I have a question on Part A after looking at the CFAI guideline answer on the pre-tax nominal reate of return: The net income needed (after-tax) is $45K. Then CFAI instruction grosses up to pre-tax instantly before adding the inflation rate in the last step. However, my understanding is to calculate the inflation-adjusted after-tax return first, then gross up to the before-tax return. Would someone please help me with this puzzle? Thanks in advance!

I think this would over-state the return requirement: Portfolio needs to generate $45K after-tax at age 60. After-tax return requirement: 45/1,000 = 4.5% + 4% expected inflation = 8.5% required AT return. Then, pre-tax would be 8.5% / .8 = 10.63% This assumes you need to gross up the expected inflation to a pre-tax figure… however, it’s double-counting because you’ve already inflated the one-year’s expenses by expected inflation of 4%. Not sure if this is where you were going?

got 10.68% me , too. I adjusted for inflation then accounted for taxes … was really frustrated when I saw that CFAI proceeded in the opposite way, this takes 10 points out of my score :(( guys, I remember having seen questions where they adjust for inflation before accounting for taxes, please correct me if I ma wrong… Thanks, M.

malek_bg We had very extensive discussions about which method to use in several threads earlier; we couldn’t reach a solution. I feel your frustration. BTW, I sent an inquiry to CFAI on 4/24/10. They replied on 4/27/10 that it was forwarded to education dept. and they would contact me in near future. So far I’ve heard nothing, but hopefully soon. Initially I was thinking posting in AF after being answered. Here is the content of the inquiry: >>>>>>>>>>>>>>>>> Question on pre-tax nominal rate of return calculation for IPS I have a question on the calculation of the pre-tax nominal rate of return for Investment Policy Statement (IPS) of individual portfolio. It is covered in the 2010 Level III Curriculum, Studying Session 4, reading 14. On page 131 of curriculum volume 2, it shows the formula as: Pre-tax nominal rate of return = (After-tax return + Inflation) / (1- Tax rate) = (3%+4%)/(1-35%)=10.8% However, the 2009 Level III exam essay guideline has a different formula for the pre-tax nominal rate of return. In question 1 part A ii, it shows the formula as: Pre-tax nominal rate of return = [After-tax return/(1- Tax rate)] + Inflation = [4.5%/(1-20%)] + 4%=9.625% If I apply the calculation from curriculum to 2009 Level III Essay question 1 part A ii, then: Pre-tax nominal rate of return = (After-tax return + Inflation) / (1- Tax rate) = (4.5%+4%)/(1-20%)=10.625%. So there is a 1% difference between the two methods. I note that on page 115 of the curriculum volume 2, the last paragraph states, “…the inflation rate should be adjusted upward by the portfolio’s average tax rate.” Therefore, I would consider the method used in the curriculum is correct and the calculation in 2009 essay guideline omits to adjust the inflation upward accordingly. Would you please confirm my assumption? Would you please let me know which method should be used in the exam? Thanks for your time.

thanks for your reply! please keep us posted once you hear from CFAI

Please do - let’s keep this one near the top

James@Houston, TKVM for your action taken. I originally plan to send inquiry to CFAI tomorrow. Please surely post CFAI’s reply here. I have been stuck by this confusion so such a long time !

AMC, No problem! Will post once it is received. Really appreciate your effort in the discussions earlier. Lots of us here deserve a clear CFA answer while studying so hard.

This was discussed quite a bit after the exam. I had 10.85 (mulitplicative) or 10.63 (additive). I scored highest in that section, so I’d be surprised if their released answer key was correct…I suspect the answer key they provided was not the same answer key graders used. Here is the post exam discussion: http://www.analystforum.com/phorums/read.php?13,1003718,page=1

I think the difference depends on whether capital gains and income is taxed or just income. If its both then include the inflation in when /(1-T). if its just income then add inflation after dividing the real return by (1-T).

Finally I got the CFAI response!! CFAI indicates that 2009 Q1 is a tax-deferred porfolio that expects a tax rate of 20% to apply to the “Tracys’ withdrawals” from the investment account. So tax is not applied to inflation. For the exam – I guess if you only got taxed on withdrawals, then you won’t have to gross up tax for inflation. PLEASE COMMENT… There have been discussions that either method should be acceptable in the exam (note that this is an opinion not a fact). see the following thread: http://www.analystforum.com/phorums/read.php?13,1140680,1140905#msg-1140905 Below is the actual message from CFAI: >>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>> Thank you for your email. Your question raises an important issue with respect to calculating the nominal return required to maintain the purchasing power for an individual’s investment portfolio. The need to adjust the inflation component of the required return depends on the tax status of the underlying portfolio. In the case of a portfolio where capital gains and income are taxed when earned/received, the required return inflation component will be “grossed up” by (1 – tax rate), i.e., inflation/(1 – tax rate). In the case of a tax-deferred portfolio where only the withdrawals from the portfolio are taxed, the inflation component is not tax-adjusted. The guideline answer to Question #1 on the 2009 exam assumes that the Tracys’ portfolio is a tax-deferred portfolio: The question states that “Briscoe expects a tax rate of 20% to apply to the Tracys’ withdrawals from the investment account.” Based on a cash-flow analysis, the Tracys need their investment portfolio to generate $45,000/4.5% on an after-tax basis ($56,250/5.625% on a pre-tax basis) to make up for the shortfall between their living expenses and income. With expected inflation equal to 4%, in order to maintain the purchasing power of their investment portfolio the Tracys must earn an additional 4% return. Therefore, the nominal required pre-tax return on their portfolio equals 9.625%. In the curriculum examples you reference, the returns on the investment portfolio, capital gains and income, are taxed when earned; therefore, the inflation component to the required rate of return should be inflation adjusted. I hope this helps.

don’t want to beat this to death, but this has been explained before http://www.analystforum.com/phorums/read.php?13,1127642,1132653#msg-1132653

James@Houston, TKVM for the post of CFAI’s reply. Its very bad that I almost forgot what we have been discussing. I am quite frustrated by the fact that I can not retain much of the exam material studied. I must look into this question/issue again ! Anyway, TKVM !

elcfa and AMC, TKVM for analyzing this issue all along!

elcfa Wrote: ------------------------------------------------------- > don’t want to beat this to death, but this has > been explained before > http://www.analystforum.com/phorums/read.php?13,11 > 27642,1132653#msg-1132653 I guess CFAI guys stole elcfa’s idea of TDA. They replied James’ email days after his/her post.

Just bumping this because I lost track of it and forgot that James was going to give us a reply. So, to summarise: - if it is a TDA, then you convert the after-tax amount into the pre-tax amount and then adjust for inflation - if it is not a TDA, you adjust the after-tax amount for inflation and then convert it into the pre-tax amount Does that sound correct?

> > - if it is a TDA, then you convert the after-tax > amount into the pre-tax amount and then adjust for > inflation > - if it is not a TDA, you adjust the after-tax > amount for inflation and then convert it into the > pre-tax amount > > Does that sound correct? Yes, per CFAI way. I still argue that you need to do the second method for both types of account, but let’s not spend more time on this.

I agree with you elcfa, but let’s suspend reality for three weeks and make sure we pass this damn thing

elcfa, James@Houston & others, I just revisited the question & CFAI’s reply. I don’t think most candidate will assume that “the Tracy’s portfolio is a tax-deferred portfolio” on the exam because no explicit indication about this assumption. Acually, I found CFAI was not so seriously in writing the exam. 2009 AM Q2 is another example, I could not find the terms of “implied assets / liabilities” in 2009 curriculum at all. On the other hand, I found the CFAI’s curriculum is not well organized and systematic. There are many overlapped topics with different terms/denotations/expressions and many statements are vague which cause very much confusion, especially in L3 curriculum. I hope you will pass the forthcoming exam and do something to improve it after your becoming a charterholder and thank you very much for sharing your opinions.

Reading Sponge_Bob’s thread from 2009… if people log onto AF at the lunch break on June 5th and discuss answers from the am section, then is helping out others?! This has probably been discussed over and over… but it just occurred to me (new to AF this year). Anyway, I’m sure people are sick to death of talking about problem 1b) from the 2009 exam.