Private Wealth Management and Institutional Investors

Question 1

Private clients

vs

Institutional clients,

Answer 1

Private clients have a wide range of investment objectives, such as maintaining the real value of the investment portfolio, being financially secure in retirement, and providing financial support to family members. Shorter time horizons. Pportfolios are usually smaller compared to those of institutional clients. Certain assets such as real estate and hedge funds may be less suitable.

Institutional clients, on the other hand, are more likely to have clearly defined objectives that are usually focused on funding liabilities (e.g., defined benefit pension plans and insurance companies). The investment objectives of institutional clients also tend to remain stable over time. Typically have a single time horizon for a clearly defined objective. Formal investment governance structure with investment committee. More likely to display emotional biases

Question 2

Investment Objectives IPS Data:

IPS Investment Parameters

IPS review

IPS Appendix

Personal information gathered for an IPS:

Answer 2

Investment Objectives:
Client BACKGROUND - name, age, PERSONAL and FINANCIAL information.

INVESTMENT OBJECTIVES - Should be quantified when possible and show goals: funding a lifestyle needs, supporting a family member, phalanthropic goals, bequest goals. Or one time goals - purchasing a second home.

Key investment parameters:

Risk Tolerance - willingness to withstand volatility.
Time horizon - a range ie in excess of 15 years or less than 10 years.
Asset class preferences - where some assets may not be approved.
Liquidity preferences (stated cash reserves or needs to sell a portfolio relatively quickly)
Constraints - ESG considerations
Portfolio asset allocation. (target allocation and upper and lower bounds)
Portfolio management and implementation. (Discretionary authority ie freedom to make investment decisions)
Rebalancing - time based and threshold-based.
Tactical changes - Paraementers for deviations around the IPS.
Implementation - use of proprietary funds or use of third-party funds and ETFs too. Passive vs active.
Duties and responsibilities of the private wealth manager.
Specific return or investment objectives. (Capital sufficiency analysis). Plus priority of each.

IPS review - How frequently a manager will review the IPS with the client

IPS Appendix - Looks at ‘Modeled Portfolio Behavior’ such as a range of possible performance outcomes. Also looks at Capital Market expectations - expected returns and standard deviations of asset classes plus correlations.

Other investment preferences (includes concentrated asset positions)
Investment time horizon (stating a time “exceeding 5 years etc)

PERSONAL Information:

ID&V
age,
current employment,
Investment background and knowledge,
Investment objective,
liquidity needs.
Family circumstances, including marital status, and number and age of family members.
Proof of client identification (e.g., passport).
Future career aspirations.
Retirement plans.
Sources of wealth.
Specific return or investment objectives.
Unique investment preferences.
Further discussion of risk tolerance

Question 3

Tax avoidance

Tax reduction

Tax deferral

Answer 3

Tax avoidance = ISAs for tax free earnings

Tax reduction = investing in tax free securities and/or lower tax jurisdictions

Tax deferral = Retirement plans. Ie tax free contributions with tax paid on withdrawals

Question 4

soft skills

technical skills

Answer 4

Soft skills - Communication skills, social skills, education and coaching skills, business development skills.

Technical skills = language fluency (multinational clients speaking mor than one language falls under technical) capital market proficiency, portfolio construction ability, financial planning knowledge, quantitative skills and technology skills.

Question 5

Planned Goals

Unplanned Goals

Answer 5

Retirement goals (e.g., funding a comfortable existence post-retirement).
Specific purchases (e.g., primary or secondary residence).
Funding the education of dependents.
Funding significant family events (e.g., wedding celebrations).
Charitable giving.
Wealth transfer during a private client’s lifetime or at death.

Where amount is unknow it’s unplanned such as future insurance sun to cover a sick relative.
Unexpected financial expenditures are more difficult to deal with. Expenditures related to property repairs and unexpected medical expenses that are not covered by health insurance. long term care cost.

Question 6

Quantifying goals

Prioritizing goals.

Changing goals.

Answer 6

Quantifying goals = looking for the best way to fund a holiday home or retirement. Sentences such as ‘it is estimated she will need $60,000 per year’. You would perhaps need to quantify children’s college tuition etc.

Prioritizing goals. = sentences such as ‘supporting my family is my top priority’

Changing goals. = a meeting to discuss financial goals could be needed as clients may priorities short term goals at the expense of long term goals.

Question 7

Risk tolerance

Risk capacity

Risk perception

Answer 7

Risk tolerance = This reflects both the client’s willingness and ability to take risks. The opposite of risk tolerance is risk aversion. Risk tolerance questionnaire, how much are you willing to lise in a given year, 5%, 10% or 20%? It may vary for different goals.

Risk capacity = This addresses a private client’s ability to take financial risks, based on the client’s wealth, income, investment horizon, liquidity requirements, importance of goals, and other relevant considerations. The higher the risk capacity, the greater the ability of the client’s portfolio to sustain losses without putting the client’s goals in jeopardy.

Risk perception = subjective measure of investment risk (e.g., whether a private client thinks of investment losses in absolute or percentage terms). Edwards states that he is happy whenever his portfolio outperforms the S&P 500 index

Question 8

overview of the financial stages of life

Answer 8

Early career 18 - 35 - Completes education. Enters the workforce, often starts a family, insurance is valuable. Significant expenses.

Career development 35 - 50 - Skill development, retirement savings increase rapidly.

Peak accumulation 51 - 60 - Maximum earnings potential reached, increased interest retirement income planning, more concerned with tax strategies. More concerned with losing employment.

Preretirement - The few years preceeding retirement and maximum career income. Begin reducing risk and volatility with focus on retirement distribution options.

Early retirement (first 10 years of retirement) - Possibly changing lifestlye commensurate with an individuals savings. Most active time in retirement with less cognitive and mobility issues. Some retirees may seek part time/full time jobs with less stress.

Late retirement (uncertain period) - Unpredictable due to unknown period til death. Cognitive ability and mobility declines which may deplete assets. Need for long term care may become necessary.

Question 9

Private wealth managers need to consider the following behavioral biases associated with retirees.

Increased loss aversion

Consumption gaps

The annuity puzzle.

Lack of self-control (self control bias)

Answer 9

Increased loss aversion = Compared to younger investors, retirees are likely to be more loss-averse.

Consumption gaps = Consumption spending by retirees tends to be lower than what economic studies forecast.

The annuity puzzle. As discussed previously, life annuities can be used to reduce longevity risk. However, individuals tend to avoid buying annuities to meet their spending needs in retirement. Possible explanations for this annuity puzzle include (1) reluctance to give up hope of funding a better retirement lifestyle, (2) a desire to keep control of assets, and (3) the high cost of annuities.

Lack of self-control = Retirees prefer to meet their spending needs from investment income rather than by liquidating securities.

Question 10

Mortality tables

Monte Carlo simulation for retirement quantifies of shows probability??

Answer 10

Private wealth manager considers the probability that the client will live to a certain age and then predicts the client’s retirement spending requirements using the probability that the client will still be living in a given year.

Monte carlo simulation can show PROBABILITY OF SUCCESS, (not quantifying magnitude of anything) that a clients portfolio will meet the clients financial goals. It does not show by how much the portfolio will fall short.

Question 11

Risk tolerance

Time horizon

Asset class preferences

Answer 11

Risk tolerance considers a client’s willingness and ability to accept investment risk Low for important goals, high for lower priority goals.

Time horizon is stated in a range ie “likely to exceed 10 years, 20 years or 30 years. etc”

Asset class preferences are acceptable asset classes for the client’s portfolio (or alternatively asset classes that are unsuitable for the client), together with the risk-return characteristics of each asset class.

Liquidity preferences. Liquidity needs that have not been specified in the Client Background and Objectives section should be included here. A private wealth manager should also include liquidity preferences that may restrict investment in certain asset classes.

Question 12

SAA vs TAA

Answer 12

Strategic asset allocation indicates a long-term target allocation for each asset class, with the portfolio being rebalanced periodically to maintain the target allocation. Tactical asset allocation is an active management strategy that normally specifies a range for each asset class rather than a specific target allocation percentage.

Question 13

The general responsibilities of a private wealth manager

Answer 13

Developing an appropriate asset allocation
Recommending investment options (pooled and direct)
Monitoring asset allocation and rebalancing
Use of derivatives
Monitoring costs associated with implementing a strategy
Monitoring third parties such as custodians
Drafting and maintaining the IPS
Reporting of performance including base currency
Reporting taces and financial statements
Voting proxies
Assisting with preparation of private fund offerings.

Question 14

Traditional approach to Portfolio Construction

Goals-based investing

Answer 14

Traditional Approach (MVO to overall portfolio):
Identify appropriate asset classes for the client’s portfolio.
Develop capital market expectations (i.e., expected returns, standard deviations, and correlations of asset classes).
Determine portfolio allocations - use MVO to get a general idea of asset allocation.
Asset constraints - such as ESG
Implement the portfolio - Active vs passive etc.
Determine asset allocation - final allocation with Tax considerations applied here.

Goals based approach (MVO to each goal):
Goals-based investing essentially follows the same steps as the traditional approach to portfolio construction, the critical difference being that instead of constructing a single portfolio, the private wealth manager creates separate portfolios for each of the client’s goals.

Asset allocation approaches, such as mean-variance optimization (MVO) and Monte Carlo simulation, are covered in an earlier reading. A private wealth manager can use these approaches to establish an optimal portfolio that maximizes expected return for a specified level of risk consistent with a client’s risk tolerance.

Question 15

Key considerations when implementing the portfolio include:

Answer 15

Use of active or passive management (or a combination) for each asset class.
Degree of focus on specific sectors of each asset class (e.g., style factors for equity and credit quality for fixed income).
Manager selection.
Use of individual securities or pooled investment vehicles.
Degree of hedging required (e.g., for currency exposure).
Choosing asset location (e.g., placing investments that generate significant levels of taxable income into accounts that offer tax exemption).

Question 16

Portfolio Reporting

you need to remember at least 4

Answer 16

A portfolio report for a private client typically includes the following items:
Performance summary for the current period.
Market commentary for the current period to provide context for the portfolio’s performance.
Portfolio asset allocation at the end of the current period, including strategic asset allocation weights or tactical asset class target ranges.
Detailed performance of asset classes and individual securities.
Benchmark report comparing asset class and overall portfolio performance to appropriate benchmarks.
Historical performance of client’s investment portfolio since inception.
Transaction details for the current period (e.g., contributions, withdrawals, interest, dividends, and capital appreciation).
Purchase and sale report for the current period.
Impact of currency exposure and exchange-rate fluctuations.
Progress toward meeting goal portfolios when using a goals-based investing approach.

Question 17

Portfolio Review

Answer 17

A portfolio review enables the private wealth manager to reassess a client’s IPS:
Appropriateness of client’s existing goals and investment parameters and if any changes are required.
Rebalancing of portfolio asset allocation to target allocation or ranges.
Any changes to the wealth manager’s ongoing management of the portfolio (e.g., degree of discretionary authority).
Any changes or updates in the wealth manager’s duties and responsibilities.
Any changes to IPS and portfolio review frequency.

Question 18

Degree to which an investment program is considered a success:

Goal Achievement

Process consistency

Portfolio performance

An investment program can be said to be successful only if it achieves success on all three criteria.

Answer 18

Goal Achievement: An investment program is considered a success if it fulfills a client’s goals within the specified risk parameter. the criteria for success should be whether it is still likely to meet the client’s longer-term goals (in the exam state is using capital sufficiency analysis has worked or failed)

Process consistency: Has the wealth manager implemented an investment strategy that is consistent with the client’s goals and investment preferences?
How have THIRD PARTY Managers performed?
Is the wealth manager maintaining regular communications with the client to assess the need for changes to the IPS?
What is the impact of recommended fund manager switches on portfolio performance? (state if the manager maintained regular dialogue and that they followed rebalancing guidelines to reduce trading costs)

Portfolio performance: Portfolio performance can be measured against an absolute performance benchmark (e.g., 5% fixed return) or relative to a passive benchmark (e.g., return on a domestic stock index). The impact of investment risk can be evaluated by comparing the risk-adjusted return (e.g., Sharpe ratio) of the client’s portfolio and an appropriate benchmark and by comparing the portfolio’s downside risk with the client’s risk tolerance.

Question 19

Fiduciary duty and suitability considerations are covered in the following Standards of Professional Conduct:

Answer 19

Standard I(B) Independence and Objectivity.
Standard III(A) Loyalty, Prudence, and Care.
Standard III(C) Suitability.
Standard V(A) Diligence and Reasonable Basis.

Buzzwords for answers:
Confidentiality.
Conflicts of interest.
Inconsistency with IPS
KYC requirements to confirm AML checks

Question 20

Mass Affluent Segment

High-Net-Worth (HNW) Segment

Ultra-High-Net-Worth (UHNW) Segment

Robo-Advisors

Answer 20

0 - $250k: Robo-advisors are automated wealth management advisors that assist private clients with their portfolio management needs. scalable technology. ETFs and Mutual Funds.

$250k - $1m: The mass affluent segment requires a wide range of wealth management and FINANCIAL PLANNING services, such as portfolio construction, risk management, and retirement planning. It is characterized by a larger number of clients per wealth manager and greater use of technology in delivering services such as account creation and portfolio reporting. larger client-to-manager ratio

$1m - $50m liquid assets: The HNW segment exhibits TAILORED solutions to a smaller number of clients per wealth manager compared to the mass affluent segment. Wealth management services provided in this segment are more likely to concentrate on tailored investment solutions, tax planning, and estate planning. The portfolios of HNW clients are more likely to contain sophisticated strategies (e.g., derivatives-based) and alternative investments. lower client-to-manager ratio.

$50m+ A UHNW wealth manager typically manages the portfolios of MULTIGENERATIONAL family members, requiring consideration of family governance and inheritance issues. UHNW clients are more likely to be serviced by a client relationship team that includes legal, tax, and investment experts in addition to a relationship manager. Some UHNW individuals may also choose to employ a family office of financial experts to manage their assets.

Question 21

Self control bias for retirees

Answer 21

Preference for spending investment income instead of liquidating shares to meet spending requirements. Retirees prefer to meet spending from investment income.

Question 22

Best way to determine someones risk?

Answer 22

A risk-assessment survey should always be the first stop in considering a clients risk tolerance.

Question 23

Portfolio report

Portfolio review

Answer 23

Portfolio report for a private client, a detailed breakdown of individual security performance and asset class performance is included.

The portfolio review examines potential changes to the client’s investment strategy and IPS, which is outlined before any investments are undertaken.

Question 24

prioritizing goals.

quantifying goals.

changing goals.

Answer 24

prioritizing goals. refers to when a client’s goals are difficult to reconcile (i.e., saving for retirement vs. paying for a child’s education)

quantifying goals. refers to when a client needs help calculating specific retirement goals, such as how much is required to save to retire comfortably.

changing goals. a client reevaluates their financial goals after an alteration in financial circumstances

Question 25

Clients net worth statement:

Life insurance

Answer 25

Life insurance is considered an asset with a cash value on a client net worth statement (Not equity or liability)

Question 26

Situational Profiling

Answer 26

With situational profiling, the source of an investor’s wealth is considered an indicator of the investor’s risk tolerance. It should be used cautiously. Situational profiling considers an individual’s preferences, economic resources, goals, and desires.

Question 27

Liquidity requirements covers

Answer 27

Liquidity requirements covers issues relating to on-going expenses, emergency reserves, alterations in on-going expenses, and transactions costs

Question 28

Deterministic forecasting

Answer 28

Deterministic forecasting uses single period simple linear return analysis to analyze a client’s likelihood of meeting their financial objectives.

Question 29

What is an Investment Policy Statement (IPS)?
Investment objectives
Investment parameters?

Individual vs Institutional IPS differences?

Answer 29

The IPS is a written planning document which describes a clients investment objectives, risk tolerance over a relevant time horizon and any constraints applicable. It is the link between a client’s unique considerations and the SAA.
Investment objectives - name, age, personal and financial information. Objectives - philanthropic, supporting family members, purchase of second home, funding of lifestyle needs.
Investment Parameters - Risk tolerance, time horizon, asset class preference, ESG considerations. Liquidity preferences.

IPS review

IPS Appendix - Looks at modeled portfolio behaviour such as possible performance outcomes. Also looks at Capital Market expectations - expected returns and standard deviations of asset classes plus correlations.

Other - Discretion authoristy (how much discretion is given), rebalancing methodology either time based or threshold based (deviation from target weights).

An individual’s investment policy statement differs from an institution’s in that time horizon, taxes, and unique circumstances play a more prominent role.

Institutions are more concerned about funding liabilities.

Question 30

time-based rebalancing

Threshold-based rebalancing

Answer 30

Time-based rebalancing, with periods set in advance, is most appropriate for clients who are less concerned about variations between target and actual asset allocation.

Threshold-based rebalancing is more strict and looks at asset thresholds which cannot be breached.

Question 31

Institutional Vs private clients, risk tolerance most accurately refers to

Answer 31

Unlike institutional investors, private clients’ risk tolerance is determined by both their willingness and ability to take risks. (Institutional investors, by comparison, are nearly always willing to take risks, but are limited by their ability to take risks.)

Question 32

There are four common metrics used in examining tax efficiency

Answer 32

1. After-tax holding period return
   Relevant taxes are computed and deducted when investments are disposed of
   Accounts for interest income, dividend income, and realized gains/losses but not unrealized gains/losses
2. After-tax post-liquidation return
   An extension of what was just listed but there is an assumption of overall portfolio disposition after a specific period (e.g., 5 or 10 years)
   This measure accounts for unrealized gains/losses
3. After-tax excess returns
   Either of the metrics just listed compared to a benchmark value
4. Tax-efficiency ratio
   After-tax annualized total return versus pretax annualized total return

Question 33

After-Tax Holding Period Return

After-Tax Post-Liquidation Return

Tax-Efficiency Ratio (TER)

Answer 33

After-Tax Holding Period Return

R′ = [(value1 – value0) + income – tax] / value0

Alternatively, R′ = R – (tax / value0)

After-Tax Post-Liquidation Return

RPL = [(1 + R′1)(1 + R′2)…(1 + R′n) – (liquidation tax / final value)]1/n – 1

liquidation tax = (final value – tax basis) × tax rate on capital gains

The TER is calculated as after-tax return (R′) divided by pretax return (R).

TER = R′ / R

Question 34

A portfolio generates a total return of 15%. The tax rates on interest, dividend, and capital gains are 35%, 20%, and 20%, respectively. The proportions of the portfolio return from interest, dividends, and realized capital gains are 10%, 25%, and 35%, respectively. Using the information provided, the net return after all taxes is closest to:

Answer 34

The return after taxes on interest income, dividends, and realized capital gains factors in the proportions of the return sources and the respective taxes on each is calculated as follows:

0.15[1 – 0.10(0.35) – 0.25(0.20) – 0.35(0.20)] = 0.15(0.845) = 0.12675 = 12.68%

Question 35

Charitable gifting has several key potential advantages

Answer 35

or the giver, the capital gains upon transfer to a qualifying charity of appreciated assets is deemed to be nil in some countries; in such instances, it is best to gift low-basis assets from taxable accounts.
For the giver, the fair market value of the gifted assets would qualify for a tax deduction/credit in some countries and that lowers personal taxes payable.
For the giver, if the assets are shares from a concentrated asset position, then the gift will lower the risk associated with the concentrated position.
For the receiver, because the charity is tax exempt, it will not pay tax on any investment income or gains related to the gifted assets.

Question 36

Tax Lot Accounting .Consider an investor who bought 100 shares of stock on three different dates for $10,000, $12,000, and $15,000.

HIFO

FIFO

LIFO

Answer 36

When an investor makes a partial sale and has acquired the stock on different dates, each at a different cost, the investor may select which tax lots applied to the sale.

Highest in, first out (HIFO) is generally optimal and the 100 shares with a cost basis of $15,000 should be designated as sold. If the sales price is higher than $15,000, that will minimize the gain and capital gains tax due now. If the sales price is less than $15,000, that will maximize the realized loss and he immediate tax benefits.

first in, first out (FIFO) may be better and the 100 shares with a cost basis of $10,000 should be designated as sold. It will create a higher immediate tax bill (but at lower tax rates) and it defers the higher tax lots for sale in the future.

first in, first out (FIFO) may be better and the 100 shares with a cost basis of $10,000 should be designated as sold. It will create a higher immediate tax bill (but at lower tax rates) and it defers the higher tax lots for sale in the future.

Question 37

Quantitative Tax Management

Answer 37

The general idea behind quantitative tax management is to minimize tracking error and trading costs as well as to minimize realized gains and maximize realized losses. The goal is to manage all that while meeting any other portfolio constraints (e.g., sector, country).

Question 38

2 techniques for managing a concentrated positions in public equities which may suffer a tax liability?

Staged Diversification Strategy

Completion Portfolio

Answer 38

Staged Diversification: Sale strategy is done over multiple years to spread out the tax liability accordingly.

Completion Portfolio: An Index based portfolio which when added to the concentrated position creates an overall portfolio with similar exposures to the investors benchmark.

Question 39

Exploring alternatives to selling stock

1. Equity Monetization

Step 1

Step 2

2. Covered call writing
3. Exchange fund
4. Charitable remainder trust

Answer 39

1.Equity Monetization

Step 1: Hedge a large part of the risk through short sale, TR equity swap, zero cost collar etc in a liquid derivative market.

Step 2: Borrow against the hedged position which is used as collateral. Use proceeds to invest in a diversified portfolio. Often able to obtain a high LTV.

2. Covered call writing could be used to generate additional premium. While not an explicit diversification strategy, it may allow to reduce positions while generating income over time.
3. Exchange fund: consider 10 investors, each of whom has a concentrated position in a single stock with a low cost basis. Each investor’s position is in a different stock. The investor contributes a holding into a newly formed exchange fund and each investor now owns a pro rata share of the new fund.
4. Charitable remainder Trust - A philanthropic approach. The trust could sell shares without realising a tax liability which could be used to provide income for the life of the named beneficiaries. On death of the last beneficiary the remainder capital would go to charity. Gift into trust would provide a tax credit.

Question 40

exchange fund

Answer 40

exchange fund: consider 10 investors, each of whom has a concentrated position in a single stock with a low cost basis. Each investor’s position is in a different stock. The investor contributes a holding into a newly formed exchange fund and each investor now owns a pro rata share of the new fund.

Question 41

Leveraged Recapitalization

Employee Stock Ownership Plan (ESOP)

Answer 41

Leveraged capitalization - A private equity firm (PEF) could arrange the financing for the company to purchase the owner’s stock. In exchange, the PEF receives equity in the company. The owner would maintain a minority ownership of the stock.

The owner sells stock to the ESOP, which in turn, sells the shares to company employees. In a leveraged ESOP, the company borrows money to finance the stock purchase. In the United States (subject to additional restrictions), the owner’s sale of shares may not trigger a capital gains tax.

Question 42

Donor-Advised Fund (DAF) or Charitable Trust

Mortgage financing

Answer 42

DAF gifts the property to a charity of choice and takes a full deduction. Lose control of assets.

Mortgage financing: Normally, a sale of an income-producing property to an external party results in the immediate payment of capital gains taxes, loss of control, and no ability to benefit from future appreciation. Therefore, mortgage financing can be an attractive strategy to raise funds without suffering from any of those three negative effects.

With a nonrecourse loan, the lender’s only recourse is to seize the property if the loan is not paid.

Question 43

testamentary bequest or a testamentary gratuitous transfer

Answer 43

If assets are transferred upon death, the process is known as a testamentary bequest or a testamentary gratuitous transfer (or an inheritance from the perspective of the beneficiary). Estate or inheritance taxes may be due and set on a flat rate basis or progressive tax rate schedule, with increasing rates for greater wealth transferred.

Question 44

Charitable Gratuitous Transfers

There are three benefits of charitable gifts

Answer 44

• The donor usually does not have to pay gift tax.
• The donor receives an immediate tax deduction for the gift, which reduces the donor’s current year tax liability.
• The charity is usually tax exempt so it can invest the funds and there would be tax-free compounding.

Question 45

Irrevocable trust

Discretionary trust

Answer 45

Settlor relinquishes ownership and control. Trustee is considered owner for tax purposes. Trust protects assets from claims against the settlor.

Trustee determites how to distribute assets. Primary concern is they benefit the beneficiaries. The beneficiaries have no legal right to either income of assets of a DT.

Question 46

Several reasons for using a trust:
(Common law countries)

Answer 46

• Avoid giving control of assets to beneficiaries who would not be able to properly manage them.
• Allows the settlor to direct the assets for specific uses.
• Avoid dilution of ownership interest in a private business in countries where there is joint ownership and division of assets acquired during marriage.
• Avoid probate.
• There may be potentially lower tax rates. For example, the trust or the beneficiaries may be subject to a lower tax rate than the settlor. Or the trust could be set up in a country with a low tax rate.

Question 47

controlled foreign corporation (CFC)

Family Governance

Answer 47

(CFC) is set up in a country outside of the investor’s home country for which the investor may hold assets. The investor would have a controlling interest in the company. It may be possible for the investment income earned in the CFC to escape taxation until the dividends are paid to the shareholder(s) or when the shares are sold.

Family governance: first generation generates wealth, next generation holds onto the wealth, and the last generation spends it.

Question 48

Board of Directors (BOD)

Family Council

Family Assembly

Family Office

Family Foundation

Family Conflict Resolution / constitution

Incapacity: Living wills and durable powers of attorney

Answer 48

A BoD is applicable at a much more advanced phase of the family business and may start out as an “advisory board” before evolving to a more formal BOD. Here, external expertise is brought in to assist in mitigating overconfidence bias, particularly with the business founder.

Family Council: Certain family members are selected to liaise directly with the BOD. Details of the family council are included in the family constitution

Family Assembly: The family assembly is an annual (or more frequent) meeting of the family members to review the direction of the family business

Family Office: The family office is an investment management hub but also fulfills other administrative duties such as accounting and legal.

Family Foundation: The family foundation is the philanthropic arm of the family, which is usually long term in nature. It is important to determine and agree upon the philanthropic goals.

Family Conflict Resolution: As conflicts are inevitable within families, it is important to have a clear family constitution in place.

Living wills and durable powers of attorney can be used to address potential incapacity in the future. A living will addresses be an individual’s medical care upon becoming incapacitated and is usually a legally binding document. A durable power of attorney allows a guardian to act on behalf of the grantor even after the grantor becomes incapacitated. The power of attorney often covers financial and medical matters.

Question 49

Generation Skipping Transfer Tax (GSTT)

Answer 49

Generation-skipping transfer taxes serve the purpose of ensuring that taxes are paid when assets are placed in a trust, and the beneficiary receives amounts in excess of the generation-skipping estate tax credit.. Asset owners must check whether his country has a GSTT and whether it might have a lifetime GSTT exclusion amount so that only transfers above the exclusion amount would attract GSTT. In the US Grandparents paying into a trust for grandchildren (skipping parents) would only pay 40% on assets in excess of $11.4m.

Question 50

Gift or bequest forumula

Maddie, 77, is wondering whether it would be wise to help her granddaughter, Emily, reduce her mortgage with funds Maddie plans to leave to Emily in her will. Maddie has $150,000 available to gift today and has a life expectancy of two years. If Maddie holds onto the funds she expects to earn 3.0% annually, subject to an effective rate of tax of 18%. The rate of return that Emily will receive is expected to be 4.5% annually which is effectively the rate of interest on the mortgage. Emily’s effective tax rate on these funds will be 0%. If the tax on gifts is 40% and the tax on estate bequests is 35%, should Maddie gift the funds now assuming Emily pays the gift tax

Answer 50

No, as the relative value of the taxable gift is less than 1.

1 + 0.045(1-0)^2 (1-04) / 1 +0.03 (1-0.18)^2 (1-0.35)

60.6553 / 0.6824 = 0.96

Question 51

Probate

Answer 51

Probate is a legal process that takes place at death, during which a court determines the validity of the decedent’s will, inventories the decedent’s property, resolves any claims against the decedent, and distributes remaining property according to the will.

Question 52

Human capital

Financial capital

What are defined benefit payments classified as?

What is Unvested and Vested pension classified as, financial or human capital?

Answer 52

Human capital (HC) is the mortality weighted discounted present value of expected future labor income. Ie younger investor has 97%, 96%, 95% etc.. chance of living to the next year. The discount rate applied to the future cash flows is related to the riskiness of the cash flows. It is equivelant of holding a large illiquid asset. It is highest once the young investor starts investing (not at age zero)

Financial capital (FC) is the sum of all the other tangible and intangible assets of an individual such as vested pensions, cars and stock & bonds.

Vested pensions are financial capital whether drawn or not.
Unvested pensions contingent on future earnings so are human capital.

Question 53

Difference of Net worth and Net Wealth

Answer 53

A person can have negative net worth and positive net wealth ie they are in early career with student loans and negative net worth. You may have positive net wealth if you discounted human capital is positive.

Question 54

Drivers of the cost for life insurance

Answer 54

Mortality expectations
Loading
Discount rate

Question 55

Who bears risk company or insured? Which is more costly?

Temporary (Term) insurance

Permanent insurance (2 types)

Which of the below has a non-forfeiture clause?

Whole life

Universal life

Answer 55

Temporary (term) insurance covers only a designated period such as 1, 5, or 20 years. The cost can be fixed or increasing over the designated period. The policy then ceases at the end of the period unless it includes a provision to renew the policy. Term insurance is LESS costly than permanent insurance because the mortality risk is lower for the insurance company. a term life policy primarily reflects the mortality risk to the individual for a short, usually one year, period. (company bears risk)

Permanent insurance is more costly and lasts for the life of the insured. Non-cancelability. More options for investing the cash value. (company bears risk (not policy holder)

Whole life typically has a fixed annual premium payment. The policy continues and the policy cannot be canceled by the insurance company as long as premiums are paid. The non-cancelability makes purchase at a young age more desirable as new insurance may be unavailable or much more expensive if the insured person’s health deteriorates. It will also generate a cash value which can also be drawn upon later in life sometimes tax free. Non-forfeiture clause where benefits will be received even if payments are missed. (More expensive than term and insurance company bears risk)

Universal life is similar in concept but with more flexibility. The premium payment can be increased or decreased to increase or decrease the amount of insurance and/or the rate at which cash value grows. There may be investment choices for where the premiums are invested. Premium payments can be discontinued and the insurance continues (a non-forfeiture clause)

Question 56

What is the correlation of human capital and demand for life insurance?

Answer 56

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.

risk aversion and probability of death are positively correlated with demand for life insurance.

Question 57

Insurance amount = $250,000
Annual premium = $4,850
Expected annual dividend = $1,190
Time to maturity = 30 years
Expected surrender value = $70,000
Based on a discount rate of 8%, the net surrender cost index per 1,000 of insurance is closest to:

Answer 57

The CFA convention is premiums are paid at the start of the year as is the annuitized cost (annuity due) and dividends are received at the end of the year (ordinary annuity).

FVpremiums = $593,377.46 (annuity due: $4,850 annual payment, 30 years, 8%)
FVdividends = $134,807.02 (ordinary annuity: $1,190 annual payment, 30 years, 8%)
FVnet = $388,570.44 (future value of premiums less dividends and surrender value)
Annualnet = $3,176.00 (annuity due payment: $388,570.44 future value, 30 years, 8%)
NSCI = $12.70 per $1,000 per year (net annual cost divided by 250 [$250,000 / $1,000])

Question 58

Deferred vs Immediate annuity. Which is irrevocable?

Deferred variable annuity

Deferred fixed annuity

Immediate variable annuity

Immediate fixed annuity

Advanced life deferred annuity

Answer 58

Deferred allows individual to purchase income stream beginning at a later date and may have cah out options.
Immediate provides monthly payments over a specified period or life with irrevocable exchange of money for the contract.

Deferred variable annuity is more like a mutual fund with different risk profile chosen. Expensive, more choice, a menu of options. Death benefit pays beneficiary entire amount used to purchase the annuity.

Deferred fixed annuity - payout begins at a future date. You can cash out before calling on the annuity. Once in retirement you are more likely to begin annuitizing. (differs to deferred variable where investors often choose not to annuitize).

Immediate variable annuity - permanently exchanging a lump sum for a variable amount based on performance of a portfolio of assets. Income floors can be purchased.

Immediate fixed annuity - promised income for the life of an individual. Some offer 10 year period certain where benefits are guaranteed for 10 years at least.

Advanced life deferred annuity - hybrid of deferred fixed and immediate fixed. You pay a lot less immediately for payment at a future date.

Question 59

What are mortality credits?

Which type of annuity allows for early redemption in some cases? fixed or variable?

Loss control

Answer 59

Mortality credits refer to annuities. With a long life, the individual will collect more payouts than the average annuitant and benefit (earning the positive mortality credit). In contrast, the payout on life insurance will be further in the future, and they are effectively subsidizing (earning a negative credit) those with a shorter life whose beneficiaries are paid the policy amount sooner..

Variable annuities may allow for early redemption at the market value they track less surrender fees.

Loss control refers to risk avoidance ie not going rock climbing or installing burglar alarms.

Question 60

Risk reduction

Risk Transfer

Risk retention

Risk avoidance

Answer 60

Risk reduction: low-frequency, low severity events.

Risk Transfer: (buying insurance) when losses are very severe but occur infrequently.

Risk retention: (Self insurance) when losses are not severe and occur frequently. Self insurance is the only protection from job losses under the CFA curriculum (they don’t recognize unemployment insurance)

Risk avoidance = high severity, high frequency.

Question 61

Net worth

Net wealth

Traditional vs Economic Balance sheet

Answer 61

Net worth takes into account traditional assets and liabilities.

Net wealth is the sum of financial capital and human capital less any liabilities owed.

Traditional balance sheet includes assets and liabilities.

Economic balance sheet supplements traditional with human capital, pension wealth and consumption and bequest goals.

Question 62

An economic (holistic balance sheet)

Answer 62

Extends from a traditional balance sheet to include Human Capital such as future labour income as well as DC and DB pension plan balance. Liabilities are extended to include consumption and bequest goals.

Question 63

Who bears risk for the following insurance products. Policy holder of the company? (Money is held in a general or separate account?)
Whole term
Universal
Fixed annuities
Variable life insurance
Variable annuities

Answer 63

Whole term - Company bears risk (general account)
Universal - Company bears risk (general account)
Fixed annuities - Company bears risk (general account)
Variable life insurance - Policy holder bears risk (Separate account
Variable annuities - Policy holder bears risk (separate account)

Question 64

Capital sufficiency analysis and Capital needs analysis

Actions if the probability of success falls below an acceptable range

Answer 64

Capital sufficiency analysis & Capital needs analysis use deterministic forefacting which is a straight line assumption ie 6% annualised or monte carlo simulation which generates random outcomes according to assumed probability assumptions.

Actions if the probability of success falls below an acceptable range:
Increase contributions
Reduce goal amount
Delay timing of a goal
Take a higher risk approach increasing expected return

Question 65

Calculating insurance needs

Human life value

Needs analysis value

Answer 65

Human life value - replacing net contribution of future family finances.

Needs analysis value - looks purely at financial needs of kids up until education and the surviving spouse for life discounted back to a present value.

Question 66

Types of health and medical insurance US

Indemnity plan

Preferred provider organization

Health maintenance organization

Answer 66

Indemnity plan - pays a specified percentage of reasonable fees

Preferred provider organization - a large network of physicians

Health maintenance organization - very low cost for visits encouraging visits to find health problems early.

Question 67

Risk attribution for bottom up and top down.

Which a) attributes trackign risk to relative allocation and selection decisions. b) positions marginal contribution to tracking risk?

Within sector security selection, top down or bottom up?

Answer 67

Top down - attributes tracking risk to relative allocation and selection decisions. Total risk.

Bottom up - positions marginal contribution to tracking risk using a positions marginal contribution to total risk.

Within sector security selection is a top down approach to risk

Question 68

Allocation effect looks at stocks or sector level?

Answer 68

Allocation effect highlights sector allocation decisions. Negative allocation effect shows a bad decision at sector level. Positive shows a good sector allocation decision.

Question 69

Defined benefit pension plans are subject to
Endowments are usually subject to
Life insurance is subject to
ERISA. UPMIFA. NAIC

Answer 69

Defined benefit pension plans are subject to ERISA.
Endowments are usually subject to UPMIFA.
Life insurance is subject to state and NAIC regulation.