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Private Wealth Management

IPS guideline for exam: Will add to this whenever I think of stuff. -Always review portfolio using RRLLTTU, and categorize the issues they face based on these. -Always remember the following may be pertinent: -emergency portfolio, specific details should be given -possible need for health benefits & life insurance -Use the Sharpe ratio to determine appropriate portfolios -remember, some needs may not be needs (may be wants). These should not be included in the return requirement It wouldnt hurt to read the case study at the beginning of this reading before the review here. Investor Characteristics- Situational profiling is the first step in determining their individual characteristics. From there you can go more in depth. -Source of wealth- this offers insight into their views of risk. Self made individuals will usually be more willing to take risk than people who became wealthy passively. The self made type want to have personal control over the types of risk though, and can be very resistant to risk if it is outside of their control. Passive recipients of wealth take on less risk, as they are less experienced, and less confident that they can rebuild their wealth if they lose it. -Measure of wealth- this measures perception of wealth. An investor who views themselves as wealthy will generally exhibit more risk taking behaviours. If their view their wealth as small though, they will be more risk averse. This also includes how much the investor relies on the portfolio. The more sources of wealth they have, the more likely they are to take risks with this specific portfolio. -Stage of life- Theoretically, an investor will start with very high risk tendencies which will temper as they get older. The foundation stage is when they are just getting started, and have little else than a marketable skill. These investors are young, and can usually take on a lot of risk, as they have a long time horizon to make up any losses. That said, they may have low capital and many expenses, such as children or starting a business. It is ironic that when people can afford to take the most risk, they generally refuse to do so because of other uses of their capital. In the accumulation phase, the investor starts to make money and build their portfolio. They gain experience which makes them more marketable, so their income is higher, and they are earning returns on their portfolio. Expenses also start to increase as well though, and will continue to rise until any children grow up (which is the late accumulation phase). They may also start purchasing luxury items, which hinders their total savings. Next, the maintenance phase is when the individuals retire, therefore foregoing most of their current income. In this phase their focus is on maintaining their investment portfolio, which simultaneously drawing their income from it. If they saved properly during the accumulation phase, this is possible. They usually move out of high risk assets, as they do not have the time to recover from

any potential losses (risk tolerance declines). They cannot be too conservative though, as they need to maintain purchasing power parity. Finally, the distribution phase is when they start thinking of how to efficiently transfer their assets to their beneficiaries. This can be done either in gift form (while theyre alive), or in bequest form, as part of their estate. This is difficult do to tax and legal constraints. This can be done with trusts, foundations, gifts, or their estate, and the benefits of each depend on the individual. -People do not have to follow the above four phases linearly- i.e. they may go back to school at some point, so they can go from any stage back foundation. Illness may move anyone to the distribution stage. -Investment advisors should focus on the information they gather from this process, rather than trying to fit them into a specific category. Psychological profiling-this is observing the psychological process that investors go through in making decisions. This can bridge together the differences between traditional and behavioural finance. -traditional finance holds that investors: exhibit risk aversion, hold rational expectations, and practice asset integration. Rational expectations assume investors are coherent, accurate, unbiased forecasters who will learn from their past mistakes. -behavioural finance holds that investors exhibit loss aversion, hold biased expectations, and practice asset segregation. Biased expectations are when the investor is not properly calibrated, so they will be overconfident, and will exhibit the different themes mentioned before such as frame dependence. -Personality typing- people are shaped by various socioeconomic factors, such as their background, personal experience, and current wealth status. Personality typing tries to determine the drivers that lead an investor to make the decisions they make. This can be done either subjectively by the advisor, or objectively through the use of a questionnaire. The crucial question to ask of these questionnaires is simply do they work. They should consistently assign respondents to risk taking and decision making styles that explain their actual behaviour. If they dont, they do not add much value. -Based on these results, the investor is classified into one of four types of investorcautious, methodical, spontaneous, or individualistic. -Cautious investors are risk averse with a strong need for financial security. They dont like to make decisions, but are not easily persuaded either. Their portfolios exhibit low turnover and volatility. -Methodical investors rely on hard facts, and are always looking for better information. They are not very emotional, and tend to be more conservative than aggressive. -Spontaneous investors constantly adjust their portfolios, and fear negative consequences from not acting quickly. They are sceptical of outside advice, and have high turnover and costs. Most experience below average returns. Are more concerned with missing opportunities than they are with their overall risk levels. -Individual investors are very self assured. They gain information from a variety of sources, and will spend the time necessary in researching. They will make strong if decisions if they feel their information is accurate. -if there is a strong correlation between the questionnaire and their decision making process, the exercise has value- if not, it must be revised. -Methodical/individualistic are based on thinking, cautious and spontaneous on feeling

Investor Policy StatementDefinition- is a client specific summation of the circumstances, objectives, constraints, and policies that govern the relationship between advisor and investor. Also states operational guidelines and a basis for monitoring and review. -Works as an educational process for the client, as they are able to see what their goals are in terms of risk and return and what they need to reach them. An IPS is also portable, so the client can go to other investment advisors if necessary. Setting Return Objectives- Return decision must be made concurrently with the risk decision. Also, it is important to differentiate between return requirements and return desires. A requirement is the return necessary to generate the capital needed to fund all imperative objectives, such as childrens tuition or retirement. A return desire is the amount necessary to fund objectives the client wants, but doesnt need, such as luxury vacations. -There is a conception of income and growth objectives (income for short term, growth for long term), but these terms are flawed. They complicate the asset allocation decision, as income usually means lower risk and growth higher. All required objectives must be evaluated the same (i.e. a total return approach). -return requirements can also be evaluated in nominal or real terms. Normally they are evaluated first on a nominal basis, but even short term goals typically have to consider inflation (real returns adjust for inflation). -A total return approach looks at all of their goals, and the cash flows necessary to meet them. The required return is a function of meeting those cash flows (cash flow analysis) -When return requirements are inconsistent with the risk tolerance of the client, a resolution is necessary. This can be either lowering their expectations, or increasing their risk tolerance (counselling for their willingness, increased savings for ability). -If an investor is ahead of schedule, they can either decrease their risk to protect it, or increase risk to try and reach even higher returns. **See page 115 of book 2 to see an example of examining cash flows Setting Risk Objectives- Risk can be broken down into ability to take risk, and willingness to take risk. Ability is simply based on the traditional numbers approach, whereas willingness is a function of the investors behaviour. -Three questions to ask regarding ability: 1) what are the investors financial needs and goals, both long and short term? This shows the investors liquidity needs and time horizon, as well as the size of their portfolio in relation to the needs they have to reach. 2) How important are these goals, and how serious are the consequences if they are not met? This is pretty simple, the more important the goals and the more dire the consequences of missing them, the less risky the investor can afford to be. The difference between goals and desires is important here, as it is with the return requirement. 3) How large an investment shortfall can the investors portfolio bear before jeopardizing its ability to meet major short term and long term investment goals? The limit of a portfolios ability to tolerate risk is reached when the probability of missing the goals are unacceptably high. That said, willingness will play a role here too. -Willingness to take risk is much more subjective. No absolute measures exist, nor any assumptions that willingness will stay constant. Psychological profiling helps, but

usually the person administering the test will just have a knack for determining this. ConstraintsLiquidity- generally refers to the ability to meet the investors anticipated and unanticipated demands for cash distributions when they come due. Two trading characteristics that determine this are transaction costs (higher transaction costs make assets less appropriate when liquidity is a concern), and price volatility (when liquidity is a concern, large price volatility increases the chance of having to sell the asset at a low price). -liquidity requirements include the need to meet ongoing expenses, having a suitable emergency reserve, and sufficient ability to meet negative liquidity events (such as a charitable gift, or anticipated home repairs). Positive liquidity events can be listed in the IPS as well. They would include future inheritances, etc. -The IPS should specifically mention the definition and amount of illiquid holdings that can be tolerated. This could be real estate, private investments, etc., -The primary residence of the investor can be included in the portfolio as an illiquid asset, or be excluded, and assumed to help meet future housing needs (similar to cash flow matching or defeasance). That said, it can still be a source of short term cash flow issues, with the mortgage and possible repairs/renovations. Time Horizon- time horizons of greater than 15 years can be assumed to be long term, and less than 3 years are short term. Between that is a transition period that investors perceive differently. The second issue is whether the investor has a single or multi-stage time horizon. -Stage of life characteristics are usually correct, but not entirely accurate all the time. Younger investors typically have long term, multi-stage time horizons, but not always. For example, elderly investors may be looking at succession planning, so they are definitely long term. Taxes- probably the most complex constraint, as taxes affect everyone differently. Different types of tax are: -Income tax- a tax charged on income, can be either progressive or flat -Gains tax- tax on capital gains- can have long and short term rates, and is usually lower than the income tax rate -Wealth transfer tax is applied when assets are transferred without sale between two parties. Estate, inheritance, and gift taxes all fit in this category. -Property tax is a tax paid on a real estate, and is usually a small percentage of the value. Is straightforward in theory, but can be difficult due to valuation issues -taxes affect portfolio value in the sense that they proportionately reduce the return for the period, and that they reduce future performance as that value cannot be reinvested. -tax deferral is pretty straightforward- think of RRSP. This can also be achieved with long holding periods on capital gains. Loss harvesting also helps, as it reduces taxes today, at the expense of the future. -Tax avoidance is to avoid all taxes when it is legal to do so. This can be done with tax exempt securities, accounts, or gifting assets to a beneficiary in a lower tax bracket. The cost of these strategies is usually lower return, lower liquidity (minimum holding periods in tax exempt accounts), and diminished control. -tax reduction is structuring the portfolio around assets with lower tax treatment, such as capital gains. Since theyre also only taxed when theyre sold, capital gains strategies

also provide tax deferral benefits. -Wealth transfer taxes are more of a focus for legal and tax experts than a portfolio manager. Strategies for transferring assets depend on the timing of the transfer, and the structure used. Transfers at death is the default, but early transfers, such as gifting and philanthropic gifting may provide better after tax values for the estate. Legal and regulatory environment- these affect individuals much less than institutions, and relates primarily to setting up trusts and foundations. Manager follows the prudent investor rule when seeking qualified legal advise. -the personal trust is set up by a grantor, who drafts a trust document for the purpose and set up of the trust. Theyll name a trustee to administer the trust, who may or may not be the grantor himself. The trust is funded when the grantor transfers assets to the trust. -There are two types of trust- revocable and irrevocable. The first is when the grantor can revoke it at any time, and therefore has a tax liability associated with it. In an irrevocable trust the grantor permanently gives up claim to the assets, so the creation of this is deemed an immediate and irreversible transfer of assets (so a wealth transfer tax is paid). The trust though, and not the grantor is responsible for all subsequent taxes. The family foundation is more common in civil law states. This is an independent entity, typically governed by family members. Can serve as a multigenerational estate plan, and gets younger members involved in managing family assets. Like trusts, foundations are just tools in a succession plan, not the plan itself. -Jurisdiction can be quite flexible depending on the individual, as some countries have both national and regional taxes. By choosing to live in a low tax jurisdiction, they may reduce their tax liability. Unique circumstances- could be anything, such as socially responsible investing, directed brokerage arrangements, and privacy concerns to name just a few. Basically anything not named in the other sections of the IPS. **See page 127 for an example of an IPS Introduction to Asset Allocation-The main goal is to find an allocation of assets that achieves the clients required rate of return without exceeding their risk level. It also must comply will all constraints listed in the IPS. It also must be completed from a taxable perspective by taking into account: 1) after tax returns, 2) any tax consequences of a shift from the current allocation, 3) the impact of future rebalancing, and 4) asset location (tax exempt or regular accounts, etc.). -typically a process of elimination is used to identify the correct asset allocation. **There is another IPS for an investor at this point in the reading** -the normal distribution is usually acceptable as a measure of risk. -once the risk and return requirements have been determined, it is necessary to determine how to achieve those numbers. Typically this is done by 1) eliminating those that dont have sufficient return, then 2) those that are too risky, either in outright risk terms, or those that violate other risk issues, such as too high a probability of exceeding their largest acceptable loss per year. 3) Eliminate portfolios that violate the investors constraints. 4) Finally, evaluate the remaining allocations and diversification attributes and select the one that looks most rewarding for the investor. -make sure all portfolios are compared to the IPS consistently, i.e. after tax, real returns. Monte Carlo Simulation in personal retirement planning- has become much more

affordable, so individuals can take advantage of it. -is the process by which probability distributions are arrayed to create path dependent scenarios to predict end stage results -is better than steady state or deterministic forecasting because it takes variability in long term assumptions into account. Long term averages can be oversimplifications. -very customizable, as ranges can be applied as inputs, rather than just single points -each simulated trial incorporates a potential blend of economic factors, in which the blending reflects the economic factors probability distributions. -has several advantages: 1) probability forecasts are more accurate than point estimates, 2) the simulation can give info on the possible trade off between short term risk and the risk of not meeting a long term goal, 3) takes taxes into account much more thoroughly, 4) takes the variability of returns into account (a good return this year is the base amount invested the following year). This final point can be very complicated, but MC handles it much better. Drawbacks- not every MC product out there is identical or equally reliable; the output is only as good as the data inputted, and historical data varies widely depending on how it is interpreted; the manager should run the MC on the investors actual investments, not just the asset classes. This means taking all fees into account, and other investment specific issues like trading costs); it must take into account all the investors specific tax rate information, which is difficult to understand and implement. -basically the MC tool is very useful, but must be used properly with full knowledge of its drawbacks. **questions 12-14 of reading 14 were left unanswered for later studying. Taxes and Private Wealth Management in a Global Context -most literature is based on pre tax numbers, which makes sense as most institutional investors are tax exempt. Overview of global income tax structures- based on regional, national and local laws. -taxes on income- can include taxes on salaries, interest, dividends, realized & unrealized capital gains. Structure of system depends on locality. -wealth based taxes- taxes on the holding of certain types of property, and taxes on wealth transfers -taxes on consumption- sales & value added taxes. -this reading focuses mostly on income taxes, with some wealth based taxes. This reading focuses on setting up a framework, rather than going into country tax laws. International comparisons of income tax- in most tax jurisdictions, different forms of income are taxed different ways: i.e. capital gains are taxed at a lower rate than interest usually. -Progressive systems are when income taxes for every marginal dollar earned gets higher and higher. -Unless special rules exist (i.e. Argentinean bank interest is tax free), interest income is taxed at the investors regular tax rate. -Dividends are the same, although special rules, such as tax credits and exceptions, are more common. -Capital gains (losses) typically have special tax rules, although they vary greatly from

country to country. Typical rules include lower taxes payable on long term gains, and countries providing favourable tax treatment for domestic securities. General income tax regimes- Common progressive regime- progressive system with favourable tax treatment for all there investment types -Heavy dividend/interest/capital gains tax regime- same as progressive, but the heavy investment income is taxed at regular rates. -light capital gains tax regime- basically a heavy interest and dividends regime -flat and light regime- flat tax with favourable for all three -flat and heavy- flat tax with favourable interest treatment Other considerations- other concerns include tax deferred retirement accounts. These defer tax on returns within the account, may permit a deduction for contributions, or may permit tax free distributions After tax accumulations and returns for taxable accounts- taxes have a substantial impact on future returns. All the models that follow assume a flat tax rate, which isnt that much of a stretch given that within the brackets of a progressive system, the rate is flat as well. Remember, the below equations are used to measure future taxes, so the cost basis is assumed to be equal to the current (todays) market value. Its covered below when thats not the case. Returns based taxes: Accrual taxes- FVIF= [1+r(1-t)]n -this method assumes accrual taxes are paid every year on the return. The after tax return (each year) is equal to the pretax return, r, multiplied by the (1 t), where t represents the tax rate applicable to investment income. -there is a tax drag that accumulates with this method, as the after tax return for the period is less than [1+r]n * (1 t). -The higher the pretax return, and the longer the investment horizon, the greater the tax drag. There is a multiplicative effect if they both increase. Return based taxes- deferred capital gains- FVIF= (1+r)n (1 tcg) (tcg) -This could apply to a portfolio of non dividend paying stocks, as it is very rare to tax unrealized gains, unless they assets are transferred out of one jurisdiction to another. -(tcg) is added back because it represents the tax that is not paid on the original cost basis of the security. This assumes the tax basis is equal to initial cost. -The after tax return in this case is equal to the pretax return * (1 t), regardless of time horizon or pre-tax return. -deferred (capital gains) taxes are more efficient than accrual (interest) taxes. In fact, even if CG taxes are higher than interest taxes, they may still be cheaper in the long run due to the deferral. -In cases where CG taxes are lower, the investor gets a dual benefit. Cost basis- this is generally the amount that was paid to acquire an asset. This serves as the basis for calculating the capital gain. Under some situations the tax basis may be increased, or even transferred from another investor. -the example above assumes that the cost basis is equal to the current market value. In the calculations, the cost basis is measured as a proportion of the current market value (i.e. less than one). That is then multiplied by the (tcg) term at the end of the above equation: FVIF= (1+r)n (1 tcg) (tcg)B

Wealth based taxes- FVIF= [(1+ r)(1 + tw)] n -the above equation assumes these taxes are paid annually. -Wealth based tax rates are much lower than income tax rates, as they are applied to the entire capital based. For the most part they relate the real estate, but can be applied to other things, such as estates. -because they are applied annually, they follow similar rules to accrual taxes. They increase as the time horizon increases. However, wealth taxes are not as sensitive to the investment return, as they apply to the entire capital base. Because of this, their impact decreases when the investment return increases (i.e. if its a two percent tax and returns are two percent, it wipes out the entire gain. But if the gain is four percent, it only wipes out half the gain). Blended taxing environments- the above calculations make the simplifying assumption that the portfolio is only subject to one kind of tax. This is unlikely in real life, because of diversified portfolios having dividends paid, interest, realized capital gains, etc. -interest, dividends and realized gains are explicit numbers, so unrealized gains are the difference between the sum of those, and the increase in the value of the total portfolio (assuming reinvested dividends and interest). r* = r (1 piti pdtd pcgtcg) -the effective after tax return, r*, reflects the tax erosion caused by a portion of the return being taxes as income, and other portions being taxes as realized gains and dividends. It does not capture the tax effects of deferred unrealized capital gains. -holding the tax rate on capital gains constant, the impact of deferred gains taxes will be diminished the more the portfolio that is in some way taxed annually. The effective CG tax= tcg (1 pi pd pcg) / (1 piti pdtd pcgtcg) FVIFtaxable= (1 + r*)n (1 T*) + T* - (1 B)tcg -although this appears pretty crazy, it is the same as the accumulation for an investment taxed entirely as a deferred capital gain, as shown above. The only difference is the treatment of the basis, and that r* and T* are substituted for the other returns. -this equation also reduces to the other ones mentioned above, if the entire portfolio is deferred as a capital gain, or accrued as interest. Accrual equivalent returns/tax rates -An accrual equivalent return is the return an equivalent value tax free portfolio would have to earn to be the same as the original portfolio. Will be lower as it doesnt pay taxes. The difference between the accrual equivalent return and the pre-tax return is a measure of the tax drag of the portfolio. -the RAE is less than R* (return after realized taxes) because RAE takes into account the value of the deferred taxes as well as those that accrue annually. RAE is always lower, but approaches R* when the time horizon increases, which shows the value of deferred taxes (the smaller the gap between the two, the less taxes that are being paid). -the accrual equivalent tax rate is r(1 TAE) = RAE -this is a hypothetical tax rate that makes the pre tax return equal to the RAE - TAE will increase when either the return had a high component of assets taxed at the normal rate, or if dividends and capital gains were taxed at less favourable rates. -can be used to (1) measure the tax efficiency of the portfolio, or asset classes within the portfolio, 2) illustrate to clients the benefits of longer holding periods, 3) assess the

impact of future tax changes. Types of investment accounts-the previous section assumed regular taxable accounts, where the tax payable was based on the type of asset/and or style of the portfolio. -tax advantaged accounts are predominantly set up to encourage retirement savings -three types of investment accounts; taxable, tax exempt, or tax deferred. Taxable were covered above, and include after tax contributions. Tax exempt are contributed with after tax money, but all gains and future distributions are tax free. Finally, tax deferred are made with pre-tax money, and the gains accrue tax free. The investor is taxed at their income rate on withdrawals however. FVIFTDA= (1 + r)n(1 Tn) -just remember, the contributions are pre tax. FVIFTaxEx= (1 + r)n -these contributions are after tax After tax asset allocation- 1.5mm in equity in a TDA, & 500K of bonds in a tax exempt account. Traditional view is 2MM in assets with a 75/25 split. -the true MV is 1.4MM, with a 64/36 split, as the equity is taxable, and the bonds are not. -taxable accounts would complicate this, as time horizon and portfolio construction come into play. The main decision making point with contributions between these is whether the investors tax rate is higher now, or will be when the funds are withdrawn. If its higher now, TDA is better because you save with the pre tax contribution. If itll be higher later, TEA are better, as you dont have to pay tax when its withdrawn (when your taxes are higher). -Another way to look at it with a TDA, is that once the funds are invested, the taxing authority owns Tn of the principal. Tn is the tax rate when its withdrawn. This is true regardless of the asset type held. -value of a pretax dollar invested in a TEA is (1 T0) (1 + r)n . the implication is that taxes reduce the beginning investment. Implications for wealth management- using the below techniques is called tax alpha Asset Location- typically asset class decides tax treatment, but when tax preferred accounts are available, there is an interaction between the accounts and the classes -the choice of where to place an asset is called asset location -basic strategy is to hold their heavily taxed assets in tax preferred accounts, and lower taxed items in the taxable accounts. Then, you can borrow and short assets to make the asset allocation fit. (i.e. borrow bonds, which is taking a loan, and invest in stocks) -impediments to this strategy are borrowing costs, liquidity constraints, etc. -municipals bonds in taxable accounts, and stocks in TDAs is not a great strategy, as the municipal bond return will be lower than the added tax savings on the stocks, as they receive preferential tax treatment. Better to put regular bonds in TDAs, and stocks in taxable accounts -in a regime where everything is taxed annually, asset location doesnt matter, as all assets have the same tax treatment. -other factors that influence this decision are behavioural constraints, access to credit facilities, age, time horizon, and investment availability.

Trading behaviour- below assumes that there is a difference between long and short term -trader- this is an investor who trades frequently, so they do not get the preferential long term tax rate. They are essentially taxed at the income tax rate. -active investor- doesnt trade as frequently as the trader, so they do get some of the benefit from the capital gains tax -passive investor- all holdings are intended to be long term. Benefits the most from the lower tax rate -tax exempt investor (institution)- does not pay tax regardless, so their decisions are not affected by tax law. -Optimal asset allocation and location are likely to be different for each four. **see page 200 for the calculations -holding all else constant, the trader accumulates the least, while the tax exempt accumulates the most. -because of this, trader/active investors must have a pre-tax returns that is far superior to that of passive investors, as they must pay higher tax rates (and higher txn costs) -another strategy is to be a trader in the tax preferred accounts and passive in the taxable ones (does not advocate trading just for the sake of it though, as there are still txn costs) Tax loss harvesting- not all trading is necessarily tax inefficient. If an investment is sold at a loss, the investor is allocated to use that loss to reduce the taxes paid on their capital gains. -some jurisdictions do place caps on the amount of losses that can be realized, and the type of gains they can be matched against (i.e. short or long term gains). -tax loss harvesting is the process of actively realizing losses to reduce the amount of current taxes paid. -this comes at the expense of future taxes though, because youll have to purchase an identical asset back at market value. This means that youll have a higher future tax liability (or less of a tax asset) -most jurisdictions wont allow for a sale and subsequent repurchase -the benefit comes due to the time value of money, as tax savings now are better than equivalent $ value tax savings in the future. This is because you can invest the money today and earn a (hopefully) positive return -a related idea to tax loss harvesting is HIFO, where the investor is allowed to sell their highest cost lots first. This allows the investor to delay taxes paid (and expedite tax losses) -this benefit is greater in jurisdictions with higher capital gains taxes -this benefit is not as great when theyre in a lower tax bracket, and is especially a bad idea when youll be in a higher tax bracket in the future Holding period management- this strategy is to take advantage of lower CG taxes on long term holdings -in an area where there is a 20% long term rate, and a 40% short term rate, by trading before the threshold, you are foregoing 20% of the investment. If the trader insists on trading heavily, they must generate sufficiently superior pre-tax returns to account for the taxes paid -other areas of holding period management are more tactical. If investors are taxed on a calendar basis and are thinking of selling stock in December, it may make sense to wait until January. Then the taxes are due in the following tax period. The attractiveness of

the asset compared to alternative investments must be considered as well. After tax mean-variance optimization- pre-tax optimized portfolios may not be optimal in an after tax setting (i.e. different efficiency frontiers pre-tax and after-tax) -an important concept to note is that an asset held in different types of accounts will yield distinctly different accumulations. i.e. stocks and bonds can be four securities (if we only consider 1) taxable accounts and 2) tax preferred accounts). -therefore it may be beneficial to substitute accrual equivalent returns/standard deviations for pre-tax returns/standard deviations in the optimization decision -optimization must also include related constraints like the level of assets allowed to be held in tax preferred accounts. Estate Planning in a Global ContextDomestic estate planning- estates, will & probate-elements of an estate can be different for tax and legal purposes (i.e. assets in a trust) -a testator is the person who authored the will, and whose assets will be transferred -probate is the legal process to confirm the validity so that the interested parties can rely on its authenticity. A person without a will is said to have died intestate -probate can be avoided by joint ownership, living trusts, or retirement plans -Civil law was developed primary through legislative statutes or executive action. Common law systems are developed primarily through decisions in the courts. -Sharia (Islam) is similar to civil law in regard to estate planning -common law counties allow a testator to have freedom in determining the rights others will have to their property after death. Civil law does not typically give the same freedom. -trusts are mostly a common law thing- some civil law countries do not even recognize trusts (such as France and Germany) -forced heirship rules state that children have a right to a fixed share of parents assets, and it does not matter if theyre estranged, or conceived outside of marriage -these can attempted to be circumvented with things like lifetime gifts, but there are clawback provisions if the remaining estate is not large enough to cover the childs share -common property rules are similar, as a spouse has an indivisible claim to half the income earned during marriage -Civil law countries may have separate property regimes, so the spouses keep their assets separate Income, wealth, and wealth transfer tax- types of tax are income taxes, spending taxes, wealth taxes, and wealth transfer taxes -wealth transfer taxes take two forms- lifetime gratuitous transfer taxes, and testamentary gratuitous transfer taxes. Taxation of both of these depends on the residency or domicile of the donor and recipient, the tax status of the recipient, the type of asset transferred, and the location of the asset. -the taxes may be levied against the transferor or the recipient. -tax rate may also depend on the relationship of the two parties, i.e. spousal transfers are often tax free. Core capital and excess capital- the challenge of sustaining wealth over generations is that they may grow exponentially over time, and taxes may erode the value of the

portfolio. -the starting point of developing an estate plan is deciding how much wealth to transfer to future generations, philanthropic causes, or elsewhere. The answer begins with determining how much the current generation need to retain for their own spending. -there is an idea of a life balance sheet, with all assets and liabilities. This includes human capital. -liabilities include explicit ones such as mortgages/loans, while implicit liabilities include the capitalized value of the investors desired spending goals (retirement, childrens education, etc.) -the amount of capital required to fund these necessary spending goals is called core capital. -an investor has excess capital if they have enough to fund these required spending needs, and this amount can be transferred without jeopardizing the investors lifestyle Estimating core capital with mortality tables- the most straightforward way to determine core capital is to look at the investors spending needs over their remaining life expectancy. A large enough buffer is necessary though, as around half of the investors will outlive their life expectancy. -can be done with either nominal values and interest rates, or real values and interest rates. -another approach is to calculate the expected future cash flows by multiplying the explicit cash flows by the survival probability. p(survival)= p(Husband survives) + p(wife survives) p(husband survives) x p(wife survives) PV(Spending needs)= Sum of [(p(Survivaljj) x spendingj)/ (1/r)j] -The numerator is the expected cash flow for year j. -The sum of each years present value of expected spending equals their core capital needs. -the approach can be modeled to take into account different spending needs if only one spouse survives. -discounting this formula with the risk free rate is appropriate, even if mortality risk is non-diversifiable and non-systematic. This is because it can be hedged with life insurance. Discounting with the rate of return on the assets is not suitable as the spending needs of the investor is not related to the ROR on the assets. -typically these calculations will give results that a bit too optimistic in the real world, as capital markets expectations and the investors life expectancy can be much different than forecasted. The defence of this is to augment the calculated core capital with a safety reserve. This reserve can be calculated subjectively. -Safety reserve also allows the investor to change their spending habits. Estimating core capital requirements with Monte Carlo analysis-rather than discount future expenses, this method estimates the size of a portfolio necessary to generate sufficient withdrawals to meet those expenses. It does this by generating paths that conform to the rules and constraints of the portfolio, which generates a distribution of possible outcomes. - you can incorporate future spending needs, irregular liquidity, taxes, inflation and other considerations into the analysis. -to estimate core capital, the wealth manager may estimate the amount of capital necessary to support spending in 95% of all trials. Higher confidence level leads to

higher amounts of core capital. -safety reserve may still be added to the core capital estimate. -Milevsky and Robinson developed a method of calculating similar results to Monte Carlo, but without the need for simulation. Their analysis includes life span uncertainly, and financial market risk. The end product is an array of ruin probabilities, which are dependent on their retirement and median age of death, and their real annual spending. -it holds the mean arithmetic return, and the volatility constant. -asset allocation affects the expected return and volatility. Higher return implies a lower necessary core capital. Volatility decreases the sustainability of a spending program for two reasons: A) volatility decreases future accumulations ($100 * 150% * 50%= only $75). The second reason is due to the periodic withdrawals from the fund. The end value of the portfolio over a series of periods does not depend on the order of the returns (a gain of 10% followed by a loss of 5% is equal to a loss of 5% followed by a gain of 10%). This is not the case though when there are periodic withdrawals. The funds may have to be withdrawn at an inopportune moment, with can severely affect the funds future value. Diversity is particularly useful here, as it reduces the overall portfolio volatility. Transferring Excess Capital- the next difficulty once youve determined your core capital + safety reserve, is to work out a plan to most efficiently transfer your assets to the ultimate beneficiary. Lifetime gifts & testamentary bequests- most jurisdictions that impose estate taxes typically impose gift taxes as well. Otherwise it would be very simple to avoid them. -some gifts can avoid taxes by falling below a certain threshold. Some countries allow gifts up to a total dollar figure (100,000 ZAR for instance) before they impose a tax. -even if no gift exclusions exist, it can be tax efficient to start a program early and transfer the assets slowly over time. This is magnified if there is a small exclusion amount (in the US its $13,000 per child per year). -the amount of wealth transferred is also higher because it is given time to accumulate in the donees portfolio. So a gift of 10,000 today is obviously worth much more than 10,000 10 years from now if it can be done tax free. -in general, the relative after tax value of a tax free gift made during ones life compared to a bequest made a death is equal to: RVTaxFreeGift= FVGift/FVBequest= [1 + rg (1 tig)]n / [1 + re (1 tie)]n (1 - Te) -the above equation is for a tax free gift. -i stands for investment (i.e. return or tax), e for estate, and g for gift (i.e. donee). -if the investment returns are the same for the recipient and donor, the equation reduces to 1/(1 Te). -taxable gifts- RVTaxableGift FVGift/FVBequest= [1 + rg (1 tig)]n (1 Tg) / [1 + re (1 + re(1 tie)]n (1 - Te) -again, if the investment returns are equal for both parties, the equation reduces to: (1 Tg)/( 1 Te). This means that if the gift tax rate is less than the estate tax, gifting can still be efficient. -in a progressive system (gift and estate taxes get larger with the dollar value), it is more tax efficient to use small gifts over time than to do all of it at once at death. -even though the gift may be smaller than eventual bequest (due to it compounding in the estate), that does not mean that the gift is more efficient as the gift tax applied up front

will reduce future returns. -another strategy is to gift higher return assets to the younger generation. No risk this will work though, as the assets inherently have a higher volatility. Location of the gift tax- who pays the tax has important consequences. First of all, if there is a cross border transfer, both parties may have to pay tax. Second, if the tax is paid by the donor, this strengthens the case for gifts vs. bequest. This is because it reduces the total value of the taxable estate, rather than decreasing the amount that the party receives as a gift. The relative after tax value of a gift when the donor pays the gift tax is: FVGift/FVBequest= [1 + rg (1 tig)]n (1 Tg + TgTe) / [1 + re (1 + re(1 tie)]n (1 - Te) -the term TgTe represents the tax benefit from reducing the taxable estate by the amount of the gift tax. This can be viewed as a partial gift tax credit= TgTe * gift amount. -this also saves the hassle of when someone is gifted an illiquid asset. Generation skipping-where permitted, generational skipping is an efficient strategy because taxes are only paid once, to presumably someone who is in a lower tax bracket. Taxes would normally be paid twice to get them to a grandchild. -some jurisdictions impose a generational skipping tax that makes donating directly to the grandchild, or indirectly through the parent equivalent. Spousal exemptions- spouses usually have exemptions to transfer to each other tax free. Smaller estates also can sometimes skip estate taxes (usually a maximum tax free amount, available to each spouse). If the minimum is excess capital that will likely be transferred once the other spouse dies, the spouse should gift it to someone else tax free while they have the opportunity. Valuation discounts- this is taking advantage of securities that are discounted more than other securities, i.e. shares in private companies, shares with a minority/illiquidity discount. By transferring these, the tax will be lower as its assessed at a lower rate. Deemed dispositions-some countries treat bequests as a sale, and treat any unrecognized gains as realized. In cases with deemed disposition regimes, it may be more beneficial to gift highly appreciable assets. Charitable Gratuitous transfers- in most regimes, charitable gifts are not subject to a gift tax. Also, many of these regimes offer income tax deductions for the amount of the gift. -see page 245 for charitable tax benefit equation. -the tax advantages allow the donor to either donate more with the same money, or donate the same with less money than if there was not any tax benefit. Estate Planning Tools tools include trusts, foundations, life insurance, and companies Trusts- a trust is not a legal entity- it is a relationship in which the trustee holds and manages assets for the benefit of the beneficiaries. The trustee is considered the legal owner, and the beneficiaries are the beneficial owners. All the conditions are laid out in the trust document. -in a revocable trust, the settlor is considered the owner for tax bankruptcy purposes. In an irrevocable trust, the trustee/trust is liable for tax payments. -a fixed trust has terms that dictate the distributions to the beneficiaries. A discretionary trust gives the trustee the control. Also, the beneficiaries have no legal avenue to the assets, so creditors cannot touch it, because the trustee can choose to stop distributions for a while. -in terms of tax in a (irrevocable) trust, the taxes may be lower than if they were still held

by the settlor. Also, if its discretionary, distributions can be timed to minimize the taxes payable. Foundations- a foundation is set up to hold assets for a particular person. Unlike a trust, it is a legal person. Life Insurance- can be useful in civil law countries where trusts are not recognized. -is afforded beneficial tax treatment in many jurisdictions. Premiums are not considered part of the estate, and the benefits may tax exempt. -also allows the beneficiaries to receive assets without having to deal with probate. Also can be useful to provide cash to pay inheritance taxes. -specific laws include the need for the beneficiary to have an insurable interest in the person. They can also be combined with a discretionary trust to provide for beneficiaries who are unable to provide for themselves. Companies and foreign controlled companies- companies can be set up in foreign countries with the sole purpose of managing family assets. Benefit can be that taxes can be deferred until they are distributed to shareholders, and that there is control over distributions. -there are various rules to discourage these, i.e. if one investor holds more than 50% of the shares, etc. Deemed disposition may take place on earnings of the company, even if distributions have not been made. Cross border estate planning- passing ownership upon death may be difficult, and may trigger multiple tax liabilities. -the Hague conference is an intergovernmental agency that works towards the convergence of private international law. **Check text page 250 for the details. Tax system- there are residential and source tax jurisdictions. Residential is taxing an individual based on where the live, regardless of where the income generated. Source taxation is based on where the income was generated, rather than where they live. -residency tests vary by country, but depend on social, family, and economic ties. taxation of wealth and wealth transfers- residency/source taxation issues can arise on wealth and transfer taxes as well. **read the text to get the specifics of this section as well. -source/residency conflicts can lead to possible cases of double taxation. Also, two countries may claim residency of the same individual, two countries may claim the same source jurisdiction (i.e. a company changing jurisdictions). -in source residency conflicts, the residency country is usually expected to provide relief, if there is any. -tax credit method- in this method, the tax payable equals the greater of the source tax or the residency. If the source is larger, residency gets nothing, if residency is larger, they get the difference. -exemption method- in this method, the residency country exempts the income from taxation, so the investor only pays source taxes. -deduction method- this method allows the investor to deduct any foreign taxes paid on their tax return. = TR + TS - TRTS -US provides estate tax relief from foreign countries, but not gift tax relief. May be advantageous to forgo gifts until they become bequests. Double taxation treaties- these are treaties between countries that try to limit double taxation by limiting source jurisdiction. Most countries use the OECD Model treaty,

which sanctions the credit and exemption methods. -this treaty holds that interest and dividend income have their source in the country paying the interest/dividend. It advocates low WHT rates to the source country, so the residency country gets some too (if using the credit or deduction method). -in contrast, capital gains are based on the location of the person selling the assets. Gains on immovable property are taxed based on the country they are sourced though. -DTTs resolve residency/ residency conflicts by providing a criteria to determine residency. This includes the location of their permanent home, the center of their vital interests, their habitual dwelling, and their citizenship. -DTTs do not typically solve source/source conflicts. Transparency & offshore banking- this section relates the increasing transparency of the international banking sector, and the increasing sharing of information between countries. -bank secrecy provides legitimate benefits such as security, intra-family dynamics, privacy, and politics. Low Basis Stock- while under US tax law the basis of a security does not have to equal the purchase price net of commissions, it usually is pretty close to that figure. -low basis stock can be acquired through an estate, stock acquired privately before the company went public, the sale of a company for stock, stock options, or simply a very astute stock pick. -the two main issues in dealing with low basis stock are psychological and investment barriers (including tax). A holding may mean a lot to an individual as its been good to them, and they may have loyalty to it. Or it was given to them by a loved relative, etc. -investment concerns are the risk/return issues of it, and of course the tax issues of a sizeable taxable gain that will be generated up its sale. Understanding stock risk- typical breakdown of market & specific risk, as well as regulatory risk (tax authorities reject the tax treatment youve chosen. Equity holding life- there are three stages: Entrepreneurial stage- dealing with only an idea, specific risk is very high and the company is very immature. Most/all of the wealth of the person is tied up in the company. Executive stage- this is when the company is taken public. They still have high specific risk as the company is not diversified, but theyve accumulated some personal wealth to invest in other things. Investor stage- this is when the company is mature, and when the investor moves to transition their portfolio to be more diversified. This stage is when you move from creating wealth, to protecting and growing wealth. This stage starts at the diversified investor level, and may move to the indexing stage, which is the ultimate in diversification. -the greatest challenge is going from the executive to the investor stage. This involves lowering your holding somehow (to diversify in other securities) which creates psychological problems and possible tax issues. -the key to going between these stages is getting the investor to realize the difference between an operating investment and a financial one. Reducing a concentrated exposure- there are various ways to reduce an exposure, generally where the taxes paid are inversely related to their complexity/difficulty.

-Outright sale- simple but expensive, as it will generate a significant tax liability. -exchange funds- an advisor brings together a number of individuals, each having a different concentrated position, and invites them to pool their assets. Public exchange funds- the investor must enter into this fund for seven years, and the portfolio has to be 20% illiquid assets. The portfolio is then diversified immediately and in seven years, as the fund is liquidated, with each person getting a proportionate share of the fund. The drawbacks are management costs, lack of control, and inflexibility. Also, the tax basis for this diversified fund is the original tax basis, so the tax liability is only delayed. Private exchange funds- relatively new idea- still unproven. An investor with a low basis position teams up with someone who just purchased the holding at its current market value. They then start a series of partial hedges, borrowing, and reinvestment transactions. The investment of an unrelated investor with a goal other than the hedging of the security is thought to be the part necessary to make it qualify as a private exchange fund. The benefits are twofold- the hedging allows the investor to borrow at better rates, and it softens the psychological blow of selling the security. Private exchange funds do not have the same drawbacks as public funds, such as exposure to illiquid assets and lack of investment control. Completion portfolios- single asset class- investor needs to have other liquid investments. The point of this method is to allow the investor to create a portfolio that behaves like a desired index or basket by combining the liquid assets with the low basis holding. The first way of doing this is the reinvest dividends to purchase further diversification. The other, more sophisticated strategy is use a passive structured strategy. The manager would reinvest dividends, and would also harvest any tax losses on the liquid portfolio to chip away at the large tax liability of the low basis holding. -multiple asset class- this is when the investor uses other asset classes in the completion portfolio, i.e. using small cap equities to shelter the taxable gain on a large cap equity. This produces more diversified returns and volatility. The drawbacks are that you need a large pool of liquid assets at the outset, and that it takes a long time to reduce the tax liability. Therefore at the outset the investor is not hedging the low basis position. Hedging Strategies- the investor has to be careful how they hedge, as the below can be considered constructive sales. 1) short sale of the same or substantially identical property, 2) an offsetting notional principal contract with respect to the same or substantially identical property, and 3) a futures or forward contract to deliver the same or substantially identical property. -the key decisions to make is do they want to protect their gains or let profits run, and/or get the money out of the position without triggering a taxable event. -the first question is the hedge or not, the second is to monetize or not. -equity collars- this can be a pure hedging strategy. Same as any other type of collar, but the key decision is making sure they dont run afoul of constructive sale rules. The different types depend on the cost, as whether theyve costless, or cost or make money. -monetizing the position- you can monetize the position after a collar has been implemented. You can borrow anywhere from 50-90% of the strike price of the put option. -a variable pre-paid forward is a forward sale of a contingent number of shares of an underlying stock with an agreed future date, in exchange for a cash advance today.

-the relative attractiveness of a monetized collar or a variable pre-paid forward relates to the deductibility of the interest paid on the borrowings associated with the collar. -from a psychological standpoint, hedging seems to be the best option as you delay the sale, and still reserve a bit of the upside. Goals based investing: integrating traditional and behavioural finance -with this approach, investment principles are redefined to the viewpoint of the investor rather than the practitioner. Risk management is also redefined to measure the risk of failing to meet investor goals. Strategies are then implemented to meet each goal, rather than one single portfolio strategy. The benefit is that the investor has a much clearer understanding of their goals and risks, while the drawbacks relate to the higher complexity. Meeting investor goals- are best stated in terms of lifestyle needs, wealth transfers, and charitable gifts that will ultimately be applied. Risk measurement- in the traditional sense, risk is related to standard deviation, kurtosis, heteroskedasticity, etc. In the behavioural sense, risk management is measuring the probability that goals will not be reached. -traditional finance says that investors are risk averse, while behavioural finance says that investors are loss averse. -many risk measures are time sensitive (i.e. annualized), which leads to issues in terms of under/overestimating the risk. To combat this, risk measures can be used that do not state a time period- i.e. the probability of not reaching a goal. Risk profiling- this is done to determine the investors risk profile, i.e. the ability and willingness to assume risk. Ability is based on traditional factors such as time horizon, liquidity constraints, etc., while willingness is based on behavioural aspects. Profiling is determining the behavioural aspects. A questionnaire is best able to do this, although subjective analysis based on experience helps as well. Decision framing- this is when subtle differences in the way the question is asked can lead to substantially different answers (i.e. saying 50% chance of success vs. 50% chance of failure). The implications are that the questionnaire should be very carefully worded to not have any positive or negative connotations (i.e. be neutral). Mental accounting- this is where you have multiple attitudes about risk, with different tolerances for different goals. People are very risk averse with their childrens education funding, for example. This is inconsistent with traditional finance because it advocates a total return approach for all goals. Managing behavioural biases-Overconfidence- this is when investors have too narrow a confidence interval, so they are surprised far too frequently. It also leads to higher trading (and costs). Hindsight bias- this is when people believe they predicted something, when they in fact, did not. Leads to overconfidence, and leads investors to question advisors when something was obvious in hindsight, even if it was difficult to predict ex ante. Overreaction- people are overly influenced by random events. If they lose money in stocks due to a crash, they may be hesitant to invest in stocks in the future. Belief perseverance- this is when people are unwilling to change their opinions, even when new information becomes available. Regret avoidance- is the tendency to avoid actions that could create discomfort over prior

decisions. Leads to losses from holding onto losers for too long, as selling would mean the investor would have to admit to making a bad decision. Goals based investing is a process to try and reconcile all of these behaviour and traditional methods into a process that best works for the client. It does this by reducing the frictions between the investors and practitioners perceptions. Implementing a goals-based approach- client goals are based on the investment portfolios eventually use, such as current or future lifestyle needs. Risk management objectives are stated in terms of risk measures that are best matched to the particular goal. Goals are combined into asset pools based on similar characteristics. These asset pools are then combined to create a full investment solution. -the benefits are that it is much more clearly defined for the investor, and makes describing the job of the portfolio easier for the advisor. The main drawback is its complexity, which makes it challenging to implement. A way to reduce the cost would be for the practitioner to create a suite of investment products, and then use those to determine a portfolio allocation that fits for each client (rather than a custom one for each client) -regular asset allocation models work best for clients without specific goals Investing to meet current lifestyle needs- trade-off between higher expected cash flow returns and worst sustainable spending rate (i.e. if you choose a risky portfolio, it has the potential to lose significant value). -it is not just the end result that matters as well- it is the path that is taken to get there. An outcome might be reached, when before it looked unlikely that it would be. It is possible that in such a situation the investor may lose faith, and adjust their allocations to minimize potential losses (i.e. allocations are path dependent). -the probability that a minimum sustainable spending limit may not be reached is an effective way to convey the risk of the portfolio. It is event specific rather than time specific risk measure. -the practitioner cannot solely rely on risk measures that are meaningful to the client. However, the expected sustainable spending rate is dependent on the return of the portfolio, and the worst possible sustained spending rate is dependent on the downside risk of the portfolio. The portfolio manager can then use the portfolio return and downside risk to implement a suitable allocation. -the basis process is that the investor determines the minimum spending rate they can handle based on their current lifestyle needs. Then, based on the amount of risk that must be assumed to meet that minimum goal, the investor and manager then implement the allocation with the highest return that still meets the minimum loss requirement. -put differently, performance objectives are absolute, rather than relative. Cash flow matching- in some instances, current lifestyle goals can be stated much more precisely. In these cases, laddered bond portfolios can be the best option to make sure that all goals are reached. The process to follow is to pick a bond that matches the last cash flow, then work backwards so that all cash flows are paid for by bond coupon/ principal payments. The drawback of this strategy is that it is very conservative, and it may better serve the clients needs to try a more aggressive approach Investing for a fixed planning horizon- fixed planning horizon could coincide with a life event such as retirement or childrens university, or simply as an arbitrary date for planning purposes. Reward can be measured as the expected portfolio value at the

horizon date, or the expected growth rate. Risk can be measured one of two ways- 1) recognizing the amount of capital that could be lost, and viewing losses as the opposite of growth. The 2nd approach is to measure the worst portfolio value, given a 99% confidence interval. This approach is a period specific risk however, that does not consider the path the portfolio takes to get there (which may not be appropriate for all investors). -Fixed horizon strategies- risk free investment for a relative return strategy is the index, cash for absolute strategies, and a high quality zero coupon bond that matures near the horizon date for fixed planning strategies. -when the risk free horizon is cash, invest enough in cash to reach the minimum, then invest the rest aggressively to maximize returns -for relative returns strategies, set a target for the worst portfolio value. Then pick the best returning portfolio that still meets this minimum. -for a fixed horizon strategy, we consider cash flow matching: 1) is the horizon likely to change, 2) is the investor satisfied with the lower return, 3) can the investor tolerate the volatility of the zero coupon bond, knowing that the principal payment doesnt change, even if the market value does? Lifetime Financial Advice: Human Capital, Asset Allocation, and Insurance-risk tolerance depends on both the willingness to take risk, and the ability to do so. -younger investors have higher ability take risk, which is a direct application of the human capital approach. Since their financial portfolio is small compared to their human capital, they can afford to be more aggressive with it. What is human capital- it is defined as the economic present value of an investors future labour income. It should be treated like any other asset class; it has its own risk and return properties and its own correlations with other financial asset classes. Role of Human Capital in Asset Allocation- the asset allocation decision is far and away the most important. A fully tenured professor has little need for fixed income securities, as his income is very stable. He could do well to increase his exposure to equities in his financial portfolio. His students however, have human capital that closely resembles equities, so it would be a good idea to have some allocation of fixed income. (however, as they are young, they can handle more volatility). -most empirical evidence shows that most people dont efficiently allocate their total assets. Also, by viewing a survey that says human capital is not correlated to stocks (roughly -.2 to +.1), many people have over invested in risky assets. -in most households, human capital is by far the majority of capital in the household -the equation to determine human capital is that is the inflation adjusted earnings before and after retirement (adjusted for social security and pension payments), discounted at an inflation adjusted discount rate. -next, the utility (CRRA level) of the investor is determined by summing the human and financial capital of the investor, and adjusting it based on their total correlation between the two. **see page 323 for the equations -CRRA risk tolerance levels, 1-10. Double check for which side is risk taking. -when human capital is risk free, they should invest fully in stocks, and then scale back slowly to bonds over time, as human capital is becoming smaller. Also, they lose time to

replace any losses they take on. -when human capital is risky, it can be risky in the sense that it is related to market movements, or just risky when it comes to keeping employment. -when its correlated with the market, a perfect example would be a PM. He makes more money when the market goes up, makes less when it goes down. If he and a schoolteacher have the same income, age, risk tolerances, etc., he should invest in more bonds, as his human capital is more invested in equities. -when it is risky, but not related to the market, the investors proper allocation is very similar to that when HC is risk free. The only difference is that when the risk of their human capital increases, they should reduce their financial portfolios risk, to keep total risk constant. -when an investor has a lot of initial wealth, their investment can be more moderate. This is because HC does not dominate their portfolio, and their allocations can look a little more normal. -correlations of wage growth bills and the stock market lead to higher allocations to fixed return assets. -financial advisors should be aware that: a) they should invest financial assets to diversify/balance out human capital, b) a young investor with stable income should invest heavily in risky assets, c) an investor with HC that is highly correlated with the stock market should invest more in fixed income. -therefore they need to determine if HC is risk-free or risky, and if it is correlated with the stock market. Human Capital, Life Insurance, and Asset Allocation -human capital and life insurance are perfectly inversely related -how much life insurance to get should be part of the asset allocation decision -in deriving the optimal insurance demand, the two important components are the expected value of human capital, and the risk return characteristics of the insurance contract. -empirical studies have shown the underinsurance is common, which is mostly due to questionable financial advice, inertia, and the unpleasantness about thinking of ones death. -the following model assumes one year, renewable term policys are used. -see page 334 for the model, but the point is to maximum utility, which is the sum of the living utility, and dead utility. -important factors are how much the investor wants to leave a bequest, the conditional probabilities of death, their wealth level, and their level of human capital. -human capital is the central factor. -all else being equal, as the correlation between shocks to income and risky assets increase, the optimal allocation to risky assets declines, as does the optimal quantity of life insurance. -the reason is that the higher correlation leads to a higher discount rate to human capital. This lowers its present value, which lowers the amount of insurance needed to replace it -the bequest motive is second only to human capital levels in terms of the importance to how much insurance to purchase. -also, investors with less risk tolerance will buy more insurance, as will people who feel they have a higher probability of dying.

Retirement Portfolio & Longevity risk-an investor has two goals in regards to retirement- the primary one is to ensure a comfortable lifestyle in retirement. The second is to possibly leave a bequest -there are three risks to consider once youre retired- financial market risk, longevity risk, and the risk not saving enough (spending too much). Inflation is included in the third one Financial market risk- this is the risk that although they rise in the long run, they may lose a significant amount of their value in the short run. To put it another way, even if the assumed long term returns may be sufficient to meet the cash flows into perpetuity, there is a risk it will fail to do so because of the volatility of those returns in the short run. Monte Carlo analysis can be used to model the probabilities of failure. -Longevity risk- this is the risk out outliving your assets. Most investors arent rich enough when they retire to live off of their portfolio without reducing the principal on their portfolio, and even those that are may fail to do so anyway. If they life for a long time they may run out of money. Also, most retirement plans only expect the individual to live until 85. -The risk of spending uncertainty is pretty self explanatory, and includes the risk of inflation overwhelming the portfolio. There is also the risk that the investor will not save enough to support their spending needs (different from longevity needs). An example of investors not saving enough is that many do not even contribute enough to their work pension plans to maximize employer contributions. -to control these three risks: -financial market risk can be mitigated by using modern portfolio theory -longevity risk can be mitigated with insurance products such as annuities -saving/spending risk is mostly behavioural, so counselling may help. -longevity has zero financial benefit. The way to protect yourself (if you dont have a DB pension plan) is to purchase annuities which will pay until death. -in terms of not saving enough, SMarT plans may help, as you are getting investors to contribute parts of future raises to their retirement. Viewing this as money they didnt have before, more are willing to do so. Longevity Risk & Sources of Retirement Income-Social Security (SS) and defined benefit pension plans dont have longevity risk, as they last until you die. -DC plans have considerable longevity risk, as they rely on the investors contributing and managing their own portfolios. The main defence, as mentioned above, is an annuity, but the risk of them is that if they die quickly, they will have paid quite heavily for it. They also are not available for bequest, as they do not pay out once the beneficiary passes away. Longevity risk & payout annuities- payout annuities are the inverse of life insurance, as the buyer is worried about dying too far in the future. There is also fixed and variable annuities. Fixed are fixed in their payments, so they are susceptible to inflation. Also, they reflect the interest rate at the time they were purchased, so if you buy them when rates are high, the payout will be low. -variable annuities are tied to the fortunes of some underlying index. -typically the best alternative is a combination of fixed and variable annuities, as well as systematic withdrawal. -