Estimated study time: 45 minutes
Content:
The Investment Policy Statement (IPS) for individual investors is the cornerstone of wealth management at CFA Level 3. The individual IPS documents the client's financial situation and investment mandate in a way that guides all portfolio construction decisions. Constructed-response questions on the CFA L3 exam frequently ask candidates to identify, justify, or critique elements of an individual IPS — often presenting a client scenario and asking for a specific IPS component.
The IPS for individual clients addresses six components, often called the RRTTLLU framework: Return requirement, Risk tolerance, Time horizon, Taxes, Liquidity, Legal/regulatory constraints, and Unique circumstances. Return requirement is determined by the client's financial goals — living expenses, portfolio growth needed to maintain purchasing power after inflation, and any specific goals (education, bequest, purchase). Return must be expressed in terms the portfolio can realistically achieve: pre-tax or after-tax, nominal or real, before or after advisory fees.
Risk tolerance has two components: risk capacity (ability to bear risk, based on financial situation — income stability, asset base, time horizon, liquidity needs) and risk willingness (psychological comfort with volatility, determined by questionnaires and behavioral assessment). Both must be considered. When risk capacity and risk willingness diverge (e.g., a client with high capacity but low willingness), the IPS should reflect the lower of the two — the portfolio should not expose the client to more risk than they can psychologically bear, even if they could financially sustain it. However, the advisor has an obligation to educate a client who irrationally underestimates their capacity.
Time horizon is the investment period relevant to each major financial goal. Individual investors typically have multi-stage time horizons — working years (accumulation phase), early retirement (distribution phase), and late retirement. Each stage may call for different asset allocation. A client who retires at 65 with a 25-30 year life expectancy has a much longer effective time horizon than a 10-year "retirement horizon" might suggest.
Liquidity needs encompass both known near-term spending requirements (a home purchase in two years, ongoing living expenses) and the need for emergency reserves. Liquidity constraints directly limit the portfolio's allocation to illiquid assets. A client with high liquidity needs cannot allocate substantially to private equity, real estate, or hedge funds with lock-up periods.
Tax considerations include the client's marginal income tax rate, treatment of capital gains (long-term vs. short-term rates), tax-deferred accounts (IRA, 401(k)), and tax-exempt accounts (Roth IRA, municipal bonds for high-bracket investors). Asset location — choosing which assets go in which account type — is a critical tax efficiency strategy: place high-turnover, high-yield assets in tax-deferred accounts; place tax-efficient assets (index funds, municipal bonds) in taxable accounts.
Key Terms:
Quiz Questions:
Q1. A 45-year-old physician earns $400,000 annually and has $1.5 million in investment assets. She has no debt, three years of living expenses in cash, and expects to retire at 65. She tells her advisor she is very uncomfortable with volatility. Her financial situation supports a high-risk portfolio, but her stated psychological comfort level is low. How should the IPS treat this conflict?
A) Default to risk capacity — the client can financially bear high risk, so the portfolio should be aggressive B) Default to risk willingness — the portfolio should be conservative regardless of capacity C) Reflect the lower of the two (risk willingness), but the advisor should educate the client on why tolerance for more risk may be in her long-term interest D) Average the two assessments and construct a moderate portfolio
Answer: C — When risk capacity and risk willingness diverge, the IPS should not expose the client to more risk than she is comfortable with — overriding her stated preference would be a violation of suitability. However, the advisor's duty includes educating the client on the long-term cost of an overly conservative portfolio (inflation erosion, insufficient retirement income). The IPS should currently reflect low-to-moderate risk with a plan to revisit as the client becomes more educated about risk-return tradeoffs.
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Q2. A retired couple, ages 68 and 70, has $5 million in investments. Their annual spending is $180,000. They have Social Security income of $60,000/year. They want to leave a bequest of at least $3 million to their children. Their required portfolio return is approximately:
A) 180,000 / 5,000,000 = 3.6% (spending rate only) B) (180,000 − 60,000) / 5,000,000 = 2.4% plus inflation to maintain purchasing power and grow toward the bequest goal C) 3.6% plus inflation equals approximately 5.5-6.5% nominally D) Cannot be determined without knowing the time horizon
Answer: C — The portfolio must fund the $120,000 annual shortfall (spending minus Social Security), maintain purchasing power (inflation ~2-2.5%), and grow toward the $3M bequest goal. Required return: ($120,000 / $5,000,000) + inflation = 2.4% + ~2.5% = ~4.9% real or ~5.5-6.5% nominal. Ignoring inflation (answer A) would result in an inadequate return objective that erodes the portfolio in real terms.
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Q3. A client inherited a large concentrated position in a single tech company, representing 60% of her portfolio. She refuses to sell because of emotional attachment to the company. Under the IPS, this is best classified as:
A) Risk willingness — she is choosing to bear concentration risk B) A unique circumstance that must be explicitly documented in the IPS, including the tax implications and the risk of concentration C) A return requirement — the concentrated position is expected to generate high returns D) A liquidity consideration — large concentrated positions cannot be sold quickly
Answer: B — A concentrated inherited position is a classic "unique circumstance" in the IPS. The advisor must document the concentration, explain the risk, and note the client's decision not to diversify. Tax consequences (embedded gains) may also be relevant. The IPS does not override the client's decision but must clearly record the constraint and its implications for portfolio risk.
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Q4. Human capital is most relevant to the IPS for which type of client?
A) A 70-year-old retiree with a fixed pension and $3 million in investments B) A 35-year-old engineer with $50,000 in investments and expected salary income of $2 million in present value terms over her career C) A 60-year-old semi-retired business owner planning to sell her business in five years D) A charitable foundation with a perpetual time horizon
Answer: B — Human capital (present value of future labor income) is most relevant for working-age individuals with most of their wealth still "in" their career. For the 35-year-old engineer, human capital ($2M) dwarfs financial capital ($50K). This affects appropriate risk level in the financial portfolio: since human capital is relatively stable (like a bond — steady income), she can afford to invest her financial capital more aggressively in equities. For the retiree (Answer A), human capital has been largely converted to financial capital — it is no longer relevant.
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Q5. A high-income client in the 37% federal tax bracket is deciding between a corporate bond yielding 5.5% and a municipal bond yielding 3.8%. The tax-equivalent yield of the municipal bond is approximately:
A) 3.8% B) 3.8% / (1 − 0.37) ≈ 6.03% C) 3.8% × (1 − 0.37) ≈ 2.4% D) 5.5% × (1 − 0.37) ≈ 3.47%
Answer: B — Tax-equivalent yield = municipal yield / (1 − tax rate) = 3.8% / (1 − 0.37) = 3.8% / 0.63 ≈ 6.03%. Since 6.03% > 5.5% (corporate yield), the municipal bond offers a better after-tax return for this client. This is the standard calculation used to compare taxable and tax-exempt bonds.
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