Investment Advisor Risk Management and Insurance in Financial Planning 2 — Questions and Answers
Question 1: Longevity risk in retirement planning refers to:
- The risk of dying too soon and leaving dependents without income
- The risk of outliving one's retirement assets (Correct answer)
- The risk of inheriting a large estate
- The risk of low stock market returns
Correct answer: The risk of outliving one's retirement assets
Longevity risk is the risk that a retiree will outlive their savings — a key concern as life expectancies continue to increase.
Question 2: Which strategy is most commonly recommended to hedge longevity risk in retirement?
- Investing entirely in short-term bonds
- Purchasing an annuity that provides guaranteed lifetime income (Correct answer)
- Spending down assets as quickly as possible
- Holding all assets in money market funds
Correct answer: Purchasing an annuity that provides guaranteed lifetime income
Annuities that guarantee income for life are the primary tool for hedging longevity risk, ensuring retirement income regardless of how long the retiree lives.
Question 3: Interest rate risk primarily affects which type of investment?
- Stocks
- Fixed-income (bond) investments (Correct answer)
- Real estate investment trusts
- Commodities
Correct answer: Fixed-income (bond) investments
Bond prices move inversely to interest rates — when rates rise, existing bond prices fall — making fixed-income investments most exposed to interest rate risk.
Question 4: Duration is a measure used to estimate a bond's sensitivity to changes in interest rates. A bond with a duration of 5 years will approximately lose how much in value if rates rise by 1%?
- 1%
- 3%
- 5% (Correct answer)
- 10%
Correct answer: 5%
Duration approximates the percentage price change per 1% change in interest rates — a duration of 5 means approximately a 5% price change for a 1% rate move.
Question 5: Credit risk (default risk) is best described as:
- The risk that an investment will be difficult to sell at fair value
- The risk that a bond issuer will fail to make promised payments (Correct answer)
- The risk that inflation will outpace returns
- The risk that interest rates will change
Correct answer: The risk that a bond issuer will fail to make promised payments
Credit risk is the risk that a bond issuer will default on interest payments or fail to repay principal, resulting in loss to bondholders.
Question 6: A client asks about protecting against the risk of a major stock market decline in their portfolio. Which strategy provides the most direct hedge?
- Buying more equities to lower average cost
- Purchasing put options on a stock index (Correct answer)
- Moving all assets to money market funds
- Increasing the portfolio's beta
Correct answer: Purchasing put options on a stock index
Put options on a stock index increase in value when the index declines, providing a direct hedge against portfolio losses from market downturns.
Investment Advisor Risk Management and Insurance in Financial Planning 2
Longevity risk in retirement planning refers to: