Following is a question from Schweser Qbank, (SS15, reading 42, LOS c) Jill Frenkel, 62, works for the Smithton Company as the firm’s controller. Frenkel is covered by a generous retirement package upon her retirement which is not indexed for inflation, she is in excellent health, and is also covered by the company health plan in retirement. Frenkel’s current asset allocation is 70 percent large cap stocks, 25 percent intermediate-term, high quality bonds and 5 percent cash for emergency needs. Given Frenkel’s circumstances, she should: A) Not rebalance her portfolio at this time. B) Sell stock index futures and buy bond index futures to synthetically create a 20% stock / 80% bond allocation and save on transaction costs. C) Eliminate her cash reserve entirely. D) Reduce her allocation to stocks significantly and buy low quality bonds for her portfolio with the proceeds because Jill faces the need for inflation protection in this stage of her lifecycle. Should I consider this question incomplete? There is no mention of the size of her portfolio, return and risk objectives, spending needs. Or is there a way to extract enough of info from the question to answer it properly?
B) by process of elimination, really. A) is ridiculous because 70% equity allocation is too much with retirement imminent. C) Why should she do that? You should always have a small allocation of cash. D) No, b/c stocks are a better hedge against inflation than bonds (junk or not). B) makes sense b/c you are removing some equity risk (desirable with retirement imminent) and you are saving on transaction costs, so that is sensible. Agreed?
I agree it is a little incomplete. If her retirement is Generous and it will cover all her living expenses, then A is appropriate. But if it won’t then I would go with B.
P.S. also make sure her IPS states that Jill has a high risk tolerance as she likes to run up hills to fetch a pail of water and then tumble down and possibly break her crown.
Thinking in a similar way only to find that it was not correct. Schweser gives item A as the correct answer. Their reasoning is as follows; Your answer: B was incorrect. The correct answer was A) Not rebalance her portfolio at this time. “Given the fact that Jill is in good health, is covered by the health plan and also has a healthy retirement portfolio, she should leave her allocation intact because since the retirement plan is not inflation indexed, she may need the growth potential of equities in the future.” --------------------------------------------------------------------------------
the key is that her retirement is not inflation indexed. the best hedge against inflation has been stocks. thus, the current allocation is appropriate. agree that the question is not very complete, but you can eliminate the other answers to arrive at A.
Good point lig, bonds are not a good hedge against inflation especially after-taxes.
Not very long ago, I would have eliminated B pretty quickly by pointing out that there is no such thing as bond index futures, at least not in the developed world (they have them in Australia).