Wealth Planning Flashcards
Human capital VS Financial capital: pension benefits / Economic net worth
Economic net worth = Net worth from the traditional balance sheet + (Present value of future earnings + Present value of unvested pension benefits) − (Present value of consumption goals + Present value of bequests)
Unvested pension benefits are part of human capital.
Vested pension benefits: components of financial capital.
Annual insurance cost calculation
Insurance surrender cost = PMT of total cost of insurance / insurance size, insurance size = death benefit notional /$1000
Total cost of insurance = FV of annuity premium - FV of dividends to receive - cash value at the end
Future value of premiums (annuity due, 5%, 20 years) $416,631.02
Financial calculator operations:
N = 20, I = 5, PV = 0, PMT = −12,000, mode = begin: FV → 416,631.02
Future value of dividends (ordinary annuity, 5%, 20 years) ($66,131.91)
N = 20, I = 5, PV = 0, PMT = 2,000, mode = end: FV → −66,131.91
20-Year insurance cost $350,499.11 (=416631.02-66131.91)
Annual payments for insurance cost (annuity due, 5%, 20 years) ($10,095.24)
N = 20, I = 5, PV = 0, FV = 350,499.11, mode = begin: PMT → −10,095.24
Net payment cost index ($10,095.24/500) ($20.19)
500 = 500,000 face value/ 1000, net payment cost index (per $1,000 of face value, per year)
Insurance terms: non-forfeiture clause, health maintenance organization plan, long-term care insurance:
non-forfeiture clause: whereby there is the option to receive some portion of the benefits if premium payments are missed
health maintenance organization plan: a type of medical insurance that allows office visits at no, or very little, cost.
Long-term care insurance: designed to cover a portion of the cost of home care, assisted living facilities, and/or nursing home expense
joint life annuity, advanced life deferred annuity’s
a joint life annuity is the best method to insure that this goal will be achieved. A joint life annuity provides a guaranteed series of fixed payments for as long as either of them is alive in exchange for a lump sum payment. VS Although the Monte Carlo output would include the probability of achieving the Benetton’s goal, it would not guarantee that their goal is achieved, nor would it necessarily measure the “shortfall magnitude” to achieving their goal. Thus, they run the risk of outliving their assets and may need to reduce their annual income (spending) goal at some point.
advanced life deferred annuity’s (ALDA’s) payments begin later in life—for example, when the individual turns 80 or 85. An ALDA would provide the greatest supplemental level income relative to the cost because the payments are made far in the future, life expectancy is shorter when the payments begin, and some policyholders will die without receiving payments.
Types of pension funds
the Canadian model does entail a large allocation to alternatives + to manage alternative investments in-house. Small institutional investors do not have the scale to hire or develop this expertise.
The Norway model passively invests in publicly traded securities subject to environmental, social, and governance concerns. largely passively managed assets with tight tracking error limits.
Advantages: costs/fees are low, investments are transparent, manager risk is low, and there is little complexity for a governing board (the model is easy to understand).
Disadvantages: limited potential for value-added (i.e., alpha from security selection skills), above-market returns.
endowment model: significant active management, a high allocation to alternative investments, and externally managed assets
advantage of using the endowment model is a higher potential for value-added, above-market returns.
difficult to implement for small institutional investors because they might not be able to access high-quality managers. Also difficult to implement for a very large institutional investor because of the institutional investor’s very large footprint. Furthermore, relative to the Norway model, the endowment model is more expensive in terms of costs/fees.
Pension fund: funded status vs age of employees
Given the age and average tenure of current employees, the vast majority are vested; therefore, there is no uncertainty regarding the benefit due. Further, should non-vested employees leave, their accumulated benefit would remain in the portfolio, increasing its funded status, to the benefit of beneficiaries and the plan sponsor.
Shareholders benefit from the plan’s overfunded status as it is an asset on the balance sheet, potentially increasing the value of stock. Also allows management to potentially lower employer contributions to the plan and increase net income. It also lowers financial risk, which may reduce volatility in the stock price.
Yet, decreasing employee turnover will increase plan liabilities and worsen the funded ratio.
ASC 715, Compensation—Retirement Benefits requires that an overfunded (underfunded) plan appear as an asset (liability) on the balance sheet of the corporate sponsor.
defined benefit pension plans: Liability driven approach
The basic two-portfolio approach
Mean–variance optimization
defined benefit pension plans have adopted a liability-driven approach in which the duration of plan assets is chosen to match the duration of plan liabilities
The basic two-portfolio approach assumes the pension plan has a surplus that can be allocated to a return-seeking portfolio.
Mean–variance optimization is an asset-only approach to asset allocation –> Institutions that maximize their Sharpe ratio for an acceptable level of volatility would be following an asset-only asset allocation approach, and, as such, they would not be concerned with modeling their liabilities.
Pension plan discount rate
Discount rate should be the returns to high-grade bond yields averaged over the last 25 years, which is the maximum discount rate permitted in the United States.
Not discount rate based on the returns to its current asset allocation, which includes small-cap equity, private equity, and illiquid real estate investments. Therefore, the value of liabilities is being calculated with a higher-than-allowed discount rate and has likely been understated.
For any defined benefit plan, the required return should take into account the anticipated change in future liability cash flows. The cash flows are affected by changes in active employee salaries, changes in active employee longevity, and the rate of inflation (retired employees). The valuation of liability cash flows will change as market interest rates change. In general, the required return for plan assets should exceed the discount rate on plan liabilities. The required return specified in the proposal does not reflect appropriate market interest rates used to discount liability cash flows (investment-grade long-term bond yields) and double counts inflation, which is a primary factor in active employee salary increases.
Wage discount rate = risk free rate + occupational risk rate
personal loan secured by her private company shares
VS Leveraged recapitalization
personal loan secured: mitigating the concentration risk of both ownership positions without triggering a taxable event while maintaining sole ownership. this type of borrowing should not cause an immediate taxable event. Although at some point the debt will need to be repaid, Payne would have access to cash to diversify her concentration risk while maintaining sole ownership of the company. the interest expense paid on the loan proceeds should be deductible for tax purposes.
Leveraged recapitalization: a private equity firm provides or arranges debt with senior and mezzanine lenders. The owner of the privately owned business receives cash for a portion of her shares and retains a minority interest in the freshly capitalized entity. The owner is typically taxed currently on the cash received. If structured properly, a tax deferral is achieved on the stock rolled over into the newly capitalized company.
leveraged employee stock ownership plan - sell some or all of his shares to a pension plan that is created by the company.
With a charitable remainder trust, Omo would make an irrevocable donation of his shares to a trust and receive a tax deduction for the gift. He would no longer have ownership of the shares. The trust would provide income for the life of its named beneficiaries (the beneficiaries would owe income tax on this income). When the last-named beneficiary dies, any assets remaining in the trust would be distributed to the charity named in the trust.
Inheritance tax: basis step-up on death
basis “step-up” on death, meaning that someone who inherits an asset would have a tax basis equal to the fair market value of the asset on the date of death.
Tax efficient
tax efficient = lower percent capital gain exposure (PCGE)
= Net gains (losses)/Total net assets. where net gain =(gain - distribution - loss)
Asset allocation with Black-Litterman / Mean variance optimization / reverse optimization
Black–Litterman starts with the excess returns produced from reverse optimization, which commonly uses the observed market-capitalization value of the assets or asset classes of the global opportunity set. It then alters the reverse-optimized expected returns that reflect an investor’s own distinctive views yet still behaves well in an optimizer.
mean–variance optimization tend to be concentrated in a subset of the available asset classes. outputs of an MVO are the asset allocation weights, which are based on (1) expected returns and covariances that are forecasted using historical data and (2) a risk aversion coefficient.
vs reverse optimization method takes the asset allocation weights as its inputs that are assumed to be optimal.
The reverse-optimized returns are calculated using a CAPM approach, Return on Asset Class = Risk-Free Rate + (Beta) (Market Risk Premium)
Reverse optimization takes as its inputs a set of asset allocation weights that are assumed to be optimal and, with covariances and the risk aversion coefficient, solves for expected returns. The asset allocation using reverse optimization would not take into account the investor’s own views.
Asset allocation
Risker asset allocations are over-diversified, not under-diversified. asset allocations do inherit the estimation errors in the original inputs. Asset classes should have high within-group correlations but low correlations with other classes: asset classes should be diversifying, low pairwise correlations with other asset classes is not sufficient. An asset class may be highly correlated with some linear combination of the other asset classes even when pairwise correlations are not high.
Asset classes should have a return premium based on an underlying market risk factor (e.g., beta) and not any underlying skill of the investor.
marginal contribution to total risk
marginal contribution to total risk (MCTR) is the beta relative to the portfolio multiplied by the standard deviation of the portfolio:
Deferred variable annuity vs fixed annuity
deferred variable annuities offer a diversified menu of potential investment options, whereas a fixed annuity locks the annuitant into a portfolio of bond-like assets at whatever rate of return exists at the time of purchase.
