Nominal vs real required return

CFA Level III Portfolio Management
#1

Dear all

I’m looking at Q1 2013 am exam questions about Voort. Living expenses last year were 300k.

Inflation expected is 2.5%, so his expenses next year are 300k× 1.025= 307.5k with pension nominal income of 87.5k after tax next year i.e required net investment income next year is 220k.

Investment portfolio is 11m, so required return is 220k/11m is 2.0%. This is now where I get confused, as model answer states this is a real required return and adds the 2.5% expected inflation, to state nominal required return is 4.5%. However, if the 2.5% was already added to the 300k expenses from last year, then why are we adding the 2.5% and I’m confused why 2.0% is not the nominal

required return and adding the 2.5% would be double counting the required inflation adjustment?

Thanks in advance

#2

I’m not reading the original problem ( just your message) but the inflation originally added to the expenses is just increasing it to next years value. Which takes care of 1 year only. ( every year will be higher because of inflation)

So the 2.5 % needs to be added to the return every year going forward so that the principal increases with inflation to keep is real value.

#3

Thanks, but the question asks for the required nominal after tax return for the COMING year - i.e. not every year going forward…

#4

Your post says “last year” (2016). so the $87.5K is this year for 2017. So in the coming year 2018 you would still need to include it.

#sneakyCFAI

#5

Calculate the real return and add inflation rate to it you will arrive at the nominal rate.

#6

The final addition of inflation is the maintain the purchasing power of the portfolio. You have “inflated” current living expenses you want out of the portfolio, but you have not accounted for the fact that the portfolio in its current state cannot buy as much as it could have, because all the “prices” have gone up.

#7

You’re trying to accomplish two things here:

  1. Cover this year’s expenses
  2. Grow the corpus so that the same return next year will cover next year’s expenses

You increase last year’s expenses by 2.5% to get this year’s expenses; that handles #1.

You add 2.5% to the required return, growing the corpus by 2.5% (i.e., you’re not spending that this year); that handles #2.

#8

Got it, thanks to all who have replied

#9

My pleasure.