CFA Practice Question

CFA Practice Question

Connie Nielsen is a manager of an individual trust. The trust's current beneficiary is an old widow who depends on the trust's income for her current needs. Her son is the remainderman. Connie has purchased several low-risk premium bonds for the trust's portfolio. Connie has ______
A. violated Standard III (C) - Suitability regarding suitability of investments for the trust.
B. not violated any standard as she has emphasized higher coupon income for the current beneficiary and invested in bonds permitted by the trust's investment guidelines.
C. violated Standard III (A) - Loyalty, Prudence, and Care.
Explanation: Connie has violated Standard III (A) - Loyalty, Prudence, and Care as she has failed to balance the interests of the current beneficiary against the interests of the remainderman. By investing in premium bonds, whose coupon is greater than the current yield, she has paid more than the face value of the bonds. Since the bonds will be retired at the lower face value, this will result in a transfer of wealth from the remainderman to the current beneficiary in the form of higher current income.

User Contributed Comments 23

User Comment
MUSK What does remainder man mean?
malley Remainderman is the person who inherits the estate after the previous owner (or beneficiary) dies. I dont agree with this answer as I thought the beneficiary was the primary concern (making the premium bonds a correct purchase).
Misah Why B is wrong? Her client is an old person and she bought low risk bonds. It seems very reasonable to me.
pers The beneficiaries are younger and can afford to to lose that premium on the bond. The fact that she depends on the TRUST's INCOME is an indicator that C is correct!
ontrack D looks like the correct answer as the beneficiary's interests are most important and premium bonds provide higher coupon payments as income to the widow.
malawyer It is mentioned she bought "several" bonds but not that the whole AuM are invested for the current trustee. From a legal perspective (German law), if B would have invested only in stocks for example, to enhance the remaindermans benefit, she could be held reliable from the current trustee. B should be correct.
twotwo since there's no declaration on how the the distribution of income to old widow and son then the intention of the investor is to generate max income for the beneficiaries. C correct
copus This is a tough question, but you need to remember that in the same way that being too aggressive in an investment portfolio can be imprudent, soo too can being too cautious. The widow needs income and therefore buying a premium bond is completely imprudent.
u0302638 Hi copus..
If the window needs income, buying the premium bond would give her higher coupon payment , which in turn higher income...
Why is that completely imprudent?
Magoo The presumption here is that the interests of a trust's beneficiary and it's remainderman are equivalent and must be treated as such. Therefore by buying premium bonds you are converting some principal into current income, favoring the beneficiary over the remainderman.

However, given that the only fact regarding your clients is that the widow has a need for current cash flow and there is no explicit offsetting restriction regarding preservation of principal in the trust, it is a huge leap of faith to suggest that this must be a violation of the standards. The trust could easily have an investment policy that states the manager should minimize risk while generating at least $x in annual cash flow. In such a case this policy would be much more prudent than buying junk bonds to generate more coupon, but putting much more of the principal at risk.

If this is a violation any asset allocation in a trust with multiple beneficiaries could be considered a potential violation. Let's say two siblings are the benficiaries. Based on their ages, health and other sources of income, different risk profiles are appropriate. How do you possibly manage the trust in that case?
jpducros All this is really unclear ! Would someone have a good explanation ?
Nando1 I guess this all hinges on "premium" bonds. If Connie had purchased par or discount bonds B would be correct.
czar Could it be because the remainderman is a Prospective client? and Connie as a duty towards him as well? just a thought? others?
MaresaJaden How you manage a trust and its assets is governed by the trust document. The document will state the priority of the beneficiaries.

If the trust document says to generate enough income to support the current beneficiary you will invest accordingly. A lot will depend on if the benes have the right to invade principle. If this is the case you would invest the trust assets for total return (higher allocation to equities to support the growth of principle) and make distributions from the trust that are enough to support the bene but are not necessarily 'income.' This will both support the current bene while accounting for the fact that there is a remainderman who is able to assume more risk.

This is dumb. I answered B.
RAustin I don't think anyone would get in trouble for advising an old widow to invest in premium bonds and following the trust guidelines, and without knowing her age or the risk tolerance of the remainderman B seems the logical choice here.
Oksanata why loyalty prudence and care is violated? I thought it was suitability, because if widow is dependent on cash income than low risk premium bonds are not suitable to buy...
mrpman so basically this is a violation of the standards because the reinderman will be screwed over in the end? The investment advisor has a duty to both the widow and reindeerman?
alexchav Exactly, Oksanata. In any case, there is a violation of Suitability.
CalebMast It seems safe to say that many posting here got this answer incorrect. Nando1 seems to have the most helpful answer. To add to it, it's worth noting that both beneficiaries must be helped by investment. The remainderman must be taken into account. Moreover, buying a bond at premium does not make sense in this case. I'm trying to think of a case where it does, but that's where Nando1 primarily hits issue on the head. I missed the fact of premium being bad - sounds like most of us did. Without a remainderman, it seems the premium bond should still be a bad idea - lack prudence and loyalty.
mpeterson The son should be happy he is getting anything.
epfrndz I think B is the right answer. The client has not expressed any intention to change the investment guidelines. Given her old age, the low-risk bond is a good option, easier to liquidate than many other bonds and provides some return.

As a fund manager I am not in a position to decide for her since there is no evidence that she cannot decide on her own.

Think about it, how would you feel if your fund manager just assumed that you will eventually die and pass on your wealth. I never told him that a portion of the fund is to be liquidated and be given to some endowment or charity.
chesschh I also chose B, but according to explanation, key to remember is BALANCE.
If we have a young remainderman, premium bond is not the best option.
ashish100 So much junk in the comments. Just read what AN said. Simple and concise.
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