6.3 - Financial Goals/Objectives
An investment adviser using an insurance approach to capital needs analysis would: A) determine the insurance coverage needed to complete the customer's financial objective should the customer die before the objective is met. B) invest exclusively in insured securities such as insured municipal bonds or Ginnie Maes. C) select securities based upon the customer's investment experience. D) only invest in securities guaranteed by the FDIC.
Answer: A An insurance approach to a customer's capital needs analysis involves purchasing life insurance sufficient to complete the customer's financial objective should he die before it is met.
In preparing a financial plan for a client couple, you are asked about the role of certificates of deposit available at their local bank branch. You could state that the bank CD: A) eliminates interest rate risk. B) is a savings account with a maturity date. C) can only be purchased in $1,000 increments. D) must be for at least 3 months.
Answer: A Interest rate risk, the uncertainty that the price of a security will rise or fall based upon changes in interest rates, is eliminated with a certificate of deposit. Regardless of changes in the market, the CD's value remains fixed. It is not the same as a savings account because regular additions and withdrawals are not made. Minimums are set by the bank itself as are any minimum time periods and can be as low as $100 and one week. This is not the negotiable (jumbo) CD traded in the money market.
A client is risk averse and is planning on retiring in 16 years. The client is rolling over $100,000 from his 401(k) plan, all of which is currently invested in his former employer's stock. As the client's investment adviser, which of the following would you recommend? A) Keeping the money in the employer's stock. B) AAA rated zero-coupon bonds maturing in 16 years. C) Laddering US Treasury bills. D) Highly rated preferred stocks paying liberal dividends.
Answer: B Because the assets are in a rollover IRA, the "phantom" tax on zero coupon bonds is not an issue here. Being risk averse, the safety of AAA bonds with the guaranteed return of increased principal in 16 years makes this the most appropriate investment. The T-bills will probably not offer as much return and will be subject to continual reinvestment risk. Dividends on preferred stock are not guaranteed, even with a highly rated company, and the current tax advantage offered to dividends is wasted in an IRA. Most would agree that the worst option would be to keep the money in one single stock.
Which of the following is generally NOT an appropriate product for retirement planning? A) Bonds. B) Commodities. C) Life insurance. D) Mutual funds.
Answer: B Commodities are among the most speculative investments and not generally an element in retirement planning.
Among investor objectives is preservation of capital. Which of the following would be most appropriate for inclusion in the portfolio of this kind of investor? A) International funds. B) A money market fund. C) Blue chip stocks. D) U.S. Treasury bonds.
Answer: B Preservation of capital means no fluctuations. Money market funds are the only logical choice here. True, the treasury bonds do not have default risk, but, because they can have maturities as long as 30 years, they are subject to interest rate risk.
The two general categories of investment objectives are income and capital growth. An investor primarily seeking income would be least interested in which of the following? A) U.S. treasury bonds. B) Interest. C) Capital gains. D) A stock paying a high dividend.
Answer: C Capital gains is an example of capital growth. An investor who is primarily interested in generating income will be less interested in the potential capital gains provided by an investment than its potential interest and dividends.
Investors who buy shares in state-specific municipal bond funds may be subject to: A) out-of-state property tax. B) no taxation. C) capital gains tax. D) federal income tax.
Answer: C Interest received from municipal bonds and municipal bond funds is generally income tax free on a federal basis, but taxable in states other than the state of issue. State-specific funds avoid that problem. These investments are subject to capital gains taxes if sold at prices above investors' cost.
A 68 year-old client of yours indicates that he is interested in changing the portfolio mix of his IRA to become largely invested in noninvestment grade bonds. You would probably infer from this that the client: A) is risk averse. B) is now in a lower tax bracket. C) has insufficient retirement savings. D) has recently come into a large inheritance.
Answer: C Most studies have indicated that seniors with insufficient retirement savings attempt to compensate by being tempted to reach for higher yields to maximize retirement income without full consideration of the increased risk that comes along with the possibility of higher returns.
An individual has just received a bonus of $12,473 and wishes to generate some income without risking loss of capital. Assuming the client is in a low tax bracket, which of the following would be the most suitable choice? A) Public utility stocks. B) Insured municipal bonds. C) Bank insured CDs. D) Growth stocks.
Answer: C The only choice here with no risk to capital is the bank insured CD. Although the insured municipal bond is guaranteed to repay principal at maturity, the bond will still be subject to interest rate risk and, with the client in a low tax bracket, municipal bonds are generally unsuitable investments.
Although NASAA's rules dealing with customer suitability do not specify unique requirements for seniors, it is generally accepted that agents will give greater consideration to which of the following when making recommendations to their senior clients? Age. Life stage. Retirement savings. Tax status. A) I and II. B) I and IV. C) III and IV. D) II and III.
Answer: D All of these are important suitability considerations for all customers. But, when it comes to seniors, it is felt that life stage (including whether the customer is employed, retired, or nearing retirement) and current retirement savings relate particularly to seniors.
A client is risk averse and is planning on retiring in 16 years. As the client's investment adviser, which of the following would you recommend? A) A diversified open-end investment company concentrating in small-cap stocks. B) A high-yield bond fund. C) A government bond fund. D) 50% in an S&P 500 index fund; 50% in a portfolio of high quality bonds.
Answer: D Even though the government bond fund carries less market risk, with a 16-year retirement goal, some inflation protection is necessary. The index fund carries some market risk, but does offer purchasing power protection. The 50/50 mix would seem to be most appropriate.
Your retired 72 year-old client still lives in the home he purchased 35 years ago for $40,000. It is currently valued at $700,000 and there is no mortgage. The client has almost $500,000 in his self-directed IRA rollover account. When determining suitable investments for this client, you would base your recommendations on the fact that: the client is an accredited investor having a net worth in excess of $1 million. a home equity loan could more than double the amount of funds available to invest. as a retiree, any losses suffered cannot be made up from current income. the client's time horizon could be as long as 20 years. A) I and II. B) I and IV. C) II and III. D) III and IV.
Answer: D One of the risks facing senior investors who are retired is that, unlike those still employed, loss of principal can be devastating. With today's medical advances, a 72 year-old can be looking at 15 to 20 additional years of life. Therefore, recommendations must be made to maximize the probability of the client's assets lasting that long. Effective with the Dodd-Frank Bill of 2010, this investor is no longer accredited because the value of the primary residence must be excluded from the net worth computation. And, even if he were, eligibility does not equal suitability.
A 74 year-old widower has been your client since his early 50s. He is a well-informed investor and has always seemed capable of understanding most investment concepts you have presented. At least twice a year, the two of you meet to evaluate his current financial situation and objectives. In your last meeting, it seemed to you that he was distracted and somewhat forgetful. It would be appropriate for you to do all of the following EXCEPT: A) take detailed notes on future conversations and meetings with him. B) inform your supervisor of your concerns about his memory loss. C) ask him to invite a friend or family member to accompany him to appointments with you. D) wait to see if there are further causes for concern about his capabilities.
Answer: D Taking action in advance could help protect you and your firm should a client subsequently indicate that he does not remember having agreed to a recommendation. Taking detailed notes can help verify what has been discussed in conversations or at meetings. Having others present may help to verify what has been discussed and agreed upon.
A 55-year-old customer in the 18% tax bracket wants to maximize current return with a moderate degree of risk. He has just inherited $25,000 and seeks a bond investment. A suitable bond would have which of the following features? A) Tax-exempt status. B) Rating below Ba but above D. C) Little or no call protection. D) Relatively high rating.
Answer: D The investor's tax bracket is not high enough to take advantage of a bond's tax-exempt status, but a bond with a low rating is not suitable because the investor is willing to bear only moderate risk. A bond with call protection and a relatively high rating would meet this customer's needs.
Dr. Howard dies. Which of the following life insurance policies will be included in his gross estate? Policy I-owned by Dr. Howard, he is the insured and his wife is the beneficiary. Policy II-owned by Mrs. Howard and she is the beneficiary. Policy III-originally owned by Dr. Howard, Mrs. Howard is the insured and he gave the policy to his daughter 5 years ago. Policy IV-owned by Dr. Howard, Mrs. Howard is the insured and he is the beneficiary. A) I and II. B) II and III. C) I, II, III and IV. D) I and IV.
Answer: D The question asks which will be included in the gross estate, not which policies will be part of the taxable estate. Any policies which are owned by the decedent at the date of death will be included in the decedent's gross estate. Of course, there may be a deduction from the gross estate for anything left to a spouse. Policy II was never owned by the decedent, therefore it is not included. Policy III is not included because it was given away more than three years before Dr. Howard's death.
Which of the following is (are) advantages of irrevocable insurance trusts? Provide estate liquidity. Insurance proceeds are removed from the estate of the insured for tax purposes. The insured has the flexibility to alter the trust arrangements. Once set up, no changes may be made. A) I and III. B) II and IV. C) III and IV. D) I and II.
As with all life insurance, the proceeds are available almost immediately upon death providing estate liquidity. When done properly, the proceeds of the policy are not included in the deceased's estate thereby saving estate taxes. The trust is irrevocable - no changes can be made, and this is one of the few disadvantages.
A professional tennis player seeking advice regarding the purchase of life insurance would like to avoid inclusion in her taxable estate at death, and would like the death proceeds to be income tax free to her beneficiary 9-year-old daughter. What do you suggest? A) Purchase the policy herself and gift the policy to an irrevocable trust (with her daughter as beneficiary) at least 3 years after purchase. B) Use an Irrevocable Life Insurance trust (ILIT) to purchase the policy. She will gift the premiums to the trust. C) Purchase the policy herself so that she will get the insurance. Then have her gift the policy and the premiums needed to pay for it to her daughter until she turns 19. D) Purchase the policy herself and sell it to her daughter at a price the daughter can afford when she is over 19 years old.
Answer: B Only an ILIT can provide the features which she desires. A direct purchase will subject the proceeds to inclusion in the gross estate if she transfers or gifts the policy to the daughter within three years before she dies. A sale will trigger transfer for value rules and subject the beneficiary to income tax on the proceeds upon the death of the insured.
The separate account sub-accounts chosen by the purchaser of a variable life insurance policy have had outstanding performance over the past 15 years. There would generally be no tax implications in which of the following situations? A) There is a cash withdrawal in excess of the cost basis B) The death benefit is paid C) A loan is taken equal to 95% of the policy's cash value D) The policy is surrendered
Answer: C Funds obtained from a policy loan are not considered taxable income (same as any loan - you owe the money). If the amount received at policy surrender is greater than the cost basis, the excess is taxed as ordinary income. The same is true with the withdrawal. Although the death benefit will always be free of income tax, it could be subject to estate tax.
If a new client has $200,000 to invest and wants to retire in 15 years, which of the following client information is least necessary for an adviser to recommend a suitable investment program? A) The age of the client. B) Current income and cash flow requirements. C) The amount of income he requires for his retirement years. D) Tolerance toward risk.
Answer: B While current income and cash flow requirements are ordinarily important considerations, in this question we are being asked about the investment of a lump sum, not periodic additional investments. The amount of income required will determine the types of investments and how they must be structured in order to achieve the retirement income desired. The client's age is necessary to determine the time horizon. That is, if the client is currently 35 and wishes to retire at age 50, the money will have to last a lot longer than if we are dealing with a 55-year-old who wishes to retire in 15 years at 70. A client's tolerance toward risk is among the most important non-financial considerations in determining investment suitability.
Which of the following mutual funds should an investment adviser representative recommend to a corporate client whose objective is current income with moderate risk? A) Money market fund. B) High-yield bond fund. C) Preferred stock fund. D) Aggressive growth fund.
Answer: C Preferred stock generates current income in the form of dividends. Aggressive growth funds strive for capital appreciation rather than current income. Money market funds have low yields, not the high yields that an income investor wants. While high-yield bonds provide current income, they entail a high, rather than a moderate, degree of risk.
Which of the following investment strategies would be appropriate for an advisory client with a 20-year time horizon before retirement? Holding more stock. Holding less cash. Holding fewer bonds. A) II only. B) II and III. C) I, II and III. D) I only.
Answer: C With a long time horizon before retirement, equity securities such as common stock would offer the highest potential return and cash would be least suitable. Given purchasing power risk, bonds would not provide the returns associated with common stock.
Having sufficient funds to pay off a 30-year mortgage on a home with an initial loan amount of $200,000 would be A) an investment constraint B) decreasing term insurance C) taking too much risk for most clients D) a capital need
Answer: D A capital need is generally for one of three purposes: payoff of a mortgage and other debts, providing education for dependents, and a stream of income for survivors. It is generally shown with a specific dollar amount, and that is the easiest way to recognize that it is not an investment constraint. Decreasing term insurance may be the best way to provide the funds, but that doesn't answer the question.
