# 2007 Essay Q1 IPS

The Ingrams have 4200K in their portfolio to invest. Tje Ingrams agree that their current annual pre-tax income need is 200k. They expect their inflation-adjusted expenses will remain constant during retirement. They plan to fund their living expenses by taking annual distributions fromt heir poprtfolio with the first distribution to occur immediately. Swann believes an appropraite long term inflation rate is 2.5% and an appropraite planning horizon is 35 years. Upon their death, the Ingrams wish to leave gifts to paul and to a local charity. They wish to maintain the purchasing power of these gifts to be equivalent to \$2000k and \$1000k respectively, in today’dollars. Prepare the nominal pre-tax retrun objectives and show your calculation. My thought: Initial investment=4200k-200k. Ending future value=1000K+2000K=3000K. Each year there has to be a cash outflow of 200k*1.025 ( year 1), 200k*1.025^2 ( year 2), …until 200k*1.025^35 Then you can calculate the required return. Of course this is not what the answer says

PV = 4m, FV 3000m, PMT = 205000, N=35, I/Y =? I/Y + 2.5% inflation. This exam is effing hard.

Yea, it is hard for me too. A lot of corner concepts. I still do not understand why Pmt is adjusted for the first year but not the following years after. I would have imagined it is either 200k flat for all 35 yrs or 205K with 1.025 increase each year. I might be missing the definition of “inflation adjusted expense will remain constant”

By adding 2.5% to the answer, the payment IS adjusted for the following years after. The reason 5K is added to the spending next year is because the spending hasn’t occurred yet (will occur “next year” - with the inflation of 2.5%).

I agree with Ashwin. The return requirement’s for each year, so grossing up by 2.5% would offset the expected inflation. Compounding, i.e. (1.025)^2 in year 2, isn’t necessary because that implies inflation’s dynamic, not static (as they assume). Also you look forward a year on the return calculation, so gross up the spending requirement by 5%. I know it’s not intuitive. Trust me.

You guys so awesome! So it is a one time static inflation of 2.5% that applies to all years ONCE. it is not a compounding inflation year after year. Got it.

This inflation adjustment is hard to understand… Assume in above example, there is no desire to leave 3m gift at the end of time horizon. Would we still use 205k in calculating required return? 205k/4m= 5.1250%, and 5.1250+2.5(inflation)=7.6250%

We all understand why the expenses for the following year are 205,000 as this is the current expense of 200,000 compounded at 2.5% for 1 year. “They expect their inflation-adjusted expenses will remain constant during retirement” means that the expenses remain constant in real terms during retirement but should be adjusted for inflation at 2.5% each year. This is not reflected in the calculation in my opinion leaving me pretty confused. I don’t think this has been effectively explained - does anyone understand this question 100%?

Net investable asset: 4200K - 200K (need to fund this year’s living expense immediately) =4000K Terminal value we to achieve (real value) = 3000K Next payment of living expense (real value) = 200K(1.025) = 205K So PV = -4000, FV=3000, N=35, PMT = 205 = 4.84% (real pretax return) 4.84%+2.5% = 7.34% (norminal pretax return). Even there is no desire to leave 3m gift, we still use 205K because this year’s 200 living expense has been paid. the next payment is 205.

a_thinking_ape Wrote: ------------------------------------------------------- > We all understand why the expenses for the > following year are 205,000 as this is the current > expense of 200,000 compounded at 2.5% for 1 year. > “They expect their inflation-adjusted expenses > will remain constant during retirement” means that > the expenses remain constant in real terms during > retirement but should be adjusted for inflation at > 2.5% each year. This is not reflected in the > calculation in my opinion leaving me pretty > confused. > > I don’t think this has been effectively explained > - does anyone understand this question 100%? I agree i am really struggling to understand this. Would anyone else like to have a go at explaining this?

a_thinking_ape Wrote: ------------------------------------------------------- > We all understand why the expenses for the > following year are 205,000 as this is the current > expense of 200,000 compounded at 2.5% for 1 year. > “They expect their inflation-adjusted expenses > will remain constant during retirement” means that > the expenses remain constant in real terms during > retirement but should be adjusted for inflation at > 2.5% each year. This is not reflected in the > calculation in my opinion leaving me pretty > confused. > > I don’t think this has been effectively explained > - does anyone understand this question 100%? regarding the inflation in the return calc - my understanding - someone please correct me if i’m wrong - is that by adding the 2.5% onto the return req as a flat number, that is where inflation is being accounted for. that is why it’s a stable 205k per year in the calculation, and that is why we can use \$3 million straight as the FV, when the FV would be much more if we did not account for that inflation by adding the 2.5% on the end. now, i have 4 other questions regarding the constraints in this question (1-D) 1 - regarding the low basis company stock - it makes sense to me to put it in the tax section due to potential big tax effect upon liquidation. but there’s an IPS in CFA book 2 pg 154 - the maclins - where they have a similar issue, and the answer key does NOT mention this in the tax section, and DOES mention it in the unique section. can someone explain to me if there’s a difference between these 2 questions i’m not seeing? 2 - would anyone in the world have thought to put in the legal section (as the answer key did) that the fact that he SHOULD sell some of his company stock to diversify, but could then face insider issues if he did? seems like such a stretch to me. 3 - having a house they wanna donate after death is really a unique constraint? my understanding is that the house, being an illiquid asset, would not have been part of the investable asset base anyway? so why does it affect us to put it here? 4 - i was also under the impression that desire to leave a big post-death gift would create a new time stage, which it did not in this question. was i wrong about that?

bump anyone do this problem? are my questions dumb?

All your questions are legit. And I concur with you points 1,2,3! The exam was just brutal. Scored 111/160 = 61% yest night.

I screwed the pooch on this question. The inflation adjustment was just one problem. I don’t like the fact that in every other question of this nature we are not supposed to invade corpus of the investable assets. Yeah, I know they say they are going to leave a lesser amount to son and charity, but I guess I am supposed to assume that it is okay to eat principal? And where do they get 35 years? They are only going to live to be 85? To calc a req return based on these assumptions is lamo. Regarding dpcfa question, I don’t know to what extent the guideline answers are the only way to approach it. There were several places on that exam, that even after reading the guideline answer, I liked mine better. But that may mean I am screwed on test day. Issue 1 - it is clearly a tax issue. Prob wouldn’t hurt to add it to unique also, but not sure. Issue 2 - I mentioned in the legal constraint that his membership on the BOD caused some legal exposure. Don’t know if that would be enough. It seemed like such an odd add-on in info of the question, I figured they wanted it somewhere. Issue 3 - Clueless on this one. I think it is bit of a stretch. Ultimately, anything could be considered a “unique circumstance.” Issue 4 - My understanding is that if you added a timeline for this it wouldn’t be negative points. Again, that is from a Schweser class. Maybe you didn’t get all the points available, but I bet you got a good chunk of them.

Just managed to come to this 2007 exam finally. Wondering if writing: Legal - Prudent investor rules apply Unique - None can get any points? It’s so hard to find things to write for these 2 constraints!

dfcfa wrote: 3 - having a house they wanna donate after death is really a unique constraint? my understanding is that the house, being an illiquid asset, would not have been part of the investable asset base anyway? so why does it affect us to put it here? 4 - i was also under the impression that desire to leave a big post-death gift would create a new time stage, which it did not in this question. was i wrong about that? My responses: 3. I think the point is to consider something that is part of networth (but not a part of investable assets) in Unique Circ. UC is a bit of a basket of all unique leftovers. 4. Big post-death gift does not remain part of one’s IPS as it becomes part of recipient’s IPS. However, if the question relates to a multi-generational trust then because it outlives the investor only then it creates a new time stage.

we are creating the IPS for current investor. Even if its multigenerational, this IPS terminates after the death. Its someone elses problem