IPS always makes up some challenging questions for me and I still cannot give perfect answers for such kind of questions. vignette: Jack and Ruth Ingram have an asset base of $4 million. their current annual pre-tax income need is $200,000. Inflation rate is 2.5%. They wish to leave total $3 million (real value) to their son and a local charity after their death. Their life expectancies are 35 years. What is nominal pre-tax return objective for their IPS? Correct Answer: N–>35, PV—>$4,000,000, FV—> -$3,000,000, PMT—> -$205,000 (200,000*1.025), so, I/Y–> 4.84% required nominal pre-tax return = 4.84%+2.5% I don’t understand why need to inflation-adjust annual spending but remain other inputs in today’s real value. I would use N–>35, PV—>$4,000,000, FV—> -$3,000,000, PMT—> -$200,000 to calculate the required rate of return. Is there anybody can explain it? Thank you in advance.
To preserve portfolio value you adjust for inflation after calculating spending returns…as was done in the example… To adjust current income for inflation, the inflation adjustment will be part of the return calculation (e.g. I/Y --> (1.0484*1.0250)-1=.07461 -->7.461%)
I am trying to calculate backwards, and I cant seem to get the answer I am using N–>35, PV—> $4,000,000, PMT—> -$200,000, I/Y ----> 7.461% Solve for FV = ? SHould give me 3M, but I cant get it … I get like 18M What am I going wrong?
You need to plug I/y 4.84% , 7.46 is after adding for inflation.
Still nobody answered YYK’s question—why the spending(200K) should be inflation adjusted?
it is confusing. the reason we have to multiply the income need by 1.025 is that $200,000 is the current need, but the income need for next year, to keep it all in real terms, will have to be increased by 1.025 as it will occur AFTER one year has passed. Hence the need to multiply. Now all the parameters are in “real” term.
just to add. the question says that the first 200,000 withdrawl will be immediate, therefore not considered in the investors portfolio. So the first withdrawl from the portfolio will be in 1 year, at which point the real value of 205000 will need to be taken
Thank you all. I read your posts and consider this question again. But still confused. Built up a spreadsheet to test the result. I used “Solver” function. Resulting required rate of return is 7.32354593481266%, slgihtly different from the CFAI answer (7.34%). However, if I use N–>35, PV—>$4,000,000, FV—> -$3,000,000, PMT—> -$200,000, resulting rate will be 7.32354587508648% [(1+2.5%)*(1+4.71%)-1]. TI calculator gives the same result. I don’t know how to post a spreadsheet. I probably focus on details too much. Just want to perform better in IPS questions, which is a key part of the whole level 3.
why are you using your PMT of 200k? The PMT needs to be adjusted for inflation since it’s it’s one year.
Ok, so for next year we use 200,000*1.025 but then going by the same logic, why don’t we use 200,000*1.025*1.025 in year 2 200,000*1.025*1.025*1.025 in year 3 and so on?
bhaiyyu Wrote: ------------------------------------------------------- > Ok, so for next year we use 200,000*1.025 > > but then going by the same logic, why don’t we use > 200,000*1.025*1.025 in year 2 > 200,000*1.025*1.025*1.025 in year 3 and so on? you could do it that way, but then you need to express the 3 million FV also in “nominal terms”, ie multiply it by (1.025)^35. The NPV calc wont work this scenario, you need to solve using Excel. Its much easier keeping everything in “real” numbers and then in the end, simply add the inflation factor.
Usually the pre-tax return is for IPS for the next one year. remember IPS is to be reviewed yearly. So at this point, you are reviewing the after-tax return for the next one year… The question states that their CURRENT income is 200000. So IN THE NEXT ONE YEAR, their income need spending will be 200,000*1.025=205,000. This is what is factor to arrive at the after-tax return UNADJUSTED FOR inflation effects on PORTFOLIO ASSET VALUE. The also indicated that they want to leave real value of their asset to their son. Any question that says anything in the range of maintaining same portfoio value - or value of real assets - will require that you add (approximate method, or multiply, exact method) the inflation rate to the after-tax return unadjusted for inflation effects on the portfolio value. Unless specified, your calculations for required return are usually based on the next one year. Check on the past questions and answers for 2000-2008…hope this helps
yyk6221 Wrote: ------------------------------------------------------- > > Correct Answer: N–>35, PV—>$4,000,000, FV—> > -$3,000,000, PMT—> -$205,000 (200,000*1.025), > so, I/Y–> 4.84% > > required nominal pre-tax return = 4.84%+2.5% > > I don’t understand why need to inflation-adjust > annual spending but remain other inputs in today’s > real value. I would use N–>35, PV—>$4,000,000, > FV—> -$3,000,000, PMT—> -$200,000 to calculate > the required rate of return. > > Is there anybody can explain it? Thank you in > advance. You need to see your N, PV, AND I/Y as inputs at beginning of year (now) and your PMT and FV as what you receive at end of one year (in one year’s time)…
yodhava Wrote: ------------------------------------------------------- > bhaiyyu Wrote: > -------------------------------------------------- > ----- > > Ok, so for next year we use 200,000*1.025 > > > > but then going by the same logic, why don’t we > use > > 200,000*1.025*1.025 in year 2 > > 200,000*1.025*1.025*1.025 in year 3 and so on? > > you could do it that way, but then you need to > express the 3 million FV also in “nominal terms”, > ie multiply it by (1.025)^35. The NPV calc wont > work this scenario, you need to solve using Excel. > Its much easier keeping everything in “real” > numbers and then in the end, simply add the > inflation factor. Thanks Yodhava, that makes it clear to me.
omoobagberume Wrote: ------------------------------------------------------- > Usually the pre-tax return is for IPS for the next > one year. > > remember IPS is to be reviewed yearly. So at this > point, you are reviewing the after-tax return for > the next one year… > > The question states that their CURRENT income is > 200000. So IN THE NEXT ONE YEAR, their income need > spending will be 200,000*1.025=205,000. This is > what is factor to arrive at the after-tax return > UNADJUSTED FOR inflation effects on PORTFOLIO > ASSET VALUE. > > The also indicated that they want to leave real > value of their asset to their son. Any question > that says anything in the range of maintaining > same portfoio value - or value of real assets - > will require that you add (approximate method, or > multiply, exact method) the inflation rate to the > after-tax return unadjusted for inflation effects > on the portfolio value. > > Unless specified, your calculations for required > return are usually based on the next one year. > Check on the past questions and answers for > 2000-2008…hope this helps Thanks a lot.