The Smiths' Liquidity...

Question 12, reading 10. Answer is on P 227 at the very top

When forming the liquidity statement for their IPS, there is no mention of the fact that they need 45k a year, adjusted for inflation. All of the other quesitons, if some form of annual payment is required, basically states something to that effect.

It states in the answer that “their current annual living costs (150,000) are being met” and that they need to plan on the 200k expenditure of their home, but their spending needs are not being met…then need 45k a year to pay them…

This is confusing to say the least…why do they not need the 45k per year that is increasing with inflation in their liquidity statement?

Have you accounted for the income they are deriving from the family portfolio? The portfolio is worth $1.2m and is invested in very safe securities i.e. they are earning an income on the $1.2m which can be calculated from exhibit 7.

For example, they could be meeting the $45k living expenses by investing in portfolio A which has an after-tax yield of 4.2%, so $1.2m * 0.042 = $50,400. You get the exact same answer if you assume they invest entirely in US treasury notes with a yield of 6% then adjust for the 30% tax rate.

So the living costs are being met from the family portfolio, it just needs to generate a minimum after-tax income of $45kpa going forward to make up the difference in covering the $150k in living costs. It is just a balancing number which is why it must grow at 10% from year 1 to year 2 because the gift fund and pension distributions are fixed so won’t grow with inflation like the living costs will.

what about question 13 B ii…why are the annual net expenses not included in the liquidty portion of the IPS?

@KFCFA - yes I am accounting for that - I agree - the family portfolio is covering that - but isn’t that precisely what a portfolio liquidity requirement is? It has to provide 45k in income annually?

Why is it not considers a liduidity requirement from the family portfolio? Not to nitpick, but their portfolio is 1,000,000 after their house expenditure, so their need is at minimim, the 45k inflation adjusted income every year

45k/1,000,000 4.5% +3% inflation = 7.5%, nearly all of which has to be paid out…so again I am asking why is that 45k not in their liquidity statement?

Yes…Why is that also?

Can you elaborate what this 45K requirement is?

Is it the 65K Income + 40 K from the Gift Fund Less 150 K from the Living Expenses Part?

If so - you are not including anything that is coming out of the 1.2 Mill $ Portfolio - there is no number indicating what is the payout from there.

From what I have seen - CFAI seems to treat something that needs to be paid out IMMEDIATELY, ONE TIME as a Liquidity requirement. Not Something that is a continuous year after year treatment.

This seems to be the case on the Maclin Case (13 B ii) where the 26 K Payout is not considered Liquidity but donation to Alice’s father’s charity and the Down payment for the home are. And they are deducted immediately from the Portfolio on hand as well.

Yes CP, its the 5K Income + 40 K from the Gift Fund Less 150 K

Looking at 11a IV it mentions the 15k for the kid’s college tuition as a liquidity requirement, and its a repeating expense

Even more confusing is 10 a.iv. Where the text speaks of the need to consider 2000 per month for taylor’'s living expenses plus the 2000 mother support.

9 a.iii. Says he needs "no regular cash flow requirements’ seemignliny indicating that “regular cash flow requirements” are a liquidity consideration…

It seems the treatment is inconsistent.

So my quesiton is twofold

  1. When is a cash flow considered a liquidity need and when is it considered to be ignored

2)If on the exam we put cash flows as a liquidity need, will it detract points, assuming we recognize the other singular liquidity needs?

Liquidity – certain anticipated expenses thar are named ( probably no option but to provide for it , is more immediate or over 3-5 years ,e,g children’s education , home renovation , medical treatment etc)

Living expenses are ongoing , repeating expenses that are everything but the definition above. Can be or might have to be reduced with discretion if portfolio underperforms

I understand the distinction that is being made between income and short term needs, but the text seems to show both ways…Im trying to reconcile why, in one question, the guy’s 2000 per month income need is a liquidity requirement, and in another question an income shortfall is not…

I am very confused by your words. I don’t see that $2000 is shown as part of liquidity requirement in q 10 or in 12 . Return requirement in 10 is given as 2000 per month . It does not say that this is a liquidity requirement .

In 11a the children’s tuition is repeating , but not over the parents lifetime. It is only for specific number of years . Their living expenses on the other hand is recurring forever. There is a clear distinction.

In 12 liquidity makes it even more clear that AFTER their daugher completes her college their income should cover living expenses adequately and so the portfolio need not be touched.

Since we’re talking about 1 rate of return long term , we’re declarng those items which need to be drawn from the portfolio as “liquidity” ( which means a capital reduction ) and those items that are recurring until they die as living expenses.

I just do not see a contraddiction

look at the answer keys Janakisri.

10 iv. The liquidity section is partially appropriate.

  • Wheeler addresses potential liquidity events.
  • Wheeler fails to specifically consider ongoing expenses ($2,000/month for Taylor’s living expenses and $2,000/month to support his mother) relative to expected portfolio returns.
  • The reference to a “normal, ongoing cash reserve” is vague. The reserve’s purpose and size should be specified.

11 iv. Liquidity. The Muellers need $50,000 now to contribute to the college’s endowment fund. Alternatively, they may be able to contribute $50,000 of Andrea’s low-cost-basis stock to meet the endowment obligation. In addition, they expect the regular annual college expenses ($40,000) to exceed their normal annual savings ($25,000) by $15,000 for each of the next five years. This relatively low cash flow requirement of 2.7 percent ($15,000/$550,000 asset base after $50,000 contribution) can be substantially met through income generation from their portfolio, further reducing the need for sizable cash reserves. Once their daughter completes college, the Muellers’ liquidity needs should be minimal until retirement because their income more than adequately covers their living expenses.

[Here the 15 K (25 K saving less 40 K spend for College) is an extra expense - which is stated as coming as income from the Portfolio - and hence discussed under the liquidity requirement].

Now in 12 - we have a shortfall (65K from Fixed Annual Pension Amount, 40 K from the Gift Fund - 150 K is the annual living expenses … there is a 45K shortfall - but stated as being covered by the portfolio, [again under the liquidity requirement since the portion is coming from the investment portfolio and covered].

_ Rolo - going back to your original post - you are stating that they did not talk of the 45K - when they are talking of the 150K - there is no need to separately talk of the 45K is there? _

So in all of the above - so now I am lost - we started out with something - but it does turn out that CFAI is consistent (or am I biasedly stating something wrong? ]

13 b II - the other question - where they did not put the 26K as an annual liquidity requirement - I guess this is a slightly different problem given the Maclin’s total required size of the portfolio of 2 Mill is provided and 26K is required every year for 18 years going forward, while 50 K goes out immediately NOW (and hence is the liquidity).

Jana and CP, I appreciate your patience. I will try to be clearer, specifically to clarify for CPK, as his post seems confused.

Ok. Start with 10 iv.

Here, the liquidity statment says

“Wheeler fails to specifically consider ongoing expenses ($2,000/month for Taylor’s living expenses and $2,000/month to support his mother) relative to expected portfolio returns”

In this instance, it implies an ongoing expense ~24000 per year which undoubtedly will be covered by the portfolio returns is to be included in the liquidity statement.. This appears to be an ongoing income need.

Q. 12 There is a 45000 shortfall, which, for the life of me I dont see the distinction here between the 24000 per year in income need in Q 10 and this income need.

In this instance, it appears that the ongoing income requirement, which like number 10 is being met by portfolio returns is not part of liquidity statment. Why is this different form the annual income need in 10, that is part of liquidity statement.

In 10 and in 12, the porttolio is meeting the income requirement, but one has the expense in the liquidity statement and one doesn’t…

13 b Again here, there is an annual cash flow need of 26000, almost the same dollar amount as in 10, but in 10 the statement says they “failed to consider the 2000 per month” in the liquidity statement but yet in 13, the 26000 annual shortfall is excluded from the liquidity statement. To reiterate, in 10 the annual expense, long term, ongoing, met by portfolio is included and in 13, the annual, long term ongoing, met by portfolio expense on nearly the same dollar amount is excluded.

All three are income needs, all three are met by the portfolio, all three are ongoing, but it is only part of the liquidity statement in number 10. Why?

See why this looks like a discrepancy?

officially confused…

i too don’t understand when a CF is supposed to be an ongoing liquidity requirement and when it is not…Surely in question 13,if the advisor does not include the 26000 in the IPS and assuming the Maclins followed the IPS to the bone…they would be under the impression that ALL they need to pay was the 50000 NOW…wouldn’t there be a rude awakening when they find out that they are 26000 short every year?

If however we assume that the EOC answers are all consistent and complete to the relevant degree needed, then the ONLY plausible reasons for them not to include the 26000 are :

[a] this is being met by some source of funding.

[b] the question/objective implies no need to consider the 26000

Now,if we use past EOC answers as becnhmarks,it seems to me that EVEN IF income meets expenses, there is still SOME mention of the fact that this is the case.Since q.13 has NO mention of this at all…i rule out possibility [a]

…which leaves me with [b]

13 - this statement makes the 26K an annual expense, not a liquidity need.

After-tax salary increases will offset any future increases in their living expenses.

That plus the fact that there is a value provided for portfolio NOW (where you take off the currently required 20K + 30K) , a future expectation of 2 Million and this annual spending payment over 18 years.

12 again has : Our annual after-tax living costs are expected to be $150,000 for this year and are rising with inflation, which is expected to continue at 3 per- cent annually.

which makes the 150 K a liquidity need. This plus the fact that they state the payments of 65K and 40K are FIXED.

Beyond this - this statement They expect little change in either their incomes or expenses on an inflation-adjusted basis other than the addition of their daughter’s college expenses. - makes the 15K a liquidity requirement over the next 4 years.

In 10 … they state that both the 2000$ living expenses and the 2000$ required for his mother grow with inflation - but have not been considered in his liquidity … which again is right. We were asked to critique the constraints here. The 300K one time, and the 100K for investment in the business was mentioned the other two pieces were not.

So we can summarize? Are living expenses supposed to be included in the liqudity section of the portfolio if they are being paid out by the portfolio?

Also, if someone is donating money to charity, is that both a liquidy constraint and a unique circumstance?

OK i have come to another conclusion for question 13.

Facts for the question relevant to our discussion:

We are 26000 short every year, and we need our portfolio to make up for this shortfall. Why is the 26000 not included in the liquidity portion? It is as if we do not require the portfolio to make up for this shortfall which does not make sense.

The reason why the 26000 is not incorporated in the statement is because it represents so little of our investable asset base of 1235000…26000/1235000= 2.1 %…if you look at question 11, there is an annual requirement of 15000 for 5 years for the daughter’s education BUT since this is only 2.7 % of the investable asset base…we do not need to specify a liquidity need BECAUSE we rely on portfolio’s income generation to COVER the 15000…

So…again…we do not include the 26K in the liquidity portion because it is so small relative to the asset base such that the income generated from the portfolio is expected to cover the small net expense…

If the annual education cost in question 11 was higher, then,judging from the wording of the EOC answers, we would need to include a liquidity requirement as the costs would be A LARGE proportion of asset base.

if the net expenses of question 13 were higher,then we would have to include this as a liquidity need because it becomes a LARGE proportion of asset base.

So if any of this makes any sense…then the general framework for liquidity portion is:

[a]One-off negative liquidity events (trivial)

[b]Annual after tax inflows > annual outflows -> Do not need to draw on portfolio

[c]Annual after tax inflows < annual outflows ->differentiate between two cases

  1. net cash flows are small relative to asset base->can count on income generation of portfolio to cover -> NO NEED TO SPECIFY
  2. net cash flows are large relative to asset base ->need growth in portfolio to account for shortfall-> NEED TO SPECIFY


That actually is pretty helpful. So only when you need to dip into the principal, should you state it as a liquidity constraint.

well,JP_RL_CFA, the truth is idont know…that why this thread…lol

…guys what say you?

Worth sending a note to cfai ? Will they give an answer?