CHAPTER 28: INVESTMENT POLICY AND THE FRAMEWORK OF THE CFA INSTITUTE
CHAPTER 28: INVESTMENT POLICY AND
THE FRAMEWORK OF THE CFA INSTITUTE
PROBLEM SETS
1. You would advise them to exploit all available retirement tax shelters, such as 403b,
401k, Keogh plans, and IRAs. Since they will not be taxed on the income earned from
2. a. The least risky asset for a person investing for her child’s college tuition is an
account denominated in units of college tuition. Such an account is the College
b. The least risky asset for a defined benefit pension fund with benefit obligations
that have an average duration of 10 years is a bond portfolio with a duration of 10
c. The least risky asset for a defined benefit pension fund that pays inflation-protected
benefits is a portfolio of immunized Treasury inflation-indexed securities with a
3. a. George More’s expected accumulation at age 65:
n i PV PMT FV
b. Expected retirement annuity:
n i PV FV PMT
28-1
CHAPTER 28: INVESTMENT POLICY AND THE FRAMEWORK OF THE CFA INSTITUTE
c. In order to get a fixed-income annuity of $30,000 per year, his
accumulation at age 65 would have to be:
n i PMT FV PV
His annual contribution would have to be:
n i PV FV PMT
4. a. Using the financial calculator, first calculate future value, before taxes:
30
/ 1
/ 5
0
$5,000(cash outflow into the retirement account)
CPT $332,194.24
n
P y
i y
PV
PMT
FV
=
=
=
=
=-
=
Calculate the 20-year consumption stream (assuming monthly payouts):
20 12 240
/ 12
/ 5
$232,535.97(purchase retirement stream)
0
CPT $1,534.63
n
P y
i y
PV
FV
PMT
= ´ =
=
=
=-
=
=
b. Using the financial calculator, first calculate future value, before taxes:
30
/ 1
/ 5
0
$5,000 (1 .3) 3,500(after-tax contributions)
CPT $232,535.97
n
P y
i y
PV
PMT
FV
=
=
=
=
=- ´ – =-
=
CHAPTER 28: INVESTMENT POLICY AND THE FRAMEWORK OF THE CFA INSTITUTE
Calculate the 20-year consumption stream (assuming monthly payouts):
20 12 240
/ 12
/ 5
$232,535.97(purchase retirement stream)
0
CPT $1,534.63
n
P y
i y
PV
FV
PMT
= ´ =
=
=
=-
=
=
c. If you tax rate decreases to 25% upon retirement the Roth IRA still provides a
However, the Traditional IRA now provides (using the financial calculator):
30
/ 1
/ 5
0
$5,000(cash outflow into the retirement account)
CPT $332,194.24
n
P y
i y
PV
PMT
FV
=
=
=
=
=-
=
Calculate the 20-year consumption stream (assuming monthly payouts):
20 12 240
/ 12
/ 5
$249,145.68 (purchase retirement stream)
0
CPT $1,644.25
n
P y
i y
PV
FV
PMT
= ´ =
=
=
=-
=
=
CFA PROBLEMS
1. a. (i) Return requirement: IPS Y has the appropriate language. Since the plan is
CHAPTER 28: INVESTMENT POLICY AND THE FRAMEWORK OF THE CFA INSTITUTE
(ii) Risk tolerance: IPS Y has the appropriate language. Because of the fund’s
(iii) Time horizon: IPS Y has the appropriate language. Although going-concern
(iv) Liquidity: IPS X has the appropriate language. Because of the early
b. The current portfolio is the most appropriate choice for the pension plan’s asset
allocation. The current portfolio offers:
(i) An expected return that exceeds the plan’s return requirement.
The higher expected return will ameliorate the plan’s underfunded status
somewhat, and the change in the fund’s risk profile will be minimal. The portfolio
The Graham portfolio offers:
(i) An expected return that is slightly below the plan’s requirement.
The Michael portfolio offers:
(i) An expected return that is substantially above the plan’s requirement.
2. c. Liquidity
28-4
CHAPTER 28: INVESTMENT POLICY AND THE FRAMEWORK OF THE CFA INSTITUTE
4. a. An approach to asset allocation that GSS could use is the one detailed in the
chapter. It consists of the following steps:
1. Specify asset classes to be included in the portfolio. The major classes
usually considered are:
Money market instruments (usually called cash)
2. Specify capital market expectations. This step consists of using both
historical data and economic analysis to determine your expectations of future
3. Derive the efficient portfolio frontier. This step consists of finding portfolios
4. Find the optimal asset mix. This step consists of selecting the efficient
b. A guardian investor typically is an individual who wishes to preserve the
purchasing power of his assets. Extreme guardians would be exclusively in AAA
short-term credits. GSS should first determine how long the time horizon is and
5. a. OBJECTIVES
1. Return
The required total rate of return for the JU endowment fund is the sum of the
spending rate and the expected long-term increase in educational costs:
The expected educational cost increase is 3 percent. The sum of the two
2. Risk
28-5
CHAPTER 28: INVESTMENT POLICY AND THE FRAMEWORK OF THE CFA INSTITUTE
Ability: Average risk
Endowment funds are long term in nature, having infinite lives. This long
However, creative tension exists between the JU endowment’s demand for
Willingness: Above average risk
University leaders and endowment directors have set a spending rate in
In addition, the current portfolio allocation, with its large allocations to
direct real estate and venture capital, indicates a willingness to take above-average
risk.
2. Liquidity.
Generally, endowment funds have long time horizons, and little liquidity is needed
3. Taxes. U.S. endowment funds are tax-exempt.
4. Legal/Regulatory.
U.S. endowment funds are subject to predominantly state (but some federal)
28-6
CHAPTER 28: INVESTMENT POLICY AND THE FRAMEWORK OF THE CFA INSTITUTE
5. Unique Circumstances.
Only 25 percent of donated Bertocchi Oil and Gas shares may be sold in any
b. (Answers may vary)
Liquidity needs for the next year are
Total liquidity of at least $297 million is required (14.85 percent of current
Intermediate global bond fund: 10% (Range: 10% – 20%)
To achieve a 10 percent portfolio return, the fund needs to take above average
risk (e.g., 10% in global bond fund and 20% venture capital). An allocation
Bertocchi Oil and Gas common stock: 15%
To help fund short-term outflows, exposure to real estate will be decreased.
28-7
CHAPTER 28: INVESTMENT POLICY AND THE FRAMEWORK OF THE CFA INSTITUTE
To help fund short-term cash outflows, exposure to venture capital will be
reduced. This will be a modest decrease since divesting more than 1/5 (25%
The suggested allocations (point estimates) would allow the JU endowment fund
to meet the 10 percent return requirement, calculated as follows:
Asset
Suggested
Allocation
Expected
Return
Weighted
Return
0.15
4.0%
0.600%
0.10
5.0
0.500
0.15
10.0
1.500
0.15
15.0
2.250
0.25
11.5
2.875
0.20
20.0
4.000
1.00
11.725%
The allowable allocation ranges, taken in proper combination, would
6. a. Overview. Fairfax is 58 years old and has seven years until a planned retirement. She
has a fairly lavish lifestyle but few money worries. Her large salary pays all current
expenses, and she has accumulated $2 million in cash equivalents from savings in
OBJECTIVES
Return Requirement. Fairfax’s need for portfolio income begins seven years from
now, at the date of retirement. The investment focus for her savings portfolio should
be on growing the portfolio’s value in the interim in a way that provides protection
28-8
CHAPTER 28: INVESTMENT POLICY AND THE FRAMEWORK OF THE CFA INSTITUTE
against loss of purchasing power. Her 3 percent real, after-tax return preference
If the market value of Reston’s stock does not change, and if she is able to earn a
10.8 percent return on the savings portfolio (or 7% nominal after-tax return), then,
by retirement age, she should accumulate:
Risk Tolerance. The information provided indicates that Fairfax is quite risk averse;
she is unwilling to experience a decline of more than 10 percent in the value of the
savings portfolio in any given year. This would indicate that the portfolio should
have below average risk exposure in order to minimize its downside volatility. In
28-9