CFA Level III Private Wealth Management Study Set

Primary Capital

Primary capital is the sum of the personal and market risk bucket holdings.

Parts of the IPS

1. Background and Investment Objectives 2. Key Investment Parameters - Risk Tolerance; Time Horizon; Asset Classes; Liquidity Preferences; Other (Unique/ESG); Constraints

Tax Drag (annual taxation)

1. Over a time horizon of more than one period (n > 1), the tax drag percentage exceeds the tax rate because the periodic payment of taxes reduces the benefits of tax-free compounding over time. 2. The adverse effects increase as the time horizon increases. Both the tax drag amount and percentage increase because the effects of lost pretax compounding increase. 3. The adverse effects increase at higher rates of return as the dollar amount consumed by taxes is higher each year. Again this leads to a loss of pretax compounding. Both the tax drag amount and percentage increase. 4. The time horizon and level of return effects compounding, meaning tax drag is further increased when both time horizon and rates of return are longer and higher.

Tax Drag (capital gains)

1. The tax drag amount will increase as the time horizon and/or rate of return increase because the tax will be on a larger pretax ending value. 2. The relationship of the tax drag percentage and stated tax rate will depend on the basis (B). 2.a. If there is no initial unrealized gain or loss and B equals 1.00, the tax drag percentage is equal to the tax rate. 2.b. If there is an initial unrealized gain and B is less than 1.00, the tax drag percentage is greater than the tax rate because there is an additional initial gain subject to tax. 2.c. If there is an initial unrealized loss and B is greater than 1.00, the tax drag percentage is less than the tax rate because the portion of the return earned during the period back to the cost basis is untaxed.

Personal vs. Market vs. Aspirational Risk Buckets

Allocate funds to a personal risk bucket to protect the client from poverty or a drastic decline in lifestyle. Low-risk assets such as money market and bank CDs, as well as the personal residence, are held in this bucket. Safety is emphasized, but a below-market return is likely. Next, allocate funds to a market risk bucket to maintain the client's existing standard of living. Portfolio assets in this bucket would be allocated to stocks and bonds earning an expected market return. Remaining portfolio funds are allocated to an aspirational risk bucket holding positions such as a private business, concentrated stock holdings, real estate investments, and other riskier positions. Allocating these holdings to the aspirational risk bucket highlights their risky nature for the client. If successful, these high-risk investments could substantially improve the client's standard of living.

IPS Backgrounds and Investment Objectives

Background information includes, personal, financial, and tax information. In terms of objectives, you are looking for investment return objectives. You want to quantify objectives where possible and reconcile competing objectives. Additionally you want to prioritize primary vs. secondary objectives.

Situational Profiling

Due to the extensive number of possible individual situations, situational profiling must be applied cautiously. It should be applied as only an initial step in developing an understanding of an individual's preferences, economic situation, goals, and desires. Situational influences include external factors such as environmental or cultural elements that shape our behavior.

Earnings Risk

Earnings risk (insure with disability insurance) refers to loss in HC. Job loss and other career disruptions can reduce HC and may even lead to the need to consume FC prematurely. Some jobs are inherently more risky than others. A logger has a higher probability of death or injury and resulting loss of HC. A high risk security manager may have a higher risk of job termination. Other jobs are at risk of a location transfer, which could disrupt the HC of a spouse whose job is less mobile and reduce the household's total wealth. Other jobs are cyclical, and income for the self-employed can be less certain.

Risks to Human and Financial Capital

Earnings risk (insure with disability insurance) refers to loss in HC. Job loss and other career disruptions can reduce HC and may even lead to the need to consume FC prematurely. Some jobs are inherently more risky than others. A logger has a higher probability of death or injury and resulting loss of HC. A high risk security manager may have a higher risk of job termination. Other jobs are at risk of a location transfer, which could disrupt the HC of a spouse whose job is less mobile and reduce the household's total wealth. Other jobs are cyclical, and income for the self-employed can be less certain. Premature death risk (insure with life insurance) can be a serious risk early in the career when substantial HC could be lost. In addition, it may cause unexpected expenses that consume limited FC of the survivors. Longevity risk (insure with annuities) is the opposite of premature death risk as individuals who live too long are at risk of outliving their FC. The determination of how much capital is required for retirement is complicated and risky. A given individual's lifespan is highly uncertain. The return on portfolio assets, rate of inflation, the inclusion or exclusion of inflation adjustment in DB payouts, distribution needs, and other income sources must be estimated. Mortality tables and Monte Carlo simulations are generally used to quantify longevity risk. Property risk (insure with property insurance) refers to sudden loss in value of physical property (FC). A house or car can be damaged or lost in a flood, a direct loss. This can also trigger unexpected needs such as temporary living or transportation expense or lost income such as rental income, leading to consumption of FC and reduction in total wealth. The loss of business property could reduce FC and also HC of the owner if the property is necessary to generate business income. Liability risk (insure with liability insurance) refers to being legally responsible for damages and a reduction in FC. The driver of a car may be responsible for damages or loss of life caused by an accident. Health risk (insure with health insurance) can lead to direct loss of FC to pay illness or injury related expenses. It can reduce HC through diminished or inability to work. It can also affect future expense needs and life expectancy. Coverage for health risk varies widely by country. Government and/or private insurance may provide for short-term but not for long-term care.

Six Retirement Stages

Education. The private client gains knowledge and skills through formal and informal education and apprenticeships. The emphasis in this stage of life is on developing human capital rather than saving for retirement. Early career. The individual enters the workforce, often starts a family, and assumes other personal responsibilities. Saving for retirement usually begins at this stage, although there are many other competing financial goals. Career development. After becoming established in a career, job skills can continue to expand and upward mobility increases. Financial obligations often increase to fund the college education of children. Successful individuals generally build financial capital and retirement savings over time. Peak accumulation. Financial capital accumulation is typically greatest in the decade before retirement as human capital is converted into financial capital. Earnings and the need to accumulate funds for retirement (including pension benefits) are high. The private client also reduces liabilities, such as mortgage debt. Preretirement. Emphasis continues to be on accumulating financial capital for retirement and reducing liabilities. Early retirement. Private clients depend on cash flows from pension income (and part-time employment income in some cases) and their investment portfolio to fund their retirement lifestyle.

Exchange Funds

Exchange funds allow a client to diversify concentrated position into mutual fund. Taxes are deferred; basis carries over. The exchange fund simply exchanges an undiversified single asset holding for a share in a somewhat more diversified portfolio. The tax basis in the new fund is the same as before the exchange with no tax due currently and the unrealized tax liability is unchanged. With the increase in diversification the investor could seek a loan to monetize the exchange fund holding and use the funds for even further diversification. How much a lender will loan against a relatively illiquid exchange fund is unclear but this is the best answer choice offered.

Premature Death Risk

Premature death risk (insure with life insurance) can be a serious risk early in the career when substantial HC could be lost. In addition, it may cause unexpected expenses that consume limited FC of the survivors.

Health Risk

Health risk (insure with health insurance) can lead to direct loss of FC to pay illness or injury related expenses. It can reduce HC through diminished or inability to work. It can also affect future expense needs and life expectancy. Coverage for health risk varies widely by country. Government and/or private insurance may provide for short-term but not for long-term care.

Health Risk

Health risk can lead to a direct loss of financial capital to pay illness or injury-related expenses. It can also reduce human capital through diminished or inability to work.

Liability Risk

Liability risk (insure with liability insurance) refers to being legally responsible for damages and a reduction in FC. The driver of a car may be responsible for damages or loss of life caused by an accident.

Liability Risk

Liability risk refers to being legally responsible for damages and mainly reduces financial capital; there is no direct impact on human capital.

Longevity Risk

Longevity risk (insure with annuities) is the opposite of premature death risk as individuals who live too long are at risk of outliving their FC. The determination of how much capital is required for retirement is complicated and risky. A given individual's lifespan is highly uncertain. The return on portfolio assets, rate of inflation, the inclusion or exclusion of inflation adjustment in DB payouts, distribution needs, and other income sources must be estimated. Mortality tables and Monte Carlo simulations are generally used to quantify longevity risk.

Longevity Risk

Longevity risk refers to individuals outliving their financial capital; the assumption is that in retirement there is no human capital and so there is no impact.

Net Wealth

Net worth takes into account an individual's traditional assets and liabilities, whereas their net wealth also takes into account their human capital, pensions and the present value of their future lifestyle costs.

Property Risk

Property risk (insure with property insurance) refers to sudden loss in value of physical property (FC). A house or car can be damaged or lost in a flood, a direct loss. This can also trigger unexpected needs such as temporary living or transportation expense or lost income such as rental income, leading to consumption of FC and reduction in total wealth. The loss of business property could reduce FC and also HC of the owner if the property is necessary to generate business income.

Tax Residency

Residency refers to where you are treated as living for tax purposes. Having a residence or how long you spend in the country are objective plausible indicators of residency. Percentage of income is not a factor because it is not unusual for income to be earned from multiple countries, hence the existence of tax treaties to deal with multiple income sources.

Risk Transfer

Risk transfer strategies (buying insurance) are most appropriate in situations where the loss is relatively large, but not expected to occur frequently.

Credit Method

The Credit Method provides complete resolution of the residence-source conflict. Under the credit method the residence country allows the individual to take a tax credit for taxes paid to a source country. The tax rate paid by the resident on the foreign source income is the greater of the domestic and source tax rates.

Deduction Method

The Deduction Method provides only partial resolution of the residence-source conflict. Under the deduction method, the individual pays the full tax to the source country, and is only allowed to deduct the amount of taxes paid to the source country in calculating total world-wide income.

Risk Perception vs. Risk Aversion

risk perception is a subjective assessment of the risk involved in an investment decision. risk aversion is how the individual behaves when faced with negative outcomes.

Exemption Method

The Exemption Method provides complete resolution of the residence-source conflict. Under the exemption method, the country of residence charges no income tax on income generated in a foreign country that enforces source jurisdiction (i.e., that income is exempt from domestic taxation). This effectively eliminates the residence-source conflict, because foreign-generated income is taxed by the source country, only.

Differences between an Individual IPS and an institution IPS

The process is very similar. However, an individual's investment policy statement differs from an institution's in that time horizon, taxes, and unique circumstances play a more prominent role. The overall process is the same.

Flat Tax Regimes

There are 2 Flat Tax Regimes 1) Flat and Light 2) Flat and Heavy Both regimes tax ordinary income at a flat rate. However, under a flat and light regime, favorable tax treatment is given to interest, dividends and capital gains whereas under a flat and heavy regime only interest receives favorable status.

Progressive Tax Regimes

There are 5 progressive tax regimes 1) Common Progressive 2) Heavy Dividend 3) Heavy Capital Gain 4) Heavy Interest 5) Light Capital Gain Under all regimes ordinary income is taxed at a progressive rate. Under "heavy regimes" all forms of investment income are treated favorably except the heavy source. Under the light capital gains tax regime only capital gains receive favorable treatment.

Residence (tax) Jurisdiction

Under residence jurisdiction, the most prevalent type of jurisdiction, a country taxes the income of its residents, whether generated inside or outside the country. Citizens of residence jurisdiction countries pay taxes on their worldwide income, regardless of their current place of residence (i.e., whether currently living in the country or not). Under residence jurisdiction, citizens and residents pay transfer taxes, regardless of the of the assets.

Source (tax) Jurisdiction

Under source jurisdiction (a.k.a. territorial tax system) a country levies taxes on all income generated within its borders, whether by citizens or foreigners. Under source jurisdiction (a.k.a. territorial tax jurisdiction), transfer taxes are levied on assets located within (e.g., real estate) or transferred within a country, whether by citizens or foreigners.

FV of Investment AT (annual taxation)

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