Competency 12 Knowledge Check Flashcards
- Volatility is measured by Kurtosis
False. Volatility is measured by standard deviation. (LO 12-1-1)
- Portfolio risk is the volatility of the returns generated by a portfolio of assets over time.
True. (LO 12-1-1)
- Risk tolerance is determined by both one’s ability and willingness to take risk.
True. (LO 12-1-1)
- Most individuals exhibit increasing marginal utility from consumption
False. Most people exhibit decreasing marginal utility from consumption. (LO 12-1-1)
- The length of time until retirement can be a determinant of one’s risk tolerance
True. (LO 12-1-1)
- A client’s insurance decisions can provide signals of his or her level of risk tolerance
True. (LO 12-1-1)
- Market risk can be eliminated through the process of diversification.
False. Market risk cannot be eliminated through portfolio diversification. (LO 12-1-2)
- Company-specific risks can be eliminated through the process of diversification
True. (LO 12-1-2)
- Portfolio risk can be decreased through diversifying across industries
True. (LO 12-1-2)
10.Modern portfolio theory optimization incorporates the correlation structure of asset returns
True. (LO 12-1-3)
11.The objective of modern portfolio theory optimization is to find a portfolio that offers the highest return per unit of risk
True. (LO 12-1-3)
12.The optimal risky portfolio is also known as the optimal household portfolio
False. The optimal risky portfolio is rarely the same thing as the optimal household portfolio because investors differ in terms of their tolerance for risk. The optimal household portfolio is comprised of both a risk-free asset and the optimal risky portfolio. (LO 12-1-3)
13.A 90-day T-Bill is often used to represent a risk-free asset in mean-variance space
True. (LO 12-1-3)
14.Tactical asset allocation is a strategy where asset allocation changes over time based on future market expectations
True. (LO 12-1-4)
15.Tactical asset allocation focuses on long-term expectations of macro-economic conditions.
False. Tactical asset allocation focuses on shorter-term macro-economic conditions. Strategic asset allocation focuses on long-term conditions. (LO 12-1-4)
16.Modern portfolio theory can rely upon either tactical or strategic asset allocation expectations for the assumptions used in determining an appropriate asset allocation of a portfolio
True. (LO 12-1-4)
17.Secular bear markets often result in the reliance on strategies such as: picking individual stocks, sector rotation, adding alternative investment classes, and tactical asset allocation
True. (LO 12-1-4)
18.Market valuation is a popular indicator for making tactical investment decisions because stock valuation provides some of the best information for determining long-term returns.
True. (LO 12-1-4)
19.One common strategy based on macro-indicators is to weight more heavily certain stock sectors based on economic conditions
True. (LO 12-1-4)
20.In a retirement income portfolio, tactical planning can be both an opportunity and an efficiency.
True. (LO 12-1-4)
- Human capital is the present value of the wages one earns over his or her life
True. (LO 12-2-1)
- One’s human capital is greater during retirement than during his or her working years
False. At retirement, there is very little human capital remaining as a retiree is not expected to be working and earning wages anymore. (LO 12-2-1)
- People with a stable stream of earnings from their job have human capital that is like a stock.
False. This is more analogous to a bond. A person with a volatile income stream has human capital more similar to a stock. (LO 12-2-1)
- People with a stable stream of earnings from their job can afford to take more risk when investing for retirement
True. (LO 12-2-1)
- Solomon Huebner and Alfred Marshall pioneered the concept of human capital
True. (LO 12-2-1)
- People with defined-benefit plans need to have safer investments.
False. People with well defined-benefit plans already have a level of safety and can take riskier investments in other investment areas. (LO 12-2-1)
- In today’s environment, an investment in a 90-day Treasury bill will generally provide a higher rate of return than prepaying principal on a 30-year fixed mortgage
False. The T-bill rate is likely to be substantially lower than the rate on a 30-year fixed mortgage. (LO 12-2-2)
- In a typical 30-year mortgage, mortgage payments in the final years comprise mostly of interest payments
False. Mortgage payments near the end of the term of the loan are mostly payments of principal. (LO 12-2-2)
- It is less risky to make mortgage prepayments of principal regularly than to accumulate an investment fund to pay off the loan later
True. (LO 12-2-2)
10.Generally, the best course of action is to pay off consumer debt before mortgage debt.
True. (LO 12-2-2)
11.If you have a stock mutual fund with an average rate of return of 7% and a fixed rate mortgage with an interest rate of 5%, it is always better to hold onto the investment fund than to prepay the mortgage
False. This is an individual decision. Many will see a risk-free return of 5% as a better deal than a risky return that averages 7% (especially an older client looking to increase the portfolio allocation to less risky assets). (LO 12-2-2
12.The benefit of rebalancing is that it keeps portfolio risk at an appropriate level
True. (LO 12-2-3)
13.Percentage-of-portfolio rebalancing is simpler to execute than calendar rebalancing
False. Calendar rebalancing is the simplest form of rebalancing. (LO 12-2-3)
14.Calendar rebalancing makes changes to asset allocations more quickly than percentage-of-portfolio rebalancing in response to movements in the market.
False. Percentage-of-portfolio rebalancing requires an examination each day of trading, while calendar rebalancing only occurs at set days. (LO 12-2-3)
- With the risk/return paradigm that applies to a retirement income portfolio, return is measured as the rate of return on the portfolio.
False. Return is measured as the amount that is withdrawn from the portfolio each year. (LO 12-3-1)
- When considering both retirement income considerations and a legacy goal, investing in bonds is the best way to protect a client’s legacy goals.
False. A reliance on bonds can result in low returns and inflation-related problems with the portfolio. (LO 12-3-1)
- Modern Portfolio Theory is important to retirement income planning in that it addresses how to lower variability without reducing return through different combinations of assets
True. (LO 12-3-1)
- A 4 percent withdrawal rate may be too low for the risk tolerant and too high for the risk averse
True. Risk tolerance is an important consideration that affects the appropriate withdrawal rate for a client. (LO 12-3-1)
- Research shows high levels of portfolio equity allocations in a retirement income portfolio (75-100%) can increase average remaining legacy left to heirs.
True. High equity levels will increase the average legacy, even though it will also increase the risk of portfolio failure/exhaustion. (LO 12-3-1)
- There is no single optimal withdrawal rate that is applicable to every client
needs, and wealth. (LO 12-3-1)
- A retiree with more guaranteed life time income is likely to have more risk capacity when considering a withdrawal rate from a retirement income portfolio.
True. (LO 12-3-1)
- Historically, a sustainable withdrawal rate varies considerably depending upon the year that an individual retires
True. The actual safe withdrawal rate varies considerably between 4% and 10%. We use 4% since it is sustainable in the worst case scenario—but for many years the safe withdrawal rate is actually much higher. (LO 12-3-2)
- Choosing a savings target based on a 4% withdrawal rate may be an appropriate way to estimate retirement needs for a young client, but is not an accurate approach for those nearing retirement
True. (LO 12-3-2)
10.The 4% safe withdrawal rate might not be a safe withdrawal rate for retirees in 2012
True. The safe withdrawal rate is based on historical worst case scenario data, but we do not know that it will be sustainable in the future. (LO 12-3-2)
11.The safe savings rate for a client can be impacted by the market performance, length of savings period, and length of retirement
True. All of these factors can impact a client’s safe savings rate that is needed to meet spending needs in retirement. (LO 12-3-2)
12.The safe savings rate is similar to the safe withdrawal rate in that it identifies how much an individual needs to save each year to meet spending needs in retirement in the worst case scenario.
True. (LO 12-3-2)
13.There is a very strong relationship between the success of a portfolio five years before retirement and at retirement
False. Even as close as five years before retirement, it is very difficult to predict the success of a portfolio. (LO 12-3-2)
14.Research shows if portfolio returns are positive, the sustainable withdrawal rate will be lower the following year
True. (LO 12-3-2)
15.Retiring during a bull market at retirement means a lower sustainable withdrawal rate than retiring in a bear market
True. Research has shown that when retiring during the height of a bull market, the sustainable withdrawal rate is lower and the opposite is true for a bear market retiree. (LO 12-3-2)
16.When determining a safe savings rate, the length of the retirement period is more important than the length of the savings period
False. Research shows that the length of the savings period has a greater impact on the safe savings rate than the length of the retirement period. (LO 12-3-2)
17.The longer the retirement period, the higher the safe savings rate.
True. The longer the retirement period, the higher the safe savings rate will need to be, or the longer the savings period will need to be. (LO 12-3-2)
18.Keeping a steady allocation between bonds and equity (60/40) can help sustain withdrawal rates
True. (LO 12-3-2)
19.During retirement, a steady reduction in equities over time is the best way to protect the retirement income portfolio.
False. Research shows it is best to keep a mixed allocation between bonds and equity even as a client ages. (LO 12-3-3)
20.Reducing equity exposure during retirement can be an appropriate strategy when assets have performed well and locking in gains allows the client to meet income objectives.
True. (LO 12-3-3)
21.Since annuities have similar investment characteristics to bonds, it is always appropriate to liquidate the bond portion of the portfolio when purchasing a life annuity to create a retirement income floor
False. Even though academics often equate these two types of investments, when looking solely at the investment portfolio after the purchase, the portfolio may be viewed by the client and regulators as too heavily weighted in equities. (LO 12-3-3)
- A drawback of the historical analysis approach for testing sustainable withdrawal rates is that it does not provide actual data showing correlations between stock and bond performance
False. One of the benefits of the historical approach is that it shows actual data regarding correlations between stock and bond performance. (LO 12-4-1
- The standard 4% safe withdrawal rate that was tested using historical analysis was successful in 90% of the 30-year retirement periods tested.
False. The 4% safe withdrawal rate was shown to work 100% of the time. It is a worst case scenario rate. (LO 12-4-1)
- The historical approach methodology is best used when future market performance is expected to be similar to the past
True. (LO 12-4-1)
- It is unlikely that a 4% withdrawal rate tested with Monte Carlo analysis will achieve a 100% success rate
True. Because of the number of observations, it is very difficult to have a 100% pass rate. (LO 12-4-1)
- A drawback of the Monte Carlo approach is the GIGO (garbage in garbage out) problem
True. The Monte Carlo approach requires a significant amount of inputs and unrealistic assumptions provide unrealistic results. (LO 12-4-1)
- The bootstrapping methodology ignores historical data.
False. It is an approach using Monte Carlo analysis but applying assumptions based on historical returns. (LO 12-4-1)
- A drawback of the bootstrapping methodology is that randomly ordered historical returns may result in sequences of returns that are unrealistic.
True. While each year did occur, it is possible that such years could not occur in the actual order generated by the model. (LO 12-4-1)
- The safe withdrawal rate drops approximately 1% for each additional ten years of retirement
False. Typically, safe withdrawal rates drop by approximately .5% for each additional ten years added on to the retirement time horizon. (LO 12-4-2)
- Optimal asset allocation for longer retirement periods includes more bonds and less stock
False. Longer retirement periods typically need higher levels of equity because they need slightly more growth. (LO 12-4-2)
10.Longevity is a factor when determining an appropriate withdrawal rate for a client
True. A longer or shorter retirement period impacts the appropriate withdrawal rate. (LO 12-4-2)
11.Early research on safe withdrawal rates ignored issues such as investment fees and taxes
True. (LO 12-4-2)
12.Higher tax rates will reduce a client’s safe withdrawal rate for taxable assets.
True. (LO 12-4-2)
13.The 4% safe withdrawal rate was not based on historic international market conditions
True. The safe withdrawal rate was only based on U.S. historical data. (LO 12-4-2)
14.Research shows that the safe withdrawal rate for a 40% equity portfolio is substantially lower than that of a 60% equity portfolio.
False. Research shows that the safe withdrawal rate for a 40% equity portfolio is almost identical to a 60% equity portfolio. (LO 12-4-2)
15.The 4% withdrawal rate was not sustainable in many of the industrialized countries of the world in the 20th century
True. (LO 12-4-3)
16.Current market conditions suggest that current retirees can safely choose a 4% withdrawal rate
False. The 4% withdrawal rate has a high failure rate if assumptions are tied to current interest rates and a reasonable equity premium. (LO 12-4-3)
17.Life cycle finance theory advises that people should shift consumption from times of plenty to times of need
True. (LO 12-4-4)
18.Utility theory suggests that an individual receives the same level of satisfaction for each additional dollar spent
False. Utility theory states that as spending increases, the happiness created by each dollar spent increases but at a decreasing rate. (LO 12-4-4)
19.When determining a withdrawal rate for a client, it is important to understand the client’s spending flexibility and longevity risk aversion.
True. (LO 12-4-4)
20.An optimal withdrawal rate is always the same as the safe withdrawal rate
False. Clients who are more risk tolerant might make the rational choice of spending more now and be willing to risk having to spend less later. (LO 12-4-4)
21.The optimal withdrawal rate is based on risk tolerance, spending flexibility, and other income.
True. (LO 12-4-4)
22.The buffer zone strategy is to set aside money in cash (i.e. money market mutual fund) and put the rest into an investment portfolio of riskier assets.
True. (LO 12-4-5)
23.A basic premise of the buffer zone strategy is it allows the individual to avoid selling the portfolio when prices are down
True. (LO 12-4-5)
24.The stock market often sees extended years of down years, ranging between three and five consecutive years of down returns
False. While there has been one example of a 4-year downturn and two examples of 3-year downturns, the stock market has never experienced five consecutive years of downturns. (LO 12-4-5)
25.Research shows that the buffer zone strategy works over a 100% portfolio investment because the reduced risk and variability always outweighs the lower average returns.
False. The research shows that the buffer zone strategy is generally inferior to the 100% portfolio strategy, implying that the lower returns is the dominant factor in this case. (LO 12-4-5)
- Bond ladders to meet retirement income needs are most typically built with coupon bonds
False. Bond ladders are typically built with zero-coupon bonds or other bonds that mature at a given time but do not pay interest in the intervening time. The maturing bonds provide the cash flow needed for each year’s income. (LO 12-5-1)
- For flooring purposes, planners may want to use income STRIPs of TIPS to build an inflation adjusted income floor
False. TIPs are a good alternative for building an income floor, but you would be more likely to purchase the principal interest in the TIPS. (LO 12-5-1)
- A common way to floor benefits is with federal government bonds because federal government bonds eliminate default risk.
True. (LO 12-5-1)
- Some planners avoid using municipal bonds to build a bond ladder to floor their client’s benefits because these bonds have default risk
True. (LO 12-5-1)
- Treasury bonds are exempt from state income taxes.
True. (LO 12-5-1)
- Original issue discount bonds avoid taxation until they mature
False. Original issue discount bonds result in taxable imputed income each year. (LO 12-5-1)
- TIPs can make an excellent flooring product because they address both default risk and inflation risk
True. (LO 12-5-1)
- Flooring strategies using bond ladders will always eliminate the client’s longevity risk.
False. Flooring strategies with bond ladders do not automatically eliminate longevity risk. However, the planner can choose a conservatively long time horizon to combat longevity risk. Alternatively, flooring strategies with annuities take away longevity risk. (LO 12-5-1)
- Bond mutual funds are not optimal for flooring because it is difficult to match a client’s exact income needs with a mutual fund payment over time
True. (LO 12-5-1)
- Withdrawing funds first from a taxable account prior to taking withdrawals from tax-deferred and tax-exempt accounts will generally result in a more rapid depletion of the portfolio than starting with the tax-exempt account
False. Taking withdrawals from the taxable account first will probably add years to the portfolio’s longevity. All else being equal, the extra rate of return will make a difference to extend the portfolio. For example, there is a 1.4 percent after-tax return greater on a Roth or tax-deferred account that earns 5 percent (after-tax = 5 percent) versus a taxable account (after-tax at the 28 percent bracket = 3.6 percent). (LO 12-6-1)
- The planner should look throughout retirement for opportunities to take withdrawals from a tax-deferred account at a tax rate lower than the client’s regular marginal tax rate.
True. (LO 12-6-1)
- Your client has the opportunity to take withdrawals from a Roth account, a tax-deferred 401(k) and a taxable account. He should take out all funds from the taxable account before touching the Roth or 401(k) account
False. Clients should first take some withdrawals from the 401(k) to take advantage of a lower than average tax rate (for many this will be up to top of the 15 percent bracket), then take from the taxable account, and then from the Roth account in order to extend the portfolio’s longevity. (LO 12-6-1)
- A significant amount can be withdrawn by a retiree from a taxable account at a zero percent tax rate because the personal exemption, the standard deduction, and additional deduction for those age 65 or older
True. (LO 12-6-1)
- It is better to pay taxes on a 401(k) withdrawal in year one at 15 percent than in year three at a 25 percent rate
True. (LO 12-6-1)
- Clients who expect future tax rates to increase should take money out of their Roth account first (before tax-deferred and taxable accounts).
False. If tax rates are expected to rise in the future, the client should consider holding on to Roth money. (LO 12-6-1)
- Holding on to Roth investments (as opposed to tax-deferred and taxable investments) may be appropriate if the client expects future tax rates will increase
True. (LO 12-6-1)
- Saving a portion of the tax-deferred account until later years may be prudent as many older clients experience increased medical expenses and can take withdrawals at a low tax rate due to increased medical deductions
True. (LO 12-6-1)
- Taking withdrawals in a tax efficient manner can end up distorting the client’s asset allocation
True. (LO 12-6-2)
10.Planners must be prepared to plan for volatility in tax rates.
True. (LO 12-6-2)
11.If capital gains tax rates are expected to increase, the client should consider harvesting losses as soon as possible
False. Wait to harvest losses if capital gains rates are expected to increase. (LO 12-6-2)
