Goals and Asset Allocation
You have new clients, Erik and Senta Bruckner. They are in their mid- 30s and have two children, Stella and Chloe, ages 6 and 8. The Bruckners’ primary financial objective is to provide for their children’s college education. Their secondary objective is to plan for retirement. They own a home with a mort-gage and have total family income of $ 100,000. Senta’s employer provides medical insurance and life insurance. She participates in her employer’s 401(k) retirement plan and currently has $ 40,000 in the plan. The funds are invested in her company’s stock. Erik is self- employed and works from their home. He has not established a retirement plan. After deducting the amount of the mortgage, the family has total assets of $ 200,000 available for investing in addition to the $ 40,000 in the retirement account. The Bruckners want sufficient liquid assets to cover six months’ income as a precaution
(0.5 3 $ 100,000 5 $ 50,000). At least 20 percent of the $ 50,000 should be in exceedingly liquid assets, but the remaining 80 percent may be invested elsewhere provided that the assets meet the objective to pro-vide sufficient liquidity. The remaining assets ($ 150,000) are available for other investments. These funds could be allocated in numerous ways. Since the couple is generating income, you expect the Bruckners to conclude that income- producing bonds are not a necessary component of their portfolio. That conclusion, however, is not necessarily correct. Bonds do offer potential diversification and may be included as part of any tax- deferred retirement account. The interest income will not be taxed until the proceeds are removed from the retirement account and the flow of interest income will compound over time. If Senta’s employer offers a bond fund as part of the retirement plan, selecting the bond fund instead of the company’s stock makes sense from an overall asset allocation perspective.
You decide to develop a sample asset allocation illustration. Once the Bruckners have grasped the concept, you can further subdivide the allocation. The starting amount is $ 240,000: the $ 40,000 in the retirement account, the $ 50,000 needed for liquid assets, and the $ 150,000 balance. You decide that the retirement account should be invested in bonds and the liquid assets should be in a money market mutual fund that stresses federal government Treasury bills. The balance should be divided equally between large cap and smaller cap stocks. To illustrate the allocation and its possible results over time, prepare answers to the following questions.
1. How much is allocated to each class of assets?
2. The expected returns for each asset class are as follows:
Large company stocks 10%
Small company stocks 12%
Corporate bonds 6%
Treasury bills 3%
How much will be in each account when the girls approach college age ten years from now?
3. Given the terminal values in the previous question, what is the portfolio’s asset allocation? What steps should be taken?
4. The expected returns in Question 2 are based on historical returns, but the period 2008–2009 has proven that returns can be much lower than those in Question 2. Suppose the returns on large cap and small cap stocks were only 1.4 and 3.2 percent, respectively. How much would be in the account after ten years? (Assume the yields on corporate bonds and Treasury bills remain 6 percent and 3 percent, respectively.)
5. If the Bruckners do not need the funds to finance their daughters’ college educations, how much will be in each account when they approach retirement in their mid- 60s under the original allocation? (Use the expected returns in Question 2.)
6. If the rate of inflation is 3 percent, goods and services cost that $ 100 will cost how much at their retirement? How much annual income is necessary to maintain the purchasing power of their $ 100,000 current income?
7. If their combined life expectancy is 15 years at their retirement, can the Bruckners maintain their standard of living if they have the amount determined above and their funds earn 7 percent after they retire? What is the future rate of inflation assumed in your answer? Is that assumption reasonable?
8. Based on the above answers, what are some suggested courses of action the Bruckners should consider taking?
