I would have to look at the two other than this vague summary. But, in general, even if both salary and expenses grow at inflation, therefore creating a constant real inflow/outflow each year, you still need to protect the portfolios value from inflation so it should be added (or multiplied) to the return requirement.
E.G. expenses is one area in which inflation needs to be considered, the portfolio is the other (and larger) part.
Thanks markCFAIL, your answer clarifies the vague question for me.
I think the key here is that 2008 q says salary and expense rise at the rate of inflation .
But EOC #13 says salary growth offsets living expense growth .
offset is a bigger deal while growing linearly may not offset . For example if living expense is 100k and salary is 80k then gap is 20k in the beginning. If both go up by 5% ( i.e. no offset ) then the gap between living and salary will go up by 5% , so that the portfolio will begin to erode. So we must calculate a nominal rate of return as the current rate + 5% ( being inflation ) . The portfolio has to be the offset .
In EOC 13 the gap remains constant . Which can only mean that salary has to record a higher increase than 5% , so that we can simply shoot for a current rate with no need for providing for inflation.The salary increases makes the gap constant.
I may be paranoid , but I think you have to read the words very closely .
Of course none of this will occur to me during the actual test
Actually I was not looking at it with that much granularity janak, but that is a very interesting point.
TBH when i see the words “preserve real value”, “inflation adjusted”, or “grows with inflation”… or basically anything that even looks similar to these phrases, i always add in inflation. That is why i missed the 2008 morning where it says “salary and expenses are a wash”. I am not 100% sure when they want to add it and when they don’t, but I think between Janakisri’s comment and my halfwit attempt at an answer, we may be getting closer.
I think Janak may be right on with regards to “both grow at inflation” versus “salary and expense growth offset eachother” – the former requiring including inflation in the return, the latter not.
I’ll defer to smarter individuals than myself to put the nail in this coffin.
I am unsure on #3, all others I agree with. It depens on whether “match” means in terms of percentage, or dollar amounts. If percentage then it is the same as #2. Ugh, i hate this test and its nuances.
#3 infered from 2010 AM ques 1. There is no inflation number given in vignette. They say it is expected to match. Though we have not used this since #4 applied while calculating return. TVM was given to purchase the annuity.
Still not convinced on that Janak… offset is more clear cut, expenses and salary are neutralized in prepetuity. “match” could mean matchin percentage increase, which would make it the same as #2 as I mentioned. Matching dollar increase would be offsetting.
And the inference on the 2010 AM Q is tricky because that involves a TVM calc as rahuls said, so we cannot be sure that #3 infers not adding inflation.
This is still a grey area for me though I feel I am closer. The uncertainty around inflation adjustment and also when to include charitable gifts/bequests into return calculations are the two parts of individual IPS that really confuse me. Text says gifts/bequests are “desired” and not “required” so should not be part of required return. However I saw a past morning test that did just the opposite. I may have to reach out to CFAI on these. Anyone know the general email address for this type of question and about how long it usually takes to get a reply?
They immediately give you a response saying 1-2 business days. And they are usually good about curriculum book related errata / doubts.
I am however not sure if they will provide you with an answer there.
If you had the question in mind - post it here … so we can all try to arrive at a resolution together / with the help of other outside resources. I know a lot of folks are doing classes and could ask the Professor (either live or during chat sessions) and so on.
sorry to bring this back from the dead when we all thought it was resolved, but i just did the 2008 question today.
in 2008, the expenses = salary. it says “salaries just cover their living expenses”. so there is no gap. if expenses were 120K and salary was 119K, then fine, the gap increases each year. but theyre the same. so even in 300 years, they’ll both be equal if both grown at the same inflation rate.
i think the real key is that the maclin case does not desire to grow the portfolio at the inflation rate (no mention of preservation made, no inflation rate given). DO NOT ADD INFLATION.
the 2008 case part I explicitly says they want to maintain the portfolio value in real terms, and it is even listed in the formulation of the objective. ADD INFLATION.
in the 2008 case, in the second part, you dont add inflation. they have no real wealth preservation objectives. in that new paragraph, no mention is made of wealth preservation, and it is not included in the new formulation of the return objective. to me, this meant that real value does not need to be preserved. just get to a desired terminal value, like the maclin case. DO NOT ADD INFLATION.
in the 2007 case, they explicitly say they want to increase the portfolio with inflation. so you need one portion of your return to cover expenses and one portion to cover real welth preservation of the asset base. ADD INFLATION.
if this is correct (please correct me if u disagree), then i think there is something off with the way CFAI explains this in the answer key. in the maclin case and in 2008 part 2, they say that salary and expenses just offset. im not sure i understand this explanation. both salary and expenses offset in the 2008 question part 1, yet we still added inflation there. so to me, the key is wealth preservation vs. reaching a terminal value, not salary and expenses offsetting.
TheShow… totally agree with your assessment, and if it’s wrong I don’t know how to correct it anyhow. I also agree the CFAI answers are too surface level and inconsistent. I emailed them with multiple detailed questions over a month ago and never got a reply. I have had run-ins with them in the past and once you back them into a corner they just choose to not answer. How very “ethical” of them.
yea i mean i agree with all of the math and answers so i wouldnt say its wrong. they probably are just being very unclear/vague with the notes they have in both maclin and 2008 cases. “salary/expense is a wash”–are you kidding me?
TheShow, theoretically for the maclin case, what has to happen for inflation adjustments to be made?
Suppose expense/income do not offset and that expenses increase at inflation while income does not…would we multiply the expenses by (1+infl) in the CF section AND NOT add inflation in return requirement ?
Suppose expenses/income do not offset and that expenses increase at inflation while income does not AND we want to preserve purchasing power…would we multiply the expenses by (1+infl) AND add inflation in return requirement?
Now that I think about it, the notes they put for the Maclin case and the 2008 case don’t address inflation of the portfolio whatsoever. The notes are not wrong–they just simply refer to the expenses/income rather than the tacking on of the inflation.
In the Maclin case, the note is just referring to why the annual salary and living expenses are not higher numbers.
In the 2008 case, the note is just referring to why the PMT function does not need any adjustment for living expenses–it’s because the salary covers it.
That’s all they are saying. In other words, they are stating the obvious to us (that salary = expenses and the return objective does not need to be increased to account for living expenses). And they are NOT making any reference whatsoever to the inflation rate that is to account for real portfolio growth, but that’s because it is unnecessary to add them in both places.
I think this is the answer to this problem and makes the 2007, two 2008, and Maclin returrn objectives agree. Not bad for three hours of brain torture.