I have a question that I was wondering if anyone can help with. In the CFAI textbook , volume 2 on question 13, pg.216, there is a question regarding the Maclin family. The solution in part b for the liquidity constraint indicates that the Maclins have one time expenses totalling 50,000 pounds. The answer does not indicate that the portfolio needs to generate 28,000 to cover the difference between the Maclin’s living expenses and the salary generated by the Maclin’s. Should the 28,000 amount to cover living expenses not also be included in a complete response indicating liquidity requirements? Any assistance is greatly appreciated!
First the diff between salary and expense is 26,000 not 28,000 . I kept scratching my head wondering how you got 28000 !
Second liquidity is a provision apart from living expenses. It usually means a 1-time expense that reduces available capital.
The returns cover the actual shortfall between ongoing ( i.e. not 1-time) expenses and income.
Liquidity implies that you must keep the required amount in cash or liquid asset , so you can get at it rapidly . This means it is not available to the portfolio to generate a return.
Thanks for the reply Janakisri, sorry for the transcription mistake!
However, I do have a question in regards to your response. For question 11 in reading 10, the solution in the CFAI book for the Mueller family, does not only cite liquidity requirements as being a 1 time expenses reducing investable capital, but also references the need to generate liquidity to cover annual college expenses and that this amount ($15,000) exceeds their normal savings of $25,000 annually after taxes, met through income generation from their portfolio. This answer appears to be somewhat divergent to the response in Q13, as it includes an ongoing expense (for five years) as a liquidity requirement. Where am I going wrong here?
5 years college expense is a liquidity provision item , not an ongoing expense.On going expense are things that are longer term , increase with inflation. Expenses needing liquidity provision most likely impact ( reduce ) the invesatble capital . college expense is an item that is not a living expense. So is a relative’s illness requirng treatment for 3 years. Also a planned house purchase in 5 years . These are examples of unusual items that are highlighted in the question , specifically as items requiring liquidity drain.
Living expenses are just lumped together and are the main focus of the income generating part of the portfolio
Living expenses needing to be provided by the portfolio =( total living expenses - non-portolfio income such as pension payments).
Liquidty requiring items are never included in total living expenses
I believe while writing about IPS liquidity contraints, apart from the unusal items which causes liquidity drain you should also write the spending need to be met by portfolio (which income - expenses).
This shortfall is also used during formulating return objective i.e minimum return from the portfolio to keep up the life style. Then this shortfall is highlighted in liquidity apart as well along with other one time or unusal expenses (college, donation, planned house etc)
Immediate one year expenses are deducted from investable assets & also need to be kept in cash or liquid funds.
If the person retires , then ongoing expense is a liquidity constraint .
If the person is working and expenses equal salary or other income then ongoing expense is not a liquidity constraint on the portfolio.
In this case the Christopher Maclin has not retired , but his income is not sufficient to meet their expenses . So the 26k shortfall should be listed in liquidity constraint and CFAI is not complete in their answer .
Guideline answer for 2009 makes it a point to show the difference between the year before retirement ( 2009) , the case when they retire at 60 ( i.e. in 2010 , so they need the liquidity in 2009 end ) and the case when they put off retirement until 2015 , in which case 2009 doesn’t have the liquidity requirement .
However CFAI is right even when they’re wrong , so I better shut up now.
i think he is trying to figure out manually why the two percentages (the 26K pmt as a % of assets) and the return needed to grow from 1235 to 2000 add to a higher rate. I think he is missing an effect of compounding. With a financial calculator this is straightforward
I was trying to arrive at the same answer using the two return individually and arithmaically adding them up. There may be some arithmatic vs geometric bias where I am coming up with an extra 80bp return reqd.