Private wealth management in practice (CFA institute investment perspectives)

ffirs.indd i 11/12/08 7:47:14 PM PRIVATE WEALTH ffirs.indd i 11/12/08 7:47:14 PM CFA Institute Investment Perspectives Series is a thematically organized compilation of high-quality content developed to address the needs of serious investment professionals The content builds on issues accepted by the profession in the CFA Institute Global Body of Investment Knowledge and explores less established concepts on the frontiers of investment knowledge These books tap into a vast store of knowledge of prominent thought leaders who have focused their energies on solving complex problems facing the financial community CFA Institute is the global association for investment professionals It administers the CFA® and CIPM curriculum and exam programs worldwide; publishes research; conducts professional development programs; and sets voluntary, ethics-based professional and performancereporting standards for the investment industry CFA Institute has more than 95,000 members, who include the world’s 82,000 CFA charterholders, in 134 countries and territories, as well as 135 affiliated professional societies in 56 countries and territories www.cfainstitute.org Research Foundation of CFA Institute is a not-for-profit organization established to promote the development and dissemination of relevant research for investment practitioners worldwide Since 1965, the Research Foundation has emphasized research of practical value to investment professionals, while exploring new and challenging topics that provide a unique perspective in the rapidly evolving profession of investment management To carry out its work, the Research Foundation funds and publishes new research, supports the creation of literature reviews, sponsors workshops and seminars, and delivers online webcasts and audiocasts Recent efforts from the Research Foundation have addressed a wide array of topics, ranging from private wealth management to quantitative tools for portfolio management www.cfainstitute.org/foundation ffirs.indd ii 11/12/08 7:47:14 PM PRIVATE WEALTH Wealth Management in Practice Stephen Horan, CFA John Wiley & Sons, Inc ffirs.indd iii 11/12/08 7:47:14 PM Copyright © 2009 by CFA Institute All rights reserved Published by John Wiley & Sons, Inc., Hoboken, New Jersey Published simultaneously in Canada No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning, or otherwise, except as permitted under Section 107 or 108 of the 1976 United States Copyright Act, without either the prior written permission of the Publisher, or authorization through payment of the appropriate per-copy fee to the Copyright Clearance Center, Inc., 222 Rosewood Drive, Danvers, MA 01923, (978) 750-8400, fax (978) 646-8600, or on the web at www.copyright.com Requests to the Publisher for permission should be addressed to the Permissions Department, John Wiley & Sons, Inc., 111 River Street, Hoboken, NJ 07030, (201) 748-6011, fax (201) 748-6008, or online at http://www.wiley com/go/permissions Limit of Liability/Disclaimer of Warranty: While the publisher and author have used their best efforts in preparing this book, they make no representations or warranties with respect to the accuracy or completeness of the contents of this book and specifically disclaim any implied warranties of merchantability or fitness for a particular purpose No warranty may be created or extended by sales representatives or written sales materials The advice and strategies contained herein may not be suitable for your situation You should consult with a professional where appropriate Neither the publisher nor author shall be liable for any loss of profit or any other commercial damages, including but not limited to special, incidental, consequential, or other damages For general information on our other products and services or for technical support, please contact our Customer Care Department within the United States at (800) 762-2974, outside the United States at (317) 572-3993 or fax (317) 572-4002 Wiley also publishes its books in a variety of electronic formats Some content that appears in print may not be available in electronic books For more information about Wiley products, visit our web site at www.wiley.com ISBN 978-0-470-38113-7 Printed in the United States of America 10 ffirs.indd iv 11/12/08 7:47:14 PM CONTENTS Foreword ix Introduction PART I: LIFE-CYCLE INVESTING CHAPTER The Future of Retirement Planning Robert C Merton Reprinted from The Future of Life-Cycle Saving and Investing, The Research Foundation of CFA Institute (October 2007):5–18 CHAPTER Is Personal Finance a Science? 19 Paul A Samuelson Reprinted from The Future of Life-Cycle Saving and Investing, The Research Foundation of CFA Institute (October 2007):1–4 CHAPTER Lifetime Financial Advice: Human Capital, Asset Allocation, and Insurance 23 Roger G Ibbotson; Moshe A Milevsky; Peng Chen, CFA; and Kevin X Zhu Reprinted from The Research Foundation of CFA Institute (April 2007) CHAPTER The Theory of Optimal Life-Cycle Saving and Investing 99 Zvi Bodie, Jonathan Treussard, and Paul Willen Reprinted from The Future of Life-Cycle Saving and Investing, The Research Foundation of CFA Institute (October 2007):19–37 CHAPTER Is Conventional Financial Planning Good for Your Financial Health? 117 Laurence J Kotlikoff Reprinted from The Future of Life-Cycle Saving and Investing, The Research Foundation of CFA Institute (October 2007):55–71 CHAPTER The Life Care Annuity 133 Mark J Warshawsky Reprinted from The Future of Life-Cycle Saving and Investing, The Research Foundation of CFA Institute (October 2007):103–106 v ftoc.indd v 11/13/08 5:20:16 PM vi Contents CHAPTER The Longevity Annuity: An Annuity for Everyone? 137 Jason S Scott Reprinted from the Financial Analysts Journal (January/February 2008):40–48 CHAPTER A Sustainable Spending Rate without Simulation 151 Moshe A Milevsky and Chris Robinson Reprinted from the Financial Analysts Journal (November/December 2005): 89–100 CHAPTER Asset Allocation without Unobservable Parameters 169 Michael Stutzer Reprinted from the Financial Analysts Journal (September/October 2004):38–51 PART II: INVESTMENT MANAGEMENT FOR TAXABLE PRIVATE CLIENTS CHAPTER 10 Investment Management for Taxable Private Investors 191 Jarrod Wilcox, CFA; Jeffrey E Horvitz; and Dan diBartolomeo Reprinted from The Research Foundation of CFA Institute (January 2006) CHAPTER 11 Core/Satellite Strategies for the High-Net-Worth Investor 299 Clifford H Quisenberry, CFA Reprinted from CFA Institute Conference Proceedings Quarterly (December 2006):38–45 CHAPTER 12 The Higher Equity Risk Premium Created by Taxation 311 Martin L Leibowitz Modified from the Financial Analysts Journal (September/October 2003):28–31 CHAPTER 13 Tax Deferral and Tax-Loss Harvesting 317 Jeffrey E Horvitz Reprinted from CFA Institute Conference Proceedings: Wealth Management (October 2005):24–30 CHAPTER 14 Tax Management, Loss Harvesting, and HIFO Accounting 327 Andrew L Berkin and Jia Ye Reprinted from the Financial Analysts Journal (July/August 2003):91–102 ftoc.indd vi 11/13/08 5:20:16 PM vii Contents CHAPTER 15 Investing with a Tax-Efficient Eye 345 Robert N Gordon Reprinted from CFA Institute Conference Proceedings: Wealth Management (October 2005):31–40 CHAPTER 16 Diversifying Concentrated Holdings 361 Scott D Welch Reprinted from AIMR Conference Proceedings: Investment Counseling for Private Clients III (August 2001):30–35 CHAPTER 17 Hedging Low-Cost-Basis Stock 373 Robert N Gordon Reprinted from AIMR Conference Proceedings: Investment Counseling for Private Clients III (August 2001):36–43 PART III: TAX-EFFICIENT WEALTH ACCUMULATION CHAPTER 18 Tax-Advantaged Savings Accounts and Tax-Efficient Wealth Accumulation 387 Stephen M Horan, CFA Reprinted from The Research Foundation of CFA Institute (June 2005) CHAPTER 19 After-Tax Asset Allocation 475 William Reichenstein, CFA Reprinted from the Financial Analysts Journal (July/August 2006):14–19 CHAPTER 20 Withdrawal Location with Progressive Tax Rates 485 Stephen M Horan, CFA Reprinted from the Financial Analysts Journal (November/December 2006):77–87 PART IV: AFTER-TAX PERFORMANCE MEASUREMENT CHAPTER 21 After-Tax Performance Evaluation 507 James M Poterba Reprinted from AIMR Conference Proceedings: Investment Counseling for Private Clients II (August 2000):58–67 ftoc.indd vii 11/13/08 5:20:16 PM viii CHAPTER 22 Taxable Benchmarks: The Complexity Increases Contents 521 Lee N Price, CFA Reprinted from AIMR Conference Proceedings: Investment Counseling for Private Clients III (August 2001):54–64 CHAPTER 23 Explaining After-Tax Mutual Fund Performance 535 James D Peterson; Paul A Pietranico, CFA; Mark W Riepe, CFA; and Fran Xu, CFA Reprinted from the Financial Analysts Journal (January/February 2002):75–86 ftoc.indd viii About the Contributors 553 Index 555 11/13/08 5:20:16 PM ABOUT THE CONTRIBUTORS Andrew L Berkin, Director, First Quadrant, LP Zvi Bodie, Norman and Adele Barron Professor of Management, Boston University School of Management Peng Chen, CFA, President and CIO, Ibbotson Associates Dan diBartolomeo, President and Founder, Northfield Information Services, Inc Robert N Gordon, President, Twenty-First Securities Corporation Stephen M Horan, CFA, Head, Private Wealth and Investor Education, CFA Institute Jeffrey E Horvitz, Vice Chairman, Moreland Management Company Roger G Ibbotson, Professor, Yale University; Chairman, Zebra Capital Management; Founder and Adviser, Ibbotson Associates Laurence J Kotlikoff, Professor of Economics, Boston University Martin L Leibowitz, Managing Director, Morgan Stanley Robert C Merton, John and Natty McArthur University Professor, Harvard Business School Moshe A Milevsky, Associate Professor of Finance, Schulich School of Business, York University, Toronto; Executive Director, Individual Finance and Insurance Decisions (IFID) Centre James D Peterson, Vice President, Charles Schwab Paul A Pietranico, CFA, Senior Vice President, Product Development and Analytics, Allianz Global Investors U.S Retail LLC James M Poterba, Mitsui Professor of Economics, Massachusetts Institute of Technology Lee N Price, CFA, President, Price Performance Measurement Systems, Inc Clifford H Quisenberry, CFA, Managing Director, Investment Frontiers Research LLC William Reichenstein, CFA, Pat and Thomas R Powers Chair in Investment Management, Baylor University Mark W Riepe, CFA, Senior Vice President, Charles Schwab 553 bcontrib.indd 553 11/12/08 7:18:36 PM 554 About the Contributors Chris Robinson, Associate Professor of Finance, Atkinson School of Administrative Studies, York University Paul A Samuelson, Institute Professor and Professor of Economics, Emeritus, Massachusetts Institute of Technology Jason S Scott, Managing Director, Retiree Research Center, Financial Engines, Inc Michael Stutzer, Director, Burridge Center for Securities Analysis and Valuation, University of Colorado Jonathan Treussard, Lecturer, Boston University School of Management Mark J Warshawsky, Director of Retirement Research, Watson Wyatt Worldwide Scott D Welch, Senior Managing Director, Fortigent, LLC Jarrod Wilcox, CFA, President, Wilcox Investment Inc Paul Willen, Senior Economist, Research Department, U.S Federal Reserve Bank of Boston Fran Xu, CFA, Assistant Vice President, Washington Mutual Bank Jia Ye, Chief Investment Strategist, First Quadrant, LP Kevin X Zhu, Senior Research Consultant, Ibbotson Associates bcontrib.indd 554 11/12/08 7:18:36 PM INDEX Absolute return, 252–253 Accrual equivalent capital gains tax rate, 513–515 Accumulation stage, 9, 26, 80–81 Activities of daily living (ADLs), 133 Adverse selection, 134 After-tax performance improvement techniques, 236–246, 282 holding for long-term capital gains, 237–238 tax-lot management, 236–237 After-tax performance measurement, 328, 507–534 AIMR-PPS algorithm, 510–511 capital gains taxes, 512–513 estate tax issues, 515–518 individual federal tax rates, 511 marginal income tax rates, 512 questions and answers, 519–520, 532–534 taxable benchmarks AIMR after-tax standards, 522–523 capital gain realization rate, 523–525 pretax benchmark conversion, 525–530 shadow portfolios, 529–530 standard benchmark rules, 521–522 tax efficiency factors, 508–510 unrealized capital gains, 513–515 Aggregate shocks, 117–118 Aging, of population, 137 age distribution of 1992 taxable decedents, 516 probability of living to 100, 32 AIMR-PPS standards, 251, 510–511, 518, 523 Alternative asset classes, 223–224 Alternative minimum tax, 227–228, 243, 408–409, 511 Annuities See also specific annuity allocating money for, 142–143 fixed-payout, 60–61 immediate, 138 life care annuity, 133–136 longevity annuity, 137–148 longevity risk and lifetime-payout annuity, 31–33 payout, 60 premiums, 135 variable lifetime, 22 variable payout, 61–62 Arrow-Debreu prices, 110 Asset allocation, 169–187 after-tax, 475–482 adjusting for embedded gains/losses, 478 all retirement income sources, 476 asset location in after-tax framework, 482 calculating, 478 logic of, 476–478 passive investors, 479–480 sharing of principal/returns/risk, 478–481 conventional use of CRRA utility, 171–174 human capital asset allocation modeling and, 37–38, 84–87 risk considerations, 30, 33 role in asset allocation, 35–38 implications for advisers, 44 life insurance asset allocation model and, 87–91 financial resource allocation and, 33, 45–47 longevity insurance and, 65–74 longevity risk and, 62–64 model asset allocation with lifetime-payout annuities, 68–69 numberical examples/casestudies, 59–73 with payout annuities, 67–68 modifications for realistic situations, 180–181 optimal, 36 quantitative route to investor-specific advice, 169–170 555 bindex.indd 555 11/12/08 7:18:47 PM 556 Asset allocation (Continued ) reconciliation of methods, 179–180 shortfall-probability minimization, 174–179 eliminating risk-aversion parameter, 177–179 risk-aversion parameter assessment problems, 175–177 taxable equivalent asset allocation, 451–453 Asset location, 393 in after-tax framework, 482 borrowing constraints, 453–454 empirical evidence of investor behavior, 457 liquidity restraints, 456 municipal bonds, 454–455 between taxable and tax-deferred savings accounts, 449–458 taxable equivalent asset allocation, 451–453 trading behavior, 455–456 Assets, inflows versus withdrawals, 508 Baby Boomer retirement, 25, 146 Basis step-up, 513 Bellman, Richard, 121 Benartzi, Shlomo, 30 Benchmarks after-tax benchmark indices, 251 AIMR after-tax standards, 522–523 capital gain realization rate, 523–525 “dual benchmark” problem, 261 multiple managers or accounts and, 263 portfolio performance measurement, 251 pretax benchmark conversion first level of approximation, 525–528, 531 second level of approximation, 528–529, 531 special problems, 529–530 third level of approximation, 529 questions and answers, 532–534 shadow portfolios, 529–530 standard rules, 521–522 Bequests, traditional, 516 Black-Scholes derivation of option, 13 Bogle, Jack, 22 Bonds, 222–223 bond swaps, 346 capitalizing the income stream, 243 in individual retirement plans, 269, 270 inflation-indexed, 105 taxation, 229–230 tax-efficient investment strategies, 346–347 zero-coupon, 139–140 Browne, Sid, 183 bindex.indd 556 Index Brownian motion, 156 Bush, George W., 21, 321 Capital asset pricing model, 204 Capital gains, 512–515, 518 accrual equivalent capital gains tax rate, 513–515 capital gain realization rate, 523–525 “constructive sale,” 271 dividend yield versus, 508 holding 12 months for long-term gains, 237–238 short-term vs long-term, 230, 318–319, 512 taxes as trading costs, 260 Capital losses, 228, 230 Cash, 223 Charitable remainder trusts, 273–274, 363 Charitable strategies, 368–369 Cheney, Dick, 380–381 Cloning, 258–259 Collars, 271, 272, 370, 379, 382, 383 equity collars, 365–366 and VPFs compared, 367 Collectibles, 231–232 College Savings Plans, 391 Completion funds, 368, 370 Concentrated risk, 271–274, 284, 288–292 borrowing, 271–273 broad objective function, 289 complementary fund construction, 273 pooling, 273–274 spreadsheet implementation, 289–291 Constant relative risk-aversion (CRRA), 170, 171–174 Constructive sale, 271, 356–357 Consumption, spending and risk management, 216 Consumption habit formation, 111–112 Consumption smoothing, 117–124 current and future variables in, 118 dynamic programming model, 121 household savings/investments and, 118–119 Social Security and, 118 standard of living and, 120–121 taxation and, 118, 121 Contingent claims, 103–108 inflation and, 105 limitations, 105–106 pricing of, 106–108 Contingent tax liability, 251 Conventional financial planning, 117–132 consumption disruption, 129 11/12/08 7:18:47 PM 557 Index consumption smoothing, 122–124 distortion of portfolio advice, 129–130 methodology, 120–121 mistakes in consumption/saving/insurance, 127–129 mis-targeting spending, 124–127 results, 121–122 Core/satellite strategy, 300–308 benchmarks, 300, 301, 309 constructing the core portfolio, 302 core/satellite model, 302–303 major advantage of, 300–301 model results, 303–305 observations on structure of, 308 optimal core allocation, 305–308 questions and answers, 309–310 satellite portfolio construction, 302 Corporate pension plans, 147 CRRA See Constant relative risk-aversion (CRRA) “Current Occupation Survey” (U.S Dept of Labor), 36 Death tax, 233 See also Estate tax issues Defined-benefit plans, 7–8 demise of, 137 life care annuity with existence of, 133 longevity risk and, 24 shift to personal savings vehicles from, 27 Defined-contribution plans, 8–11 See also Individual retirement plans increasing importance of, 24 popularity of, 27 simplicity and constancy of, 10–11 Derivatives hedging and, 245, 354 prepackaged liquidity and, 13 tax sheltering with, 243–244 tax treatment of, 232–233 Diamond, Peter, 21 Diversification, 34–35 See also Core/satellite strategy benefits of, 28–29 of concentrated holdings, 361–372 comparing alternative strategies, 367–369 equity collars, 365–366 hedging, 364–365 questions and answers, 369–372 variable prepaid forwards, 366 versus concentrated portfolios, 252 equity risk management, 362–364 human capital and, 35–36 transaction costs, 381 bindex.indd 557 Dividends, taxation and, 230 Dividend yield vs capital gains, 508 Donor-advised funds, 367 Dow Jones Industrial Average, 529 Dynasty trust, 325 Earnings risk, 29, 30 Economic Growth Tax Relief Reconciliation Act (2001), 321, 389, 391, 393, 408 Economic Recovery Tax Act (1981), 391 Economics: An Introductory Analysis (Samuelson), 20 Education, and human capital, 25 Effective marginal tax rate, 512 Efficient frontier, 28 Employee retirement plans defined-contribution plan form, 135 defined contribution plans, 137 Employer matching, 411–415 reinvesting tax savings into 401(k), 410, 411–413 into a taxable account, 413–415 Endowments, 162 Enron Corporation, 30 Equity collars, 365–366 Equity flex options, 382 Equity risk management, 362–364 client concerns, 362–363 hedge candidate characteristics, 364 investor characteristics, 363 Equity risk premiums, 311–315 hierarchy of returns (2% inflation rate), 313, 314 returns comparison under varying inflation rates, 313, 314 tax and inflation effects, 312 tax effects, 312 volatility-matched after-tax returns, 313 Equity swaps, 354 Estate tax issues, 233–234, 515–518 changes from 2005-2011, 322 mitigating estate taxes, 321–323 taxable gifts, 517–518 tax deferral and estate tax, 241 tax-free inter vivos gifts, 516–517 traditional bequests, 516 wealth transfer, 218–221 Estimated reciprocal gamma formula, 159 European-style options, 371 Everett, Robert, 176 Exchange funds, 273, 367–368 Exchange-traded funds (ETFs), 231, 257, 350, 532–533 Expected-growth-rate-of-wealth, 170 Expected-utility maximization, 181–182 11/12/08 7:18:47 PM 558 Exponential lifetime random variable, 157 Exponential reciprocal gamma, 158–159 Fama and French pricing model, 536–537 Fama-MacBeth two-step estimation technique, 540 Federal tax rates (variations based on individual), 511 Financial analysts, 458–462 portfolio management investment constraints and, 460–461 investment objectives and, 458–460 portfolio optimization, 461–462 Financial market risk, 31, 55–56 Financial planning See Conventional financial planning Fixed income, 222–223, 229–230 Fixed-income indexes, 530 Fixed-payout annuity, 60–61 “Forced realizations,” 513 Forward contracts, 370–371 401(k), 16–17, 267, 391, 410–413 403(b)(7), 268 Friedman, Milton, 20 Fund of funds, 355 Gifts, 233–234, 517–518 taxable, 517–518 tax-free inter vivos gifts, 516–517 Global Investment Performance Standards (GIPS), 251 Grantor retained annuity trust (GRAT), 370 Greenough, Bill, 22 Gross-to-net investment returns, 221–224 investment expenses, 221 taxation/inflation impact, 221–222 Halliburton stock, 380–381 Health care savings accounts, 391–392 Health insurance, 102, 105 Hedge funds, 232, 533 offshore hedge funds, 354 tax inefficiencies of, 353–356 Hedging, 112 impetus for, 364–365 low-cost-basis stock, 373–383 customized analysis, 378 hedging vs montitizing, 374–378 merger-related stock, 378–379 pre- or post-1984, 379–381 questions and answers, 381–383 rolling over the hedge, 382 HIFO (highest in, first out) accounting, 327, 329 High-net-worth investors, 214–215 bindex.indd 558 Index diversifying concentrated holdings for, 361–372 equity risk management, 362–364 Horvitz, Jeffrey, 351 Households high-net-worth, 214–215 making gifts of at least $10,000 a year, 517 percentage paying various marginal tax rates, 512 Housing risk, 13 Human capital, 34–45 academic literature, 36–37 asset allocation modeling, 37–38, 84–87 calculating, 37–38 case studies, 38–44 human capital as risk-free asset, 39–41 human capital as risky asset, 41 impact of initial financial wealth, 42–43 wage growth rate/stock returns correlation, 43–44 defined, 30, 34–35, 44 diversification to reduce risk of, 30 as dominant asset, 37 investment risk and, 34 life insurance and asset allocation decisions, 45–46 protecting with life insurance, 26 role of, in asset allocation, 35–38 Hurley, Mark, 351 IBM, 7–8 Immediate annuity, 138 Income taxes federal tax rates (variations based on individual), 511 history of, 388 marginal income tax rates, 512 Independence axiom, 182 Index funds, 262 Individual retirement plans, 265–271, 283 See also IRAs (individual retirement accounts); specific plan asset classes held in, 269–270 asset location, 265–266, 268–269, 284–288 location problems, 286–288 mean-variance optimization, 285–286 tax aspects, 268–269 employer matching, 410–419 401(k), 267 403(b)(7), 268 Keogh profit sharing, 267 nontax aspects, 269 rebalancing, 270 regular IRA, 266 11/12/08 7:18:47 PM 559 Index Roth IRA, 266 SEP-IRA, 267 SIMPLE IRA, 266–267 suitability of, for various wealth levels, 268 Individuals as business or traders, 232 Inflation contingent claims and, 105 equity risk premium and, 312 returns comparison under varying rates of, 313, 314 “wealth effect” and, 253 wealthy investors and, 279 Inflation-indexed bonds, 105 Insurance value, 138–139 Insurance wrappers, 244 International taxation, 235 Inter vivos gifts, 516–517 Inter vivos liquidations, 323 Investment advice, demand for, 27 Investment advisers, 44 Investment horizons, 217–218, 404–405 Investment management, for taxable private investors, 191–295 See also Portfolio manufacturing; Individual retirement plans assessment and benchmarking, 274–280, 284 assessing risk, 277 inflation, 279 measuring long-term viability, 276–277 measuring return as purchasing power, 275–276 method criteria, 274–275 related entities and asset location, 279 tax considerations, 278–279 concentrated portfolios, 252 concentrated risk, 271–274, 288–291 ethical standards, 197–198 identifying client objectives, 247–249 mean-variance optimization, 247–248 utility function, 248–249 life cycle investing, 207–213, 278, 281 portfolio performance measurement, 250–252 benchmark comparisons, 251 private wealth investment challenges, 195–197 relative and absolute return, 252–253 tax considerations, 249, 281–282 theory and practice, 199–207, 280–281 Investment services customized for HNW clients, 255 “separately managed account” programs, 255–256 Investment total return, 156–157 Investors (individual) bindex.indd 559 client portfolio with cash withdrawals, 509–510 retirement funding as primary goal of, 27 traditional advice model for, 27–29 IRAs (individual retirement accounts), 266 breakeven investment horizon, 442–447, 467–468 simplified capital gain tax structure, 443–447 simplified ordinary income tax structure, 442–443 “catch up” contributions, 393 contribution limits, 398 converting to Roth IRA, 415–419 breakeven withdrawal tax rate, 417–419 conversion tax, 416–417 front-end-loaded tax benefits, 391 investments in, 137 nondeductible IRAs, 392–393 breakeven withdrawal tax rate for, 466–467 nondeductible IRAs versus taxable investments, 419–425 analysis, 420–424 partially deductible taxable equivalent value withdrawn as an annuity, 440–441 taxable equivalent value with lump-sum withdrawal, 432–434 popularity of, 389 and Roth IRAs compared, 393–410 breakeven withdrawal tax rates, 405–408 equalizing the investment, 395–397 general foundation of traditional IRA, 398–405 standardized pretax investment in, 395–396 taxable equivalent value withdrawn as an annuity, 434–438 taxable equivalent value with lump-sum withdrawal, 426–429 value ratios, 401–403 withdrawal penalties, 393 withdrawal tax rate decreases and, 401 Jobs and Growth Tax Relief Reconciliation Act of 2003, 389, 398–399, 401, 408, 409 Joint-life annuities, 91–92 Keogh profit sharing, 267 Labor income, 30, 105 Labor income flexibility, 36 Legacy portfolio, 261–262 Leverage, with short sales and tax-loss harvesting, 271–272 11/12/08 7:18:48 PM 560 Life care annuity, 133–136 with defined-benefit pension and Social Security, 133 home health care/nursing home stay, 133 long-term care and, 133 motivation for development of, 134 “pop-up” disability payments in, 133 Life-cycle investing, 99–112, 207–213, 281 accumulation stage, 80–81 asset allocation with lifetime-payout annuities, 68–69 longevity insurance and, 65–74 with payout annuities, 67–68 balance sheet, 278 basic questions, 99 case example, 209–212 central problem of, 24 in changing retirement landscape, 27 consumer needs, 111 consumption choice and portfolio selection, 100–102 disposition of excess wealth, 213 equities and, 109 event tree, 100–101 financial stages earning (accumulation) stage, 26, 80–81 growing up and education phase, 25 retirement stage, 26 flexibility of earnings and spending, 212 health insurance, 102 human capital and asset allocation, 34–45 key concepts asset allocation, 109–110 “contingent claims” construction, 103–106 lifetime budget constraint, 102–103 risky assets in life-cycle model, 108–109 securities prices, 106–108 life-cycle/wealth interaction, 208–209 life insurance, 45–54 lifetime risks, 212–213 modeling, 84 new financial products, 110–112 retirement portfolio and longevity risk, 54–65 retirement stage, 26, 82–84 risk factors and hedges, 29–33 traditional advice model, 27–29 when to annuitize, 74–79 Life-cycle retirement mutual funds, 20 Life expectancy conditional probability of survival at age 65, 154 time spent in retirement and, 31 bindex.indd 560 Index use of, in measuring long-term viability, 276 at various ages (1994), 515 Life insurance asset allocation decisions and, 45–46 model and, 87–91 case studies, 49–53 bequest motive strength, 50–51 financial wealth, 52 human capital/financial asset allocation/life insurance demand, 49–50 risk tolerance impact, 51 wage growth rate/stock returns correlation, 53 family protection, 33 in financial planning process, 24 model description, 47–49 mortality risk and, 30–31 pricing for one-year, renewable term, 87–88 survivor’s needs and, 121–122 uncertainty of human capital and, 46 Lifetime annuities, 32–33 Lifetime budget constraint, 102–103 Lifetime savings accounts, 391 Lognormal random variable, 156–157 Longevity annuity, 137–148 advantages of, 138 allocating money to, 142–143 as alternative to bonds, 140 appropriateness of, 146 companies offering, 145 leverage available from, 143 to maximize spending, 141–143 public policy considerations, 146–147 robustness analysis, 143–145 spending curve, 142–143 Longevity insurance asset allocation and, 65–74 benefits of, 65–67 Longevity risk, 29 DC plans and personal savings, 59 life annuities and, 24 payout annuities and, 60 in retirement, 56 retirement portfolio and, 54–65 Social Security and DB pension plans, 58–59 Long-term care insurance, 134 See also Life care annuity Loss harvesting See Tax-loss harvesting Marginal income tax rates, 389, 512 Margin loans, 380, 383 11/12/08 7:18:48 PM 561 Index Markowitz, Harry M., 12, 30, 476 Markowitz mean-variance model, 27–29, 200–203 Markowitz-Sharpe assumptions, 156 Mean-variance criterion function, 170 Mean-variance portfolio model, 11–12, 16, 27–29, 285 Medicaid, 135 Mencken, H.L., 264 Merger and acquisitions hedging merger-related stock, 378–379 S&P 500 and, 528 Minimum required distributions (MRDs), 146 Minimum variance portfolio, 28 Modern portfolio theory, 27–29, 170 Monte Carlo simulations, 329–342 base-case assumptions, 330–332 base-case results, 332–335 varying market conditions, 335–338 dividend rates, 337–338 market returns, 336–337 risk, 335–336 varying portfolio conditions, 338–342 cash flows, 340–341 tax rates, 341–342 turnover, 338–340 Mortality credits, 65–67 Mortality hazard rate, 165 Mortality risk, 29, 30–31, 45 Multiple disciplinary accounts, 263 Municipal bonds, 242, 246, 454–455 Mutual funds after-tax performance, 509, 535–552 cash flows and, 538–539 data, 539 Fama and MacBeth two-step estimation technique, 541 full sample of funds, 541–546 fund characteristics and, 536–539 implications, 548 manager tenure and, 544–546 manager turnover and, 539, 544 measuring returns, 536 methodology, 539–541 results, 541–548 tax-adjusted returns, 549–551 tax efficiency measurements, 538 three-factor asset pricing model, 536–537 time-series regression equation, 537 turnover and, 538 with built-in losses, 351 fund of funds, 355 bindex.indd 561 with hedge-fund strategies, 354 kept outside the retirement account, 270 life-cycle retirement mutual funds, 20 reporting after-tax returns, 527, 534 taxation and, 231 tax-aware index fund alternative, 256 time-series persistence in after-tax returns, 256 Vanguard S&P 500 index fund as performance measurement, 318 Net present value, 324 Noninvestment assets, 224 Nuclear decommissioning trusts, 330, 533, 534 Olsen, Robert A., 171 Option valuation theory, 204–205 Passive foreign investment company (PFIC), 354 Passive indices, 256 Payout annuities, 60 See also Lifetime annuities guaranteed payment floors, 92 longevity risk and, 62–64 payment-period guarantees, 92 single-life and joint-life annuities, 91–92 Pension Protection Act (2006), 147 Personal finance, 19–22 Peru, 13 Portfolio building, and human capital, 30 core/satellite strategy, 300–308 dealing with new client’s preexisting, 261–262 legacy portfolios, 261–262 traditional structure approach, 299–300, 301 Portfolio diversification, 35–36 Portfolio manufacturing, 254–265, 283 goal of, 254 investment process roles, 254 investment style accomodations, 262–264 legacy portfolios, 261–262 “mass customization,” 254–256 multiperiod analysis, 262 shortcut failure, 264 tax management for HNW market, 256–261 Portfolio rebalancing, 245 Portfolio theory, 27–29 Portfolio tilts, 243 Portfolio turnover, 508 Preliquidation, 522 Prepaid variable forwards, 271, 272–273, 371, 379–380 Private equity, 232 Pro rata ownership, 367 11/12/08 7:18:48 PM 562 Pseudopassive accounts, 256 Qualified terminal interest property (QTIP) trust, 234 Quasi-efficient market, 199–200 Rabin, Matthew, 171, 182 Random Walk Down Main Street, A (Malkiel), 34 Real estate, taxation and, 231 Realized basis advantages, 522 disadvantages, 523 Reciprocal gamma random variable, 157–158 “Regret” insurance, 13–14 Regulation T, 380 Rehypothecation of securities, 371 Reichenstein, William, 171 Relative return, 252–253 Remaining lifetime random variable, 157 Retirement See also Retirement planning; Sustainable spending rate asset allocation, payout annuities, and savings, 62–64 changing landscape of, 27 controlling risks in, 57–58 defined-contribution plans, 27 early retirement trend, 31 financial market risk, 55–56 fixed-payout annuity, 60–61 investment retirement accounts (IRAs), 27 life cycle stage of, 26, 82–84 longevity risk and, 54–65, 56, 58–62 DC plans and personal savings, 59 payout annuities and, 60 Social Security and DB pension plans, 58–59 rising life expectancies and, 31–32 trends, 137 variable-payout annuities, 61–62 Retirement accounts tax-advantaged, 241–242 Retirement finances triangle, 152–153 Retirement income systems, 112 Retirement planning, 7–18 behavioral finance and regret insurance, 13–14 defined-benefit plans, 7–8 defined-contribution plans, 8–11 housing risk, 13 human capital and, 12 objective function of, portability of, prepackaged liquidity, 13 wealth vs sustainable income flows, 12–13 bindex.indd 562 Index Reverse mortgage, 13 Risk, concentrated, 271–274 Risk-adjusted return, 253 Risk assessment, 277 Risk-aversion parameter assessment problems, 175–177 eliminating, 177–179 Robustness analysis, 143–145 Roth, William, 391 Roth Employee Retirement Savings Accounts (ERSAs), 392 Roth IRA, 266, 482 See also Tax-advantaged savings accounts back-end-loaded tax benefits, 391 basic framework, 397–398 breakeven investment horizon, 447–449, 467–468 converting to, from traditional IRA, 415–419, 465–466 breakeven withdrawal tax rate, 417–419 conversion taxes, 416–417 401(k) investment compared, 413–414 investment return increase and, 401 standardized pretax investment in, 395–397 taxable equivalent value with lump-sum withdrawal, 429–432 withdrawn as an annuity, 438–440 Taxpayer Relief Act and, 389, 391 and traditional IRA compared, 393–410 breakeven withdrawal tax rates, 405–408 equalizing the investment, 395–397 traditional IRA conversion to, 415–419 value ratios, 401–403 Rubinstein, Mark, 183 Ruin probability, 159–161 for balanced portfolio of equity and bonds, 163 sustainable spending rate resulting in, 165 for various portfolios at age 65, 164 “Ruin tolerance” level, 164 Samuelson, Paul A., 182–183 Savings See also Tax-advantaged savings accounts longevity risk and, 59, 62–64 to reduce wage earnings risk, 30 transition from savings to distribution retirement phase, 33 Savings accounts tax-advantaged, 241–242 tax-sheltered, 234–235 Schizer, David, 351 Schumpeter, Joseph, 19 SEC Section 16 rules, 366 11/12/08 7:18:48 PM Index Section 529 College Savings plans, 391 See also Tax-advantaged savings accounts “Separately managed account” programs, 255–257 SEP-IRA, 267 Shadow portfolios, 529–530 Sharpe, William F., 12, 155, 179 Short against the box, 364 Shortfall constraints, 216–217 Short sales against the box, 271 Short-term capital gains and losses, 318, 324 Siegel, Jeremy, 170, 173, 181 SIMPLE IRA, 266–267 Single-life annuities, 91–92 Sixteenth Amendment, 388 Social Security, 21 computing benefits, 118 longevity risk and, 24 as percentage of retirement income, 27 Spiders (S & P Depositary Receipts), 348 Standard deviation, 28, 29 Standard of living (in retirement), 134 Standard & Poor’s Depositary Receipts (SPDRs), 348 Standard&Poor’s 500 Index, 522, 525–529 creating an after-tax benchmark for, 526 shadow portfolio example, 529 strategies for tax-efficient investing, 348–353 mutual funds with built-in losses, 351 time horizon impact, 348–350 wash-sale rules, 351–353 Standards of living, maintaining, 117 State-contingent prices, 110–111 State taxation, 235 Stochastic growth theory, 205–207 Stochastic present value, 152, 153–156 Stocks, 223 hedging low-cost basis, 373–383 customized analysis, 378 hedging vs monitizing, 374–378 merger-related stock, 378–379 pre- or post-1984, 379–381 questions and answers, 381–383 individual retirement accounts and, 269 liquidating low-basis, 368 taxation and, 230 Straddles, 367, 381 Style indexes, 529 Subjective survival probability, 48 SURGE funds, 328 Survey of Consumer Finances, 511 “Survey of Consumer Finances,” 27, 37 bindex.indd 563 563 Sustainable spending rate, 151–167 analytic formula for, 156–158 exponential lifetime random variable, 157 lognormal random variable, 156–157 reciprocal gamma random variable, 157–158 exponential reciprocal gamma, 158–159 investment strategies, 161–165 numerical examples, 159–161 retirement finances triangle, 152–153 stochastic present value of spending, 153–156 Swaps, 243–244, 380–381 Synthetic hedges, 233 Target-shortfall-probability minimization, 171 Taxable Portfolios Subcommittee, 532 Tax-advantaged savings accounts breakeven investment horizon for IRAs, 467–468 contribution/eligibility/withdrawal policies of, 394 discount rates, 408 financial analysts and, 458–462 in foreign countries, 389 401(k) reinvestment, 411–413, 465–466 future value interest factor of taxable annuity, 467 future value of Roth IRA conversion, 465–466 high net-worth investor and, 493–496 proof of equivalency, 462–464 time value of money, 387, 389–390 traditional and Roth IRAs compared, 393–410 withdrawal location with progressive tax rates, 485–500 algorithms for withdrawal strategies, 498–500 model, 486–487 residual accumulations/withdrawal sustainability, 487–496 Taxation See also Tax-loss harvesting alternative minimum tax, 227–228, 243 capital gains, 508, 512–515 capital losses, 228 categories of investment tax strategies, 245–246 consumption and, 118 contingent tax liability, 251 different asset classes, 228–233, 281 estate taxes, 515–518 federal taxation of investments, 225–236, 281–282 income, 226–227, 511–512 individual retirement plans and, 268–269 11/12/08 7:18:48 PM 564 Taxation (Continued ) international, 235 private wealth and, 213–246 pro forma tax return, 278–279 specialized tax circumstances, 511 state taxation, 235 tax deferral estate tax and, 241 turnover and, 240–241 as trading cost, 259–261 Tax-aware index fund, 256 Tax credits, 329 Tax deferral, 317–323 algebra of deferred taxes, 319–320 disadvantages of short deferral, 320–321 length of holding period and, 320–321, 325 mitigating estate taxes, 321–323 short- vs long-term capital gains taxes, 318–319 Tax-deferred account (TDA), 388, 482 See also Tax-advantaged savings accounts adjusted gross income and, 409 tax reforms and, 389 Tax efficiency factors, 508–510 Tax-efficient investing, 328, 345–359 academic findings, 345–346 constructive-sale rules, 356–357 hedge fund issues, 353–356 mutual funds with built-in losses, 351 questions and answers, 357–359 S&P 500 index strategies, 348–353 U.S bond strategies, 346–347 Tax-gain harvesting, 326 Tax-loss harvesting, 238–240, 258, 261, 302, 323–324 HIFO and, 328, 329 operational problems of, 324 volatility and, 325 Tax management HIFO accounting, 327 for HNW market, 256–261 levels of tax awareness, 257–258 tax and other overlays, 258–259 treating taxes as transaction cost, 259–261 past studies, 328–329 Tax overlay, 258–259 Taxpayer Relief Act of 1997, 373, 389, 391, 486, 513 Tax Reform Act (1986), 391 Tax reforms, 389 bindex.indd 564 Index Tax-sheltered assets, valuing, 425–441 Tax-sheltering swaps and other derivatives, 243–244 tax-sheltered savings accounts, 234–235 TDA See Tax-deferred account (TDA) Term life insurance, 87–88 Thaler, Richard, 171, 182 TIAA-CREF variable lifetime annuity, 22 Time horizon, 348–350 Time-weighting, 251 Total wealth, 34–35 Treasury Inflation-Protected Securities (TIPS), 17, 105, 173, 178, 222 Two-step estimation technique (Fama-MacBeth), 540 Utility theory and investment risk taking, 200 Value strategies, 262–263 Variable lifetime annuity, 22 Variable payout annuities, 61–62 Variable prepaid forwards (VPFs), 366, 367 Venture capital, 232 Von Neumann-Morgensterm axioms for decision making, 181 Wage earnings risk See Earnings risk Wash sale, 230, 257, 310, 331, 351–353 Wealth, 34–35 See also Investment management, for taxable private investors certainty equivalents of, 43–44 of high-net-worth households, 214–215 human wealth measured as fraction of current income, 104 individual retirement plans and, 265 versus sustainable income flows, 12–13 taxation and private wealth, 213–246 Withdrawals See also Sustainable spending rate naive and informed strategies, 487, 490–493, 499–500 tax-advantaged savings accounts and, 485–500 WorldCom, 30 Yook, Ken, 176 Zero-cost collar, 379 Zero-coupon annuities, 142 Zero-coupon bond, 139–140 11/12/08 7:18:48 PM The Essentials to Performance Management 978-0-470-39502-8 Hardcover • $95.00 US The latest investment research and cutting-edge strategies from leading professionals Available at wiley.com, cfainstitute.org, and wherever books are sold bcfa.indd 565 11/12/08 7:18:13 PM The CFA Institute Investment Series: Setting the Industry Standard Corporate Finance: A Practical Approach Michelle R Clayman, Martin S Fridson, George H Troughton Managing Investment Portfolios: A Dynamic Process, Third Edition Quantitative Investment Analysis, Second Edition John L Maginn, Donald L Tuttle, Dennis W McLeavey, Jerald E Pinto Richard A DeFusco, Dennis W McLeavey, Jerald E Pinto, David E Runkle ISBN 978-0-470-19768-4 ISBN 978-0-470-08014-6 ISBN 978-0-470-05220-4 Corporate Finance: A Practical Approach, Workbook Managing Investment Portfolios: A Dynamic Process, Third Edition, Workbook Quantitative Investment Analysis Second Edition, Workbook Michelle R Clayman, Martin S Fridson, George H Troughton John L Maginn, Donald L Tuttle, Dennis W McLeavey, Jerald E Pinto ISBN 978-0-470-28243-4 ISBN 978-0-470-10493-4 Richard A DeFusco, Dennis W McLeavey, Jerald E Pinto, David E Runkle ISBN 978-0-470-06918-9 International Financial Statement Analysis Equity Asset Valuation Fixed Income Analysis, Second Edition Thomas R Robinson, Hennie van Greuning, Elaine Henry, Michael A Broihahn John D Stowe, Thomas R Robinson, Jerald E Pinto, Dennis W McLeavey ISBN 978-0-470-05221-1 Frank J Fabozzi ISBN 978-0-470-28766-8 ISBN 978-0-470-05282-2 International Financial Statement Analysis Workbook Equity Asset Valuation Workbook Fixed Income Analysis, Second Edition, Workbook John D Stowe, Thomas R Robinson, Jerald E Pinto, Dennis W McLeavey ISBN 978-0-470-06919-6 Thomas R Robinson, Hennie van Greuning, Elaine Henry, Michael A Broihahn Frank J Fabozzi ISBN 978-0-470-28765-1 ISBN 978-0-470-28767-5 Available at wiley.com, cfainstitute.org, and wherever books are sold bcfa.indd 566 11/12/08 7:18:14 PM $95.00 USA/$105.00 CAN (continued from front flap) Horan • Part II addresses the numerous issues confronting high-net-worth investors and explores tax-efficient asset allocation and portfolio management techniques • Part III develops an analytical framework and rules of thumb for investors facing decisions involving tax-advantaged savings accounts such as 401(k) plans and Roth IRAs • Part IV describes the challenges involved in estimating after-tax performance and identifies mutual fund characteristics that drive a fund’s tax drag Jacket Design: Loretta Leiva Jacket Photograph:© Stockbyte/Getty Images “The collection of material in Stephen Horan’s Private Wealth assembles in one, organized tome a critical core treatment of ideas upon which most aspects of modern private wealth management are founded It is sure to be a useful reference for those who deal with the challenging task of balancing the myriad needs and preferences of individuals and families alike in the single or multigenerational management of their wealth I am confident that advisors will find Private Wealth as useful in their practices as we will in wealth management coursework at Wharton.” -Professor Christopher C Geczy, PhD Academic Director, Wharton Wealth Management Initiative, The Wharton School “Private Wealth is an excellent compilation of the best research in private wealth management published by the CFA Institute Stephen Horan has done a superb job not only at selecting articles that reflect the most forward thinking about the theory and practice of private wealth management, but also at organizing them around the topics that matter the most to today’s wealth managers Private wealth management is undoubtedly one of the most complex areas in investment management for the many dimensions involved in the process of selecting and implementing the appropriate asset allocation for private taxable investors Wealth managers can find in Private Wealth a helpful reference when confronting today’s complex challenges.” -Luis M Viceira, PhD Professor of Business Administration, Harvard Business School Private Wealth STEPHEN M HORAN, PHD, CFA, manages professional education and private wealth management content for CFA Institute members Dr Horan has served CFA Institute as both an editorial board member and abstractor for the CFA Digest and as an ad-hoc reviewer for the Financial Analysts Journal He holds a PhD in finance from the State University of New York at Buffalo, publishes frequently in academic and professional journals, and has authored several books Prior to joining CFA Institute, he was a professor of finance at St Bonaventure University, principal of Alesco Advisors LLC, and a financial analyst and forensic economist in private practice, providing expert witness testimony and preparing economic impact studies Private Wealth Wealth Management in Practice Today’s wealth managers must be familiar with both financial assets in general and the implied assets and liabilities in an individual’s or family’s portfolio They must also have a firm understanding of the complex interactions among investments, taxes, and estate planning With Private Wealth as your guide, you’ll quickly discover how to excel at this difficult, but important, endeavor and learn how to effectively provide optimal financial solutions for your clients PRAISE FOR @ E M