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发表于 2012-3-23 13:46
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Karl and Karen Arlt are both thirty-five years old and have two children, Noah and Jamie ages 5 and 7, respectively. Karen is a tenured professor at the local state college and Karl is an engineer working at an electrical utility company. Together the Arlts have a combined income of $150,000 per year. The Arlts are meeting with a financial consultant Katherine Ryals, CFA, for the first time who was recommended to them by Karl’s brother who is also training with Ryals to become a financial consultant himself. The four of them are meeting around the Arlt’s dining room table where Ryals is gathering information to determine an investment policy statement for the Arlts who state they want to retire when they are 60 years old. One of the questions asks the Arlts about their general feelings of risk and Karen blurts out “the recent turmoil in the financial markets due to the mortgage crisis makes me sick to my stomach!” Up to this point in their lives the Arlt’s have not amassed a significant amount of financial wealth nor have they given much thought about leaving a bequest.
It is now two weeks later and the Arlt’s are meeting with Ryals and Karl’s brother again. Ryals suggests that they purchase a million dollar variable universal life (VUL) policy whereby their premium payments will go into mutual fund type investments resulting in equity-like returns. She states “because your incomes are stable your human capital is fixed income-like thus to be able to replace your steady income your demand for life insurance is high.” She goes on to state “since your incomes are stable your assets should be invested in more equity-like investments like the ones found in the VUL thus it is the perfect investment vehicle for you.”
Ryal’s analysis reveals that to maintain their current $150,000 per year income when they retire in 25 years at age 60 assuming a 3% increase in income per year would require an income stream of about $314,000 per year. This represents a portfolio worth approximately $3.3 million at retirement, assumes they live another 20 years during retirement, achieve a 7% rate of return on their portfolio during retirement, and there is nothing left of the portfolio at the end of 20 years. Ryals goes on to further explain that to amass the equivalent of $3.3 million 25 years from now given they have no retirement savings now and assuming a 10% yearly rate of return would require them to save roughly $2,500 per month.
After careful consideration of their insurance needs the Arlts decide to purchase term insurance on both of them and invest a portion of their after tax income into a deferred variable annuity. Upon retirement the Arlts are expecting to choose the largest cash outflow possible from the annuity utilizing the “joint and survivor” payout option. Based on the information regarding Karl and Karen’s incomes the discount rate used to determine their human capital would be: A)
| high because their incomes would have a low variability over time. |
| B)
| low representing lower risk due to their stable incomes. |
| C)
| indeterminate since the discount rate is based on factors other than the variability in their incomes. |
|
The Human Capital equation is:
 Since the Arlts both have stable incomes with Karen being a tenured college professor and Karl working in the utility industry, neither of which are closely tied to the economy, the risk of their incomes is low thus the risk premium would also be low resulting in a lower overall discount rate and higher human capital. (Study Session 4, LOS 14.g)
Given the Arlt’s personal information gathered from the questionnaire, which of the following statements regarding the correct asset allocation of their portfolio is most accurate? A)
| Their portfolio should be allocated more towards risky assets since their human capital is bond-like. |
| B)
| Since they are in the early part of the accumulation phase of their careers they can tolerate more risk in their portfolio and thus should be invested more heavily in equities. |
| C)
| Their portfolio should be allocated more towards less risky assets because they have a below average willingness to accept risk thus their overall risk level is below average. |
|
Even though the Arlt’s human capital is bond-like indicating they should invest their portfolio more towards equities, Karen’s statement about the mortgage crisis indicates a below average willingness to take risk, thus their overall level of risk tolerance is below average. Knowing the size of their portfolio is relatively small the advisor should defer to the client’s willingness to take risk if willingness is below ability and the portfolio is not appreciably large. (Study Session 4, LOS 14.g)
The statements made by the financial consultant regarding the demand for life insurance and the asset allocation of the policy premiums are: A)
| correct for only one of the statements. |
| B)
| incorrect for both statements. |
| C)
| correct for both statements. |
|
The statements made by the financial consultant are correct for both statements. Since the incomes of both Karen and Karl are stable their human capital is bond-like thus to replace this income their demand for life insurance is high and their assets should be allocated more aggressively in equity type investments. (Study Session 4, LOS 14.g)
A disadvantage of the Arlt’s choice of the annuity is: A)
| the annuity will lose real earning power in periods of high inflation. |
| B)
| the annuity is less tax efficient than utilizing a 401k or 403b account. |
| C)
| if they both die before their predicted life expectancy the remainder of their assets will go to the insurance company instead of their heirs. |
|
One disadvantage of an annuity is that a person may die sooner than their predicted life expectancy in which case if they also choose the largest payout this means they aren’t leaving anything to beneficiaries. In that case the rest of their assets in the annuity would go to the insurance company instead of being passed on as a bequest to their heirs. Real earning power is only lost in a fixed annuity in which the income stream is fixed and thus would not keep pace with inflation. The Arlts purchased a variable annuity which should keep pace with inflation assuming the investment returns are at least as high as the rate of inflation. A deferred annuity is not necessarily less tax efficient than a 401k or 403b account because in all these accounts income and capital gains are tax deferred so they are equivalent from that tax standpoint. One tax difference between the 401k / 403b accounts and annuities is the 401k / 403b accounts are funded with pretax dollars which lowers the investor’s taxable income by the amount contributed. In contrast the annuity is funded with after tax dollars thus the investor’s taxable income is not lowered at the time of the contribution as occurs with the 401k / 403b contribution but they owe less income taxes when they withdraw the money during retirement. The goal of the Arlts was to mitigate longevity risk which can only be done with an annuity which offers lifetime payments which is not an option with a 401k / 403b. Although taxes should always be considered they are not specifically mentioned as an issue in this case. (Study Session 4, LOS 14.g)
The planning Ryals is helping the Arlts do regarding showing them how much they would have to save today to meet their retirement needs is helping to mitigate what type of risk?
Savings risk is the risk of spending too much now and not saving enough for later on in life. This risk is usually caused by a lack of proper planning which Ryals is helping the Arlts determine how much they would have to save given their various constraints of when they want to retire, how long they will live, expected returns before and during retirement, and whether or not to assume there will be anything left over of the portfolio after they die.
Note: CFA Institute almost always assumes the asset base in the portfolio will not be touched in retirement and that the investor will live off the total return of the portfolio instead of a combination of the total return and principal as in this question. (Study Session 4, LOS 14.e)
What type of risk will the purchase of the deferred variable annuity mitigate against? | B)
| Financial market risk. |
| |
The deferred variable annuity will mitigate against longevity risk which is the risk of living too long by paying out an income stream for the remaining life of the purchaser of the annuity. Savings risk relates to consuming too much now and not saving enough for retirement. Purchasing an annuity may help to decrease savings risk because this forces the person to save a portion of their income but the main purpose of an annuity is to provide an income stream for life. Financial market risk is the risk of a person’s wealth decreasing due to a downturn in the financial markets. A remedy for financial risk is to diversify your assets. A variable annuity can hedge against financial risk because they offer the ability to diversify among many different types of equity and fixed income investments. Thus, even though a deferred variable annuity can help to reduce savings risk and financial market risk through diversification options, the main purpose of an annuity is to provide an income stream for life which reduces longevity risk. (Study Session 4, LOS 14.e) |
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