CFA Level 3 - Portfolio Management and Wealth Planning Session 4 - Reading 14

CFA Level 3 - Portfolio Management and Wealth Planning Session 4 - Reading 14 (Notes, Practice Questions, Sample Questions) 1. Social security and other employment-related pension payments are considered: A)human capital because they are derived directly from the investor’s labor. B)financial capital because they are derived from an accumulation of the investor’s past labor. C)neither human capital nor financial capital because they are received after retirement Explanation: Since social security and other employment-related pension payments are derived directly from the investor’s labor, they are considered human capital. Thus, an individual’s human capital can have a positive value at retirement 2. Which of the following is considered human capital? A)Social Security payments. B)Investment gains. C)Inheritance Explanation: Human capital is a measure of the individual’s lifetime earning capacity. It is the present value of the individual’s expected income from salary, wages, and bonuses, as well as employment-related retirement pension income. Since social security is derived directly from the investor’s labor it is considered human capital. Both investment gains and inheritance are considered financial capital defined as the total value of financial assets owned 3. A financial asset that is specifically designed to address the problem of outliving one’s assets is called: A)a guaranteed investment contract. B)a life annuity. C)life insurance Explanation: Life annuities are designed to pay income to the owner as long as the owner is alive. Therefore, unless the insurance company issuing the annuity fails and is unable to make the payments as promised, the annuitant cannot outlive their income 4. Life insurance is most commonly used to hedge against: A)mortality risk. B)earnings risk. C)longevity risk Explanation: Life insurance is the most commonly employed hedge against mortality risk 5. Which of the following statements regarding human capital is most accurate? A)For a young investor their human capital is equivalent to a large holding of an illiquid asset. B)A person’s human capital is highest when they are born and trends downward after that. C)A person’s human capital is zero at retirement Explanation: Young investors are at the peak of their human capital which is defined as the present value of all expected future income derived from their labor. Human capital is illiquid because at the beginning of their careers young investors cannot cash in their future earnings or pension accounts which they have not earned yet. A person’s human capital is highest when they have finished their training or education for their career and it steadily trends downward from there. Social Security and pension payments are derived from labor thus they are considered part of human capital so at retirement if a person receives social security or a pension from a company their human capital at retirement would not be zero 6. A salesman is paid by his employer by the commission of his sales only. He has noticed that in the last couple years, the amount of his sales has been closely correlated with the U.S. market. The salesman should: A)weight his financial portfolio more so in risky assets. B)weight his financial portfolio more so in low risk, fixed income assets. C)have no preference for how his financial portfolio is weighted Explanation: If an individual’s human capital is equity-like (tied directly or indirectly to equity markets), he or she may want to hold a lower risk, fixed-income weighted portfolio to compensate for the riskiness of their human capital 7. In general, an individual facing retirement has a greater amount of: A)financial capital than human capital. B)human capital than financial capital. C)both human and financial capital than when they first started working Explanation: An individual facing retirement has a decreased amount of human capital, but most likely has accumulated a significant amount of financial capital. On the other hand, a young individual beginning their career most likely has minimal financial capital but a great amount of human capital 8. Financial wealth and the demand for life insurance have: A)a negative relationship. B)a positive relationship. C)either a positive or a negative relationship depending upon the individual’s level of wealth Explanation: Financial wealth and the demand for life insurance have a negative relationship which means if a person has a lot of financial wealth their need for life insurance is small and visa versa 9. Which of the following statements regarding human capital volatility is most accurate? When human-capital is bond-like, an investor’s financial assets should be: A)allocated towards low risk assets and their demand for life insurance will increase. B)more aggressively allocated and their demand for life insurance will decrease. C)more aggressively allocated and their demand for life insurance will increase Explanation: When human-capital is bond-like, an investor’s financial assets can be more aggressively allocated and the demand for life insurance will increase. On the other hand, when human-capital is equity-like, an investor’s financial assets should be allocated towards low risk assets and their demand for life insurance will decrease 10. The volatility of human capital and the demand for life insurance are: A)negatively correlated. B)positively correlated. C)uncorrelated Explanation: Human capital volatility and demand for life insurance are negatively correlated. Life insurance acts as a substitute for human capital, so its face value depends on the perceived value of the human capital it replaces. If the human capital has high volatility (equity-like), a higher discount rate is used to estimate its present value. Thus, human capital with high volatility has a smaller present value than human capital with low volatility 11. Which of the following is NOT an example of a cause of savings risk? A)The financial markets drop significantly wiping out a significant portion of a person’s wealth. B)A person expects to average a 12% rate of return in their 401k retirement account. C)A person fails to determine how much they need to save given an assumed rate of return and time frame Explanation: A drop in a person’s financial wealth due to a drop in the equity markets is an example of financial market risk and not savings risk. Savings risk is when a person doesn’t save enough for retirement and spends more than they should during the accumulation phase. Savings risk usually arises from a lack of long-term planning and is the result of consuming too much current income rather than saving it. Relying too much on growth in a 401k to make up for a lack of saving is an example of savings risk 12. The three primary risks that could jeopardize the desired lifestyle and/or bequest of an individual include which of the following? A)Longevity risk, savings risk, and inflation risk. B)Savings risk, financial market risk, maturity risk. C)Financial market risk, longevity risk, and savings risk Explanation: The three primary risks that could jeopardize an individual’s retirement plans are: financial market risk, longevity risk, and savings risk. Financial market risk refers to the effects of volatility in the financial markets that could result in significant drops in portfolio values. Longevity risk refers to the chance of out-living one’s financial assets. Savings risk refers to the chance of an individual spending more than they should so that they save less than needed during the accumulation stage. This is usually the result of poor long-term planning. Inflation risk is included in savings risk 13. Which of the following is least likely to jeopardize an individual’s desired lifestyle and/or bequest? A)Savings risk. B)Longevity risk. C)Liquidity risk Explanation: The three primary risks that could jeopardize an individual’s desired lifestyle and/or bequest are: (1) financial market risk, (2) longevity risk, and (3) savings risk. Liquidity risk is not a factor in determining an individual’s desired lifestyle or bequest 14. Which of the following is least likely a solution to longevity risk? A)SMarT programs. B)Social Security. C)Pension plans Explanation: SMarT (Save More Tomorrow) programs are considered solutions to savings risk (not longevity risk) because in the SMarT programs individuals pledge to save a portion of future raises 15. An advantage of a fixed annuity over a variable annuity is: A)the fixed annuity’s income stream is stable throughout the life of the annuity purchaser. B)the fixed annuity’s income offers a hedge against inflation during periods of stagflation. C)fixed annuities are easier to terminate than variable annuities Explanation: One advantage of a fixed annuity over the variable annuity is the stable income stream offered by the fixed annuity. Since the variable annuity’s income is tied to the return of underlying assets, which are usually equity-like the annuity’s income also fluctuates as the return on the underlying assets fluctuates. A disadvantage of fixed annuities is since their income stream is fixed they lose real earning power over time due to inflation. Once the fixed or variable contracts are annuitized meaning the investor decides to have the payments sent to them for life, both fixed and variable annuities are equally difficult to terminate