Initial Client Circumstances
Donna Scott, a vice president for Marks Consultancy, is a 42-year-old widow who lives in the United States. She has two children: a daughter, age 21, and a son, age 7. She has a $2.2 million portfolio; half of the portfolio is invested in Marks Consultancy, a publicly traded common stock. Despite a substantial drop in the value of her portfolio over the last two years, her long-term annual total returns have averaged 7 percent before tax. The recent drop in value has caused her great anxiety, and she believes that she can no longer tolerate an annual decline greater than 10 percent.
Scott intends to retire in 20 years, and her goals for the next 20 years, in order of priority, are as follows. The present values given are gross of taxes.
- Funding the cost of her daughter’s upcoming final year of college, which has a present value of $26,000, and her son’s future college costs, which have a present value of $130,000.
- Increasing the portfolio to a level that will fund her retirement living expenses, which she estimates to be $257,000 for the first year of her retirement.
- Building her ‘‘dream house’’ in five years, the cost of which (including land) has a present value of $535,000.
- Giving, if possible, each of her children $1 million when they reach age 40.
After subtracting the present value (before tax) of her children’s education costs and her homebuilding costs, the present value of her portfolio is $1,509,000. With returns from income and gains taxable at 30 percent and with continued annual growth of 7 percent before tax (7% × (1 − 0.30) = 4.9% after taxes), the portfolio’s value will be approximately $3,928,000 net of taxes at the end of 20 years.
Scott’s annual salary is $145,000, her annual living expenses are currently $100,000, and both are expected to increase at an inflation rate of 3 percent annually. Taxes on income and short-term capital gains (holding period one year or less) are substantially higher than taxes on long-term capital gains (holding period greater than one year). For planning purposes, however, Scott wants to assume that her average tax rate on all income and gains is 30 percent. The inflation and tax rates are expected to remain constant.
Currently, Scott rents a townhouse, has no debt, and adamantly intends to remain debt free. Marks Consultancy has no pension plan but provides company-paid medical insurance for executives for life and for their children to age 25. After taxes, Scott’s salary just covers her living expenses and thus does not allow her to make further meaningful capital contributions to her portfolio.
Scott’s current investment policy statement has the following elements:
Return requirement. A total return objective of 7 percent before tax is sufficient to meet Donna Scott’s educational, housing, and retirement goals. If the portfolio earns a total return of 7 percent annually, the value at retirement ($3.93 million) should be adequate to meet ongoing spending needs then ($257,000/$ 3, 928, 000 = 6.5% spending rate) and fund all Scott’s extraordinary needs (college and homebuilding costs) in the meantime. The million-dollar gifts to her children are unrealistic goals that she should be encouraged to modify or drop.
Risk tolerance. Scott has explicitly stated her limited (below average) willingness to take risk. Scott appears to have an average ability to take risk. Her portfolio has some flexibility, because her expected return objective of 7 percent will meet her goals of funding her children’s education, building her ‘‘dream house,’’ and funding her retirement. Overall, her risk tolerance is below average.
Time horizon. Her time horizon is multistage. The time horizon could be described as three-stage (the next 5 preretirement years defined by work/housing costs; the subsequent 15 preretirement years defined by work/college costs; and beyond 20 years postretirement).
Liquidity. Scott has only a minor liquidity need ($26,000 in present value terms) to cover education expenses for her daughter next year. After that, she has no liquidity need for the next five years. Only then ($535,000 in present value terms, for home construction) and in Years 11 through 14 ($130,000 in present value terms, for her son’s education) will significant liquidity concerns exist.
Taxes. Taxes are a critical concern because Scott needs to fund outlays with after-tax dollars.
Unique circumstances. A significant unique circumstance is the large concentration (50 percent of her assets) in Marks Consultancy stock. Another factor is her desire to build a new home in five years yet incur no debt. Also, she would ‘‘like’’ to give each child $1 million, but this goal is unrealistic and should not drive portfolio decisions.
Scott indicates that Marks Consultancy has a leading and growing market share. The company has shown steady fundamental growth trends, and Scott intends to hold her Marks Consultancy stock, which is expected to return at least 9 percent annually before tax with a standard deviation of returns of 20 percent.
Changed Client Circumstances
Donna Scott, now 47 years old, has recently married a coworker at Marks Consultancy. Scott and her husband are buying their dream house at a total cost of $700,000, and they have decided to make an immediate down payment of $430,000 and finance the remainder over 15 years. Scott also indicates that her son has contracted a rare disease, requiring major surgery; the disease will prevent him from attending college.
Although Scott and her husband have medical insurance that will pay her son’s ongoing medical expenses, her son’s surgery will cost an additional $214,000 immediately. The cost of medical expenditures is expected to grow at a rate exceeding the general inflation rate for the foreseeable future. Scott has decided to quit work to care for her son, whose remaining life expectancy is 40 years. She also insists on the need to provide care for her son when she and her husband are no longer capable of doing so. Scott’s parents died one year ago, and her daughter is now financially independent. Scott’s husband intends to retire in 25 years.
Given these circumstances, the investment portfolio held by Scott and her husband will need to provide an amount equal to $1,713,000 (present value) to meet their living expenses until his retirement. They also want their portfolio to grow enough to cover their living expenses at retirement, which they estimate to be $400,000 annually. They believe they will need a before-tax portfolio growth rate of approximately 8 to 10 percent annually to achieve this goal. Based on a retirement spending goal of $400,000, their corresponding effective postretirement spending rate will be approximately 6 to 7 percent annually before tax.
Scott summarizes her new financial information in Table 1. She indicates that her portfolio and her husband’s portfolio should be considered as one. She further states that her husband has taken well above-average risk in the past, but he is now willing to leave the investment management decisions to her.
Table 1: New Financial Information
Current
Allocation
Percentage of
Donna Combined
Scott Husband Combined Portfolio
Required
- Indicate how each component of Scott’s investment policy statement should change as a result of Scott’s new circumstances. Justify each of your responses with two reasons based on Scott’s new circumstances. (10 Marks)
- Recommend whether the current allocation percentage (given in Table 1) for each of the following assets should be decreased or increased as a result of Scott’s new circumstances. Justify each of your responses with one reason based on Scott’s new circumstances.
- Marks Consultancy common stock
- Money market
- Diversified bond fund
- Large-capitalization equities
- Emerging market equities
- Undeveloped commercial land (15 Marks)
