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.

Outlines

00:00

📚 Introduction to Portfolio Management and Risk Management for Individuals

Jim introduces the third part of the CFA program's level three course, focusing on portfolio management and wealth planning. He recaps the previous topics, human capital and life insurance, before diving into a comprehensive problem and discussing asset allocation. The example revolves around Jane and Mark Thompson, a Canadian couple with financial goals for their daughters' education and their own retirement. Jim emphasizes the importance of considering life insurance, especially for Jane who earns significantly more than Mark. The couple's financial situation, including their income, expenses, and existing insurance coverage, is detailed, and an analysis of their insurance needs is conducted by their financial advisor, Laura Smith.

05:02

💡 Analyzing Life Insurance Shortfall and Annuity Options

The second paragraph delves into calculating the life insurance shortfall the Thompsons might face if Jane passes away. Assumptions regarding growth rates, discount rates, and future expenses are provided. The analysis includes present value calculations for Mark's living expenses, the daughters' education costs, and Mark's income. The total financial needs are compared with the available capital to determine the shortfall, which is found to be CAD 340,073. Jim also discusses annuity options, emphasizing the need for a reliable income stream due to longevity risk and the couple's family history. He touches on the concept of an annuity providing a payout that continues as long as one of them is alive.

10:04

🛡️ Disability Insurance and Long-Term Care Recommendations

In the third paragraph, Jim addresses the recommendation for disability insurance, given Jane's substantial income and specialized job. He explains the different levels of occupational coverage and why regular occupational coverage is ideal. The discussion then moves to long-term care insurance, with a suggestion to purchase an additional policy to cover 70% of their pension benefits. Jim also talks about annuities, particularly deferred variable annuities that start at retirement, to provide a diversified investment and substantial income later in life. He concludes this section by linking back to the concept of human capital and its risks, advising on how to adjust the financial portfolio to reflect human capital risk.

15:07

🤔 Human Capital and Asset Allocation Strategies

The final paragraph focuses on how human capital impacts asset allocation. Jim explains the concept of human capital as the present value of one's future earnings and discusses the risk factors associated with it. He then demonstrates how to adjust the financial portfolio based on the level of human capital risk, advocating for a conservative financial portfolio when human capital is high risk and a higher risk tolerance when human capital is stable. The example provided illustrates how two clients with different levels of human capital would have different equity allocations in their financial capital, despite the same overall asset allocation strategy. Jim emphasizes the importance of considering human capital risk when determining asset allocation and suggests methods to mitigate this risk, such as insurance coverage and diversification of income sources.

Keywords

💡CFA Program

The CFA (Chartered Financial Analyst) Program is a professional credential offered by the CFA Institute. It is a globally recognized standard for measuring the competence and integrity of financial analysts. In the video, it is the educational context in which the discussion of portfolio management, wealth planning, and risk management is taking place.

💡Portfolio Management

Portfolio management refers to the process of overseeing and making decisions with investments with the goal of meeting specific financial objectives. In the video, it is a key topic discussed in the context of wealth planning and risk management for individuals, emphasizing the importance of a well-balanced investment strategy.

💡Risk Management

Risk management is the process of identifying, assessing, and prioritizing potential risks to an individual or organization's capital and earnings, then taking steps to mitigate these risks. In the video, it is discussed in three parts, including human capital, life insurance, and individual asset allocation, highlighting its importance in financial planning.

💡Human Capital

Human capital refers to the economic value of an individual's experience, skills, knowledge, and health. In the video, it is a significant factor in determining an individual's financial risk tolerance and is used to calculate the need for life insurance and other financial safeguards.

💡Life Insurance

Life insurance is a contract between an individual (the policyholder) and an insurer, where the insurer pays a sum of money upon the death of the insured person. In the video, it is discussed as a critical component of risk management for individuals, ensuring financial security for dependents in the event of the insured's death.

💡Asset Allocation

Asset allocation is the process of dividing investment money among different asset classes such as stocks, bonds, and cash equivalents, with the goal of balancing risk and reward. In the video, it is a central theme, where the presenter discusses how to adjust an individual's investment portfolio based on their human capital and other financial goals.

💡Disability Insurance

Disability insurance provides income replacement in the event of an insured person becoming disabled and unable to work. In the video, it is recommended for Jane due to her substantial income and specialized job, emphasizing the need for comprehensive coverage to protect against the risk of loss of income.

💡Long-term Care Insurance

Long-term care insurance is designed to cover the cost of personal care services when an individual is no longer able to perform certain activities of daily living. In the video, it is mentioned as a part of the financial planning process, particularly relevant for individuals with a family history of longevity.

💡Annuity

An annuity is a financial product that provides a stream of payments to an individual over a period of time, often for the duration of their life. In the video, it is discussed as a potential investment option for the Thompsons to ensure a reliable income stream during retirement, addressing the risk of outliving their savings.

💡Present Value

Present value is the concept that an amount of money today is worth more than the same amount in the future due to its potential earning capacity. In the video, it is used to calculate the financial needs of the Thompson family, taking into account factors like growth rate, discount rate, and future expenses.

💡Diversification

Diversification is the practice of spreading investment risk by allocating funds across different financial instruments, industries, and other categories to enhance potential returns and reduce the impact of any single investment's poor performance. In the video, it is suggested as a strategy to manage risk, particularly in the context of annuities and investment portfolios.

Highlights

The importance of considering human capital in portfolio management and wealth planning is emphasized.

The case of Jane and Mark Thompson is introduced to illustrate risk management strategies for individuals.

The concept of life insurance is discussed, particularly in relation to Jane's higher income and its impact on her family's financial goals.

The need for disability insurance is highlighted, especially for individuals with specialized jobs like Jane's.

The impact of national health insurance and long-term care insurance on an individual's financial planning is examined.

An analysis method for evaluating a family's insurance needs is presented using assumptions such as discount rate and tax rate.

The financial implications of Jane's death on the family's living expenses and the need for life insurance coverage are discussed.

The concept of annuities as a financial product to manage longevity risk and provide a reliable income stream is introduced.

The calculation of life insurance shortfall using present value formulas and the adjusted discount rate is demonstrated.

The recommendation for additional insurance policies, such as disability and long-term care insurance, is based on a comprehensive financial analysis.

The significance of aligning an individual's financial portfolio with their human capital risk is explained.

The concept of adjusting a portfolio to reflect the risk associated with an individual's profession and job security is discussed.

The impact of age on an investor's risk tolerance and the strategic shift towards bonds for older investors is highlighted.

The use of mathematical calculations to relate human capital to asset allocation in financial planning is shown.

The difference in equity allocation due to varying levels of human capital for different clients is demonstrated through examples.

The importance of considering insurance needs and human capital in conjunction with an individual's risk willingness and ability is emphasized.

The role of diversification and insurance policies in managing idiosyncratic risk is discussed.

The comprehensive nature of the reading is reviewed, covering a wide range of topics from human capital to risk management strategies.

Transcripts

hey it's Jim and this is level three of

the CFA program the topic on portfolio

management and wealth planning and part

three of risk management for individuals

let me just quickly remind you that are

part one was essentially on human

capital part two was on life insurance

and now we're gonna go ahead and end

with a pretty comprehensive problem and

then some final thoughts about asset

allocation

here's this comprehensive example that

we'll start with let me go ahead and uh

and and read much of this here I usually

just skim around when looking at the

questions done but let's go ahead and

emphasize some things here

Jane and Mark Thompson they live in

Canada

twin daughters

Jane works as a project manager in a

large Tech firm notice that Jane makes

200 000 Canadian dollars a year mark is

a high school teacher and he makes

seventy five thousand dollars a year

they have some financial goals here

they're saving for their daughter's

education and their own retirement so

see how that fits in to the policy

statement and we'll talk about that from

an insurance standpoint

annual living expenses are just 80 000

Canadian dollars let me go ahead and

pause and say boy I wish that uh my

ratio of uh

salary

of my wife and me was that much greater

than our annual living expenses all

right

let's see they both plan to work for 20

more years what are they they're both in

their mid-40s right relying on their

combined income and savings to meet

their financial goals all right so

here's the signal the signal is all

right since Jane makes

uh substantially more than Mark then

she's probably in line for more life

insurance

all right we have a new financial

advisor Laura Smith

recommends a suitable disability

insurance policy for Jane given her

substantial income all right we said

that

she has a highly specialized job all

right so currently

uh they ensure Jane with a death benefit

of 120 000 Canadian dollars uh they're

covered by national health insurance

plan

a long-term care insurance they're

eligible for long-term care at a cost

equal to 70 percent of their pension

benefits

all right so this analyst uh Smith's

worried about their existing life

insurance coverage that makes sense

she evaluates the family's insurance

needs if Jane were to die this year uses

the needs analysis method

so here are a couple of assumptions

discount rate four percent tax rate 25.

salary and living expenses grow at 2.5

percent annually you know I'm always

fascinated when uh when someone makes an

assumption about inflation and just kind

of lumps it all and that's pretty much

why the Institute almost has to do it

right you can't say oh inflation's going

to be two percent this year and seven

percent next year and 14 the following

year that would just throw the

mathematics of the problem just

completely out of kilter so it's it's

easy just to say hey 2.5 percent

salary and living expenses occur at the

beginning of each year that's just

really a time value of money convention

nothing really interesting about that

let's see suppose that Jane does pass

away Mark will continue to work family

living expenses will decrease by 25 000

per year

Mark's living expenses will be forty

five thousand per year for 40 45 years

and the daughters will be 12 000 and

those are Canadian dollars too by the

way for for seven years so what are

those girls there are what are they're

17 years old so I guess by the time

they're 25 they will have graduated from

a university and have uh and have good

jobs

some additional information that's given

to us in just a little table we're told

well there's the life insurance 120 but

now we add the cash in Investments of

750 total Capital available 870.

cash needs there's a mortgage balance uh

there's a fund there's emergency funds

so that total 615 so notice that 870 and

615 they don't equal each other so

that's probably has some implications in

another couple of slides

Thompsons are considered buying an

annuity with the following features so

let's pay attention to this starts at

retirement so they're 45 they're not

retiring until they're what mid 60s

they want to have a range of investment

options remember back in part two I I

gave you the hint that will probably

hear the word flexibility or some kind

of flex word inside of the question stem

here invest in a range of investment

opportunity options so there's another

way of saying flexible

a payout continues as long as one of

them is living

okay Gene has a father

he's also a client 76 retirement and

retired needs a reliable income stream

to manage his present and future

expenses

Davis's parents both lived to an old age

he worries about outliving his savings

Smith suggests an annuity

all right Thompson's also worried about

longevity risk due to their family

history and Healthy Lifestyles that they

are expecting to live until they're you

know 100 120 whatever it is

ensure they have the highest possible

consistent income stream relative to the

cost they're really give up willing to

give up the right to cash out of the

policy all right so we can calculate any

additional amount of life insurance

right and there will be a difference

between the total financial needs and uh

whoops and the total Capital available

so let's go ahead and put together some

kind of an estimate of what that life

insurance shortfall will be

so cash needs in Canadian dollars

there's that 615 000.

and we need to make some calculations

here there's Mark's living expenses

there's the daughter's living expenses

and then there's Mark's income all right

so that is uh

those are present values

so let's go ahead and get out our

calculators and we'll do that in the

next slide or two so let's go ahead

there are the assumptions two and a half

percent growth discount rate for

and there's the adjusted discount rate

that's one plus the discount rate

divided by one plus the growth rate now

that's assuming discount rate is greater

than the growth rate which it probably

is minus one

um

notice that that's essentially just kind

of like an F over P minus one but you

have to add one to the since it's an

interest rate to to take care of the

compounding

um here's the example that I gave my

students years ago and this is one of

the great things that I learned in

college my roommate and I we would study

for a while and he would look over and

say all right it's time to go down to

the arcade so we'll go play Pac-Man so I

want you to think about this as just a

discount rate right so you're growing at

two and a half percent but you're taking

the present value at four and a half

percent so it's like the Pac-Man machine

do you guys ever play Pac-Man and so

that adjusted discount rate is the net

effect of the Pac-Man eating this way in

the Pac-Man eating that way that's

probably a stupid example but it's

called an adjusted discount rate that is

reflective of the difference between

four and two and a half so note that

it's not four minus two and a half is

one and a half it's a little bit less

because of the effects of compounding

where else have you can you learn about

Pac-Man in uh in the CFA program

all right so there's a really great

formula for the present value of Mark's

living expenses

and I know some of you like formulas and

some of you like your financial

calculator so if you like the formulas

you can just memorize that that's that's

pretty much a standard um

uh time value of money present value of

the annuity do formula if you don't like

that and you want to get out your

calculator

let's go ahead and do this together

um set your payments to the begin mode

so do the control begin however that

works

and so what are we going to do here make

forty five thousand dollars make that

payment

1.46 make that the interest rate

uh 45 years is n zero future value and

what are we solving for present value

there you go

1.498 so either do it that way

or uh or

do it with your financial calculator

either ways either way sufficient and

you do the same thing with the present

value of the children's living expenses

and the present value of Mark's income

and so there if you just sum those you

get 5.95 so let me go back to this uh

let me go back to this one here so look

total Capital needs there's the one uh

there's 595 and so those total financial

needs there's the 1.2 million and so

total Capital available which we did in

a previous

excuse me a previous table so the

difference between the 1.2 million and

the 870 there's our shortfall so what

we're going to say hey we need three

hundred and forty thousand and seventy

three dollars worth of life insurance

all right let's continue then on

analyzing this extra stuff that we did

after life insurance so we're gonna

disability insurance recommend

disability insurance due to James

substantial income comprehensive

coverage is sensible regular upper

occupational coverage is ideal remember

there are a couple of different levels

of occupation you know I I think the

reading gives the example suppose that

you're a surgeon

and you need to use your hands and

you're right-handed or left-handed and

you you know lose the use of your right

or left hand

so you you can't

be a brain surgeon or a knee surgeon or

a shoulder surgeon but you could become

some other kind of a doctor you know

whatever that means just kind of a

general brain guy or brain girl or

um an orthopedic whatever it is so then

there's that next level

excuse me

and then if you can't even do that next

level then you could go into teaching or

something you know so that regular

occupation is ideal life insurance

there's the 340 000 that we uh that we

talked about uh long-term care

70 percent invention of the pension so

we're probably going to recommend that

additional policy and then the annuities

this is one of those things I was

telling you about so the annuity option

is suitable probably the uh the Deferred

variable annuity that starts at

retirement which allows for Diversified

investment

longevity we spent some good time

talking about the advanced life deferity

deferred annuity and so this will start

sometime later in life substantial

income later in life

all right let's go ahead and end with a

conversation that links us back to the

beginning of this reading on human

capital this is a little bit of a review

here human capital present value of

one's future earnings so what are those

risk factors of course the profession of

course job security of course health

status of course Geographic Mobility

what are the risks of human capital let

me just remind you we talked about this

that it looks an awful lot like a bond

because they are steady and predictable

returns if the job is in a salary of

course it depends on the profession and

job security riskier occupations can

lead probably to a more conservative

Financial portfolio

how do we adjust the portfolio to

reflect that human capital risk so you

know what have we talked about in all

three levels here we've talked about

putting together a portfolio based on

you know interest rate risk and default

risk for fixed income securities and

systematic risk for Equity security but

now we need to throw this extra human

capital risk in there

so what do we want to do we want to

combine our Investment Portfolio with

our human capital and we want to make

sure that they link and we want to make

sure that they're related and so look at

those block points there high risk human

capital should be paired with a safer

Financial portfolio what that means is

we want fewer equities and more fixed

income in there

stable human capital can afford higher

risk allocation

younger investors right riskier

Financial portfolios older investors

should shift towards bonds

so notice that there are multiple

reasons there older investors you know

they're willing to take less risk

they might be able to take less risk but

that is linked directly back to their

depleting level of human capital

all right let's take a look at some math

here and relate it to the final kind of

an loss about asset allocation so back

here I kind of we hinted that oh yeah

more Equity Securities less Equity

Securities now let's go ahead and do

some math

here we have two clients Emily white is

a professional athlete Robert Johnson is

a well-established doctor

they both decided on 60

Equity 40 percent fixed income for their

total wealth so let's look at Emily

white here

her human capital is 80 stock like with

a value of 1.2 million her financial

capital is one point six million so what

we're going to do is we're going to take

the 1.2 and we're going to add it to the

1.6 and then multiply that by the 60

Equity asset allocation so there's 1.6

right so that Equity allocation there's

that amount 1.6 and so that Equity

exposure is going to be the 1.2 times

the 0.8 right there's that human capital

is 80 stock light and that gets us to

96.96 million so take the difference

between those two so there's 0.72

million uh equity in her

Financial Capital so do you see how

human capital leads to asset allocation

now for Johnson we do the same thing but

notice his human capital is just 20

stock like so look at the difference

here 80 and 20 and his financial capital

is 3 million his human capital is 2.5

now remember back here 1.6 and oh I'm

sorry 1.2 and 1.6 right

all right so we do the same kind of math

there and uh there at the bottom green

allocate 2.8 million Equity to his

financial capital

all right so discuss how asset

allocation right so here let's finish up

this conversation both have 60 40 asset

allocation but their allocation uh and

to financial capital is different due to

their different

um levels of human capital so look at

the purple statement uh this is probably

a good one to memorize it's important to

understand the risk associated with

human capital when determining asset

allocation in fixed Capital so think

about what we've done you know all

through level one and level two and

level three we've done we've done all

this stuff for asset allocation now

we're adding this human capital element

to it

all right another quick slide here to

end look at the middle circle there

addressing human capital risk what do we

need to do we need to consider insurance

coverage we need to consider education

and the investment in skills and

knowledge to improve our human capital

diversification of income sources and

then uh human capital of course in a

family can have multiple earners each

with different levels of human capital

so here's just a quick simple example

here young professional on the left an

individual who is retired so you know

they probably have separate kinds of

things what do we talk about this back

in level one if we look at the

difference between a young professional

and someone who's retired they would

probably have different

willingness to take risk and different

ability to take risk but we need to add

the layer of human capital

and combine that with their insurance

needs and not just life insurance but

all those different kinds of insurance

contracts that we talked about back in

part two

and then I can't have any conversation

here without uh bringing in uh standard

deviation and Harry margowitz of course

uh systematic risk and unsystematic risk

of course the you know the professionals

typically like to call it idiosyncratic

risk so you know you know the difference

between those two we've talked about

that many many times

yeah so how do we reduce that

idiosyncratic risk if if we can do this

through diversification or an insurance

policy whether it's a life insurance

policy or a disability insurance policy

we have this asset diversification or we

can transfer the risk through insurance

and that takes us through all of the

learning outcome statements for this

really really super reading uh

I had a great time reading uh going

through this

so this is what I want you to do now

there are I think there's 23 questions

at the end of this reading three three

vignettes I think it's eight eight and

seven does that add up to 23

so many of the questions we have

addressed inside of these three slide

decks so you ought to be prepared to do

this so go ahead and work your way

through this give yourself you know I

don't know how long probably 45 minutes

or so to work through those 23 questions

hey thanks for watching uh have a great

day and good luck studying

foreign