INDIVIDUAL AND TAXATION PORTFOLIOMANAGEMENTANSWERSQuestion Part A Factors that increase ability to take risk: • large portfolio versus needs • long time horizon • the charity donations of $16,000 could be discontinued Factors that decrease ability to take risk: • Large holding of single stock • Must rely solely on the portfolio for retirement Jennifer has indicated she does not want to take risk Sample Scoring Key: point for each of the items Part B Current spendable before-tax income: $161,000 + $28,000 + $4,000 = $193,000 Adjusted for inflation: $193,000 × 1.03 = $198,790 = before-tax spendable income Adjusted for taxes: $198,790 – $55,661 taxes at 28% = $143,129 required after-tax spendable income Plus another $16,000 for tax deductible contributions: $143,129 + $16,000 = $159,129 Total investable assets: $6,487,000 – $1,179,000 (the two homes) = $5,308,000 Real after-tax required return: $159,129 / $5,308,000 = 3.0% Nominal after-tax required return: 3.0% + 3% inflation = 6.0% Alternatively: (1.03)(1.03) – = 6.1% Sample Scoring Key: point for correctly calculating the current spending needs point for adjusting the current spending needs by inflation for next year’s spending needs point for adjusting for taxes point for including charitable donation point for correctly calculating the investible assets point for correctly setting up the real after-tax required return calculation point for the correct after-tax nominal return Candidate discussion: The charitable donation is tax deductible It has both a pre- and after-tax value of $16,000 The case stated it will start in retirement so it is not subject to inflation for the next year until retirement but is subject to future inflation after that Part C Liquidity needs: all ongoing living expenses and charity donations Time horizon: long term, approximately 25 years of retirement Sample Scoring Key: point each for the liquidity and time horizon For such a small point value and given that the distribution needs are quantified in Part B, there is no point in repeating those numbers again Note that the question specified assuming they had retired If they were still a year from retirement there would be two stages; one year to retirement and then in retirement Part D Portfolio C is best It meets the 5.7% return target • • • • • • • Portfolio A at 5.4% does not meet the required return Portfolio A’s 80% cash and fixed income is excessive for an average risk couple in their 50s Portfolio A contains excessive cash at 35% Portfolio B at 5.6% does not meet the required return Portfolio B contains excessive cash at 10% Portfolio D’s 80% equity allocation is too high for an average risk couple in their 50s Portfolio D contains no cash Sample Scoring Key: points for Portfolio C and the explanation point each for explaining one reason why the other three portfolios were not chosen Part E Tabitha’s steady employment leads to a lower discount rate applied to future earnings and higher human capital now More human capital requires more life insurance to insure against mortality risk As a divorced single mother, Tabitha has obligations to her child that would continue beyond her death Jonathan’s human capital is more equity like based on a commissioned sales type job, that higher risk human capital reduces his need for life insurance Sample Scoring Key: points each for the three required items Question A Capital gains regime: The basis B = 25 FV after tax = $100,000[(1 + 0.08)15 (1 – 0.20) + 0.20(.25)] = $258,774 RAE = (258,774/100,000)1/15 – = 6.54% Annual wealth tax regime: FV after tax = $100,000[(1 + 0.08)(1 – 0.03)]15 = $200,878 RAE = (200,878/100,000)1/15 – = 4.76% The deferred capital gains location is better Sample Scoring Key: point each for the four required calculations points for the correct conclusion B A smaller initial unrealized gain means the basis is higher There is less initial unrealized gain and taxes on the sale will be lower making the ending value higher after paying the capital gains tax This makes the annual wealth tax location relatively less attractive Sample Scoring Key: points for discussing why capital gains tax will be reduced point for the correct conclusion Question A The wife is entitled to at a minimum, the maximum of: GBP 35M (0.30) = GBP 10.5M or GBP (35 – – 3M) (0.40) = GBP 10.0M The wife is entitled to a claw-back of 0.5M Sample Scoring Key: point each for each correct calculation point each for stating the correct conclusion and the amount she should receive Remember claw-back applies to the values before any gifts that were not agreed to by the disadvantaged person B Relative after tax value ratio = (1 – 0.40)[( 1+ (.095( – 0.25)))10] / [(1 + 0.075)10 (1 – 0.35)] = 1.194 / 1.340 = 0.891 The bequest will produce more future value to the receiver and is more favorable Reasons not to give: • The giver will lose control of the assets gifted • Once gifted the funds cannot be taken back and it is possible the giver underestimated his or her future needs Sample Scoring Key: point each for the correct numerator and denominator calculation point for concluding bequest point each for two additional drawbacks of gifting now C Gifting now to a charity vs a bequest • The effective annual return earned by the receiver would increase because the receiver is tax exempt • The gift would not be subject to gift taxes • The gift would provide the giver with an immediate tax deduction, which would ultimately increase the future value of their estate and presumably allow a later additional bequest in addition to the gift made now Sample Scoring Key: points each for any two of the three reasons Question A Monte Carlo is more appropriate: • It can incorporate path dependency issues such as how past distributions during periods of depressed portfolio value may lead the portfolio to be depleted sooner • It focuses manager and client attention on the more relevant issue of longevity risk instead of on the short-term issue of volatility of assets or of surplus • It is superior for multiperiod analysis because it treats modeling as a stochastic process, incorporating both starting portfolio value as well as additions and withdrawals during each period • It can display probabilistic projected value of the portfolio at future points in time, facilitating client discussion of when to retire and how much to save • It can better incorporate other factors such as taxes Sample Scoring Key: Two points for Monte Carlo Two points each for two reasons supporting that determination Candidate discussion: Discussing Monte Carlo as surplus (ALM) focused and deterministic as asset only is not correct in this case because the firm’s focus is ALM for both Deterministic can be applied directly to expected rate of change and volatility of surplus What deterministic does not is model path dependent interaction of assets and liabilities B The equity should go in the taxable and bonds in the sheltered location A substantial portion of equity return can come from capital gains, and even in a taxable account, capital gains can be deferred and effective tax burden reduced with longer holding periods The income from bonds in a taxable account cannot achieve this same tax alpha by extending holding period Sample Scoring Key: One point each for equity to taxable and bonds to sheltered One point for discussing the ability to defer gains and increase after-tax return for equity in a taxable account C Over longer time periods, the location decision becomes more important because the benefits of deferring tax compounds over time Longer periods will build greater after-tax value Sample Scoring Key: One point for more important and two for discussing that the tax benefit grows with longer deferral periods Question A Under the exemption method, only tax to the source country is owed Under the credit method, tax paid to the source country directly reduces tax owed to the residence country, and any additional tax owed the residence country is also due Therefore: • If the tax rate in the client’s residence country is more than the foreign rate of 35%, Able (exemption method) is best • If the tax rate in the client’s residence country is less than or equal to the foreign rate of 35%, Able and Bravo will have the same after-tax return and are equally attractive, so no preference for either Sample Scoring Key: One point for recognizing when Able is superior and one point for recognizing when the two are the same Two points for any relevant explanation of why the two methods not produce the same result if the residence tax rate is more than the 35% foreign rate B The charitable gift provides the greatest tax reduction because the full value of the gift is deducted from the client’s taxable income It is a tax deduction The estate tax freeze is a taxable event and increases taxes owed when the limited partnership interests are gifted to the children Sample Scoring Key: One point for recognizing the charitable gift is better One point each for discussing the gift is a tax deduction and reduces taxes owed, and the estate tax freeze will create a tax owed Candidate discussion: The estate tax freeze does have tax advantages in that gifting the LP interests to the children may be able to utilize illiquidity and lack of control valuation discounts to lower the gift taxes owed The LP gifting can also shift future appreciation to the limited partners But the estate tax freeze still creates a tax bill for the client C The real estate should be used for the charitable gift The charitable gift and lease back can be structured to give the business continued use of the property for several years In contrast, the client wants his children to eventually run the business, and the LP can be set up so that they become the owners Sample Scoring Key: One point for using the real estate for the charitable gift and two points for any discussion that conveys the lease can allow the business to use the building and/or the LP structure is needed to convey ownership of the business to the children Candidate discussion: The key is that a charitable gift with leaseback of RE will solve the need to use the property for some years, but you cannot a lease of the business as a way to make the children eventual owners of the business ... Portfolio A at 5.4% does not meet the required return Portfolio A’s 80% cash and fixed income is excessive for an average risk couple in their 50s Portfolio A contains excessive cash at 35 % Portfolio. .. be reduced point for the correct conclusion Question A The wife is entitled to at a minimum, the maximum of: GBP 35 M (0 .30 ) = GBP 10.5M or GBP (35 – – 3M) (0.40) = GBP 10.0M The wife is entitled... does not meet the required return Portfolio B contains excessive cash at 10% Portfolio D’s 80% equity allocation is too high for an average risk couple in their 50s Portfolio D contains no cash Sample