Case 2. The Bruckner’s Asset Allocation (P892).

You have new clients, Erik and Senta Bruckner. They are in their mid-30s and have two

children, Stella and Chloe, ages 6 and 8. The Bruckners’ primary financial objective is to

provide for their children’s college education. Their secondary objective is to plan for

retirement. They own a home with a mortgage and have total family income of $100,000.

Senta’s employer provides medical insurance and life insurance. She participates in her

employer’s 401(k) retirement plan and currently has $40,000 in the plan. The funds are

invested in her company’s stock. Erik is self-employed and works from their home. He

has not established a retirement plan. After deducting the amount of the mortgage, the

family has total assets of $200,000 available for investing in addition to the $40,000 in

the retirement account.

The Bruckners want sufficient liquid assets to cover six months’ income as a precaution

(0.5×$100,000=$50,000). At least 20 percent of the $50,000 should be in exceedingly

liquid assets, but the remaining 80 percent may be invested elsewhere provided that the

assets meet the objective to provide sufficient liquidity.

The remaining assets ($150,000) are available for other investments. These funds could

be allocated in numerous ways. Since the couple is generating income, you expect the

Bruckners to conclude that income-producing bonds are not a necessary component of

their portfolio. That conclusion, however, is not necessarily correct. Bonds do offer

potential diversification and may be included as part of any tax-deferred retirement

account. The interest income will not be taxed until the proceeds are removed from the

retirement account and the flow of interest income will compound over time. If Senta’s

employer offers a bond fund as part of the retirement plan, selecting the bond fund

instead of the company’s stock makes sense from an overall asset allocation perspective.

You decide to develop a sample asset allocation illustration. Once the Bruckners have

grasped the concept, you can further subdivide the allocation. The starting amount is

$240,000: the $40,000 in the retirement account, the $50,000 needed for liquid assets,

and the $150,000 balance. You decide that the retirement account should be invested in

bonds and liquid assets should be in a money market mutual fund that stresses federal

government Treasury bills. The balance should be divided equally between large cap and

smaller cap stocks. To illustrate the allocation and its possible results over time, prepare

answers to the following questions.

1. How much is allocated to each class of assets?

2. Based on the historical returns in Exhibit 10.2 in the textbook, how much will be in

each account when the girls approach college age ten years from now?

3. Since historical returns are averages, how much will be in each account assuming that

the worst- and best-case scenarios based on Exhibit 10.4 in the textbook were to occur?

(Be careful to select the appropriate time horizon for the comparisons.)

4. What would have been the impact on the terminal amounts in Question 3 if the

allocation had been 40 percent large cap companies and 60 percent small cap companies?

5. Given the values in Question 3, what is the portfolio’s asset allocation after ten years

have passed? What steps should be taken?

6. If the Bruckners do not need the funds to finance their daughters’ college education,

how much will be in each account when they approach retirement in their mid-60s under

the original allocation?

7. Based on the rate of inflation in Exhibit 10.2, goods and services costing $100 will cost

how much at their retirement? How much annual income is necessary to maintain their

standard of living?

8. If their combined life expectancy is 15 years at retirement, can they maintain their

standard of living if their funds as a whole earn 7 percent after they retire? What is the

future rate of inflation assumed in your answer to the previous question? Is that

assumption reasonable?

9. Based on the above answers, what are some suggested courses of actions the Bruckners

should consider taking?