Vol. 6, pp. 501-506
Study Session 18-72-c
define investment objectives and constraints and explain and distinguish among the types of investment objectives and constraints
Amin's return objective, as calculated by Schmit, is above average at over 13% [(5.78% + 3.00%) / (1.00 - 0.35) = 13.5%] relative to the expected average annual returns that CHT is forecasting. His risk tolerance is below average as reflected in his selection of the conservative portfolio. 

Question 6

If Schmit follows Duncan's advice regarding an appropriate strategic asset allocation, the most appropriate factor to combine with Amin's investment policy statement is the:

A. investment strategy.

B. investor specifications.

C. capital market expectations.

D. maximal and minimal permissible asset class values.

Correct answer = C

"The Portfolio Management Process and the Investment Policy Statement," John L. Maginn, Donald L. Tuttle, Dennis W. McLeavey, and Jerald E. Pinto
2008 Modular Level II, Vol. 6, pp. 497-498
Study Session 18-72-d
discuss the role of the investment policy statement in the portfolio management process and explain the elements of an investment policy statement
Capital market expectations, when combined with the investment policy statement, form the basis for creating the strategic asset allocation that is the most appropriate for the client. 

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