Question

Ten years have passed. The Muellers, now both aged 63, will retire this year. The distribution from Mark's family trust will occur within the next two weeks. The Muellers current circumstances are summarized below Personal Circumstances and Assets Pension income will total S100,000 a year and will not increase with inflation. Annual expenses will total $180,0p0 initially and will increase with inflation. Inflation is expected to be 2 percent annually Their personal investments now total S1 million (excluding trust distribution). The Muellers will rely on this S1 million portfolio to support their lifestyle and do not wish to reduce their level of spending. The Muellers have health problems and neither is expected to live more than 10 years. All health care expenses will be covered by employer-paid insurance. The Muellers' daughter is now financially independent, and the Muellers' sole investment objective is to meet their spending needs. The Muellers are not concerned with growing or maintaining principal. The income deficit may be met with both investment income and by invading principal. Trust Distribution Assets The trust distribution totals $2 million and will occur within the next two weeks. No tax liability is created by the distribution. The Muellers will maintain separate accounts for their personal assets and the trust distribution. They do not plan to withdraw income or principal. Tax liabilities produced by these assets will be paid from this portfolio. .The Muellers plan to donate these assets to an arts society when the surviving spouse dies. They have made a minimum pledge of $2.6 million toward construction of a new building. An after-tax annual return of 5.4 percent is required over five years to meet the minimum pledge. .The Muellers are concerned only that a minimum gift of S2.6 million is available. The Muellers assume that at least one of them will live at least five years and that neither will live more than 10 vears.

A. Select and justify with three reasons the most appropriate of the four portfolios from the choices on the table an asset allocation for the Muellers’ $1 million in personal assets.

B. Select and justify with three reasons the most appropriate of the four portfolios from as an asset allocation for the Muellers’ $2 million in trust distribution assets.

Answer 1

	Asset Allocation	Portfolio
		A	B	C	D
	Large caps	14%	30%	40%	30%
	Small caps	3%	5%	10%	25%
	Foreign stocks	3%	5%	10%	25%
	Immediate fixed term	70%	60%	30%	20%
	Cash Equivalents	10%	0%	10%	0%
	Total	100%	100%	100%	100%
A	Expected annual return	4.2%	5.8%	7.5%	8.5%
B	Std deviation	6.0%	8.0%	13.0%	18.0%
C	Probable changes in expected return (A*B)	0.3%	0.5%	1.0%	1.5%
D	Effective annual return considering the standard deviation(A-C) (Worst case)	3.9%	5.3%	6.5%	7.0%
E	Effective annual return considering the standard deviation(A-C) (Best case)	4.5%	6.3%	8.5%	10.0%
F	Investments (personal)	$        1,000,000	$        1,000,000	$        1,000,000	$        1,000,000
G	Investments (Trust)	$        2,000,000	$        2,000,000	$        2,000,000	$        2,000,000
Personal	Annual investment income (Worst Case) (D*F)	$              39,480	$              53,360	$              65,250	$              69,700
	Annual investment income (Best Case) (E*F)	$              44,520	$              62,640	$              84,750	$            100,300
Trust	Annual investment income (Worst Case) (D*G)	$              78,960	$            106,720	$            130,500	$            139,400
	Annual investment income (Best Case) (E*G)	$              89,040	$            125,280	$            169,500	$            200,600

Answer for A.

Pension Income for Muellers' is $100K and their annual expenses are $180K for the first year and will eventually increase @ 2% every year with the rise in inflation, their deficit initially would be of $80K.

Since the sole of objective of their personal investment is o meet their spending needs, the deficit of $80K could be well covered when $1 Million are invested in portfolio D,since it has the highest expected annual return of 8.5%. The returns from the portfolio D would adequately cover the deficit. However portfolio D has the highest standard deviation of 18% and effective annual return comes to 7% in the worst case scenario but effective return could be 10% (8.5% + 1.5%).

Most ideal would be portfolio D since it has the most diversified portfolio as compared to others.

Answer B

As per the table and calculation above, and considering the fact that they have Trust investments worth $2 million and $2.6 million of pledge towards construction of new building and the need to have an effective after tax rate of 5.4% in next 5 years to meet the minimum pledge.

The ideal consideration would be any portfolio other than portfolio A, but most ideal would be again portfolio D since it has the most diversified portfolio as compared to others.