Risk Management for Individuals – Part III (2024 Level III CFA® Program – Reading 22)

Summary

The video script is a comprehensive discussion on portfolio management and wealth planning, specifically focusing on risk management for individuals. It begins with a case study of Jane and Mark Thompson, a Canadian couple with financial goals for their daughters' education and their retirement. The script delves into life insurance, disability insurance, and annuities, emphasizing the importance of insurance coverage in relation to their income and financial needs. It also touches on the concept of human capital and its risks, suggesting that portfolios should be adjusted to reflect the level of risk associated with one's profession and job security. The video concludes with a discussion on asset allocation, highlighting how different levels of human capital can influence the balance between equity and fixed income investments. The presenter uses the example of two clients, Emily White and Robert Johnson, to illustrate how their differing human capital values lead to different financial capital allocations despite the same overall asset allocation strategy.

Takeaways

• 👨‍👧‍👧 The Thompson family's financial situation is centered around saving for their daughters' education and their own retirement, with a focus on insurance needs due to their income disparity.
• 💼 Jane's higher income as a project manager in a tech firm suggests she should have a larger life insurance coverage compared to Mark, who is a high school teacher.
• 📈 The financial advisor, Laura Smith, emphasizes the importance of disability insurance for Jane due to her specialized job and substantial income.
• 💰 The family's total capital available is $870,000, which includes life insurance and cash in investments, but they have cash needs amounting to $615,000.
• 📉 In the event of Jane's death, the family's living expenses would decrease, and Mark's living expenses would be recalculated for the remaining years until retirement.
• 🧮 The calculation of life insurance shortfall involves present value calculations, taking into account growth rates, discount rates, and future financial needs.
• 🏡 The Thompsons are considering buying an annuity to provide a reliable income stream during retirement, which would start at their mid-60s.
• 👴 Longevity risk is a concern for the family due to their family history and healthy lifestyles, which might lead to living long lives and potentially outliving their savings.
• 🔗 Human capital is an important factor in portfolio management and wealth planning, and it should be considered alongside financial capital when making investment decisions.
• ⚖️ High risk human capital should be paired with a safer financial portfolio, and vice versa, to ensure a balanced approach to risk management.
• 🧘‍♂️ The concept of human capital is likened to a bond, where steady and predictable returns are expected, and riskier occupations may necessitate a more conservative financial portfolio.

Q & A

What is the main focus of the CFA program's level three topic on portfolio management and wealth planning?

The main focus of the CFA program's level three topic on portfolio management and wealth planning is to cover risk management for individuals, including aspects such as human capital, life insurance, and comprehensive problem-solving related to asset allocation.

What are the annual living expenses for Jane and Mark Thompson?

The annual living expenses for Jane and Mark Thompson are 80,000 Canadian dollars.

What is the recommended insurance policy for Jane, considering her substantial income?

Financial advisor Laura Smith recommends a suitable disability insurance policy for Jane, given her substantial income and highly specialized job role.

What is the current life insurance coverage Jane has?

Jane currently has a life insurance coverage with a death benefit of 120,000 Canadian dollars.

How does the adjusted discount rate in the needs analysis method account for the difference between the discount rate and the growth rate?

The adjusted discount rate is calculated as one plus the discount rate divided by one plus the growth rate, minus one. This accounts for the difference between the discount rate and the growth rate, reflecting the net effect of growth on the present value calculations.

What are the Thompsons' financial goals?

The Thompsons' financial goals include saving for their daughters' education and their own retirement.

What is the significance of considering human capital when determining asset allocation?

Considering human capital when determining asset allocation is significant because it allows for a more holistic view of an individual's or family's financial situation. It helps in aligning the financial portfolio with the risk profile of the individual's earning potential and job security, leading to a more balanced and appropriate investment strategy.

How does the level of human capital affect the recommended financial portfolio?

The level of human capital affects the recommended financial portfolio by influencing the risk tolerance. High risk human capital, such as a profession with job security concerns, should be paired with a safer financial portfolio with fewer equities and more fixed income. In contrast, stable human capital can afford a higher risk allocation.

What is the role of diversification in managing human capital risk?

Diversification plays a critical role in managing human capital risk by spreading out the risk across various income sources and investments. This strategy helps in reducing the overall financial vulnerability due to the risks associated with an individual's earning potential.

What are the key considerations when recommending an annuity to a client?

When recommending an annuity to a client, key considerations include the client's retirement age, desired investment options, the need for a reliable income stream, and the client's risk of outliving their savings. It's also important to consider the client's family history and lifestyle to assess longevity risk.

How does the concept of human capital relate to the risk factors of an individual's future earnings?

Human capital is directly related to the risk factors of an individual's future earnings as it represents the present value of one's future earnings. Factors such as profession, job security, health status, and geographic mobility can influence the risk associated with human capital and, consequently, the individual's future earnings.