Risks and assumptions Flashcards
List and describe the two main types of investment risk and explain how diversification may be used to manage and reduce these risks
Non-systemic / unsystematic / specific
• The risk of bad decisions by a single company
• Systematic risk / market risk / systemic risk
• The risk of fluctuations in the stock market
• Diversification reduces risk by increasing the number of asset
classes held. Asset classes tend not to correlate
• Geographical diversification spreads the risk across a number of
different economies
• Sector spread reduces the risk associated with specific areas of the
economy
• Reduces risk of non-performance of individual companies and
number of holdings within each
• Using negative or low-correlated securities / investments (because they do not move in the same direction)
Identify and describe the various types of investment risks that are currently faced by Dan and Tara’s existing investments and pension plans.
For cash deposits, i.e. current account, deposit savings account, cash ISA, NS&I premium and income bonds.
Type of risk: Inflation risk
Definition: The spending power of cash is eroded over
time as inflation rises.
Impact on Dan and Tara:
90% of the couple’s investments are in deposit-based
investments at present, leaving them exposed to inflation risk.
May wish to consider moving some assets out of cash.
Type of risk: Default/provider risk (cash)
Definition: The risk the deposit-taker will go out of business and Dan and Tara will lose their investment.
Impact on Dan and Tara:
The FSCS limit is £85,000 or £170,000 per couple. Deposit accounts exceed this, but temporary high balance rule applies for 12 months as proceeds are from house sale. NS&I income bond £300,000,
but FSCS does not apply – government backed instead.
Type of risk: Interest rate risk
Definition: Variable rates can fall and fixed rates may become unattractive.
Impact on Dan and Tara:
The deposit savings account is likely to be paying a variable rate. With ultra-low and potentially negative interest rates on horizon, moving out of cash as soon as possible seems like a good idea.
Identify and describe the various types of investment risks that are currently faced by Dan and Tara’s existing investments and pension plans.
For equity-based funds, i.e. UK equity income, UK equity and global equity:
Type of risk: Market/systematic risk
Definition: Stock markets may fall.
Impact on Dan and Tara: Dan and Tara are cushioned to a degree from falling stockmarkets as they are so
heavily invested in cash – with regards to equities, they are predominantly invested in the UK which represents a lack of diversification and does not tie in with a high ATR.
Type of risk: Default/provider risk
Definition: The risk the investment or pension provider may go out of business leading to them losing their money.
Impact on Dan and Tara: ISAs and unit trust protected
by FSCS up to £85,000. No issues here.
Pension 100% of claim.
Type of risk: Tax risk
Definition: Government may change tax legislation
Impact on Dan and Tara: Future changes to ISAs or pensions may adversely affect the couple
Type of risk: Political risk/ regulatory risk
Definition: The risk that overseas markets may be more exposed to a less stable political and regulatory environment.
Impact on Dan and Tara: Tara’s Global Equity fund may suffer from risk of corruption / sudden change in legislation
Comment on the tax efficiency and suitability of Dan and Tara’s existing investment and pension plans
Both are basic rate taxpayers who have used their personal allowances
At present, their savings income falls into the starting rate for income
tax and is charged to tax at 0%
Their £1,000 personal savings allowances remain unused for now
Their £500 taxable dividend income (total) is covered by their dividend
allowances – they each have £1,750 of their dividend allowance
remaining
This could enable them to receive a further £1,750 in dividends tax-free
from their company
The UT could be encashed and the proceeds transferred into an ISA
with no tax liability in the current tax year. This would free up their
entire dividend allowances.
Both appear to have been using some of their ISA allowances over the
years
Neither have used their ISA allowance for the current tax year
Their UT and ISA dividends are reinvested, but they have an income
shortfall
Both have ‘high’ ATR, but this is not borne out by their 90% cash
holding in relation to their investments
However, they have stated their intend to invest this as soon as
possible for their ‘future financial security’
Tara’s Global Equity pension holding is more in line with ‘high’
The UK Equity funds (ISA, UT and pension) are not
Both have completed their nomination forms for their pensions
They are not currently making pension contributions and could be
missing out on tax relief and investment growth
Identify the main factors you would have discussed with Dan ad Tara if your task had been to establish and agree their risk profile(s)
Need to understand their capacity for loss/how much of a loss they
could bear without jeopardising their objectives/lifestyle
Other income/capital available
Timescale of investment
Appetite for risk/how much loss the couple is prepared to take
How much of their capital are they prepared to put at risk/how much to
keep in a secure area
Assess the above separately for different objectives, and for each of
them
Ensure both understand the risk characteristics of the selected
investments
Discuss volatility/explain investments can rise and fall
Explain that risk is a feature of all asset classes e.g. inflation risk of
holding cash, FSCS risk
How much risk the couple need to take/what investment return is
required to achieve objectives,
The couple’s previous investment experience/knowledge
Outline the steps that you would have followed when completing the individual
risk profiling assessments for Dan and Tara.
Explained the purpose of the risk profiling tool to Dan and Tara
Completed a risk questionnaire/series of questions including Dan and
Tara’s capacity for loss
Used computer software/manually/to produce a risk-rating/score/results
Risk rating suggests a suitable asset allocation/an efficient frontier
model
Discussed the results with Dan and Tara and agreed a suitable risk
profile for each of them
State five benefits of having used a risk-profiling tool to
assess Dan and Tara’s individual ATRs.
Benefits:
Simple/understandable/consistent/repeatable process/objective
Helps Dan and Tara to understand/consider risk
Separate risk profile for each client/objective established/attitude to risk
can change over time
Assists with appropriate asset allocation
Identifies the maximum loss tolerance/risk and reward
State five drawbacks of having used a risk-profiling tool to assess Dan and Tara’s individual ATRs.
Drawbacks:
Dan and Tara may not understand the terminology/questions
Adviser may misinterpret the results/different tools give different results
May not establish capacity for loss
Different objectives/clients may have different attitude to risk/may not
consider timeframe
May not take into consideration their investment
experience/behavioural finance/emotion
Cannot be used in isolation/further discussion needed
It does not consider taxation issues or charges
Based on historic data
Only relevant for that particular moment
Identify and explain in detail the key client-specific factors that you’d take into account when assessing Dan and Tara’s capacity for loss.
As a couple they have a more than adequate emergency fund and are
fairly wealthy
They can tolerate some loss / volatility in their investments
The couple’s income is mostly reliant on the continued
success/solvency of their company
They have an income shortfall at present and are drawing down on
cash funds to plug the gap
Neither has financial protection (life or health)
No potential inheritances
- No liabilities other than the tax bill
Currently in good health
They are unmarried with no will
They intend to privately educate their daughters starting in 9 years’
time
Identify any reasonable assumptions you might make in relation to Dan and Tara’s retirement planning.
That they retire in their mid 60s
That they remain in employment under their limited company until then
That they receive the new State pension at their State pension ages
That their national insurance records will be adequate for the full new
State pension, despite the possible gaps
That they will both make further regular contributions into pension
schemes
That their company will operate a pension scheme / make employer
contributions / operate salary sacrifice for them (if appropriate)
That ongoing contributions remain affordable
That they will consider making additional lump sum contributions
That they stay in good health
That they are willing to use their other investments in retirement
That they will be basic rate tax payers in retirement
That any DIS cover put in place will be placed under trust
Ongoing profitability of their company
Identify any reasonable assumptions you might make in relation to Dan and Tara’s financial protection planning.
That their company will be provide DIS, Key Person and income
protection as a minimum
Their non-smoking status will continue
Any debt they take on will be protected against death / incapacity
They will remain healthy
Both would continue to work in the event that one or the other were to
die or become ill
They are willing to pay for financial protection cover where necessary
The twins dependency will cease when they leave full time education
Explain to Dan and Tara why the following funds may or may not be suitable for them in relation to their attitude to risk / tax efficiency /financial objectives.
(It’s unlikely you’d be asked about more than one fund in the exam, but I’ve covered them all here, so you’ve had a chance to think about them.)
UK equity income (UT, S&S ISA):
UK equity income (UT, S&S ISA):
Adds some diversification to the overall portfolio
Focus is on income, though as it is reinvested there is the potential for
growth / inflation protection
Actively managed
Unlikely to be in line with stated ATR of high
As income is reinvested, it is not helping to resolve their income
shortfall
Single geographic sector risk
No currency / political risk
UT – income taxable / uses up dividend allowance
UT – liable to CGT on encashment, though with only £20k value this
will be covered by each of their annual exempt amounts (assuming
they have not used them elsewhere)
UT – enables them to use their annual exempt amounts
ISA – income tax-free, boosts income received
ISA – no CGT on encashment, boosts any growth
ISA – as unmarried, cannot benefit from additional permitted
subscription
Both fully protected by FSCS
Although will be included in estate for IHT purposes
Explain to Dan and Tara why the following funds may or may not be suitable for them in relation to their attitude to risk / tax efficiency /financial objectives.
(It’s unlikely you’d be asked about more than one fund in the exam, but I’ve covered them all here, so you’ve had a chance to think about them.)
UK equity (Pension)
UK equity (Pension)
Adds some diversification to Dan’s overall portfolio
Potential for growth / inflation protection
Actively managed
May not be in line with Dan’s stated ATR of high
May be in line with Dan’s need for growth
Single geographic sector risk
No currency / political risk
Won’t be included in estate on 1st death as pension fund
Fully protected by FSCS
Income and gains within fund grow free of tax
At retirement, up to 25% tax free, remainder taxed under PAYE
Explain to Dan and Tara why the following funds may or may not be suitable for them in relation to their attitude to risk / tax efficiency /financial objectives.
(It’s unlikely you’d be asked about more than one fund in the exam, but I’ve covered them all here, so you’ve had a chance to think about them.)
Global equity (Pension)
Global equity (Pension)
Adds diversification to Tara’s overall portfolio
Potential for growth / inflation protection
Actively managed
May be in line with Tara’s stated ATR
May be in line with Tara’s need for growth
May be some currency / political risk
Won’t be included in estate on 1st death as pension fund
Fully protected by FSCS
Income and gains within fund grow free of tax
At retirement, up to 25% tax free, remainder taxed under PAYE
Explain briefly to Dan and Tara the purpose of a stochastic modelling tool, the type of information it can provide and how it can be useful for school fees
planning.
Analyse potential risks and returns
Compares ATR against current portfolio
Tool suggests asset allocation
To meet objective (e.g. school fees)
A forecast shows the potential future values
In a range of different market conditions
Indicates if they need to invest more / are on track / exceeding
Especially useful for school fees planning given the different dates fees will be required
