liquidity constraint

Patricia and Alexander Tracy, both age 59, are residents of Canada. They have twin sons whowill enter a four-year university program in one year. Patricia is a long-time employee of atelecommunications company. Alexander is a self-employed sales consultant.Alexander’s annual income is now steady after years of extreme highs and lows. The Tracyshave built an investment portfolio through saving in Alexander’s high income years. TheTracys’ current annual income is equal to their total expenses; as a result, they cannot add tosavings currently. They expect that both their expenses and income will grow at the inflationrate. All medical costs, now and in the future, are fully covered through government programs.The Tracys worry about whether they have saved enough for retirement, and whether they willbe able to maintain the real value of their portfolio. Inflation is expected to average 4% for theforeseeable future.The Tracys have approached Darren Briscoe to help them analyze their investment strategy andretirement choices. The Tracys disagree about the appropriate investment strategy. Patriciaprefers not losing money over making a high return. This is partly a result of continuing regretfor a loss experienced in an equity mutual fund several years ago. Alexander’s history of makingfrequent changes in their portfolio greatly annoyed Patricia. She thinks Alexander focused onlyon potential return and paid little attention to risk.The Tracys currently have all their assets in inflation-indexed, short-term bonds that are expectedto continue to earn a return that would match the inflation rate after taxes. After retirement, theyare willing to consider changing their investment strategy if necessary to maintain their lifestyle.The Tracys are eligible to retire next year at age 60. If they do, Patricia will receive annualpayments from her company’s defined-benefit pension plan and both Patricia and Alexander willreceive payments from the Canadian government pension plan. Alexander does not participatein any company or individual retirement plan. Briscoe has compiled financial data and marketexpectations for the Tracys’ retirement, shown in Exhibit 1. Currently, Briscoe estimates that theTracys’ investment portfolio will grow to 1,100,000 Canadian dollars (CAD) by their retirementdate next year.Level III Page 37070 09Exhibit 1Financial Data and Market ExpectationsPatricia and Alexander TracyRetirement at Age 60(2010)Expected annual expenses CAD 125,000Annual pension income (after-tax)Patricia’s company plan CAD 40,000Combined government pension CAD 40,000Total annual pension income CAD 80,000Expected annual inflation 4.0%Expected annual after-tax portfolio return 4.0%Pension income from both Patricia’s company plan and the government pension plan is fullyindexed for inflation. Briscoe expects a tax rate of 20% to apply to the Tracys’ withdrawals fromthe investment account. The Tracys expect to earn no employment income after retirement. TheTracys’ residence is not considered part of their investable assets.The Tracys have the option to delay retirement until age 65. The Tracys intend to retire together,whether it is in 2010 at age 60 or in 2015 at age 65.Briscoe determines that if the Tracys retire at age 60, their risk tolerance is below average. Ifthey retire at age 60, they plan to pay off their mortgage and associated taxes by withdrawingCAD 100,000 from their portfolio upon retirement.Another consideration for the Tracys relates to funding university expenses for their sons. If theTracys retire at age 60, each son will receive a scholarship available to retiree families fromPatricia’s company that will cover all university costs.If the Tracys retire at age 65, all pension income would increase and would almost meet theirannual spending needs. If they retire at age 65, the Tracys would pay all university expensesfrom their investment portfolio through an arrangement with the university. The arrangement,covering both sons, would require the Tracys to make a single payment of CAD 200,000 at age60.A. i. Prepare the return objectives portion of the Tracys’ investment policy statement(IPS) that will apply if they retire at age 60.ii. Calculate the pre-tax nominal rate of return that is required for the Tracys’ firstyear of retirement if they retire at age 60. Show your calculations.(12 minutes)Page 47070 09Level IIIB. Indicate specific factors for the Tracys, for each of the following, which supportBriscoe’s conclusion that the Tracys’ risk tolerance is below average:i. Ability to take risk. Indicate two factors.ii. Willingness to take risk. Indicate one factor.(6 minutes)C. Prepare the current (2009) liquidity constraint for the Tracys’ IPS:i. if they retire at age 60.ii. if they retire at age 65.(4 minutes)D. Prepare the current (2009) time horizon constraint for the Tracys’ IPS:i. if they retire at age 60.ii. if they retire at age 65.