CFA 2013 Exam and Question 1 Part A

Did anyone besides me think the 2013 exam was more/to very much more difficult than 2014/2015? They hit a couple of my weak points but I felt like overall it was just more difficult. I was scoring pretty good on morning and afternoon item sets for schweser and CFAI mocks/prior exams and then hit this exam and got a reality check. I am hoping it is just a more difficult exam, nonetheless I am going to plug in the holes found in the short amount of time left and pray the exam saturday is not that difficult or its going to be a long day.

Question (1A):

If you are given income that is not inflation adjusted, and expenses that rise with inflation, it appears you need to timeline it out and inflate expenses separately and determine the net expense before the return calculation. I had incorrectly assumed adding inflation to the return would cover this but it must not because the income isn’t inflration adjusted? I am missing some connecting piece as to why you can’t do this?

This seems to imply you could only be tested on a short amount of time for return if you had to manually compute adjusted expenses because you have to do it by hand unless there is a way to do this on the calculator?

I keep finding all these little nuances in the IPS return objective that drive me crazy… I guess that is the point. Adjusting to extraneous detail under time constrained situations and breaking it down… FML, they certainly don’t make it easy.

Did it earlier and felt the same way unfortunately we have to suck it up and move on. Wouldn’t be a great question to start off the day on Staurday

In most of the questions (key word most): Calculate the real return as a percentage, then add inflation, then factor in tax. If you do this as a percentage it should resolve the issue.

Income is a constant number, I’m afraid using the net amount for real requirement is incorrect, let alone adding inflation.

In situations like these, you would need a spreadsheet to determine the optimal return target.

What do you need to ‘timeline’ out here? I think it’s a pretty straightforward question.

I approach all these questions just trying to figure out two things: 1) the cash need and 2) the investable assets.

Cash need is straightforward enough, it’s last years expenses plus inflation minus any income.

Investable assets is straightforward.

Then it’s cash need/investable assets = after tax real rate of return

After tax real rate of return + inflation = nominal after tax rate of return

Nominal after tax / (1- tax rate) = nominal pre-tax rate of return (not asked here). The one thing to watch out for is tax sheltered accounts, in which case you have to divide by (1-tax rate) first, then add inflation.

We are talking about one of the two components not matching in inflation.

Can you explain dividing tax sheltered accounts by (1-t) and then adding inflation? Are you referring to the fact that becuase it is tax sheltered, inflation component of returns is not subject to taxes?

Yes. I think.

To be honest, I don’t fully understand WHY you do it…I just know you do it. I believe 2009 Question 1 Aii is the last time this was tested. In Canada we call these RRSP accounts, where income/gains within the account tax free, but withdrawals are taxed.

If you look at the answer to that question, my way to do it is the same method as I described above.

The after tax cash flow needed is $45,000

The investable assets are $1,000,000

The real, after tax return needed is 45k/1MM = 4.5%

Then since this is a tax sheltered account I know you have to divide by (1 - tax rate) first which gets you to 5.625%. Then you add 4% inflation to get the pretax nominal return of 9.625% which is the correct answer.

Thanks all…

Time line out might have been the wrong description - as it’s only one year not 5, but what I was getting at was manually adjusting the expense for the coming year to find the cash need, that question was a little unique in how it went about it compared to previous questions where the income and expenses both adjusted for inflation.

I think the key here is laser like focus on the details in the case — I missed that the income was taxable #1, and then didn’t adjust expenses properly. As opposed to a more complicated gifitng scenario in a different question that I nailed.I attribute this to doing a full morning at 11 at night after a previous morning and entire day of studying as I was in WTF mode, but it is an important lesson of methodically writing down EVERYTHING they give you and not losing sight of it.

Schweser Volume 2 Exam 2 Question 6A also deals with this. The vignette states: Washington and Beitia discuss appropriate tax assumptions for the portfolio. There will be no tax benefit for the donation; however, they expect some tax sheltering by deferring gains and through tax location of assets. For the inital analysis, they assume the component of return equal to inflation will not be subject to tax.

Here is their Candidate Discussion:

“Applying the tax gross up before or after inflation can be confusing. It is best addressed by the client and manager making assumptions regarding the annual tax rate or in some other manner. In this case, they explicitly agree the inflation component of return is assumed not to be taxed. Therefore, the tax gross up must be done before inflation.”