You have new clients, Erik and Senta Bruckner. They are in their mid-30's 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 mortgage and have a total family income of $100,000. Senta's employer provides medical insurance and life insurance. She participates in her employer's 401K 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 home. He has not established an retirement plan. After d educting 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 Bruckner's want sufficient liquid assets to cover six months income as a percaution (0.5 x $100,00= $50,000). At least 20 percent of the $50,000 should be exceedingly liquid assets, but the remaining 80 percent may be invested elsewhere provided that the assets meet the objective to provide 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 Bruckner's to conclude that income-producing bonds are not necessary component of their portfolio. That conclusion 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 more sense from the overall asset allocation perspective.You decide to develop a sample asset allocation illustration. Once the Bruckner's 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:
3. Given the terminal values in the previous question, what is the portfolios asset allocation? what steps should be taken?
4. The expected returns in Question 2 are based on historical returns, but the period is 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 10 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 education, how much will be in each account when they approach retirement in their mid-60s under the original allocation?
6. If the rate of inflation is 3 percent, goods and services cost $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 retirement, can they maintain their standard of living if their funds as a whole 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 actions the Bruckners should consider taking?