Free CFA Level III: Private Wealth Investment Planning Practice Questions

A is correct. Tax alpha represents the additional after-tax return that can be generated through deliberate tax management strategies. These include: asset location (placing tax-inefficient assets in tax-advantaged accounts), tax-loss harvesting (realizing losses to offset gains), withdrawal sequencing (strategically ordering distributions from different account types), holding period management (achieving long-term capital gains treatment), and charitable giving optimization (donating appreciated securities). Tax alpha can add 0.5% to 1.5% per year in after-tax returns.

B is incorrect. Excess return from security selection skill is simply "alpha" in the traditional investment management sense. Tax alpha specifically refers to the incremental after-tax benefit from tax management, not from investment selection.

C is incorrect. The difference between a portfolio's return and the risk-free rate is the excess return or risk premium, not tax alpha. Tax alpha is specifically about the after-tax incremental benefit of tax-aware strategies.

A is correct. A funded ratio of 1.15 means the client's current assets exceed the present value of all identified goals by 15%. This surplus provides several options: (1) the advisor could maintain the current allocation, providing a comfortable cushion against adverse market conditions; (2) the client could pursue additional aspirational goals (larger charitable gifts, lifestyle upgrades); or (3) the asset allocation could be made slightly more aggressive to increase expected growth, since the client can afford some additional risk.

Choice B is incorrect because the funded ratio is not a performance metric relative to a benchmark. It compares the client's total assets to the present value of their financial goals, not portfolio returns to an index. A 1.15 ratio says nothing about whether returns exceeded benchmark performance.

Choice C is incorrect because a funded ratio above 1.0 indicates the client's assets exceed their goal requirements — the opposite of needing to reduce spending. A spending reduction would only be warranted if the funded ratio were below 1.0, indicating a shortfall between current assets and the present value of liabilities.

B is correct. The present value of a 20-year annuity of $280{,}000$ at 3.5% is:
$$PV = 280{,}000 \times \frac{1 - (1.035)^{-20}}{0.035}$$
$$(1.035)^{20} = 1.9898$$
$$\frac{1 - 1/1.9898}{0.035} = \frac{1 - 0.5026}{0.035} = \frac{0.4974}{0.035} = 14.211$$
$$PV = 280{,}000 \times 14.211 = 3{,}979{,}000 \approx 3{,}986{,}000$$ The floor portfolio is funded with approximately $3{,}986{,}000$, invested in high-quality bonds, TIPS, or an annuity that matches the liability cash flows. The remaining:
$$10{,}000{,}000 - 3{,}986{,}000 = 6{,}014{,}000$$
is the upside portfolio, available for growth-oriented investments (equities, alternatives) aimed at aspirational goals and legacy. This structure ensures that the client's essential spending is immunized against market risk, while the surplus is invested for long-term growth without endangering the income floor.
A is incorrect. $4{,}012{,}000$ slightly overstates the present value. The annuity factor at 3.5% for 20 years is 14.212, yielding approximately $3{,}979{,}000$ — the closest answer is $3{,}986{,}000$. The difference reflects the approximation but $4{,}012{,}000$ implies a marginally different discount rate or factor.
C is incorrect. $5{,}600{,}000$ overstates the present value by a significant margin. This figure would require either a much lower discount rate (near 0%) or much higher annual payments. Using 3.5% for a 20-year annuity produces approximately $4{,}000{,}000$, not $5{,}600{,}000$.