Hi,
I have done quite a few questions on the topic but still, do not have clarity on the difference between the two.
Sometimes, liquidity needs include regular annual expenses, sometimes do not. Sometimes, the liquidity needs are mentioned until retirement and sometimes until post retirement.
What is the rule?
Similarly, should the return objectives include all sort of requirement (including essential + one off)
Please provide some guidance on how to answer questions on Return objectives and Liquidity needs.
If the ongoing expenses needs to come out of the investment portfolio, then it is a liquidity requirement. On the other hand, if these expenses can be covered from person’s salary, then it is NOT a liquidity requirement.
Note that return requirement and liquidity requirement need NOT be exclusive. Like in the first example that I mentioned above, ongoing expenses will be a component for both return calculation as well as liquidity requirement.
The one off thing that you are saying is kind of an emergency reserve (details will be specified in the question). Its always better to subtract this one time emergency reserve (if it will require a cash outflow in future) from investable asset base while calculating required return.
If you will practice these sort of questions that are tested over the previous 5-6 years, it will get much more clear. The main thing is to read the passage carefully and figure out the relevant info for the question being asked. Rest shall flow.
Rule of thumb: If you need money from the portfolio to fund your existence/life whatever, then that is a Liquidity Need. For e.g. you have an annual salary of $60,000 but your living expenses are $75,000. So there is a shortfall of $15,000. This is a liquidity need of $15,000 from the portfolio.
You will put $15,000 in Return Objective to calculate Required Return and also mention this in Liquidity section as an ongoing need. However CFA is pretty inconsistent on this matter whether you need to list this under Liquidity or not. Sometimes they do and sometime they don’t. What is not under debate is that you need to use $15,000 under Return Calculation. On the safe side, mention under liquidity constraint as well.
Also you need to mention any emergency reserves under Liquidity needs. For e.g in the question if someone wants 3 months of living expenses as an emergency reserve, then mention it under Liquidity constraint and also include this 3 month cash equivalent in the Strategic Asset Allocation (SAA).
Also secondary needs should be listed under Liquidity constraint. For e.g. you need $500,000 in 6 months to fund a retirement/vacation home. List this under Liquidity constraint and use it in the SAA. Also you might be getting $1mn as inheritance in 6 months. List it under Liquidity Constraint as a positive one time liquidity inflow (you can also list it under Unique and/or Time Horizon). Regarding Time Horizon, the usual practice is that if you have a material inflow/outflow to/from your portfolio then you can make that as one Time Horizon. Coming back, remember to subtract $500,000 from Total Investable Base in the Return Objective Section when calculating Required Return.
- Return Calculation: If the one-off payment (emergency reserve) is after 5 years, do we subtract that amount from the asset base or the PV of that amount?
- Inheritance after 6 months will be added to the asset base at time 0. Right?
- I have seen CFAI mentioning the liquidity needs only for the next year sometimes. Until what point do we write the liquidity needs?
- Return and liquidity needs are mentioned only until retirement or even post retirement? Continuing with your example:
For e.g. you have an annual salary of $60,000 but your living expenses are $75,000. So there is a shortfall of $15,000. This is a liquidity need of $15,000 from the portfolio. You will put $15,000 in Return Objective to calculate Required Return and also mention this in Liquidity section as an ongoing need.
After retirement, there is no salary, so the liquidity and return requirement would become 75,000.
Do we also mention this in the answer? or do we stop pre-retirement?
Liquidity concern is all net outflows due within current period expressed in $ terms. Some payouts as inheritance taxes are made by immediate deduction of received funds and such payouts are not a liquidity concerns because person cannot affect on those or defer such payouts than just receives funds already deducted.
Return requirement is a minimum % percentage return which person requires to meet all his, at least primarily goals and is usually referred to period more than current. May be calculated on nominal, real basis or pre-tax or after tax basis.
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No you would not. I think you would only subtract amounts that are happening in the short term (one year or less). If you need $250,000 to create a trust in 3 months, then you would remove the $250,000 from the asset base. I don’t think you subtract amounts if they are occurring after a long time like 5 years. (maybe others can clarify)
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Why would you add that at time 0? At time 0, you don’t have that inheritance in your portfolio. It’s only arriving after 6 months. So at time 0 your asset base won’t include the inheritance.
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You can write the liquidity needs in accordance with the time horizon. For e.g if the person a two stage time horizon, one till retirement and one post-retirement, the you can mention that up till retirement the person has so and so liquidity needs and post retirement he has so and so liquidity needs. Although I think the question would be very specific and you’ll know exactly what time period is being asked for.
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Again you’ll know through the question. Questions generally mention how long you need to calculate the return for. If it’s an IRR question, you’ll be given the FV and the number of the years. Just make changes to the PV by subtracting the very short term (within a year usually) liquidity needs like emergency reserves or vacation houses type stuff and calculate the IRR. Otherwise it’ll generally be a one-year calculation of required return.
For the liquidity and return pre and post retirement thing, I think you’re overthinking the question too much. Would help if you could post a question from past papers or somewhere else.
What I can deduce from your questions is that you haven’t practiced questions on this topic. These are the sort of questions that would definitely come into mind if you have only read the curriculum readings. But I assure you, if you start doing past papers/mocks/Schweser questions on this topic, you’ll understand the flow of these return and liquidity questions.
Thanks for the advice. I should practice more past papers.
As for the questions:
- I was thinking we should include future inheritance inflow if we include future house payments in the asset base. ’
Thanks again for your excellent answers.