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THE BRENNANS

A Suggested Solution

1. Assessment of the Brennan’s current situation:

Current Situation:
Available funds: $600,000
Current spending requirements: 140,000 (1 - .30) - 18,000 - 10,000 = $70,000
(i.e., after deducting taxes, and retirement and education investment proceeds)
Current income requirements from investments = 0

Projected Situation in 5 years:


Determine portfolio size (assume they earn targeted 3% real-after tax return during the 5
years preceding retirement)

Nominal rate = (real after-tax rate + expected inflation) / (1 – tax rate)


= (.03 + .03) / (1 - .30) = 8.57%

Portfolio size = 600,000 (1.0857)5 + 18,000 [{(1.0857) 5 – 1} / .0857]


= 905,108 + 106,806 = $1,011,914

Income needs (in nominal dollars at beginning of retirement period)


= 70,000 (1.03) 5 = $81,149

Issue #1:
How long will they be able to survive based on their spending (investing) plans??
Let’s begin by assuming they earn an 8.57% nominal before-tax return (or a 5.57% real
before-tax return). This may seem ambitious since they may decide to take a more
conservative approach with their portfolio when they retire, which usually translates into
lower expected returns.

This particular problem is solved most easily by considering their spending needs in
“real” dollar terms (i.e., real dollars as of the year beginning retirement), and using the
real before-tax discount rate.

Solving by financial calculator:


FV = 0; I/Y = 5.57%; PMT = -81,149; PV = 1,011,914; Compute n = 21.88 years.

This analysis suggests that if all goes according to expectations, and they are able to earn
their desired returns that they will have sufficient funds available to support them until
they are 82, without having to sell their house, or any other assets.
Notice, however, that this does not consider any contingencies, such as earning less than
expected, having higher inflation than expected, or having large outlays for health issues,
etc.

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Issue #2:
Can they reasonably expect to earn 8.57% in nominal terms (i.e., 3% in real after-tax
returns), and still maintain the risk level of their existing portfolio, which is quite
conservative.

A quick look at Table 1 suggests their current asset mix (50% T-bills /50% Large Caps)
has the following expected return (in nominal pre-tax terms) and standard deviation:

ERp = (.5)(2.5) + (.5)(10) = 6.25%


The ER is well below their target nominal pre-tax return of 8.57%. This means they will
have to change their present mix (and become a little more aggressive) in order to
achieve this target.

Now, let’s estimate the standard deviation of their present portfolio:

SDp = [(.5)2(3)2 + (.5)2(20)2 + 2(.5)(.5)(.05)(20)(3)]0.5 = 10.19%

One of the Brennan’s stated objectives is to maintain portfolio risk at or below its current
risk level. A quick look at Tables 1 and 2 suggests that it will be hard to construct a
portfolio with risk at or below this level that will have a higher ER than their present
portfolio, which is required in order to satisfy their return objective, as discussed above.

In other words, the Brennan’s face a classic problem – they want to maintain a low level
of risk, but desire a higher expected return. In fact, the analysis above suggests that not
only may they desire this higher return, but they need it in order to provide for their
planned retirement, without curtailing their spending, or selling some assets.

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2. Investment Policy Statement for the Brennan’s

Objectives:

Return Requirement. The Brennan’s do not need any income from their portfolio for
another five years (i.e., until their intended retirement date). As such, the current focus
for the portfolio should be growth. Their target of a 3% real, after-tax return translates
into an 8.57% nominal return requirement, assuming 3% inflation and a 30% tax rate (as
computed in the solution to Question 1).

During the second stage of their investment horizon (after retirement), they face a total
return objective that focuses on both growth and income. In order to maintain their
desired spending levels, they need to generate $81,149 in annual income (inflation
adjusted) when they retire (as computed in the solution to Question 1). If they are able to
invest according to their schedule and earn their target of 8.57% return on their retirement
savings, they will have accumulated $1,011,914 by the time they retire (as computed in
the solution to Question 1). Thus, their annual spending needs will be approximately
8.02% (i.e., 81,149 / 1,011,914) of their retirement savings. As a result, they will have
enough to live on for approximately 22 years (as computed in the solution to Question 1),
barring any unforeseen problems.

Risk Tolerance. The information provided in the Introduction suggests that the
Brennan’s are quite risk averse, and are not willing to assume too much risk. This is
obvious from the current conservative nature of their portfolio, and from the fact that they
do not want the risk of their portfolio to increase. Their ability to assume risk however, is
moderate based on several facts. First, they have a reasonably long time horizon, which
indicates a higher ability to assume risk. Second, their retirement plans and stated return
target both suggest that they need to assume a substantial amount of risk in order to
achieve their objectives. Third, upon retirement they need to generate a substantial
amount of income from their retirement portfolio, which has two implications: the need
for growth over the next five years, and the need for income upon retirement. Finally, the
fact that Liam has experienced recent health problems and that their health coverage will
be terminated upon retirement, suggest an obvious need for liquidity, which restricts the
amount of risk that should be assumed.

Constraints:

Time Horizon. Two time horizons are applicable to the Brennan’s situation. The first is
the short-to-medium term between now and when they plan to retire in five years. The
second is the long time horizon between retirement and when they die, which could be 25
to 30 years, given their intention to retire at the age of 60.
The first time horizon represents a period during which they should be investing in order
to help them be prepared for surviving the balance of the second time horizon, which is
much longer, and as such is the more important of the two.

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Liquidity. The Brennan’s liquidity requirements over the next five years are minimal,
and should consist of sufficient cash reserves to meet emergency needs. However, after
retirement their liquidity needs will increase substantially as they rely on their
investments for income. In addition, their lack of health coverage after retirement, as well
as Liam’s recent health problems, dictates that they maintain higher levels of liquidity
after retirement for emergency purposes.

Laws and Regulations. There do not seem to be any applicable laws and regulations that
immediately concern the Brennan’s.

Taxes. The Brennan’s find themselves in a reasonably high tax bracket, both now, and
during their retirement years, which suggests they should consider including “tax-
friendly” investments such as dividend paying stocks in their portfolio as much as
possible (i.e., as long as they fit with the existing portfolio’s objectives and
characteristics).

Unique Circumstances and/or Preferences. A key concern for the Brennan’s is their
lack of health coverage after retirement, which gains additional importance when one
takes into consideration Liam’s recent health problems. This could cause substantial
unplanned outlays for medical attention, required assistance from nurses, etc.

Summary:

The Brennan’s Retirement Portfolio should be structured with a growth objective for the
near-term and should thereafter focus on a total return approach. Both of these
approaches should attempt to realize a 3% real after-tax return at minimum. These
objectives are complicated by the fact that their willingness to assume risk is low, while
their ability to assume risk is moderate. In fact, this is one of the main complications
facing you as the advisor. They must realize that they are able to, and are going to have
to, accept more risk than that possessed by their current retirement portfolio, or else they
will need to cut back on their spending or generate some income by selling assets (i.e.,
their house). In order to maintain a moderate level of portfolio risk, the portfolio should
be well-diversified, with a heavy emphasis on high-quality securities. In addition, upon
retirement, the portfolio should contain a significant amount of liquid assets due to
income requirements and the risk of having to pay uncovered health expenses. Finally,
tax issues should be considered and the portfolio should include tax-friendly securities to
a reasonable degree.

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3. Suggested Asset Allocation:

Many asset allocations are possible. I have provided two in the table below that can be
justified quite well.

Asset Class Today’s Allocation Allocation in Five


(%) Years (%)
T-bills 5 15
Treasury Bonds 10 5
Corporate Bonds 10 10
Large Cap. Domestic Stocks 25 30
Small Cap. Domestic Stocks 15 15
International Stocks (EAFE) 20 15
Real Estate Invest. Trusts 10 10
(REITs)
Venture Capital 5 0
TOTAL 100 100

Justification of Today’s Allocation:

This allocation is fairly-well dispersed among the asset classes, which provides good
diversification and sets a reasonable limit on portfolio risk. I have not calculated the total
portfolio risk, since there was no specific risk level stipulated in our Investment Policy
Statement (recall that the 10.18% target suggested by the Brennan’s was deemed
unreasonably low)*.

The expected pre-tax nominal return on this portfolio can be easily calculated as the
weighted average of the expected returns on the included asset classes. The expected
portfolio return of 9.225% surpasses the 8.57% pre-tax nominal return requirement. In
fact, this translates into an after-tax real return of 3.46%, which is well above the 3%
objective:
Total after-tax real return = (9.225%)(1 - .30) – 3.0% = 3.46%

* NOTE:
While the question provides sufficient information to calculate the portfolio standard
deviation, I have not done so due to the computational burden involved, and because it is
not really necessary to answer the question appropriately. In practice, this figure could be
easily computed using a computer program or statistical package. It is obvious from the
correlations provided in Table 2 that there appears to be diversification benefits available
from having exposure to most (if not all) of the asset classes, which is consistent with
both proposed asset mixes.

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Specific Comments:

T-Bill Allocation. Liquidity needs are low for the first five years and 5% is sufficient for
this class, given the growth objective during this period.
Bonds. A total of 20% is allocated to bonds, which is a low-to-moderate level that is
consistent with a growth objective, provides diversification advantages, and also assists
in trying to maintain a moderate risk level.
Domestic Equities. A total of 40% is allocated to domestic stocks, with 25% to large
caps and 15% to small caps. This high allocation is consistent with the growth objective,
with more being allocated to the large cap sector than the small cap sector in order to try
and maintain a moderate risk level.
International Stocks. The 20% allocation to this asset class contributes to expected
return and portfolio diversification. This number is maintained at a moderate level to be
consistent with the moderate risk target.
REITs. The 10% allocation to this asset class contributes to expected return and portfolio
diversification. This number is maintained at a relatively low level to be consistent with
the moderate risk target.
Venture Capital. The 5% allocation to venture capital is the most aggressive component
of this proposed allocation. While these funds are volatile, venture capital may provide
higher potential returns and some diversification benefits, so a small percentage
allocation has been incorporated.

Justification of Allocation in Five Years:

This allocation is also well dispersed among the asset classes, which provides good
diversification and sets a reasonable limit on portfolio risk.

The expected pre-tax nominal return on this portfolio can be easily calculated as the
weighted average of the expected returns on the included asset classes. The expected
portfolio return of 8.60% slightly exceeds the 8.57% pre-tax nominal return requirement.
This translates into an after-tax real return of 3.02%, which is slightly above the 3%
objective:
Total after-tax real return = (8.60%)(1 - .30) – 3.0% = 3.02%

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Specific Comments:

T-Bill Allocation. Liquidity needs are higher during the retirement period and a higher
allocation is warranted.
Bonds. A total of 15% is allocated to bonds, which is a low-to-moderate level that is
consistent with a total return objective, provides diversification advantages, and also
assists in trying to maintain a moderate risk level.
Domestic Equities. A total of 45% is allocated to domestic stocks, with 30% to large
caps and 15% to small caps. This high allocation is necessary to obtain the target return,
with an increased allocation to the large cap sector in order to try and maintain a
moderate risk level.
International Stocks. The 15% allocation represents a reduction from the initial
allocation in order to be consistent with a more moderate risk target.
REITs. The 10% allocation to this asset class contributes to expected return and portfolio
diversification. This number is maintained at a relatively low level to be consistent with
the moderate risk target.
Venture Capital. The 0% allocation to venture capital is consistent with a more
moderate risk target.

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