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CFA Level III > Private Wealth Management > Flashcards

Private Wealth Management Flashcards

1
Q

Source of Wealth

A
  1. Active creation - entrepreneur
    1. risk taker (may only like business risk, not investment risk)
  2. Passive creation - inheritance or savings over time
    1. Doesn’t like to make decisions
    2. risk-adverse
    3. Low confidence
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2
Q

Measure/Perception of Wealth and Risk

A
    • correlation between perception of wealth and risk
      • High wealth = risk taker
      • Low wealth = risk-adverse
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3
Q

Stages of Life

A
  • Foundation: accumulating wealth (savings, job, education)
    • CAN take risk but may not have the funds
  • Accumulation: earnings rise, obtain financial assets
    • High ability to bear risk
  • Maintenance: start of retirement, preserving wealth
    • Ability to take risk declines
  • Distribution: assets exceed living (look to gift assets)
    • Risk depends on succession plan
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4
Q

Personality Types

A
  1. Cautious: risk averse emotional trouble with decisions
  2. Methodical: risk averse cognitive gather lots of data
  3. Individualistic: risk taker cognitive confident/make decisions
  4. Spontaneous: risk taker emotional high turnover, chase fads
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5
Q

IPS: Benefits to Client

A
  • Identifies and documents objectives and constraints
  • Dynamic
  • Portable
  • Allows client to:
    • learn more about themselves
    • understand the advisors recommendations
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6
Q

IPS Creation Process

A

THINK: RRTTLLU

Risk, Return (Objectives)

Time Horizon, Taxes, Liquidity, Legal, Unique (Constraints)

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7
Q

Return Objectives

A
  • Required return: used for high priority items (living expenses, healthcare, etc)
  • Desired return: not as important (buying a 2nd home, etc)

Make sure to use:

  • Total Return
  • Nominal return (includes inflation)
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8
Q

Return Objective Steps

A
  1. List objectives (required and desired)
  2. Quantify the investable asset base and the numeric need
    1. Personal residence and vacation homes not part of investable assets
  3. Calculate a % return:
    1. return need / investable base
  4. Make sure to add inflation
  5. Make sure all returns are equal (all pre-tax or after-tax, nominal or real)
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9
Q

Calculate Return Objective (example)

A

Return example: client has a 30% tax bracket with $1,000,000, needing a $30,000 after-tax distribution. 2% inflation rate

calculate the real, after-tax return: 30 / 1,000 = 3.00%.

add inflation, after-tax return: 3.00% + 2.00% = 5.00%.

gross up for taxes to calculate the nominal, pretax return: 5.00% / (1 – 0.30) = 7.14%.

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10
Q

Return: Inflation (example)

A

Make sure to add inflation for each year!

Example: If 100,000 was needed last year and inflation is 4%. 104,000 is needed this coming year.

If investable base is $2,000,000

104 / 2000 = 5.2% distribution (real return)

Add inflation: 9.2%

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11
Q

Return: IRR (example)

A

Example: 4.5M in assets (includes house)

Client needs 200,000 after-tax annually
3% inflation, time horizon 25 years
Target: $2,000,000 real

Calculate the after-tax nominal return to maintain standard of living:

  • *Step 1:** investable base is 4.5M - 500K for house: $4M
  • *Step 2:** n = 25, PV = -4,000,000, FV = 2,000,000, PMT = 200,000 CPT I/Y = 3.76%
  • *Step 3:** Add inflation: 3.76% + 3 = 6.76%
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12
Q

IPS: Risk Objectives

A
  • Ability - taking losses without compromising goals
    • Based on Time horizon and expenses
      • Increased risk ability: Large portfolio to expenses, Time horizon
      • Decrease risk ability: large holding of single stock, relying solely on portfolio for income, high expenses to portfolio size
  • Willingness - based on psychological profile (emotional)
    • Clients are contradicting - look for evidence
  • Conclusion - based on ability and willingness
    • Go with more conservative
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13
Q

Return: After-Tax to Pre-Tax

A

(return + inflation) / (1 - T)

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14
Q

IPS: Time Horizon

A

Long-term: 15+
Short-term: 3 or less

Could be multi-stage (pre, post retirement, kids pre, current college)

Remember

  1. State the # of stages
  2. Look for life altering stuff
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15
Q

IPS: Tax Considerations

A

Types: Income, Capital gains, etc.

Make sure to list:

  • Material unrealized gains/losses
  • Opportunities for tax deferral, avoidance, or sheltering
  • If complex issues, seek qualified advise
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16
Q

IPS: Liquidity

A
  • Ongoing distributions need to be listed
  • One-time distributions should be listed
    • if expected in under 1yr, deduct from the investable base
  • Emergency reserves
  • List illiquid investments (and when they can sell)

Higher liquidity needs –> lower ability to take risk

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17
Q

IPS: Legal and Regulatory Factors

A
  1. If there are none, state it
  2. If trust; follow the trust document
  3. Seek qualified advice if too complicated
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18
Q

IPS: Unique Circumstances

A
  1. Special concerns (SRI)
  2. Special instructions
  3. Constraints
  4. Assets held outside the investable portfolio (home, private business)
  5. Desired objectives not attainable due to time horizon or wealth
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19
Q

Choosing a SAA

A
  1. Eliminate dissallowed asset classes or weights
  2. Excessive or insufficient cash
  3. Failing to diversify
  4. Return objectives
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20
Q

Monte Carlo Pros and Cons

A

Pros

  • Considers path dependency (so you can see what happens in a bad market)
  • More clearly displays tradeoffs of risk and return
  • Properly show impact of taxes
  • Can answer questions (increase savings, retire eariler?)
  • Can analyze skewed returns (does NOT convert to a normal distribution)

Cons

  • Garbage in garbage out
  • Uses historical data
  • Model reflects asset class not actual assets
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21
Q

Deterministic Approach

A

Point estimates and ranges to forecast values (return or TV)

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22
Q

Taxes Rate Types

A
  • Marginal - highest bracket of taxes
  • Average - average of all taxes paid
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23
Q

Annual Accrual Taxes Formula (Tax Drag)

A
  • *Step 1:** FV w/ Tax: FVAT = PV[(1 + r(1 - tax)]n
  • *Step 2:** step one - cost basis
  • *Step 3:** FV no Tax: FVAT = PV(1 + r)n
  • *Step 4:** step three - cost basis
  • *Step 5:** Difference: Step four - step two = tax drag

Example:

1000 invested for 20 years. 10% pretax return
Subject to an annual tax rate of 30%

FVAT = 1000[1 + 0.10(1 - 0.30)]20 = 3869.68
3869.68 - 1000 (cost basis) = 2869.68

FVAT = 1000(1 + 0.10)20 = 6727.50
6727 - 1000 (cost basis) = 5727.50
5727.50-2869.68 = 2857.82 (49.9%)

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24
Q

Annual Accrual Taxes Notes (Tax Drag)

A
  • Tax drag exceeds tax rate because you lose compounding over time
  • Longer time horizon = higher tax drag
  • Higher return = higher tax drag
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25
Q

Capital Gains Tax Formula (Tax Drag)

A

FVIFAT = PV[(1 + r)n(1 - tcg) + tcgB]

B = tax basis / MV

Example:

Invest $100 for 20 years at 9%, taxcg = 25%

No taxes: FV = 100(1.09)<sup>20</sup> = 560.44 - cost basis(100) = 460.44
FV = 100[(1.09)<sup>20</sup>(1 - 0.25) + 0.25(1) = $445.33 - cost basis (100) = 345.33
Tax drag ($) = 115.11 Tax drag (%) = 115.11/460.44 = 25%
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26
Q

Capital Gains Tax Notes

A
  • No lost compounding of return
  • Tax drag increases over time
  • if no initial ug/l and costs basis = 1, tax drag = the tax rate
  • if initial ug/l is a GAIN: tax drag is > than tax rate
  • if initial ug/l is a LOSS: tax drag is < than tax rate
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27
Q

Annual Wealth Based Tax Formula

A

FVAT = PV[(1 + r)(1 - tw)]n

Example:

1000 invested 20 years, pretax return of 10%.
Wealth tax of 3%. Compute value and tax drag

FVAT = 1000[(1 + 0.10)(1 - 0.03)]20 = 3658.38
3658.38 - 1000 = 2658.38
If no tax = 1000(1 0.10)^20 = 6727.50 - 1000 = 5727.50
5727.50-2658.38 = 3069.12 (53.6%)

28
Q

Wealth Tax Implications

A
  1. TD$ and TD% increase over longer time periods
  2. TD$ increases but TD% decreases at higher rates of return
    1. Tax on initial value is constant, so higher return is less of a %
  3. TD% is lowest for moderate time horizon/return
  4. TD% is higher when time horizon is longer/higher or shorter/lower
29
Q

Accrual Equivalent Return and Tax Rate Formulas

A

Accrual Equivalent Return: RAE = (FVAT / initial investment)1/n - 1

Accrual Equivalent Tax Rate: TAE = 1 - (RAE / r)

Example: 1000 invested for 20 years, pretax return of 10%.
Return has annual tax of 30%. FVAT is 3869.68, tax drag = 49.9%

RAE = (3869.68 / 1000)1/20 - 1 = 7%

TAE = 1 - (.07 / .1) = 30%

30
Q

Tax-deferred and Tax-Exempt Formulas

A

FVTEA = PV(1 + r)n

FVTDA = PV[(1 + r)n (1 - tn)]

FVtaxable = PV [1 + r(1 - tax)]n

31
Q

Use Tax-deferred or Tax-Exempt?

A

If taxes now are less than future taxes - Use Tax Exempt

If taxes now are more than future taxes - Use Tax Deferred

If they are the same, doesnt matter

32
Q

Taxes Affect on Return and Investment Risk

A

rAT = r(1 - t)

stdAT = std(1 - t)

Government shares in gains and losses: makes taxable account the lowest risk

33
Q

Trading Behavior Types

A
  1. Traders - daily investors. No tax alpha due to realized gains
  2. Active investors - many gains are longer term.
  3. Passive investors - hold equity and defers gains
  4. Exempt investors - avoid taxation
34
Q

Relationship between trading and taxes

A
  • Asset allocation is more important than asset location.
  • First get assest allocation, then try to minimize taxes
  • High trading reduces after-tax return due to taxes/costs
35
Q

Mortality Table Approach

A
  • Combined probability: (a + b) - (a * b)
  • PV: expected real spending / (1 + r)n

Risks

  • based on probabilitys. Approx. half will live longer
  • Real spending could increase
36
Q

Gift Ratio Tax- Free

A

RVtax-free = [1 + rg(1 - tig)]n
[1 + re(1 - tie)]n (1 - Te)

rg = pretax return for receiver tig = tax rate on earnings for receiver

re = pretax return for giver tie = tax rate on earnings for giver

Te = Estate tax Tg = Gift Tax

37
Q

Gift Ratio Taxable Gift Receiver

A

RVtaxable gift receiver =

[(1 - Tg)][1 + rg(1 - tig)]n
[1 + re(1 - tie)]n (1 - Te)

Note: Same as standard except for the bold

rg = pretax return for receiver tig = tax rate on earnings for receiver

re = pretax return for giver tie = tax rate on earnings for giver

Te = Estate tax Tg = Gift Tax

38
Q

Gift Ratio Taxable Gift Giver

A

RVtaxable gift giver =

(1 - Tg + TgTe)[1 + rg(1 - tig)]n
[1 + re(1 - tie)]n (1 - Te)

Note: Same as standard except for the bold

rg = pretax return for receiver tig = tax rate on earnings for receiver

re = pretax return for giver tie = tax rate on earnings for giver

Te = Estate tax Tg = Gift Tax

39
Q

Gift Ratio Notes

A
  • If RV > 1 –> Gift now
  • If RV < 1 –> Bequest at death
  • If RV = 1 – > Gift now
    • 1 / (1 - Te)
  • Tax exempt receiver is best to give now
  • Once gifted cannot be recovered
    • Could underestimate future needs
40
Q

Generation Skipping

A

FVno skipping = PV [(1 + r)n1 (1 - t)][(1 + r)n2 (1 - t)]

FVskipping = PV [(1 + r)n1 + n2 (1 - t)]

Then:

Relative value = Skip / No skip

Example: 5% return, 40% tax rate. 15 year first generation
30 year second generation

41
Q

Relief From Double Taxation

A
  • Tax treaties between countries
    • Exemption - income taxed by source country only
    • Credit - tax owed to source country reduces taxes to the residence country
      • If tresidence > tsource the difference is still owed
    • Deduction (only partial relief)
    • ALWAYS START WITH SOURCE
42
Q

Double Taxation (Examples)

A

$2.6M of income for residence. 750K of that is from source
residence tax = 35%, source tax = 40%

Exemption

Source: 750,000(.40) = 300K, Residence: 1,850,000(0.35) = 647,500
Total tax owed = 300,000 + 647,500

Credit

Source: 750,000(.40) = 300K, Residence: 1,850,000(0.35) = 647,500
Residence: 750,000(0.35) = 262,500 - less than 300K so waived
Total tax owed = 300,000 + 647,500
(if residence tax > source you owe more)

Deduction

Source: 750,000(.40) = 300K, Residence: 1,850,000(0.35) = 647,500
Residence: 750,000-300,000(0.35) = 157,500
Total tax owed = 300,000 + 647,500 + 157,500

43
Q

Managing Concentrated Positions

Objectives and Constraints

A

Objectives:

  1. Reduce the risk
  2. Generate liquidity
  3. Optimize tax efficiency

Constraints:

  1. Restriction on sale (e.g. insider)
  2. Desire for control
  3. Has other uses for assets (real estate)
44
Q

Margin Lending Rules

A

Rule-Based: defines exact percentage (think US)

Risk-Based: considers underlying economincs (derivatives can change risk and increase margin ability)

45
Q

Goal-Based Decision Process

A
  1. Personal risk bucket: protect from proverty (cash/CDs)
  2. Market risk bucket: maintain standard of living (stocks/bonds)
  3. Aspirational risk bucket: private business, concetrated positions, real estate, etc.
46
Q

Managing Concentrated Stock Steps

A
  1. Set objectives/constraints
  2. Identify best strategies
  3. Identify tax advantages/disadvantages
  4. Identify other advantages/disadvantages
  5. Document decisions
47
Q

Estate Tax Feeze

A

AKA Corporate estate tax freeze: transfers appreciation and tax liability to a future generation.

TAXABLE event

Example: restructure company with voting perferred and nonvoting common stock

Voting preferred keeps control, cash flow, and has no initial unrealized tax liability

Nonvoting common minimal initial value and tax, captures future growth

48
Q

Concentrated Positions

Limited Partnership

A
  1. Create a LP
  2. Gift the asset to the partnership
  3. Giftor serves and GP and retains control
  4. LPs have limited marketability and no control
    1. Results in valuation discounts which reduces gift taxes
  5. Future value and tax liability goes to LPs
49
Q

Concentrated Positions

Techniques to Manage

A
  • Sell the asset - triggers tax liability and loss of control
  • Monetize the asset: borrow against the asset
    • Structure to eliminate as much risk as possible without the tax liability coming due
  • Hedge the asset value: uses derivatives to limit downside risk
    • OTC: create counterparty risk, provide flexibility
    • Exchange traded; enters offsetting transaction, prices are publicly recorded, more transparent.
50
Q

Concentrated Positions

Types of Monetization Tools

A
  • Short Sale box: borrow same stock and sell short to get cash
    • Makes the position riskless (earns Rf)
  • Equity Forward Sale Contract: enter in a forward contract to sell
    • Known sale price and eliminates up/down movement
  • Forward Conversion with Options: selling calls and buying puts
  • Total Return Equity Swap: Pay return on asset and receive LIBOR
    • Returns above LIBOR investor pays.
    • Returns below LIBOR invest receives
51
Q

Concentrated Positions

Using Options

A
  1. Buy a protective put (portfolio insurance)
  2. ATM puts are the most expensive.
    1. To reduce expenses;
      1. Buy OTM put (no protection unless stock falls below strike)
      2. Buy a put with shorter expiration
      3. Use knock-out put (raises too much option terminates)
      4. Purchase a collar
52
Q

Concentrated Positions

Tax-Optimizing Equity Strategies

A
  1. Index tracking with active management
    1. Cash from a monetized position invested in an index
  2. Coordinate around the concentrated position
    1. Diversification around the concentrated position
53
Q

Perfect Hedge and Cross Hedge

A

Perfect Hedge - eliminating all risk. Could be considered a sale (Tax due ASAP)

Cross Hedge (increases unsystematic risk)

  1. Short sale a similar stock
  2. Short sale an index that contains the concentrated position
  3. Purchase a put on the concentrated position
54
Q

Concentrated Positions

Exchange Fund

A
  • Create a fund and contribute our concentrated position
    • Others do the same to create a diversified portfolio
    • Own the initial % contributed
  • High costs and legal restrictions
55
Q

Privately Business Exit Strategies

A
  1. Strategic Buyer - wants to use the business (pays the highest price)
  2. Financial Buyer - think private equity fund
    1. may restructure, add value, then sell the business
  3. Recapitalization - Issue debt to finance purchase of owner’s stock
    1. Owner can sell shares and the company takes on the debt
    2. Retain Control and could receive dividends
  4. MBO or sale to employees - taxable and loss control
    1. Requires discounted price and they have to borrow
  5. IPO or ESOP
56
Q

Concentrated Real Estate

A
  1. Use mortgage financing to borrow funds
    1. a nonrecourse loan is like a protective put (they could only take the property)
  2. Sale and leaseback
  3. Put in a chartitable trust
57
Q

Human Capital

A
  • The discounted cash flows of what you make
  • High HC requires more life insurance
    • ​Steady income = lower discount rate, higher HC
    • Sales/commission income = higher discount rate, lower HC (less insurance)
  • Start off with high HC, low FC, but switches over time

Example; wages 100,000, growth 4%, r = 3%, risk = 10%

% of Life Wages % * Wages PV
Year 1 98% 104,000 101,920 90,195
Year 2 98% 108,160 105,997 83,011
Year 3 97% 112,486 109,111 75,619

Total HC: 248,825

58
Q

Financial Stages of Life

A
  1. Education - no savings or risk managment
  2. Early Career - saving is difficult, life insurance for family
  3. Career Development - financial obligations increase (kids college), building up FC
  4. Peak Accumulation - Highest FC accumulation, financial obligations slowing, risk is reducing
  5. Preretirement - focus on FC for retirement, risk reducing, tax planning
  6. Early Retirement - new lifestyle, expenses could increase
  7. Late Retirement - highy unpredictable, longevity risk, increase health care
59
Q

Holistic Balance Sheet

A

Taking Financial and Human capital and comparing to all debt, lifetime expenses, and planned bequests.

60
Q

HC and FC Risks

A
  1. Health risk: insure with health insurance
  2. Earnings risk: losing job, disability, how risky the job is
    1. Insure with disability insurance
  3. Longevity risk: insure with annuities
  4. Liability risk (getting sued): insure with liability insurance
  5. Premature death risk: insure with life insurance
  6. Property risk (flood, fire, etc): insure with property insurance
61
Q

Types of Insurance

A
  • Term - “pure insurance” only for a period of time
  • Perm - last for lifetime and includes a cash value
    • Whole Life - set periodic premium
    • Universal life - allows adjustments to premium and how it’s invested
  • Mortality credits - risk shared/pooled
62
Q

Pricing Life Insurance

Issues and Process

A

Issues

  • When will death occur?
  • Return on premiums
  • Company expenses
  • Profit Margin

Process

  • Mortality esimates
  • Net premium (what to charge) - ROI & mortality (males get charged more)
  • Load - added to net premium to make a profit
63
Q

Fixed vs Variable Annuities

A
  • Fixed have a higher initial payout (Variable potentially higher over time)
  • Fixed payouts based on initial interest rates (if low, low payments)
  • Fixed easier to analyze
  • Variable allows an early payout/close
  • Variable higher fees (fixed lower)
64
Q

Gifting Now to a Charity vs a Bequest

A
  1. Effective annual return by receiver increases since they are tax exempt
  2. Gift would not be taxed
  3. Tax deduction immediately
65
Q

Risk/Return Tradeoff Example

66
Q

LIfe Insurance Calculations

Human Life Method

Needs Analysis

A

Human Life Method

PV of excess income * years until retirement

Needs Analysis Method

+ PV of needs
+ all expenses
- portfolio
- business or another income

67
Q

Tax Drag Table

A

↑ Time Horizon ↑ Return

Capital G. (B=1) ↑TD$, ↑TD% =TD$, =TD%

Captial G. (B>1) ↑TD$, ↑TD% ↑TD$, ↑TD%

Capital G. (B<1) ↑TD$, ↑TD% ↓TD$, ↓TD%

Annual Weath ↑TD$, ↑TD% ↑TD$, ↓TD%

CFA Level III (13 decks)

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