Cfa Level Iii - Study Session 4

Front 1

Private Wealth Management
(SS4)

Factors that affect an individual investors' risk tolerance

Back 1

1. Source of wealth (Entrepreneurs like to take risk themselves, but don't like to let a manager take that risk for them. Old money has low risk tolerance because they don't have experience taking risk and are less able to recover from a loss.
2. Measure of wealth ( $$ in the portfolio, a big number for one might be too small in their eyes, while a small number in another's eye might seem big to them - all about perception)
3. Stage of life (foundation, accumulation, maintenance and distribution). Ability to take risk starts high early in life and then declines throughout life.

Front 2

Private Wealth Management
(SS4)

Stage of Life

Back 2

i. Foundation: usually young, long time horizon, associated with above-average ability to take risk. Ironically even though this is the stage where people should take the most risk, most are unwilling to do so.
ii. Accumulation: Earnings accelerate, income rises, assets accumulate. Expenses rise during this period, with familiy, homes, children etc. Increased risk tolerance and long-term horizon.
iii. Maintenance: retired from daily employment, preserving wealth is more important, risk-tolerance declines because confidence to replace any lost money is limited.
iv. Distribution: Accumulated wealth is transferred to other entities, dealing with tax constraints is important here. Planning how you're going to distribute this begins earlier, like trusts or foundations.

You can switch between stages of life and go back 2 stages.

Front 3

Private Wealth Management
(SS4)

Psychological Profiling

Back 3

Psychological profiling bridges the gap between traditional finance and behavioral finance.

Front 4

Private Wealth Management
(SS4)

Traditional Finance

Back 4

Relies on:
i. Participants are rational and have rational expectations (coherent and unbiased where they learn from past mistakes)
ii. Information-based investors
iii. Wealth maximisers
iv. Practice asset allocation, e.g. risk vs return, assets assessed on portfolio basis, not as stand-alone investment

Front 5

Private Wealth Management
(SS4)

Behavioral Finance

Back 5

Principles of behavioral finance are where individuals:
i. Exhibit loss aversion (prefer a certain gain to an unexpected gain vs prefer an uncertain loss to a certain loss)
ii. Hold biased expectations (misplaced confidence in an individuals ability to predict the future)
iii. Practice asset segregation (evaluation of assets individually rather than in aggregate, e.g. mental accounting separate accounts based on purpose or preference)

Portfolios are made on a triangle of needs.

Front 6

Private Wealth Management
(SS4)

Personality Typing

Back 6

Personality typing helps an advisor determine an individuals ability to take risk.
i. Cautious (feeling, risk averse)
ii. Methodical (thinking, risk averse)
iii. Spontaneous Investors (feeling, more risk)
iv. Individualist Investors (thinking, more risk)

Front 7

Private Wealth Management
(SS4)

Cautious Investors

Back 7

i. Averse to potential losses
ii. Aversion comes from their life experiences, but they have a strong need for financial security.
iii. They like low-volatility investments with a low chance that they will lose principal.
iv. They don't like making their own decisions, but they are not easily persuaded and choose not to receive financial advice.
v. They miss opportunities for fear of taking action and overanalysis.

Front 8

Private Wealth Management
(SS4)

Methodical Investors

Back 8

i. Relies on hard facts
ii. Always on a quest for new, better information
iii. Have no emotional attachments to positions, they are very disciplined
iv. Pretty conservative investors

Front 9

Private Wealth Management
(SS4)

Spontaneous Investors

Back 9

i. They constantly readjust their portfolio allocations and holdings
ii. Every bit of news they fear a negative consequence
iii. They know they aren't the best investing experts
iv. Most have below average returns as any profits are eaten up by trading costs.
v. Care more about investment trends than with the pf risk.

Front 10

Private Wealth Management
(SS4)

Individualist Investors

Back 10

i. Get info from a variety of resources
ii. They have confidence that their long-term investment objectives will be achieved.

Front 11

Private Wealth Management
(SS4)

Investment Policy Statement (IPS)

Back 11

i. Presents the investor's financial objectives
ii. Shows the degree of risk that they are willing to take
iii. Details investment constraints
iv. Makes sure the investment advisor and the client are on the same page.
v. A dynamic process, not a one off event

Front 12

Private Wealth Management
(SS4)

Investment Policy Statement - Setting Return and Risk Objectives

Back 12

1. Return Objective should be attainable given the portfolio's risk constraints (there is a difference between return desire and return requirement)
When return objectives aren't compatible with risk tolerance a resolution is found by modifying low-intermediate goals, or by accepting a higher level of risk (only if s/he has the "ability" to take additional risk. e.g. deferring retirement, increase current savings, reduce standard of living in retirement.
2. Risk objective
i. Ability to take risk (determined by their financial goals relative to resources, modest goals mean greater ability, longer horizon means more time to recover from any disaster therefore greater ability) What is the impact if these goals are not met.
ii. Willingness to take risk (this is a more subjective assessment)
ii. Willingness to take risk

Front 13

Private Wealth Management
(SS4)

Investment Policy Statement - Constraints

Back 13

Look at all all economic and operational constraints
1. Liquidity - transaction costs (needs for cash distribution Look for large sales in a thinly traded asset), price volatility, emergency reserves and negative liquidity events (like retirement, charitable gift)
Some assets will never be liquid like the family home and are then excluded from active management.
2. Time horizon (single or multi-stage horizon)
3. Taxes - income, gains, wealth transfer (estate/inheritance) and property tax
To get around them people use
Tax deferral, Tax avoidance (use RSAs, tax exempt bonds), Tax reduction (pick dividend stocks, or only appreciation stocks) and Wealth transfer strategies (transfer at death or early transfers like gifting and charitable transfers)
4. Legal and regulatory environment - any fiduciary duty or prudent investor rules. (personal trusts, family foundations)
5. Unique circumstances (ethical investing, owning restricted stock in your own company that you are prohibited from selling, privacy concerns, having been burnt in the past etc)

Front 14

Private Wealth Management
(SS4)

Example - Inger's Return Objectives

Back 14

Expected cash flow requirements
divided by
Investable Assets

493,949
______
42,340,438


Required Return 1.17%
Expected Inflation 3.00%
Return Objective 4.17%

Front 15

Private Wealth Management
(SS4)

Asset Allocation

Back 15

Asset Allocation policy
i. Finds a set of asset-class weights that produce a portfolio consistent with the risk/return objective.
ii. Has to think about after-tax returns
iii. Has to think about tax consequences of shifting between assets
iv. Impact of future rebalancing
v. Asset 'location' ie. put your nontaxable assets in individual accounts, not tax-exempt accounts

Front 16

Private Wealth Management
(SS4)

Asset Allocation Concepts
Susan Fairfax Objectives

Back 16

Return Requirement
i. When does the income stream have to start e.g. 7 years (500,000 x 1.04⁷ = $658,000) .04 is inflation
ii. Real after tax rate of return
4 inflation + 3 real
_______________ = 10.8% total
1 - 0.35t
ii. Market value of stock in 7 years at retirement
($2,000,000 x 1.07⁷ = $13,211,500)
so to generate
658,000
----------- = 5%
13,211,500
If she sells her stock leaving
(1 - 0.35t)($10,000,000) + $3,211,500
= $9,711,500 to invest
Therefore required return:
658,000
------------ 6.8%
9,711,500

Front 17

Private Wealth Management
(SS4)

Asset Allocation Concepts
Susan Fairfax Constraints

Back 17

i. Susan has a below-average WILLINGNESS to take risk because she doesn't want her pf to decline by 10%. Her large wealth however give her a high ABILITY to take risk.
ii. Liquidity: Income needs or cash reserves to meet emergency needs. She has her health care paid for so she has no planned needs for cash
iii. Taxes on salary, investment income and gains: Investment strategies should maximise after-tax profits and defer tax. Since her cost base for company stock is zero, you have to be really careful with this one, maybe she should give some to charity during her lifetime or at death.
iv. Laws - like insider status when she sells or if she buys a trust the fiduciary requirement
v.Unique circumstances - High concentration in one company's stock.

Front 18

Private Wealth Management
(SS4)

Asset Allocation Concepts - 4 steps

Back 18

Allocation A B C D
Expected total
Expected after-tax total
Expected s.d.
Sharpe Ratio

1. Cross out allocations that don't meet the return requirements
2. Cross out allocations that don't meet risk objectives
3. Cross out allocations that don't meet investors constraints like liquidity, level of cash
4. Look at sharp ratio and choose the best one

Front 19

Private Wealth Management
(SS4)

Monte Carlo Simulation

Back 19

i. Uses probability distributions to create scenarios to predict end-stage results.
ii. Good because it uses multiple factors to get to the end.
iii. Better than using historical numbers because it uses future projections to get a PROBABILITY (from 10,000 simulations) not just a single point at the end-stage.
iv. Each trial has a potential blend of economic factors.
v. MC is far more informative about the risk (they beat DETERMINISTIC models with only one outcome)
Better suited to assessing multiperiod effects.
vi. No forecasting tool is perfect, rubbish in - rubbish out.

Front 20

Private Wealth Management
(SS4)

Taxes

Back 20

i. Taxes on income - interest, dividends, gains
ii. Wealth-based taxes - real estate, taxes on inheritance
iii. Taxes on consumption - sales and value added taxes

Front 21

Private Wealth Management
(SS4)

General Income Tax Regimes

Back 21

1. Common Progressive - these countries have progressive for ord income and favorable treatment for interest, dividends, gains.
2. Heavy Dividend Tax - favourable for gains, divs, not interest
3. Heavy Capital Gain Tax - Columbia
4. Heavy Interest Tax - Canada interest tax at normal progressive rates.
5. Light Capital Gain Tax - Australia
6. Flat and Light - Russia
7. Flat and Heavy - Ukraine

Front 22

Private Wealth Management
(SS4)

After-tax accumulations and returns for taxable accounts

Back 22

Returns Based Taxes
i. Accrual Taxes: taxed each year and therefore the tax drags on earnings and increase the longer the horizon is.
ii. Deferred Capital Gains: i.e. Realised Capital Gains Tax
Investors keep more of their money in this environment because there is more money left to accumulate.
iii. Cost basis: Low cost basis investments have larger tax impacts to the individual.
iv. Wealth Based Taxes

Front 23

Private Wealth Management
(SS4)

Cost Basis Example

Back 23

1. Paid each year
Invest $100 at 6% for 10 years and taxed each year 30%.
100 [ 1 + 0.06(1-0.30) ]¹⁰ = $150.90

2. If no tax
100 (1 + 0.06)¹⁰ = $179.08

3. Deferred tax until the end
100{(1+0.06)¹⁰ - [(1+0.06)¹⁰ - 1]0.30 }
contracts to:
100 [ (1+0.06)¹⁰(1-0.30) + 0.30] = $155.34
(compared to $150.90 for accrual)

4. If cost basis goes down to 80 (from 100)
100 [ (1+0.06)¹⁰(1-0.30) + 0.30(0.8)] = $149.35
compare this to $155.35 if basis is 100. The $6 is the tax liability with the embedded capital gain.

5. Wealth tax - reduces principal. If returns are small, then the wealth tax eats up all the profits.

Front 24

Private Wealth Management
(SS4)

Accrual versus Deferred returns

Back 24

1. Accrual return is ALWAYS less than the taxable return
It approaches the pretax return as the horizon increases
2. The value of deferral has value. The more any gains are deferred the more the value of the deferral increases.
3. Accrual equivalent tax rates
Where you are just as well of if you can find a tax-free investment that returns 6.166% for example as a taxed one earning 8%.
r (1 - t of accrual equivalent) = return of accrual equivalent

These rates can be used to assess tax efficiency of assets or pf management styles.

Front 25

Private Wealth Management
(SS4)

Types of Investment Accounts

Back 25

1. Tax-deferred accounts - tax owed when money is withdrawn (e.g. 9 years)
FV = (1 + r)⁹ (1-Tn)
2. Tax-exempt accounts - no future tax liabilities (so no Tn)
FV = (1 + r)⁹
3. After-tax asset allocation - can depend on time horizon which is difficult to estimate and can change over time.
4. Choosing Among Account Types
- sometimes TDA are tax deductible so they don't always beat tax-exempt accounts.

Front 26

Private Wealth Management
(SS4)

Managing Tax Liabilities - Asset Location

Back 26

1. Asset Location - (is different from asset allocation) it is all about putting tax-exempt assets outside of tax-free accounts because it is a waste.
e.g. $100,000 bonds in tax-deferred account and $25,000 in taxable account, meaning a pretax bond allocation of 80%. If the client wants only 60% bonds then they can short $20,000 bonds outside the TDA and invest it in stock.

There may be limits to executing this in reality, such as restrictions on lending, withdrawal costs from TDA and other borrowing costs.

2. Behavioural constraints may drive asset location
3. Time horizon
4. Age
5. Investment availability

Front 27

Private Wealth Management
(SS4)

Managing Tax Liabilities - Trading Behavior

Back 27

1. Trader - annually taxed short term gains
Accumulates least
2. Active investor - trades less frequently and gains are longer term in nature which may get more favorable tax treatment
Accumulates second least
3. Passive investors - buys and holds
Accumulates second most
4. Exempt investor - buys and holds but never pays capital gains tax
Accumulates most
Optimal asset allocation and asset location differ for each of these types of investors.

Front 28

Private Wealth Management
(SS4)

Managing Tax Liabilities - Tax Loss Harvesting

Back 28

1. Sometimes trading can be tax efficient, (not a tax drag)
Tax losses can offset tax gains in any given year and create value.

= TAX LOSS HARVESTING

2. Can lead to tax savings, but if you sell a stock low and buy it back low, you are reducing your cost basis leading to a higher gain down the track.

3. You can also invest the tax savings after tax-loss in year 1 to boost your earnings next year (kind of like doubling down) and end out in front. Creating value through tax-loss harvesting.

Front 29

Private Wealth Management
(SS4)

Managing Tax Liabilities - Holding Period Management and After-tax mean-variance optimisation

Back 29

1. Most jurisdictions encourage long-term investing.

The same asset, held in two different types of accounts (TDA or exempt etc) will provide a different after-tax return.
In the optimisation equation you have to use AFTER-TAX s.d. to find the weights for the optimal portfolio

2. When short-term gains are taxed more heavily than long-term gains, it can be difficult to generate enough alpha to offset the higher taxes associated with short-term trading.

Front 30

Private Wealth Management
(SS4)

Estate planning in a global context - Domestic Estate Planning

Back 30

1. Estate planning
i. Probate is the legal process to confirm the validity of the will.
ii. You can avoid probate by holding assets JTWROS joint tenancy, living trusts or retirement plans. Transfer can happen in these without a will.
2. Legal systems, forced heirship (where children are entitled to a fixed portion) and marital property regimes.
If a lot of the money has been gifted away through the lifetime, it may be 'clawed back' to figure out the child's portion.
Communal property regimes are where all marriage income is split in two. Separate property regimes are where each spouse owns property as an individual.
3. Income, Wealth and Wealth transfer taxes. Wealth tax is an annual levy on real estate, financial and tangible assets.

Front 31

Private Wealth Management
(SS4)

Core Capital and Excess Capital

Back 31

1. Core capital is the money needed to maintain an investors lifestyle.
Have to think about inflation concerns here.
Estimating this core capital can come from future income and whether it will cover them for life - survival probabilities
2. Safety reserve - subjective assessment. The bigger your reserve, psychologically you are able to take a bit more volatility because you have a buffer.
3. Estimate core capital with Monte Carlo analysis (uses actual market scenarios NOT a discount rate)
'Ruin' probability is the chance that you will overspend/outlive your earnings.

Front 32

Private Wealth Management
(SS4)

Probability of Survival example

Back 32

p(Joint survival)
= p(Woman) + p(Man)
- p(Woman)p(Man)


Annual spending
1,000,000
Expected spending
999,960
Discounted Value (@2%)
980,360
Add these up for every year and that is the capitalised value of their core capital spending.

Read a ruin probabilty off a table and then find the dollar you can take out per 100 for a 2% chance of ruin.

Front 33

Private Wealth Management
(SS4)

Transferring Excess Capital

Back 33

If the Webster's have $20 mil and their core capital is $9.3 mil then they have excess capital of $10.8 mil (to gift)

i. Lifetime gifts - tax-free gifts. Countries that have inheritance tax are also on the lookout for gift/donation taxes.
ii. If the gift tax rate is less than the estate rate, gifting can still be tax efficient.
Bequeth the lower cost base assets, because you get them off the old persons balance sheet and only the smaller gains are left there to be taxed. Give the higher expected returns to the second generation (skip one). This is looked at from the perspective of after-tax returns.
iii. Sometimes the gift tax is on the recipient, sometimes it is on the donor. When the donor pays it the value of a lifetime gift increases.
iv. Generation Skipping: prevents the estate tax being paid twice. USA has a generation skipping tax to deter this.
v. Spousal exemptions: Most places allow you to give it to your spouse without transfer tax liability. If a husband dies, it is best to transfer to a non-wife person so that when she dies it doesn't trigger an inheritance tax. This way you have another transfer exemption.
vi. Valuation Discounts (for things like minority interest in privately held company, discount for lack of liquidity like 10% and lack of control discount 15%) This reduces the basis at which they are transferred.
vii. Deemed dispositions (as if when bequest it is sold, i.e. triggers unrealised gains to be realised)
viii. Charitable Gratuitous Transfers

Front 34

Private Wealth Management
(SS4)

Estate Planning Tools

Back 34

i. Trusts
ii. Foundations
iii. Life insurance
iv. Companies
v. Partnerships

Front 35

Private Wealth Management
(SS4)

Trusts

Back 35

1. Trustee is the legal owner of the assets
2. Beneficiaries are the beneficial owner of the trust assets
3. Trusts are revocable (where the person who gives the money to the trust reserves the right to take the money back to protect it from the beneficiaries claims, i.e. the settlor is the owner for tax purposes) and irrevocable trusts that protect the assets from creditors of the person who gave it up.
4. Fixed ($5 each year) or discretionary (trustee decides how much to distribute)
5. Use trusts for giving people assets that you want to retain control of, but they are unable/can't control the assets themselves
6. Trusts can be used for tax reduction


Foundations are only in certain countries and are a legal person. They are set up for a purpose like education or philanthropy.

Front 36

Private Wealth Management
(SS4)

Life Insurance

Back 36

1. Insurance has tax and estate planning benefits. Payouts are generally tax free to the beneficiaries.
2. Some life insurance policies can build tax-deferred.
3. Best of all payouts from life insurance doesn't have to go through probate. People insure their life up to the amount that the children might pay estate tax on their other assets so they don't have a liquidity crisis.

Front 37

Private Wealth Management
(SS4)

Cross Border Estate Planning

Back 37

1. Can use a CFC (controlled foreign corporation) to defer the tax on earnings until they are distributed. Can set it up in a country where there is no tax on the company or shareholders.
2. If your assets are all around the world, it can be difficult to transfer ownership of these.
3. Hague convention - international acceptance of wills made in another country (if both countries have ratified it)
4. Tax system - US taxes assets held by residents outside US and non-US residents with assets in US, which may trigger double taxation but there are tax credits to help with this.
Also exit-tax if people like Rupert Murdoch if they cease to become citizens.
CREDIT method (off tax liability)
EXEMPTION method (no local paid)
DEDUCTION method (of foreign tax paid)
5. Transparency and off-shore banking - tax evasion (bad) and tax avoidance (legal)

Front 38

Private Wealth Management
(SS4)

Low Basis Stock

Back 38

Basis can be different to initial cost:
1. Psychological considerations:
Ancestors founded company, family name, bought by a loved dead relative or the source of family's fortune.
2. Investment risk
How much to sell some? Can I get this return from another more diversified asset?
3. Tax issues

Front 39

Private Wealth Management
(SS4)

Stock Risk - "Equity Holding Life"

Back 39

Market (systematic) vs Specific risk
i. Entrepreneur - high total inv. risk, single security holding, high specific risk. You don't want to diversify here, you want to grow your business.
ii. Executive - med total inv. risk, concentrated holdings.
Some have handcuffs or equity that vests over time so they have to stay invested. The less management the old owner has in the co. the more diversified they should become.
iii. Investor - low total inv risk = market risk. The old-owner no longer has control and should try to
multi-security holdings, operating vs controlling asset
(concentrated, active, core)

Front 40

Private Wealth Management
(SS4)

Concentrated Equity Risk (4 ways to get rid of this)

Back 40

1. Outright sale - most expensive as realised capital gain and tax. Good for people who want maximum flexibility, as it gets rid of all systematic risk, but there is less to invest.
2. Exchange fund - 50 concentrated holders invited to pool their assets. You can defer your gain this way, but bad because of management costs, no control and inflexibility.
3. Completion portfolios - for people with access to other liquid assets to help reduce overall risk of single position to bring it back to a market index holding. These strategies take time.
4. Hedging Strategies - short a similar company or buy a future/forward contract. Monetize an illiquid position.
If you want to let profits run, don't hedge, if you want to get the money out without a tax event then monetize.

Front 41

Private Wealth Management
(SS4)

Goals Based Investing

Back 41

i. Portfolio efficiency is defined in terms of client goals (risk of not meeting them), instead of traditional risk/return.
ii. Investor goals are lifestyle needs, wealth transfers and charitable gifts.
iii. Link risk measurement to investor goals, not 19%s.d but the fact that you could lose $10,000
iv. Investors aren't risk-averse they are loss-aversev.
v. Risk Profiling - decision framing and Mental accounting (fun money vs education money)
vi. Behavioural Biases (not just preferences) should be controlled not just accommodated - overconfidence, hindsight bias, overreaction, belief performance, regret avoidance.

Goals Based Investing:
Goal 1 - Risk 1 - Strategy 1
Goal 2 - Risk 2 - Strategy 2
Goal 3 - Risk 3 - Strategy 3

Traditional:
Overall risk tolerance/ Single strategy

Front 42

Private Wealth Management
(SS4)

Investing to meet current lifestyle needs

Back 42

i. Absolute return strategies
ii. Cash flow matching - e.g. pension funds use asset-liability models.
Translate the risk of loss into a worst sustainable spending rate for the client so they are better able to understand.
Laddered bond portfolios are good here if you can exactly forecast when you need the money otherwise you pay a penalty.
iii. Income strategies
iv. Fixed Horizon strategies - buy a bond that matures to what you want at the end and invest the difference in stocks now.

Front 43

Lifetime Financial Advice
(SS4)

Human Capital's impact on investment recommendations

Back 43

As a % of investor's total wealth
i. Can't trade human capital like stocks. Human capital has risk/return such as how long and how much the investor works.
ii. Often the largest asset the client has, young people have more than old people
iii. Should be treated like any other asset class with its own risk/return properties and correlations with other asset classes.
iv. People with more human capital flexibility can take more risk with their other assets. If they work in finance, they should put less in the stock market.
v. If human capital = risk free, start with more equity and wind it back over time
If human capital = risky asset
could be risky highly correlated to stock market
could be risky with low correlation to stock market
e.g. stockbroker vs school teacher
Stockbroker invests more in the risk-free asset to diversify assets.
vi. Initial financial wealth = high
Then human capital is lower % of total and human capital is less risky that the risky asset.
If initial financial wealth = low

Front 44

Lifetime Financial Advice
(SS4)

Human Capital's impact on building portfolios

Back 44

To build a portfolio look at financial capital and human capital.
i. Mortality risk (risk during accumulation) - life insurance when your human capital gets cut short. Life insurance is the hedge here, but underinsurance is everywhere. Asset and life insurance decisions should be made jointly.
ii. Longevity risk (risk during retirement) - you living longer than planned
iii. Earnings risk - financial markets risk

Front 45

Lifetime Financial Advice
(SS4)

Insurance

Back 45

i. Has an agency issue in that people who think they are more likely to die will buy more insurance
ii. If the discount rate on future human capital is high, you put less worth on your future human capital and therefore buy less insurance.
iii. Bequest vs live state
If people value the Bequest state more, they will buy more insurance.
iv. Low risk tolerance people buy more insurance and invest conservatively.

Front 46

Lifetime Financial Advice
(SS4)

Case Studies - Human Capital

Back 46

1. Human capital, financial asset allocation and life insurance demand over the lifetime:
Human capital decreases
Insurance need decreases
Allocation to risk-free asset up
Financial assets increase
2. Strong bequest motive: (as D gets larger, medium bequest = 0.2)
Highly concerned about heirs and wants to buy a lot of insurance to hedge the loss of human capital.
A strong bequest demand has little impact on asset allocation.
3. Risk tolerance: (medium risk CRRA = 4)
Low risk tolerance means buy more risk-free asset and insurance.
4. Financial wealth:
As wealth goes up, allocation to risk-free asset goes up
As wealth goes up, insurance goes down. Because if you are wealthy your human capital is less of your assets and you need less protection against losing your human capital
5. Wage growth rate and stock returns:
Higher correlation, means more to the risk-free asset
Lower insurance the less the wages and stock returns are correlated. This is because if human capital is lost, then the stock returns will go up because they are positively correlated.

Front 47

Lifetime Financial Advice
(SS4)

Risk factors in retirement (3 factors)

Back 47

1. Financial Market risk - often ignored in retirement planning by assuming a constant rate of return, then the wrong allocations are made. Use a monte carlo to scenario up different rates of return.
Fix by using modern pf theory to reduce risk.
2. Longevity risk - living longer than expected AND outliving assets. Life expectancy is only an average estimate and simple retirement planning ignores this. This is a bad risk because there is no potential reward from it.
Fix by insurance products
3. Risk of spending uncertainty - Investors don't save enough to fund the retirement portfolios.
Fix by overcoming behavioural issue. If your employer adds 50c for every $1 you put in, you are making an instant 50% return.

Front 48

Lifetime Financial Advice
(SS4)

Longevity Risk and sources of retirement income

Back 48

1. Social security - traditionally where most retirement income comes from. (39% of income)
2. DB pension plans (18% of income) tide is changing on this to DC plans
3. DC plans - under these the longevity risk is back with the investor AND they have to manage these themselves.
4. Other personal savings
i. Payout annuities (annuitization) ensure that the retiree won't run out of income no matter how long they live. If you die just after you set it up, then you lose. Also you can't leave these as bequests and the low steady income may not be enough for large expenses.
ii. Buying a lifetime annuity transfers the longevity risk to the insurance company, but they pay a price - is it worth it?
iii. Fixed-payout annuity
Downside the payout is constant each year, so the buying power reduces with inflation. Also bad because you can't trade the fixed-payout annuity once it has been purchased.
iv. Variable payout annuities - exchanges accumulated units for annuity units. Disbursements also fluctuate depending on what the investors invest in.