Risk Management for Individuals – Part III (2024 Level III CFA® Program – Reading 22)
Summary
TLDRThe 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
📚 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.
💡 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.
🛡️ 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.
🤔 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.
Mindmap
Keywords
💡CFA Program
💡Portfolio Management
💡Risk Management
💡Human Capital
💡Life Insurance
💡Asset Allocation
💡Disability Insurance
💡Long-term Care Insurance
💡Annuity
💡Present Value
💡Diversification
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
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