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Constructed-Response Questions - Post #10 - The CFP Examination - December 2017

Posted by John Gobeil on

The CFP Examination is the second of two exams that must be passed to obtain CFP certification. We have posted this entry to assist you in your preparation for The CFP Examination being held on Friday December 1, 2017.

In the last Post, we considered time management for the multiple-choice questions.                                                                                                           

In this Post, we will look at the five step process to answer a constructed-response question.

Constructed-response questions

From the Sample Examination Items released by the FPSC, we are under the impression that the constructed-response questions will not be particularly harder than the multiple-choice questions. In fact, some of the questions could be posed as either a constructed-response question or a multiple-choice question.

However, a constructed-response question will require more time than a comparable multiple-choice question because you will have to type out your answer.

The Guide to Examinations for CFP® Certification says, “Please note that comments written on examination booklets will not be read.” So, you will have the questions in hard copy, not in the software.

Sample Examination Item

The following question was released by the FPSC.

Last year, after 10 years of service, Jim, age 35, was laid off from his job. His salary was $100,000 per year, and he was eligible for an annual bonus of up to 50% of salary. He received a severance payment during the same tax year; the net amount of $50,000 is currently in a short-term deposit earning interest of 1% annually.

Sarah, Jim’s spouse, age 33, is not currently employed and will have no income this year. Jim started a new job at the same salary shortly after losing his previous job. His new employer provides a 2% defined benefit pension plan. Jim currently has no TFSA contribution room – he withdrew the full amount in the plan earlier this year to cover expenses while neither partner was working.

Jim and Sarah have been referred to Marie, a CFP professional, to provide recommendations on how to allocate the full amount of the severance. Jim and Sarah do not require any of the funds for current cash flow and would like to implement the strategies as soon as the term deposit comes due next month. Jim and Sarah have moderate risk tolerance and would like to reduce their debt load.

  • They currently have a mortgage of $300,000 at a rate of 4.5%.
  • Credit card balance: $15,000 at a rate of 19%.
  • RRSPs: Jim has $25,000 unused RRSP deduction room; Sarah has no unused RRSP deduction room. Jim currently has $40,000 in RRSP investments as well as a $50,000 LIRA from his previous employer’s pension plan. Sarah’s only retirement asset is an RRSP portfolio of $7,000. Their current registered portfolios are earning a 7% rate of return.
  • Sarah has $10,000 of TFSA contribution room.
  • Marie has advised them that they could expect to receive the same return in a TFSA as they would in their registered savings.
  • Jim’s marginal tax rate is 38%.

Response Instructions

Provide three recommendations for allocating Jim’s severance payment that will maximize expected after-tax returns and minimize current-year taxes. Include a rationale for each recommendation.  (3 marks)

Response Template

Allocation

Amount

Rationale

 

 

 

 

 

 

 

 

 

 

How to answer a constructed-response question

Given three-quarters of a page of information about Jim and Sarah, you could ask many questions about their financial situation. How could Jim split his investment income with Sarah using a loan for value? How should Jim and Sarah allocate their assets? What are the implications of Jim losing his employer group insurance benefits?

So, if you simply started reading and analyzing the client situation, your mind is going to have to consider all of the possibilities. This is a waste of time and energy.

First, read the Response Instructions. Second, examine the Response Template.

We need to determine what to do with Jim’s severance payment. The response template has three rows, which strongly suggests that there are three things that Jim should do with his severance payment.

We are also told to consider uses that will maximize expected after-tax returns and minimize current-year taxes. In the response template, we are to include a rationale for each recommendation. 

You would expect from this that the rationale for each recommendation would include its effect in maximizing expected after-tax returns and minimizing current-year taxes.

Third, determine how much time you have to answer the question.

The question is worth 3 marks. Assuming there are 100 marks per paper, you have 5.4 minutes, calculated as (3 marks ÷ 100 marks) × 180 minutes in a 3 hour paper).

Now, you have an understanding of exactly what you have to do and how long you have to do it.

Fourth, read the client situation looking for all relevant information.

In this case, look for specifics about the severance payment and opportunities to allocate the severance payment to various uses.

You can highlight the potential opportunities and relevant facts or simply make a list. I think that I would do both.

The net amount of $50,000 is currently in a short-term deposit.

My list of opportunities and relevant facts includes:

  • Jim currently has no TFSA contribution room
  • Jim and Sarah do not require any of the funds for current cash flow
  • They currently have a mortgage of $300,000 at a rate of 4.5%.
  • Jim and Sarah … would like to reduce their debt load.
  • Credit card balance: $15,000 at a rate of 19%.
  • Jim has $25,000 unused RRSP deduction room
  • Sarah has no unused RRSP deduction room.
  • Their current registered portfolios are earning a 7% rate of return.
  • Sarah has $10,000 of TFSA contribution room.
  • Marie has advised them that they could expect to receive the same return in a TFSA as they would in their registered savings.
  • Jim’s marginal tax rate is 38%.

Fifth, analyze the relevant information and complete the response template.

So, they have four possibilities:

  • While the situation does not mention any repayment privileges, they might be able to make a payment on the mortgage of $300,000 at a rate of 4.5%.
  • They could make a payment on the credit card balance of $15,000 at a rate of 19%.
  • Jim could contribute up to $25,000 to his RRSP or a spousal RRSP.
  • Sarah could contribute up to $10,000 to her TFSA.

The highest “after-tax return” would be 19% on the payment on the credit card balance of $15,000. There would be no effect in minimizing current-year taxes.

Allocation

Amount

Rationale

Payment on the credit card

$15,000

The highest “after-tax return” of 19%.
Jim and Sarah would like to reduce their debt load.

 

 

 

 

 

 

 

They could expect to receive the same return in a TFSA as they would in their registered savings. Their current registered portfolios are earning a 7% rate of return

The “after-tax return” would be 7% on the Sarah’s contribution of up to $10,000 to her TFSA. There would be no effect in minimizing current-year taxes.

Jim currently has $40,000 in RRSP investments as well as a $50,000 LIRA from his previous employer’s pension plan. Sarah’s only retirement asset is an RRSP portfolio of $7,000. Jim’s marginal tax rate is 38%.

Given Jim’s RRSP and LIRA investments of $90,000 versus Sarah’s RRSP of $7,000, it would make more sense to have Jim contribute to a spousal RRSP in order to have comparable taxable incomes during retirement.

The rate of return would be 7% on Jim’s contribution of up to $25,000 to his RRSP or a spousal RRSP. Jim would be able to deduct an RRSP contribution reducing his current-year taxes by his marginal tax rate of 38%.

If Jim’s effective tax rate in retirement on the withdrawal of the $25,000 from his RRSP is not significantly greater than 38%, the “after-tax return” on the net amount contributed to his RRSP of $15,500, calculated as (RRSP contribution × (1 – marginal tax rate)) or ($25,000 × (1 – 38%)) would be 7%.

Similarly, if Sarah’s effective tax rate in retirement on the withdrawal of the $25,000 from her RRSP is not significantly greater than 38%, the “after-tax return” would be 7% on the net amount contributed to her RRSP of $15,500.      

The “after-tax return” would be 4.5% on a payment on the mortgage: a rate less than the returns on TFSA or RRSP contributions.

The maximum credit card payment, spousal RRSP contribution and contribution to Sarah’s TFSA conveniently total $50,000.

We do not have to rank the uses of Jim’s severance payment, so Jim’s spousal RRSP or Sarah’s TFSA contribution in any order.

Allocation

Amount

Rationale

Payment on the credit card

$15,000

The highest “after-tax return” of 19%.
Jim and Sarah would like to reduce their debt load.

Contribute to a spousal RRSP for Sarah

$25,000

If Sarah’s effective tax rate in retirement on the withdrawal of the $25,000 from her RRSP is not significantly greater than 38%, the “after-tax return” on the net amount contributed to her RRSP of $15,500.

A $25,000 contribution will produce a tax refund of $9,500, calculated as (RRSP contribution × marginal tax rate) or ($25,000 × 38%).

Contribute to Sarah’s TFSA

$10,000

The after-tax return would be 7%.


Strangely, in the solution, a rationale for contribution to Sarah’s TFSA was that “Jim has no available TFSA contribution room until the following calendar year.”

The five-step process is:

  1. read the Response Instructions;
  2. examine the Response Template;
  3. determine how much time you have to answer the question;
  4. read the client situation looking for all relevant information; and
  5. analyze the relevant information and complete the response template.

This question is not very technical. However, you might be rushed to do it in 5.4 minutes, especially if you were to read the client situation before the Response Instructions and Response Template.

The Examination Items or case situations have 1 to 3 questions. With two or three questions, the best way that we have found to adjust the process is to just repeat the five step process for each question.

Next Post

In our next Post, we will look at time management for constructed-response questions.

Effectiveness of our study aids

We always appreciate feedback on the effectiveness of our study aids. Together, we can continue to have the best study aids available.

John Gobeil, BSc, CFP®
David Gobeil, CPA, CA, CFP®


Certified Financial Planner® and CFP® are certification marks owned outside the U.S. by the Financial Planning Standards Board Ltd. The Financial Planners Standards Council is the marks licensing authority for the CFP marks in Canada, through agreement with FPSB.


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