CFA Level 3 - Portfolio Management

CFA Level III Portfolio Management
#1

Hi,

Hope you all had a good weekend. Hoping to brain storm the below question on wealth management.

Question:
"Stephan and Lelia Jackson are both 41 years old, with two young children aged 2 and 6 months.

Both have combined pretax annual income of $280,000. Current living expenses of the family are $103,000 per year. Both income and expenses are expected to increase in line with inflation.

The Jacksons intend to work until their children go to college in approximately 18 years’ time, at which point they hope to have enough funds to provide for the tuition fees of the children and for their own retirement. They estimate that tuition fees will be $100,000 for each child and that they will require funds of $2 million to provide for their retirement, both stated in real terms.

The Jacksons own a residence valued at $1 million, with a mortgage of $225,000 against the property. Mortgage payments are fixed at $1,000 per month, a figure that has been included in annual living expenses given above. They are making improvements to the property over the next year, which they estimate will cost $310,000. They have a taxable investment portfolio with a current market value of $455,000.

The tax rate on all income and investment returns is 30%. The inflation rate is expected to be 2% per year.

Calculate the Jackson’s required average pretax nominal required rate of return from their investment portfolio. Show your calculations."

The way that I’m approaching this question is that:-

Based on what’s given:

  • N=18
  • PV=$455,000 (portfolio) + $280,000 (income) - $103,000 (living expense) - $331,000 (one-off property improvement cost)
  • FV=$2.2m

Using the cash flow model to solve for r (real rate), and then plus inflation of 2%, that’d solve the nominal rate.

Would this be the right way to approach this question? Appreciate if someone would comment or provide feedback.

Thanks!

#2

Not directly on point, but CFA Institute no longer asks you to calculate the required rate of return for individual investors.

You might want to pursue topics more likely to earn you points on the exam.

#3

Thanks @S2000magician for the quick turnaround.

I’m just curious to know that which part of the calculation is not on point if I may ask.

Is it because of the one-off expense should be excluded as it is treated more like a near term liquidity need?

Thanks.

#4

Your treatment of the one-off expense is fine.

What about the ongoing PMT?

#5

Thanks. Is the salary supposed to be treated as ongoing payment?

#6

The salary less the living expenses.

I presume that they’re not simply going to throw the surplus away.

#7

Yes that’s true. Thanks for clarifying and good to know the required rate for individual is not the focus too.

#8

For institutional investors - DB Plan. The rate of required return is:

a) discount rate applied to the fund’s assets is 5%.
b) for actuarial purposes the assumed long‐term rate of return on plan assets, 6%
c) directors believe that the fund should aim for a 7.5% return to reduce the contributions the company has to make to the fund. The trustees take the view that the fund should aim to build up a small surplus by exceeding the required return by 50 basis points (bps).

Which one is the most appropriate rate of return to use please?