Question

You are a managing partner of a prestigious investment counseling firm that specializes in individual rather than institutional accounts. The firm has developed a national reputation for its ability to blend modern portfolio theory and traditional portfolio methods. You have written a number of articles on portfolio management and you are considered an authority on the subject of establishing investment policies and programs for individual clients tailored to their particular circumstances and needs.

Dr. and Mrs. A.J. Mason have been referred to your firm and to you in particular. At your first meeting on August 1, 2012, Dr. Mason explained that he is an electrical engineer and long-time professor at a local university. He is also an inventor and, after 30 years of teaching, the right to one of his patented inventions has just been acquired by a new electronics company, ACS, Inc.

In anticipation of the potential value of his invention, Dr. Mason has followed his accountant’s advice and established a private corporation, wholly owned by the Masons to hold the title to the patented invention.   It was this private corporation that sold the right to Dr. Mason’s invention to ACS, Inc. ACS, Inc. has agreed to pay $1 million in cash, payable at the closing on September 30, 2012, for the right to Dr. Mason’s invention. In addition, ACS, Inc. has agreed to pay royalties to Dr. Mason’s private corporation on its sales of systems that utilize the invention.

While all parties are optimistic about prospects for success, they are also mindful of the risks associated with any new firm, especially those exposed to the technological obsolescence of the electronics industry. The management of ACS, Inc. has indicated to Dr. Mason that he might expect royalties of as much as $100,000 in the first year of production and maximum royalties of as much as $500,000 annually thereafter.

During your counseling meeting Mrs. Mason expressed concern for the proper investment of the $1 million initial payment. She pointed out that Dr. Mason has invested all of their savings into his inventions. Thus, they will have only their Social Security retirement benefits and a small pension from the local university to provide for their retirement. Dr. Mason will be 65 at September 30, 2013. His salary from the local university is currently $55,000 per year and he does not expect this amount to change between now and his planned retirement on his 65th birthday. After retirement Dr. Mason expects to continue earning $10,000 - $25,000 annually from consulting and speaking engagements.   The expected Social Security benefits are expected to be $1,800 per month beginning in October, 2013 and the annual pension from the local university is expected to be $15,000 per year beginning at the same time.

Assuming the royalty payments from ACS, Inc. are equal to $100,000 in the first year and an average of $300,000 per year thereafter, the Masons are planning to help with the education of their six grandchildren. The grandchildren range in age from 8 to 12 years old. In addition, the Masons wish to establish a scholarship fund in the name of Dr. Mason at the local university that would provide $5,000 per year to one selected electrical engineering student. This scholarship should be self- sustaining with its own investments.

Both Dr. and Mrs. Mason have strongly indicated during the first appointment that they are conservative investors and want a minimum risk of any losses.

Requirements

You and your fellow partners are to present a proposal that specifically meets the retirement investment objectives of the Masons listed below. Your proposal should be from 4 – 6 pages double spaces, Times Roman 12 pt. In addition, your team should include a cover page listing each member of your team and a separate list of any references used in preparing the proposal. The proposal must follow APA rules in structure and presentation.

Dr. & Mrs. Mason’s Retirement Investment Objectives

*Provide $65,000 of withdrawals from the investment account each year. This amount will be in addition to the university pension and Social Security received each year.

*Minimize income tax.

*Include at least three types of investments.

*Provide for active management of the portfolio with an annual fee of 1% - 1 ½% of value in the investment portfolio.

*Provide an annual growth after all withdrawals and fees of 4% - 5%.

*Provide funding for the six grandchildren’s education that will total $40,000 each when they reach the age of 18.

*Provide for a continuing scholarship at the local university in the amount of $5,000 per year.

Answer 1

The investment objectives of the Masons should be expressed in terms of return and risk. These return and risk preferences should be portrayed in terms of the Mason's preferences, their current financial status, and the stage in their life cycle.

Investment Objectives

Returning Requirement : Dr. Mason is nearing retirement. Therefore, the overriding objective is to provide the Masons with sufficient retirement income. This objective should be easily satisfied by investing the original $1,000,000 payment from ACS to provide a moderate current income level. This income, combined with Masons Social Security and pension benefits, will provide sufficient retirement income. Because of the large cash payment from ACS ( even after payment of capital gains taxes ), The Masons will have a large enough financial base to pursue their objectives, specially for the grandchildren and for the scholarships to the Essex Institute. These latter two objectives suggest a portfolio seeking long term capital appreciation. Therefore, the substantial size of the assets permits a growth oriented posture with a secondary emphasis on current income. Common stocks and equity real estate provide growth opportunities, and the latter may also provide tax benefits.

Risk Tolerance : Given the substantial size of the Masons assets, this portfolio can tolerate a larger amount of risk than is normal for a family in the latter stage of their life cycle. Coupled with the Masons retirement benefits, a moderate income from the portfolio can accept greater risk in the pursuit of higher long term capital appreciation. A significant portion of the Masons assets can be invested in growth assets, such as common stock and real estate, with the secondary emphasis on investments with a high current income yield. The greater the amount of royalities received, the greater the risk of tolerance for the portfolio.

Investment Constraints

Liquidity : The substantial size if the Masons assets and the prospects for continued high royalty income lessens the importance of the liquidity constraints. A major portion of the portfolio should be invested in relatively non liquid assets in order to achieve long term capital growth.

Time Horizon : Because the Masons are in the later part of their life cycle, one would ordinarily expect them to have a relatively short term horizon. The size of the Masons assets, however and the objectives of providing for the education of their grandchildren and for the scholarships, dictate that a substantial portion of the portfolio be invested for the longer term. Common stocks and real estate would be appropriate.

Regulatory and legal : Since this is a personal portfolio, regulatory and legal constraints are not important

Investment Policy

Given the Masons substantial assets, the investment policy should be emphasized capital appreciation and provide moderate current income. The large size of the portfolio allows the purchase of growth oriented common stocks while providing sufficient income. The policy will provide opportunity to achieve the objectives of education of grandchildren and funding the scholarships to the Essex institute, while providing enough retirement income. Growth assets should be a better inflation hedge. Real estate, tax exempt bonds, and low risk money market invetsments would provide the necessary diversification.