Preserving the Wealth
2026 Curriculum
CFA® Program Level III
Private Wealth
Refresher reading access
Introduction
The overview of private wealth management presented earlier in the curriculum establishes life cycle finance as a dominant framework to understand how investors use their wealth to achieve their goals. Although the financial stages of life are difficult to define precisely, individuals do tend to follow predictable financial patterns during their lifetimes. They might invest in education early in life, start families, accumulate assets, fund growing household expenses, transition into retirement, and ultimately pass on wealth before or after death.
The family extended balance sheet, introduced in an earlier reading, and how it evolves through these life stages are also lenses through which we can identify, measure, and manage the risks to which financial goals are exposed. This reading explores three key risks associated with the financial stages of life: the impairment of human capital, the erosion of purchasing power, and the volatility of exchange rates.
Families of all wealth levels are exposed to these risks in some form, but in different ways and to varying degrees depending on their situation and life stage. The family extended balance sheet is a useful risk management framework to identify and evaluate these risks. Wealth management, balancing human capital and other assets against liabilities and obligations, is risk management in much the same way as pension funds manage risk.
Learning Outcomes
The candidate should be able to:
- analyze the types of risks relevant to human capital;
- describe and recommend strategies to manage risks to human capital;
- recommend planning and investment strategies to mitigate the corrosive influence of inflation on preserving purchasing power;
- describe how exchange rates influence asset allocation and planning as well as approaches to mitigate the exchange rate risk.
Summary
- The two primary asset types for most individuals can be described broadly as human capital and financial capital. Human capital is the net present value of the individual’s mortality adjusted future expected labor income.
- Financial capital includes such items as a bank account, investments in individual securities, pooled investment funds, private retirement accounts, and a home. Other assets can include an interest in a family-held business, real estate, or expected inheritances.
- Individuals’ economic wealth changes over their lifetimes, reflecting human capital income, and the value of assets. For younger individuals, human capital dominates their wealth. As they age, earnings accumulate, boosting financial capital.
- Risk management for individuals involves five steps: identifying, measuring, evaluating, managing, and monitoring risks and making necessary adjustments.
- Risk management techniques include risk avoidance, risk mitigation, risk transfer, and risk acceptance. The best choice depends on the risk’s frequency and severity as well as the size of the family’s surplus.
- Earnings risk refers to the risks associated with the earnings potential of an individual: events that could negatively affect someone’s human and financial capital.
- Mortality risk relates to the death of an individual, such as a family member, whose future earnings (human capital) were expected to help pay for the financial needs and aspirations of the family.
- Longevity risk is the possibility of depleting financial capital before death.
- Mortality tables can be used to estimate the retirement needs (i.e., retirement needs analysis) using survival probabilities to weight expected retirement expenses, which becomes a liability or investment objective on the family extended balance sheet.
- Sequence-of-return risk amplifies longevity risk caused by large negative returns early in a withdrawal program.
- Longevity risk can be managed through volatility control, dynamic withdrawal programs, laddered bonds, bucket planning, and annuities.
- Liability risk refers to the possibility that an individual or other entity may be held legally liable for the financial costs of property damage or physical injury. For wealthy individuals, personal liability risk can become a key financial risk because their substantial assets may draw attention and make them targets for legal claims.
- Life insurance aims to replace the value of human capital after their death. A family’s insurance need relates to the potential loss of the individual’s future earnings or the needs of the family.
- Life insurance types are temporary (term life insurance) and permanent (whole life insurance).
- Temporary life insurance, or term life insurance, provides insurance for a certain time period specified at purchase.
- Permanent insurance, or whole life insurance, is used to provide lifetime coverage, assuming the premiums are paid over the entire period.
- Fixed annuities offer a set benefit for life. Variable annuities’ benefits change based on the performance of an underlying investment. When selecting between fixed and variable annuities, considerations include the volatility of the benefit, flexibility, future market expectations, fees, and inflation.
- Factors increasing the demand for an annuity include longer life expectancy, preference for lifetime income, reduced emphasis on inheritance, conservative investment preferences, and lower guaranteed income from other sources, such as pensions.
- A household’s decision to assume risk or purchase insurance depends on their risk tolerance. Households with higher risk tolerance are more likely to retain risk rather than purchase insurance, especially when insurance products are costly.
- At the same level of wealth, a more risk-tolerant household will prefer to retain more risk, either by choosing higher insurance deductibles or by simply not buying insurance, than will a less risk-tolerant household. Insurance products that are viewed as expensive will encourage a household to retain more risk.
- Insurance products, like annuities, can serve various roles in a portfolio, mimicking the income features of certain asset classes.
- Households that can tolerate more risk might opt for higher deductibles or forgo insurance.
- An individual’s total wealth influences their portfolio construction, including allocations to risky assets and selected asset classes, like stocks or bonds.
- The specific income features of insurance products, such as annuities, can replace, complement, or amplify income from specific asset classes. Fixed annuities are similar to bonds, while variable annuities have equity-like features.
- Idiosyncratic risks are unique to individuals and include occupational hazards, longevity risk, long-term illness, and risks of premature death or property loss.
- Systematic risks are economy-wide factors that impact all households.
- The extent of this impact varies based on each household’s asset allocation, wealth, and investment strategy.
- Inflation reduces purchasing power, posing a long-term risk to wealth accumulation and consumption level preservation. The actual inflation rate depends on a family’s consumption preferences.
- Inflation risk can be gauged by the correlation between family investment objectives and inflation, indicating the optimal hedge ratio.
- Most assets are negatively correlated with inflation, making them unsuitable inflation hedges.
- Families operating internationally face exchange rate risk. The family extended balance sheet can identify the magnitude of currency risk and recommend potential hedges. Important in this determination is the identification of a reference currency, or the currency in which a family’s investment objectives are denominated.
2 PL Credit
If you are a CFA Institute member don’t forget to record Professional Learning (PL) credit from reading this article.