I have a major problem with all IPS calculations where the portfolio has to preserve real value.
None of my calculations were good so far.
Taking as example Q6 from 2018 AM exam:
“The funding goal is to maintain the after-tax real value of their portfolio after making a donation…”
So my starting point is, that after making the donation and after deducting the living expenses, the portfolio has to equal with its original amount increased by the yearly inflation rate.
Based on the solution the portfolio is 3,464,545 (after donation, after 1 year of earning and spending for living) vs having been 4,000,000 in the beginning.
Where did this portfolio maintain its real after tax value? Nowhere.
How am I to handle this “maintain after-tax value” issue, shall I just ignore it? Then why do they write it into the question?
The point here is that the value that they want to maintain is the real value of the portfolio after they have made the donation. They are not trying to maintain the real value of the 4m. So once you have the cash outflow that needs to be covered and you are told the expected REAL return, you can divide the cash by the real return to see the principle amount that is needed so that the returns are sufficient to cover the cash and sustain the value (since it is a real return).The difference between that and the starting value is how much they can donate.
Thank you for the explanation, yes looking at the question again, I see, but then it is an English problem for me. An ‘afterwards’ instead of the ‘after’ would have been clearer for me.
I am with Moosey on this, in this case you should discount nominal cash flows with a nominal rate. Which we dont have, so you instead you would discsount a real cash flow with a real rate.
If you need to perserve real value the easiest way for me to think about it just use
(Price 1 - Price 0)/Price 0
Your regular holding period return calc!
You have 1 dollar starting but you want to make sure you never lose that dollar
You need to return by the end of the year 1 dollar but you are planning to have a 50 cent withdrawal at the end of the year. WHAT DOES THIS MEAN. Means you need 1.5 future value
Price 1 = 1.5 Price 0 = 1
You need to (1.5-1)/1 = 50% Return in the year! The formulas they use are like (p1/po) -1 all the time in the explanations
you adjust your inflows and outflows with inflation. then you find the net expenditures needed to fund the shortfall. which is 95275. this amount is automatically adjusted for real value. to fund this cash flow streams you need (95275/.0275) 3,464,545.
calc your regular REAL Req. Return ( CF needs/ Investable Asset, something like this) 2) add inflation or geometric link with inflation to reach Nominal Req Return
MM:
calc CF needs, investable assets 2) grow your investable asset at inflation --> calc the return req. to maitain purchasing power 3) CF needs + “maintain pp needs” = your return goal; 4) NOMINAL REQ Return = (3)/ Investable Asset.
i believe above two yield different answers.
I’ll prob go with CFAI method on the real one . ??
Still not sure I understand this. If the 95,275 is a nominal dollar amount (adjusted for 3% inflation), why would we divide it by the real rate of return? Can someone please help clarify. thank you!
The real return is the return for what you’re going to pull out of the account, which, in this case, is 95,275.
The nominal rate of return includes what you’re going to pull out of the account and what you’re going to leave in the account (for inflation: continued growth).
Thank you, S2000magician! Just to confirm, if the question was worded to say “maintain the after-tax nominal value of the portfolio”, then 95,275 would be divided by 5.75% (3%+2.75%) instead?
On a side note, do you advise when we calculate nominal returns in the questions by the multiplication approach (1+real% * 1+inflation)-1 or addition (real% + inflation %)?