How to account for inflation in return requirement?

CFA Level III Portfolio Management
#1

If we are given a after-tax return requirement, how do we account for inflation while computing a portfolio return requirement?

Do we compute pre-tax return, and then add inflation to it? Or do we add inflation to the post-tax return, and then compute pre-tax return?

I am confused! :frowning:

#2

It depends on if inflation related return is taxed or not.

If you assume you do not realize inflation part of gains, so you defer the tax on them into perpetuity, you first computer pre-tax and then add inflation. If you assume you tax all nominal gains annually, you first add inflation to after-tax then compute pre-tax.

The problem is that questions do not specify what is the case. My solution is that I will tax inflation related gains and add disclaimer that ā€œI assume inflation compensation gains are taxedā€.

#3

Iā€™m also irritated by this ambiguity of personal investment IPS. And also on the part of whether to compound or to simply add. Frustratingā€¦ But like what cfacandid mentioned, the best way is to put disclaimer and assumption.

But I think there are also problems if implicitly the question expects you to calculate it in some way or another through reusing the calculated number for later parts or it is a PM mcq question.

  1. With compounding and assuming inflation is taxed

[(1 + return)(1 + inflation) - 1] / ( 1 - tax)

  1. Addition and assuming inflation is taxed

[return + inflation] / ( 1 - tax)

  1. Addition and assuming inflation is not taxed

return / ( 1 - tax) + inflation

#4

In my experience, you neednā€™t assume anything; CFA Institute will tell whether the account is taxable or not.

Read the vignette carefully.

#5

Thanks everyone!

#6

But how about the part of inflation being taxable or not? This will make a key difference b/w your answers.

#7

I covered that, above:

#8

If they says account is taxable and calculate pre tax return, then should return be calculated as

(1) before tax return = (after tax return + inflation) / (1 - tax)

or

(2) before tax return = (after tax return / (1 - tax)) + inflation

#9

2

#10

This means your return to account for inflation is tax free?

Eg. you require return 3% after tax and 2% inflation with tax rate 25%. You are saying return is (3/0.75)+2 = 6 %.

But in reality if you generate 6% return. Your after tax return is 4.5% - 3% going to your after tax return and left with 1.5% which is not sufficient to cover inflationā€¦

#11

Account is taxable:

Only withdrawals are taxable:

#12

yes thank you!

#13

Can anybody please provide reference to specific questions in mocks or EOC regarding this?

#14

2009 CFA Exam, Question 1: A 20% tax rate applies to withdrawals from the account; _the account is nontaxable _.

2010 CFA Exam, Question 1: Income and gains grow tax-deferred and portfolio reallocations are not subject to tax , income taxes are paid on full amount of withdrawals ; _the account is nontaxable _.

2011 CFA Exam, Question 2: Income and realized gains are taxed at 20% , _the account is taxable _.

2012 CFA Exam, Question 1: Tax-exempt account , withdrawals are tax-free, without penalty; _the account is nontaxable _.

Read the vignette; it will tell you whether the account is taxable or not.

#15

Well done! S2000magician, youā€™re the man!

#16

My pleasure.

#17

thanks S2000

I think Iā€™m getting more confused by some of these threads. My answers to the 2011 and 2012 were both correct just by working through the specifics of the question

#18

Hey 2000 on the 2010 question would you be able to help me understand why we used pre-tax figures when working out the amount to fund the annuity?

I would have thought we would need 2,000,000/(1-tax rate)??

#19

Bump for those looking for explanation on thsā€¦ perfect explanation by S2000. Cleared my dobutā€¦ thanks :slight_smile:

#20

My pleasure.

Sorry to hear that.

As it should be.

Read carefully: they give you the information you need.