S4 Flashcards
4 Life stages of individuals
Foundation
Accumulation
Maintenance
Distribution
Risk tolerance factors
Source of wealth - active (high risk tolerance) - passive (low risk tolerance)
Measure of wealth - perception of wealth - higher wealth higher risk tolerrance
Stage of life - older less tolerant to risk
Traditional vs behavioral finance - 3 individuals characteristics
Risk aversion - loss aversion
Rational expectations - biased expectations
Asset integration - asset segmentation
Personality types
Cautious - risk averse + emotional
Methodical - risk averse + thinking
Individualistic - risk seeking + thinking
Spontaneous - risk seeking + emotional
IPS benefits for clients
The IPS identifies and DOCUMENTS investment OBJECTIVES and CONSTRAINTS.
The IPS is DYNAMIC ALLOWING CHAGES in objectives and/or constraints in response to changing client circumstances or capital market conditions.
The IPS is EASILY UNDERSTOOD, providing the client with the ability to bring in new managers or change managers without disruption of the investment process.
Developing the IPS should be an EDUCATIONAL EXPERIENCE for the client.
.. Clients LEARN MORE ABOUT THEMSELVES and investment decision making.
.. They are BETTER ABLE TO UNDERSTAND the manager’s investment recommendations.
IPS benefits for advisor
Greater KNOWLEDGE of the CLIENT
GUIDANCE for investment DECISION making.
GUIDANCE for resolution of DISPUTES.
.. Signed documentation that can be used to SUPPORT THE MANGERs investment DECISIONS as well as the manager’s denials of client investment requests.
IPS components RRTTLLU
RRTTLLU (
Return,
Risk,
Time horizon,
Taxes,
Liquidity,
Legal,
Unique).
RISK and RETURN objectives should be
Consistent with reasonable capital market expectations as well as the client constraints.
If there are inconsistencies, they must be resolved by working with the client.
Required vs desired return for IPS
Required return is what is necessary to meet high-priority or critical goals to that client. They might include living expenses, children’s education, health care, et cetera.
Desired return goals will likewise depend on the client but might be things like buying a second home, world travel, et cetera.
Nominal required return before tax for IPS, formula…
(NOMINAL AFTERTXAX + INFLATION) / (1-taxrate)
Ability to take risk in decreasing if….
Shorter time horizon.
Large critical goals in relation to the size of the portfolio.
High liquidity needs.
Goals that cannot be deferred.
Situations where the portfolio is the sole source of support or an inability to replace losses in value.
Long term vs short term horizon in IPS (years)
Long term > 15 years
Short < 3 years
Liquity constraint of IPS - emergency reserve
Holding three months to one year of the annual distribution in cash reserves could be reasonable if agreed to in advance
IPS - home ownership
The client’s ownership of a home is generally an illiquid asset and could be noted here.
Alternatively it is often recorded under unique.
IPS - trusts - legal constraint
If the client has or desires a trust, mention that the MANAGER MUST FOLLOW THE TRUST DOCUMENT.
Some types of trusts specify paying all income to the income beneficiaries during their lifetimes and then distributing assets to remaindermen at the death of the income beneficiaries. This can require the manager to BALANCE THE COMPETING INTERESTS (income versus capital appreciation) of the two groups. You should mention this if it comes up.
Unique circumstances contraint IPS, examples
Special investment concerns (e.g., socially responsible investing).
Special instructions (e.g., gradually liquidate a holding over a period of time).
Restrictions on the sale of assets (e.g., a large holding of a single stock).
Asset classes the client specifically forbids or limits based on past experience (i.e., position limits on asset classes or totally disallowed asset classes).
Assets held outside the investable portfolio (e.g., a primary or secondary residence).
Desired bequests (e.g., the client intends to leave his home or a given amount of wealth to children, other individuals, or charity).
Desired objectives not attainable due to time horizon or current wealth.
Legal/regulatory constraint when planning annual gifts to children
Expert legal and tax advice regarding her annual gifts to son and plans after death are appropriate
Monte carlo benefits
It considers path dependency.
It can more clearly display tradeoffs of risk and return.
Properly modeled tax analysis, which considers the actual tax rates of the investor as well as tax location of the assets (held in taxable or tax-deferred locations), can be assessed.
A clearer understanding of short-term and long-term risk can be gained.
It is superior in assessing multi-period effects.
Probabilistic forecasts give both the client and manager a better indication of the risk/return tradeoff in investment decisions.
Monte Carlo simulations explicitly show the tradeoffs of short-term risks and the risks of not meeting goals.
Monte Carlo is better able to incorporate tax nuances.
Monte Carlo can better model the complications associated with future returns by more effectively incorporating the compounding effect of reinvestment.
Monte carlo negatives
Simplistic use of historical data, such as expected returns, for the inputs. Returns change and have a major effect on projected future values of the portfolio.
Models that simulate the return of asset classes but not the actual assets held. Simulating the return of the Wilshire 5000 when a fund with fees will be held could significantly overstate the future value or time period over which distributions can be sustained. Real assets have expenses.
Tax modeling that is simplistic and not tailored to the investor’s situation.
Situational profiling
places individuals into categories according to stage of life or economic circumstances.
Psychological profiling assumes
assumes investors exhibit psychological characteristics such as loss aversion, biased expectations, and asset segregation.
A personality typing questionnaire attempts to
to assign the client along two dimensions: ( 1 ) risk attitudes and (2) decision-making style.
Cmmon time horizon constraint IPS
Long-term time horizon with two stages: ‘x” years to retirement and retirement of 20-25 years.
IPS
document that is developed as the result of a client interview to determine their
- risk (ability and willingness) and
- return objectives and the
- five constraints, which consist of the time horizon, unique circumstances, taxes, legal and regulatory, and liquidity constraints.
Deterministic vs probabilistic
Generates one number while monte carlo as probabilistic method determines also probabilities of various scenarios
Source of wealth indicates
Knowledge and experience with risk risk taking activities.
7 tax regimes
Common Progressive . Progressive. Fav interest, divident, capgins
Heavy Dividend Tax . Progressive. Fav int, capgains
Heavy Capital Gain Tax . Progressive. Fav div, int
Heavy Interest Tax . Progressive. Fav div, capgain
Light Capital Gain Tax. Progressive. Fav capgain
Flat and Light. Flat. Fav div, int, capgain
Flat and Heavy. Flat. Fav int?
Tax drag, 3 notes for ACCRUAL TAXES
Tax drag > tax rate.
As investment horizon increases ::::} tax drag $ and tax drag o/o increase.
As investment return increases ::::} tax drag $ and tax drag o/o increase.
Deferred capital gain taxes
FVIFcapital gains = ( (1+ R )^N*(1-Tcg) + Tcg)
Future value interestw factor
Tcg added back to avoid taxation of initial investment
Tax drag, DEFERRAL BASIS , 5 notes
Tax drag o/o = tax rate.
As the investment horizon increases . tax drag is unchanged.
As the investment return increases . tax drag is unchanged.
As investment horizon increases . value of the tax deferral increases.
As investment return increases . value of the tax deferral increases.
FVIFcapital gains (MV <> cost basis)
FVIFcapital gains (MV <> cost basis) = (1+ R )^N(1-Tcg) + TcgBasis
Basis = Cost basis / Market Value
Tcg is added back to prevent taxation of the cost basis share of inital investment.
FVIF (wealth tax) =
FVIF (wealth tax) = [ (1-Tw)*(1+R) ]^N
Tax drag … Wealth tax vs Accrual tax
As with accrual taxes, tax drag $ and tax drag % increase with investment horizon.
!!!!! Unlike accrual taxes, when investment return increases, tax drag % decreases.
Wealth taxes. Tax drag 3 notes
Tax drag o/o > tax rate.
As investment horizon increases => tax drag% / $ increase.
As investment return increases => tax drag $ increases; tax drag % decreases.
Realized tax rate . Div int capgain.
PintTint + PdivTdiv + Pcapgain*Trealizedcapgain
P = proportion of type of income in total income.
IMPORTANT !!!! just realized capgains used.
R.art
Return after realized taxes
R.art
Return after realized taxes = R * (1-portionIntTint - portionDivTdiv - portionRealizedCapgain*Tcapgain)
Tecg . Effective capital gains tax
Tecg = Tcg * (1-(Pint+Pdiv+Pcg)) / ( 1- (Pint*Tint + Pdiv*Tdiv + Pcg*Tcg)) P = propotion of type of income in total income
Effective capital gains tax rate Tecg = capital gain tax rate * unrealized capital gain rate / net after taxes on realized income
FVIF all realized and unrealized taxes
FVIF all taxes = (1 + Rart)^N(1-Tecg)+ Tecg - Tcg(1-B)
Rart = return after realized taxes.
FVIF tda . Future value interest factor for tax deferred accounts
(1+r)^n * (1-t)
Plase note there is no cost basis adjustment because in these accounts funds are being debited pretax.
Investor’s after tax risk
Standard deviation * ( 1-T )
What accounts to use for bonds vs stocks in terms of taxation
Stocks have little income and deferred cap gain. Use taxable accounts.
Fixed income. Opposite. Use tax deferred or exempt accounts.
Four types fo equity investors
Traders - forgo tax advantages due to short term trading.
Active - many gains are long term. Taxed at lower rates.
Passive - all gains long term. Taxed at preferred rate.
Exempt.
Accrual equivalent tax rate
Makes pretax return (R) equal to accrual equivalent after tax return (R.ae)
R.at = R (1- T.ae)
Accrual expuivalent after tax return (R.ae)
R.ae = N root of (FVt / PV) -1
Tax alpha
Vlue created by efficient tax management
Tax rdag
Pretax RETURN vs Aftertax RETURN
Do not confuse RETURN with FV
Probate
LEGAL PROCESS AFTER 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.
Estate taxes paid by
Grantor or transferor
Inheritance taxes paid by
Recipient
Under community property spouse receives
Half of marital property ( i.e. less than total estate )
Under forced heirship rule spouse (kids) receives
30% (30) of total estate.
If both community property and forced heirship rights are applicable, spouse receives
The highest from community or forced heirshp
Probability of joint survival
prob (joint survival ) = prob ( husband survives ) + prob (wife survives ) - prob (husband survives ) X prob ( wife survives)
Value accumulation from gift with taxes PAID by donor
FV = PV (1-Tg+. TgTe. )(1+R*(1-Tinv)
Tg*Te is added back due to Donor not recipient paying the gift tax.
Future value of a gift to charity
FVcharicablegift = (1 + Rg)^N + Toi [1 + Re (1 - Tie )^N * (1 - Te )
where:
Rg = expected return on the assets in the charity's portfolio Toi = tax rate on ordinary income Re = expected return on the assets in the donor's portfolio tie = donor's tax rate on investment income Te = estate tax rate
Trustee vs settlor
Settlor creates trust
Trustee is beneficiary of trust
Taxation, credit method
Tax paid on foreign income to foreign country, and
Also tax may be paid to residence country if residence tax on foreign income is higher than foreign country’s tax rate.
Resource residence conflict ~ taxes - solutions
Credit
Exemption
Deduction
Foreign income tax - deduction method
Tdeduction = Tresidence + Tsource(1-Tresidence). As in books
Or similar = Tsource + Tresidenc(1-Tsource)
Skipping a generation increases the value of the gift by a factor of
1/(1-t)
primary objectives of estate planning are to
. minimize taxes and to
. facilitate the tax efficient transfer of assets to heirs or recipients of charitable bequests
Four levels of taxation
Income, wealth, spending, transfers
Tax free transfer of assets to spouse…
DEFERS taxes until death of the second spouse.
The two primary ways of transferring ownership of assets are
lifetime gratuitous transfers (i.e., gifts) and
testamentary gratuitous transfers (i.e., bequests).
Excess capital represents assets
above and beyond CORE capital that can be safely transferred without jeopardizing the first generation’s lifestyle.
Probate can be avoided
probate can be avoided or its impact limited by holding assets in
joint ownership (e.g., joint tenancy with right of survivorship),
living trusts,
retirement plans, or
life insurance strategies.
Individuals can attempt to reduce or avoid forced heirship by:
■ moving assets into an offshore trust governed by a different jurisdiction;
■ gifting or donating assets to others during their lifetime to reduce the value of the final estate upon death; or
■ purchasing life insurance, which can move assets outside of realm of forced heirship provisions.
Such strategies, however, may be subject to “clawback” provisions that provide a basis for heirs to challenge these solutions in court.
Source tax system:
A jurisdiction that imposes tax on an individual’s income that is sourced in the jurisdiction.
Residence tax system:
A jurisdiction that imposes a tax on an individual’s income based on residency whereby all income (domestic and foreign sourced) is subject to taxation.
Source source conflict
The residence country A may claim foreign investments were manager from country A.
Stages of equity holding life
(1) the entrepreneurial stage,
(2) the executive stage, and
(3) the investor stage
Cost basis, diversification techniques
Sale
Exchange funds . Private or public
Completion portfolios
Hedging
Cost basis - sale - adv/disadv
ADV
Simple.
Non-systematic risk of the position is completely eliminated for shares sold.
Proceeds can be reinvested or distributed as desired.
DISADV
Most costly from a tax standpoint.
Usually requires that shares are publicly traded.
Taxes due on sale reduce the size of the invested portfolio.
Cost basis. Public Exchange funds
ADV
Can facilitate monetization (borrowing) through risk reduction.
Investor holds diversified portfolio, without recognizing capital gains.
DISADV
Management fees.
Must remain in the fund for a minimum period.
Cannot determine or adjust holdings.
Must hold min 20% in illiquid assets.
Unrealized tax liability remains in place.
Cost basis. Private exchange funds.
ADV
Can facilitate monetization (borrowing) through risk reduction.
Provides the ability to utilize hedging techniques.
Not required to hold illiquid assets.
Can adjust holding and diversification strategies.
DISADV
Management fees.
Must remain in the fund for a minimum period.
Must find outside, unrelated party willing to purchase the security and join the partnership.
Unrealized tax liability remains in place.
Cost basis. Completion portfolios
ADV
Investor builds a diversified portfolio over time.
Can provide cash and avoid capital gains to the extent of loss harvesting.
DISADV
Investor must have other assets.
May take substantial time to effect proper diversification.
Unrealized tax liability remains in place.
Cost basis. Hedging.
ADV
Fast.
Can facilitate monetization through risk reduction.
DISADV
Upside potential typically limited after hedge is in place.
Potential regulatory risk (constructive sale provision).
Unrealized tax liability remains in place.
Entrepreneurs and top executives frequently feel
psychologically ATTACHED to the single stock (i.e., the firm) and are therefore RELUCTANT to sell in order to achieve diversification…. In contrast to investor.
Risks at various equity life holding phases
Entrepreneurial - systematic, nonsystematic, liquidity
Executive - systematic, nonsystematic
Investor. - systematic and a portion of nonsystematic as he is diversifying
Completion portfolios is slowest diversification methods because
because sales of concentrated holding requires the ability to harvest offsetting losses on the holdings in the completion portfolio.
Human capital is
PV of the individual’s future earnings.
Human capital is subject to
Earnings risk. Can be reduced by saving more, investing in assets less correlated to financial capital
Reducing mortality and longevity risks
Mortality - life insurance. longevity - annuities.
The higher risk of human capital, the ? Need in lifeinsurance
Less
The larger and more important the post-death objectives are to a given individual,
the greater the need for life insurance to fund those objectives that continue beyond premature death.
Demand for life insurance increases if
HC has low risk
Importance of meeting post death objectives is high
The higher is the weight of human capital
Three risks jeopardizing desired lifestyle
Financial market risk
Longevity risk
Savings risk
Best way to mitigate earnings risk
Lower correlation between human and financial capital
