Volume 2, p. 212, Q. 11 B.

Annual expenses = \$180,000, pension income = \$100,000 (will not increase with inflation), total expenses = \$180,000, portfolio = 1 million, time horizon = 10 years, inflation = 2%.

I used my financial calculator to compute the real return as PV = -1 million, T = 10 yrs, PMT = 80,000, and found the real return to be 3.86%. Therefore , the nominal retun (after taxes) = (1.0386)*(1.02)-1 = 5.94%. The best portfolio provided in the solution is “B” which has an expected return (nominal, after taxes) = 5.8%. I am confused since the recommended portfolio DOES NOT meet the return requirement. Am I missing something?

Vol 2, p. 216, Q. 13 B ii.

Liquidity requirement: The couple has an annual income after taxes of 48,000 pounds and their annual expenses are 74,000 pounds (difference of 26,000 pounds) which has to be made up from their portfolio. However, this is not mentioned in their liquidity constraints (although this 26,000 pound shortfall is mentioned in the return requirement). Is the solution to liquidity constraint wrong?

13 b ii has been discussed many times over. This is an annual payout required from the portfolio itself. hence it is not a liquidity requirement

Q 11 B - Portfolio A is mentioned as the best portfolio. Not sure where you are seeing B for that one. I am reading Pg. 225 for that…

CPK, for the sake of my laziness would you elaborate on 13 b ii or point me to a relevant thread as you have so many times before ? I remember bumping into this problem last year and I cannot remember if I ever figured out what the issue was.

Salary is 80K before taxes = 48 K after taxes

Expenses = 74 K after taxes

Net difference of 26 K is taken as a payout from the Portfolio, not considered as a liquidity requirement in the first year.

The portfolio requires to grow from its present value of 5+160+220 - 50 (30 + 20 payout needed now) + 900 (inheritance) = 1235 K now to 2000 K in 18 years, with a 26 K Payout payment each year.

set up as

PV=-1235, FV=2000, N=18, PMT=26 CPT I/Y - gives 4.427 % return.

Question being asked is - why is the 26 K not taken as a liquidity requirement in the present year?

I think this is so because:

1. Income is < Expenses - hence this payout must come from Portfolio. This is a Spending Need - not a liquidity need - which needs to happen every year for the next 18 years.

2. Immediate expenses of 20 + 30 which are required for the down payment on house and charity - need to be immediate liquidity.

http://www.analystforum.com/forums/cfa-forums/cfa-level-iii-forum/91309470

previous discussion on the topic.

First off, as usual, thank you for your response.

The conclusion from that thread was that it was an error. I still am unconvinced (i haven’t read the question again, i will review it tomorrow, but based on the above i think it should still be included)

Any shortfall between expenses and income is always required to be met by the portfolio and also is included as a liquidity expense. Every pract test i’ve ever done includes T1 salary-exp in the liquidity constraint.

Yes, I have also learnt that if portfolio is required to meet living expenses in excess of annual income, it should be noted down in liquidity constraint.

However for this 26k shortfall is needed immediately, we can not wait for our portfolio to generate this return, so we need to deduct this out of investable asset base. Nevertheless, it should be noted down in liquidity constraint along with down payment on house & charity.

This point is reiterated also when a client is retired, his living expenses (deducting it from pension income if any) are to be met by portfolio. It impairs risk tolerance & mentioned in liquidity section (here the liquidity as % of portfolio base & base itself will determine below average or average risk tolerance).

(2009 AM section) When client decides to retire at 60 ( year end), there net expenses are written down in liquidity section along with mortgage payment.

But if he retires at 65 - only tution fees are mentioned

Before retirement, annual income are meeting expenses so no liquidity requirement (But I think, question did not say that post tax annual income = expenses, I wondering whether it was implied. Otherwise after tax income will not be enough to meet expenses)

issue is -> if the way rahuls and markcfail are saying - if it is deducted immediatedly out of the portfolio - your PV would be lower - your return requirement would be higher - and I would not want to know what that will do to the calculation.

[Remember this was a 2004 actual exam question - and I know this from just searching the forum for Maclin].

Yeah, it is a 2004 real exam (coz I have a copy of it)…

However, I think with exams getting close now we should reach to consensus that"

"Any shortfall between expenses and income, required to be met by the portfolio, shall be used in return calculation & also to be included as a liquidity expenses."

shall be used in return calculation HOW?

are you getting what I am trying to say:

That problem could have been done in one of two ways:

Way it is current solved:

PV=-1235, FV=2000, PMT=26, N=18 --> CPT i/y = 4.427% (how the model answer was presented)

Way 2:

PV = -1209 (take off 26 K in the first year as well from the portfolio. Liquidity requirement is removed immediately just like the other 30K and 20 K expenses shown)

FV=2000, PMT=26, N=18 CPT I/Y ==> 4.457%

This 2nd answer per the guideline would have provided us with 2 points less. and in a asset allocation question may have made us ignore the right asset allocation as well.

I believe what you are stating above is that the Liquidity Requirement should have stated 26 K needs to be paid out… but that is not what it is. It is not a liquidity requirement - but a spending requirement. That is the distinction here. You cannot have it both ways - that you state it as a Liquidity requirement of 26K needed, but not take it off the portfolio, if you understand what I am trying to say.

If they decided to reduce their 74K outflow (expenses) to be more in line with their salary - this would not have been 26K per year, but smaller.

Re: shortfall of 26K pounds every year.

Guys, I don’t get it. I thought that if the investor is counting on the porfolio to generate some cash year year that is a liquidity requirement. The way I see it, 26K pounds will be withdrawn in the 1st year, thereby reducing the porfolio size. However, from next year on, 26k pounds must be generated by the portfolio to supplement the shotfall in income. This, I think, is a liquidity requirement.

For example, if you look at Q.10.A.iv. on p. 211, the solution gives liquidity requirement as ongoing expenses of 2k USD per month for the investor and 2k USD per month for supporting his mother. The way I see it, this i exactly the same as p. 216, Q. 13 B ii.

Regarding the other question (11.B.), I made a mistake in typing the sugested solution (thanks cpk 123 for pointing it out). The correct answer is A, which makes it worse because it does not meet the return requirement by a wider margin now. I computed the return requirement as 5.94% and the given answer is 4.2%.

yeah you get it. I too get it.

but if you did it that way - you would get points taken off, based on the guideline answer.

so there is no definitive answer. but if you see my post just above yours - you cannot do what rahuls has suggested - which is put it in liquidity requirement- but not take it off the existing portfolio.

Sir!

I got what you are trying to say when you said it would reduce portfolio asset & also increase return requirement (coz its being used while calculating return).

But I am making a point which is it should be deducted immediately ONLY if question says so (that it is due immediately OR client wishes to take it off immediately otherwise not.) Things shown in Liquidity is not entirely taken out from portfolio base. It is shown in liquidity may be to hint manager that this much of money should be in highly liquid securities (i.e. T bill) or portfolio should generate INCOME atleast partially to offset this in the next one year.

ONLY problem with 2004 guideline ans is there is no mention of this in liquidity section. Question no where says that is payable immediately. So portfolio base is appropriate only to deduct charity & mortgage down payment.

In 2009 as well, excess of living expenses over pension income is used for return calculation. Same is not deducted from portfolio base & also mentioned in liquidity section (at age 60 offcourse). One constraint to understand this question here is it has not asked to do a return calculation incase client puts off his retirement at age 65.

Guys, any help with (11.B.) ? That is driving me crazy.

11 B - do not know where you are seeing portfolio B as the best one.

Book says A is the best one… (solution). and that is not based on return needed. that is purely based on the cash / liquidity immediately needed perspective.

and they state -

Portfolio A is the most appropriate portfolio for the Muellers. Because their pension income will not cover their annual expenditures, the shortfall will not likely be met by the return on their investments, so the 10 percent cash reserve is appropriate. As the portfolio is depleted over time, it may be prudent to allocate more than 10 percent to cash equivalents. The income deficit will be met each year by a combination of investment return and capital invasion.

Now that their daughter is financially independent, the Muellers’ sole objective for their personal portfolio is to provide for their own living expenses. Their willingness and need to accept risk is fairly low. Clearly, there is no need to expose the Muellers to the possibility of a large loss. Also, their health situation has considerably shortened their time horizon. Therefore, a 70 percent allocation to intermediate-term high-grade fixed-income securities is warranted.

The income deficit will rise each year as the Muellers’ expenses rise with inflation, but their pension income remains constant. The conservative 20 percent allocation to equities should provide diversification benefits and some protection against unanticipated inflation over the expected maximum 10-year time horizon.

Portfolio B, the second-best portfolio, has no cash reserves, so it could not meet the Muellers’ liquidity needs. Also, although it has a higher expected return, Portfolio B’s asset allocation results in a somewhat higher standard deviation of returns than Portfolio A.

Portfolios C and D offer higher expected returns but at markedly higher levels of risk and with relatively lower levels of current income. The Muellers’ large income requirements and low risk tolerance preclude the use of Portfolios C and D.

I guess it makes it pretty clear … Though I am clearly not confident in the heat of the exam I will be able to state anything.

2007 AM :

The Ingrams are meeting with Caleb Swann, CFA, their long-time advisor, to discuss financial planning issues. The Ingrams agree that their current annual pre-tax income need is C\$200,000. The Ingrams expect that their inflation-adjusted expenses will remain constant during retirement. _ They plan to fund their living expenses by taking annual distributions from their portfolio with _ _ the first distribution to occur immediately. _ Swann believes an appropriate long-term inflation rate is 2.5 percent and an appropriate planning horizon is 35 years.

Here living expenses are deducted upfront as per client’s instruction. Also used in return calculation as every year withdrawal. Liqduity constraint mentions SPENDING NEED of \$ 200k every year starting immediately.

Schweser says:

In developing the client’s liquidity constraint, we consider only those spending needs that will be met by the investment portfolio (i.e., we do not consider spending needs that will be met by salary or other income sources).

Ongoing liquidity needs are usually related to living expenses. The two most common exam situations have been (1) the portfolio must meet all or a portion of the client’s living expenses and (2) the portfolio must help pay living and/or medical expenses for a dependent or other individual. Both should be considered in determining the client’s liquidity needs and should be noted in the client’s liquidity constraint.

Please share your inputs on this & let’s try to reach consensus.

you are not going to get any consensus on this one.

It seems to be a very subjective thing … and has been the point of debate every year on end.

^

Yeah this has been debated many times…May be I should not try too hard on these IPSs

Somebody said "The only consistency in the IPS questions is that CFAi is consistently inconsistent.’

cpk123, I meant q. 11.B. Yes, the solution is portfolio A but it does not meet the return requirement. Shouldn’t that eliminate that portfolio A from consideration?

They are stating that as well there.

In this particular case - going with the other portfolios - though they meet the return requirement - either does not meet the cash required (liquidity) or introduces more risk. When compared to introducing Risk vs. not meeting the return required - they are suggesting the alternatives of

a. capital invasion.

b. in light of their health situation - have higher fixed income allocation

so the return is not as important in light of the other situations.