EOC problem # 2, Reading 8

Why are we not removing the emergency reserve (132,500) from the base?

Why did we not add the expected return on the portfolio (82,500) to the base?

Here is the passage from EOC from the curriculum:

Christa estimates that her revised annual living expenses, including a new studio and apartment, will average €132,500 (excluding Jürgen’s educational costs). If necessary, she could combine her apartment and studio to reduce spending by €32,500. She does not want her financial security to be dependent on further gifting from her parents and is pleased that, after the sale of IngerMarine, she will be able to meet her new living expenses with proceeds from art sales (€50,000) and the expected total return of the proposed investment portfolio (€82,500). Because of the uncertainty of art sales, Christa plans to establish an emergency reserve equal to one year’s living expenses. Her after-tax proceeds from the sale of IngerMarine are expected to be €1,200,000 × (1 − 0.15) = €1,020,000. She also holds €75,000 in balanced mutual funds and €25,000 in a money market fund. Christa intends to reevaluate her policy statement and asset allocation guidelines every three years.

Here’s the question:

Determine Christa’s return requirement and evaluate whether her portfolio can be expected to satisfy that requirement if inflation averages 3 percent annually and she reduces her annual living expenses to €100,000 by combining her apartment and studio.

Here’s the explanation from the curriculum:

2 After the sale of IngerMarine, Christa’s portfolio will have a market value of roughly €1,120,000, taking account of the after-tax proceeds from the sale of IngerMarine (€1,020,000), her balanced mutual funds (€75,000), and her money market fund (€25,000). Her expected portfolio return is €82,500, equal to a 7.4 percent rate of return. Her required real return, if she reduces her spending by combining her apartment and studio, is €50,000 (art sales of €50,000 less €100,000 expenses), or 4.5 percent as a rate of return on her portfolio. Because the portfolio’s expected return of 7.4 percent translates to a real return of approximately 4.4 percent (7.4 percent less 3 percent inflation), the portfolio is not expected to meet the return requirement of 4.5 percent.

Emergency reserves are part of the asset base, but are allocated to cash equivalents in SAA.

The return from her portfolio would be used to pay for living expenses, so makes no sense to include it in the base.

Those are the questions in my first post

I believe it is the following:

1. The emergency base is for emergencies , hence it is set aside as cash equivalent, so not part of the _investable base (_€1,120,000) it is part of the €1,120,000 but as cash equivalent. Basically we want that cash reserve to be in some safe instruments that can easily be liquidated (e.g T-Bills) if/when needed. So assume we put €132,500 in T-Bills, and €987,500 in riskier assets.

2. The €82,500 is the expected return of her €1,120,000 portfolio and will be used to meet her living expenses as Nenorr mentioned, so you can’t add that to the base.

I understand point number 2, but not 1.

I think we’re all saying the same thing i.e emergency reserve should be taken out but it’s not taken out in the answer provided by the curriculum.

1,020,000 (after tax proceeds) + 75,000 + 25,000 = 1,120,000 - this is the investable base.

My investable base is 1,120,000 - 132,500 (reserve) = 987,500.

On a related note, let’s suppose that we have to make a down payment of 50,000 on a house in 11 months. Do we set that amount aside as cash equivalent and take it out of investable base?

I guess a better question is is there a cutoff in terms on months when we set aside cash? 3 months? 6 months? <12 months?

I corrected my post, sorry for the confusion.

OK I was very confused but I think I have it straight now. …I think.

So, to summarize,

We don’t take the reserve amount out from the base i.e portfolio base of 1,120,000

We do take one time liquidity need out of the portfolio, for example, a down payment on the house Suppose there was a 50,000 down payment required, it would be 1,120,000 - 50,000.

The reason why we don’t take emergency reserve out of the portfolio base is because we plan to maintain the reserve and hence will always be part of the portfolio, whereas down payment will go away.

Do I have this correct?

Yes, I believe you are correct that the emergency reserve is part of the asset base (also can be called net investable assets). One-time liquidity needs are removed from the asset base since they lower the amount of funds that can be invested.

I think emergency reserves are reflected in the calculation of liquidity constraints.

Well…this comment comes 1 days before the exam but worth being mindful of and luckily I saw this was a recent enough conversation on AF. There was a morning essay question in the 2013 exam regarding Thomas and Elizabeth Voort, Question 1. I have a screen shot of the problem saved but did a google search and this website references the 2013 morning exam for reference. Pasted link below.

https://wenku.baidu.com/view/1edf8f4383c4bb4cf7ecd1e7.html

What is frustrating is that in this example the answer says to set aside \$250,000 for cash reserves (per clients request). It doesn’t explicitly say to be used for emergency funds but it also doesn’t say it is going to be used for anything else.

So Christa Inger scenario, Emergency funds are kept as part of the asset base but in the 2013 Voort example, the cash reserves are removed from the asset base. Is this vernacular that means the same thing and CFAI has overlooked this or are we being expected to know that CASH RESERVES get removed from the asset base but EMERGENCY FUNDS do not?

Someone has to pull through with an explanation in the bottom of the 9th inning, with 2 outs and 2 strikes, of time we have left before the exam. SOS. WWJD.

For that paper they accepted both, but I would stick with the method we’ve been taught (option 1):

1:

• Expenses last year wer 300k and rise with inflation (2.5%) = 307.5k
• Retirement income pre-tax is 125k, tax is 30% = 87.5k
• Base is 12.5m (sale of business [10m] and portfolio) less tax on sale (@ 15%) = 11m
• (307.5k - 87.5k) / 11m = 2% + 2.5% inflation = 4.5%.

2:

• Deduct 250k from the investment base = 10.75m
• (307.5k - 87.5k) / 10.75m = 2.05% + 2.5% inflation = 4.55%