2010 Level III AM Exam

@ravivooda, @vincentt, @marc, @Alta12‌, @AjFinance‌, @Sophie‌, @Betankrich‌, @MM12‌ thanks so much for the explanations.

@sophi, @marc, @vincentt, @alta12, @ravivooda, @betankrich, @mm12, @ajfinance:
Here is the full question (couldn’t copy the table format properly):

QUESTION 1 HAS FIVE PARTS (A, B, C, D, E) FOR A TOTAL OF 35 MINUTES.
Elisa Lima is a 34-year-old widow residing in a country that uses U.S. dollars (USD) as its currency. She has two children: age 10 and age 6. Lima works as the director of marketing at Relex Corporation. Exhibit 1 presents details of the financial environment in Lima’s home country.
Exhibit 1
Selected Data from Lima’s Home Country
Taxes
• Flat income tax rate of 25%.
• Wages, realized capital gains, and interest are taxed as income.
• Dividends are not taxed.
• Realized losses may be offset against income and may be
carried forward to offset income in future years.
Health insurance
• Government provides at no direct cost to citizens.
Tax-deferred accounts (TDAs)
• Contributions are pretax and annual maximum is USD 40,000.
• Income and gains grow tax-deferred and portfolio reallocations
are not subject to tax.
• Income taxes are paid on full amount of withdrawals.
• No penalties on withdrawals for housing or education.

Lima’s current pretax annual compensation is USD 140,000 and her current annual living expenses are USD 96,000. Her future salary increases are expected to match any increases in living expenses on a pretax basis. Lima is in good health, owns her home, and has no debt.
Lima is a disciplined investor, but a recent equity market decline caused her great anxiety. She is worried about her ability to fund her children’s education and her retirement. Lima meets with her financial advisor, Mark DuBord, to review her financial plan.

DuBord notes the following factors:
• Lima invests USD 12,000 (pretax) in a TDA at the end of every year and intends to continue doing so until she retires. The current value of the TDA is
USD 250,000.
• Lima makes annual contributions to charity of USD 6,000. These contributions are included in her annual living expenses.
• She will prepay her children’s future education costs at the end of this year.
• Lima participates in Relex’s executive retirement program. At the mandatory
retirement age of 60, she will receive a pretax payment of USD 1,000,000.
DuBord determines that the prepaid education costs for both children will require a total of USD 50,000, including all taxes. He recommends that Lima purchase a life annuity to fund her retirement. DuBord calculates she will need USD 3,000,000 (pretax) to purchase the annuity at age 60. Lima agrees with DuBord’s recommendation.

A. Formulate each of the following constraints of Lima’s investment policy statement
(IPS):
i. liquidity
ii. time horizon
(4 minutes)

One year later, after prepaying her children’s education costs and after making her annual TDA contribution, Lima has USD 225,000 invested in her TDA. Lima’s other financial information remains the same.

B. i. State the return objective portion of Lima’s IPS.
ii. Calculate Lima’s required average annual pretax nominal rate of return until her
retirement in 25 years. Show your calculations.
(12 minutes)

DuBord also advises Abella Rual, Lima’s sister, a 37-year-old single woman with no children. Rual works as a bankruptcy lawyer and is president of her own firm. Rual’s annual income is USD 450,000 and her annual living expenses are USD 180,000. She is in good health, owns her home, and has no debt.
Rual’s investment portfolio is currently valued at USD 1,500,000. Rual is confident that long- term equity market returns will more than offset losses in market downturns. She continues to invest regularly. Rual plans to retire at age 52, sell her business, and donate the proceeds to charity. Her investment portfolio will fund her retirement expenses.

C. i. Identify two factors that increase Lima’s ability to take risk. ii. Identify two factors that increase Rual’s ability to take risk.
(8 minutes)

D. Determine whether Lima or Rual has a greater willingness to take risk. Justify your
response with one reason.
(3 minutes)

During a recent review with Rual, DuBord notes that tax law changes, effective next year, will lower the tax on capital gains to 15% but eliminate the ability to offset income with realized losses. To minimize Rual’s tax liability, DuBord is considering the optimal location (tax- deferred or taxable) for her assets prior to the tax law changes. DuBord and Rual agree to maintain Rual’s current asset allocation. Rual’s investment portfolio and asset location are shown in Exhibit 2.

Exhibit 2
Rual’s Investment Portfolio
DuBord recommends the transactions necessary to achieve the most tax efficient asset allocation of bonds and equities in each account.
Asset Class
Tax-deferred Account
Taxable Account
Current Value (USD)
Current Value (USD)
Cost Basis (USD)
Bonds
250,000
500,000
550,000
Equities
500,000
250,000
150,000
Total
750,000
750,000
700,000

E. i.
Determine the “sell” amount of bonds and the “sell” amount of equities to achieve the most tax-efficient allocation in each account (tax-deferred and taxable).
ii. Determine the “buy” amount of bonds and the “buy” amount of equities to achieve the most tax-efficient allocation in each account (tax-deferred and taxable).
iii. Justify, with two reasons, why this is the most tax-efficient allocation.
Note: Assume no transaction costs or liquidity needs.
ANSWER QUESTION 1-E IN THE TEMPLATE PROVIDED ON PAGE 9.
(8 minutes)

QUESTION 8 HAS FOUR PARTS (A, B, C, D) FOR A TOTAL OF 17 MINUTES.
Rav Malik, an investment advisor, meets with a new client in the U.K., Ian Brown, to discuss his investment portfolio. Brown has managed his own assets in the past and rebalances his portfolio to target weights at the beginning of each month.
Malik suggests that Brown consider percentage-of-portfolio rebalancing with daily monitoring and rebalancing to target weights. He offers to demonstrate how the two approaches would differ after rebalancing on 1 April, given the allocations shown in Exhibit 1, with tolerance bands or corridor widths set at ± 10% of the target allocation.
Exhibit 1 Brown Asset Allocation
Asset Class
Strategic Asset Allocation: Target Weights
Closing 31 March Allocation
Large-cap U.K. equity
30%
27%
International equity
30%
28%
U.K. fixed income
40%
45%
A. Determine whether Brown’s calendar rebalancing method would result in a higher, lower, or the same weighting in international equity holdings on 1 April, as compared to Malik’s percentage-of-portfolio rebalancing method. Explain your response.
(4 minutes)