Schweser QBank 2017 portfolio management and wealth planning05 private wealth management (2)

Human capital volatility and financial wealth are both negatively correlated with the demand for life insurance.. The demand for life insurance will increase if human capital is bond-lik

Test ID: 7426251 Private Wealth Management (2)

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With no other information to go on, the lowest specific risk in a concentrated position would most likely be for the owner of:

a privately held business

publicly traded common shares

investment real estate

Explanation

With nothing else to go on the public nature and liquidity would suggest the public shares should have the lowest specific risk

Which of the following is NOT an example of a cause of savings risk?

The financial markets drop significantly wiping out a significant portion of a

person's wealth

A person expects to average a 12% rate of return in their 401k retirement account

A person fails to determine how much they need to save given an assumed rate of

return and time frame

Explanation

A drop in a person's financial wealth due to a drop in the equity markets is an example of financial market risk and not savings risk Savings risk is when a person doesn't save enough for retirement and spends more than they should during the

accumulation phase Savings risk usually arises from a lack of long-term planning and is the result of consuming too much current income rather than saving it Relying too much on growth in a 401k to make up for a lack of saving is an example of savings risk

An advantage of a fixed annuity over a variable annuity is:

the fixed annuity's income offers a hedge against inflation during periods of

stagflation

the fixed annuity's income stream is stable throughout the life of the annuity

purchaser

fixed annuities are easier to terminate than variable annuities

Explanation

Question #4 of 43 Question ID: 465099

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One advantage of a fixed annuity over the variable annuity is the stable income stream offered by the fixed annuity Since the variable annuity's income is tied to the return of underlying assets, which are usually equity-like the annuity's income also fluctuates as the return on the underlying assets fluctuates A disadvantage of fixed annuities is since their income stream is fixed they lose real earning power over time due to inflation Once the fixed or variable contracts are annuitized meaning the investor decides to have the payments sent to them for life, both fixed and variable annuities are equally difficult to terminate

The purpose of a personal line of credit secured by company stock for the owner of a private business is generally to:

extract cash from the business so the owner can use the funds for personal

purposes

convert the remaining ownership position to public stock

exit any responsibility for managing the business

Explanation

This is a monetization strategy that provides the owner with funds to use for other objectives The shares are still owned and the owner still has control of the company It does not convert shares to public stock, an IPO might accomplish that

Factors that are positively related to the demand for life insurance include:

financial wealth and probability of death

human capital volatility and risk aversion

risk aversion and probability of death

Explanation

As either risk aversion or probability of death increase, so does the demand for life insurance Human capital volatility and financial wealth are both negatively correlated with the demand for life insurance

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

life insurance

a guaranteed investment contract

a life annuity

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

Question #7 of 43 Question ID: 465104

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A measure of an individual's lifetime earning capacity is best defined as which of the following?

Total wealth

Human capital

Financial capital

Explanation

The definition of human capital is a measure of an individual's lifetime earning capacity It is the present value of the

individual's expected income from salary, wages, bonuses, etc, as well as employment-related retirement pension income Human and financial capital added together are called total wealth

Which of the following statements is least accurate regarding human capital?

When possible, one should maximize the correlation of human and financial

capital

The demand for life insurance will increase if human capital is bond-like

If an investor's human capital is equity-like they should allocate a greater amount of

their financial capital to fixed income investments

Explanation

One should always offset the risk of their human capital with the risk of their financial capital and minimize the correlation between the two If an investor's human capital is equity-like they should reduce the correlation with their financial capital by allocating a greater amount of their financial capital to fixed income investments and visa versa The demand for life insurance will increase if human capital is bond-like and decrease if human capital is equity-like

Which of the following is least likely a solution to longevity risk?

SMarT programs

Pension plans

Social Security

Explanation

SMarT (Save More Tomorrow) programs are considered solutions to savings risk (not longevity risk) because in the SMarT programs individuals pledge to save a portion of future raises

Question #10 of 43 Question ID: 465103

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Social security and other employment-related pension payments are considered:

financial capital because they are derived from an accumulation of the

investor's past labor

human capital because they are derived directly from the investor's labor

neither human capital nor financial capital because they are received after retirement

Explanation

Since social security and other employment-related pension payments are derived directly from the investor's labor, they are considered human capital Thus, an individual's human capital can have a positive value at retirement

To structure a limited partnership that would transfer tax burdens from the current owner of a real estate investment while allowing the owner to control the property the current owner should assume the role of:

angel investor

limited partner

general partner

Explanation

As general partner the current owner will still make the business decisions and controls the asset An angel investor is a term that can refer to the first non-family member investor in a new business

Life insurance is most commonly used to hedge against:

longevity risk

earnings risk

mortality risk

Explanation

Life insurance is the most commonly employed hedge against mortality risk

Which of the following is not intended to increase the loan to value ratio in a monetization strategy?

Total return equity swap

Sale of the asset

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Forward conversion with options

Explanation

Sale of the asset typically generates cash and there is no need for a loan The other strategies hedge away much of the risk in the position and should allow a higher LTV loan to be obtained

The three primary risks that could jeopardize the desired lifestyle and/or bequest of an individual include which of the

following?

Financial market risk, longevity risk, and savings risk

Savings risk, financial market risk, maturity risk

Longevity risk, savings risk, and inflation risk

Explanation

The three primary risks that could jeopardize an individual's retirement plans are: financial market risk, longevity risk, and savings risk Financial market risk refers to the effects of volatility in the financial markets that could result in significant drops

in portfolio values Longevity risk refers to the chance of out-living one's financial assets Savings risk refers to the chance of

an individual spending more than they should so that they save less than needed during the accumulation stage This is usually the result of poor long-term planning Inflation risk is included in savings risk

Financial wealth and the demand for life insurance have:

a negative relationship

a positive relationship

either a positive or a negative relationship depending upon the individual's level of

wealth

Explanation

Financial wealth and the demand for life insurance have a negative relationship which means if a person has a lot of financial wealth their need for life insurance is small and visa versa

In the following graph which of the following statements is most accurate regarding what the vertical axis represents besides dollars?

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The point in time when the individual finishes their educational training and

starts working

The point in time when the individual is born and their potential human capital is the

greatest while their financial capital is the smallest

The combined amount of human and financial capital called total wealth

Explanation

The vertical axis denotes the point in time when the investor finishes preparing for their career by completing their education

or training and starts generating income It also shows the amounts of human and financial capital separately

The volatility of human capital and the demand for life insurance are:

uncorrelated

positively correlated

negatively correlated

Explanation

Human capital volatility and demand for life insurance are negatively correlated Life insurance acts as a substitute for human capital, so its face value depends on the perceived value of the human capital it replaces If the human capital has high volatility (equity-like), a higher discount rate is used to estimate its present value Thus, human capital with high volatility has a smaller present value than human capital with low volatility

After attending a recent conference on wealth planning for high net worth individuals you prepare several summary points to present to your coworkers:

I An estate tax freeze is a good way to shift the tax burden on future appreciation to the next generation

II A family limited partnership allows the founding member of a company to shift day to day company management of the business to the next generation while retaining the benefits of appreciating value in the company for the founder

Which of the statements are most accurate?

I and II

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Explanation

An estate tax freeze is generally used to shift future appreciation and resulting tax liability to others The family limited

partnership is also designed to shift future appreciation to others and away from the giver The giver would act as general partner and therefore still have control of the business

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:

high because their incomes would have a low variability over time

indeterminate since the discount rate is based on factors other than the variability in

their incomes

low representing lower risk due to their stable incomes

Question #20 of 43 Question ID: 484995

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Explanation

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 5, LOS 13.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?

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

Their portfolio should be allocated more towards risky assets since their human capital

is bond-like

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

Explanation

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 5, LOS 13.g)

The statements made by the financial consultant regarding the demand for life insurance and the asset allocation of the policy premiums are:

correct for only one of the statements

correct for both statements

incorrect for both statements

Explanation

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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 5, LOS 13.g)

A disadvantage of the Arlt's choice of the annuity is:

the annuity is less tax efficient than utilizing a 401k or 403b account

the annuity will lose real earning power in periods of high inflation

if they both die before their predicted life expectancy the remainder of their assets will

go to the insurance company instead of their heirs

Explanation

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 5, LOS 13.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?

Earnings risk

Savings risk

Longevity risk

Explanation

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 5, LOS 13.e)

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What type of risk will the purchase of the deferred variable annuity mitigate against?

Longevity risk

Savings risk

Financial market risk

Explanation

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 5, LOS 13.e)

Which of the following is NOT a drawback to a fixed annuity?

The real value of the cash flows may decline over time

The cash flows could be zero if the underlying asset return is negative for the

investment period

The investor usually cannot void the contract

Explanation

Cash flows received on a variable pay annuity (not fixed annuity) are based on the performance of an underlying fund or set of funds selected by the investor and thus the cash flows are variable and could be zero if the performance of the underlying funds is negative for the investment period Drawbacks to fixed annuities are:

cash flows are fixed and do not increase with the rate of inflation thus the real value of the cash flows decreases over time cash flows are based on the level of interest rates at the time the annuity goes into effect If interest rates are low when the contract goes into effect this would lock in a low rate of return to the investor

the annuity is illiquid and difficult to get out of the contract

In general, an individual facing retirement has a greater amount of:

both human and financial capital than when they first started working

financial capital than human capital

human capital than financial capital

Explanation