In the answer for the liquidity requirement, it says that Smith’s current expense requirement of $150k is currently being met by their portfolio. However, examining the case, they actually have a short fall between income and expense as they only get $105K from their pension and Gift Fund combined. I don’t get how CFAI says that their expense needs are met. Were the exams this easy back in '97???
you’re forgetting the return from the Family Portfolio (which is assumed to be $45k) in order to not have a shortfall. With a $1.2mln porftolio, a return of 45k is only 0.0037% after tax. Saying that the Smith’s needs are being met is a reasonable assumption since the portfolio is invested in entirely very safe securities (since inflation is 3% risk free securities would have a return greater than that).
I failed to understand your point. There is no mention or assumption of $45K coming from the Family Portfolio. Besides, our task here is the make the IPS FOR the Family Portfolio. Thus, liquidity currently coming out of Family Portfolio should be included in the return requirement calculation however much that may be. Another problem here is the fact that it does not state whether or not the “implied” 45K is inflation adjusted or fixed - because the other income in the case or NOT inflation adjusted. What we need to do is to calculate the return requirement with exact liquidity needs for the portfolio. If current income coming from the portfolio is some kind of a murky number, I’m not sure if I can do better than a murky answer. Am I just completely missing the point? Or was this CFAI level 3 exam ('97) just messed up?
ok - let me try again. In the return section of the IPS, which you construct before the constraints you need to incorporate a $150k after tax return. you know $105k comes from the pension and gift fund, therefore the other $45k must be met by the family portfolio. and you know that the $45k would also have to grow with inflation since expenses are expected to grow with inflation. thus your return part of the IPS is constructed. Therefore the necessary return on the FAMILY portfolio is $45k, adjusted for inflation. And then when you get the liquidity constraint, you now know based on your previous work that other than meeting the annual expenses, the Smith’s only other liquidity issue would be the home renovation. the 97 CFA exam is fine. They don’t mention the $45k coming from the family portfolio because that is the ‘trick’ part of this question that separates pass from fail. Every CFA question contains one ‘trick’ that accomplishes that.
I see your point. But this doesn’t seem very precise, especially considering the fact that the 45K will have to grow at a logarithmic growth rate starting around 10%, then 9.2% then 8.8. Clearly the required return to achieve their primary objective AND secondary objective is to state that the return objective is in excess of 10% per year. Otherwise, they may not even achieve their primary objective without eating into the principal. Yet, for some odd reason, the magic number seems to be about 7 to 8% per year (pre tax) when CFAI will say something like, “the secondary goal is unrealistic and that they should stick with lower return. … council the client that they may have to eat into principal” In other words, at some point, the client wishes go out the window and we have to clamp down at a certain reasonable % number where we are comfortable achieving. Iguess that is the fudge factor on Level III.