Two questions. When calculating the required return for an individual investor do we always assume that the current expenses are adjusted for inflation (ie 90,000 * (1+i)? Next, for calculating the pre-tax return, should we take the after required need from above, then divide by (1-t) and then add the inflation on to that figure? I always thought you could take the return (1+r)(1+i)/(1-t). Can anyone help me sort this out? Thanks

I think you would get credit for both if you decribed what you were doing, but I think the preferred method is: (1+r)(1+i) / (1-t) [but I do think I’ve seen it done the other way on some CFAI solutions]

Thx prockets. Can anyone else confirm what they have seen. I have been all over the place with respect to the solutions from CFA and Schweser

I dont think that will be a big issue. I have almost always seen everyone add on the inflation in the very last step. Thats what I will do

this has been discussed before and i think both ways were agreed upon but the one where you add inflation at the end makes absolutely no sense to me… what that’s telling me, is that inflation appreciation is not taxed… If I buy a stock today for 100 and sell it for 110, I cant tell the govt to not tax my 10 because it was inflation return and not capital gains / appreciation… if the inflation is not incorporated into the return prior to tax adjustment, the income of the individual will always be short by the amount of the tax… but hey, thats just me…

Thanks for the input. My specific example would be from Schweser (Book 1 p. 224) Question 6. If you do it their way of adding the inflation at the end you get 7.36% if you if you run it by applying the tax rate to the whole amount ((1+r)(1+i) / (1-t)) you get 8.53%. Obviously I care about what the ‘CFA’ way is.

problem 1 adds it http://cfainstitute.org/cfaprog/resources/pdf/2007_level_iii_guideline_answers.pdf

Quorky I dont think that really makes sense what you were saying. The point is to add on inflation to show that you need to make up for the entire value. If you tax inflation, you are really only attempting to grow the portfolio to keep up with part of the inflation. You should calculate the tax on the return only, because inflation isnt a tangible factor…you dont get taxed in inflation. By adding it on at the end you account for the fact that you need to make the portfolio return grow for all of inflation, not just part

i have seen it both ways and I see it on the exam but I thought I saw them do it both ways, either in the curriculum or on one of the other exams… I wish they would be consistent

Philly, but if you don’t include the tax on the inflation you would come up short. Say your after tax return is 5% and inflation is 2%. After you pay cap gains on the total amount, the increase in the asset base due to the inflation will be adjusted downward by the tax rate.

philly20 Wrote: ------------------------------------------------------- > Quorky I dont think that really makes sense what > you were saying. The point is to add on inflation > to show that you need to make up for the entire > value. If you tax inflation, you are really only > attempting to grow the portfolio to keep up with > part of the inflation. You should calculate the > tax on the return only, because inflation isnt a > tangible factor…you dont get taxed in > inflation. By adding it on at the end you account > for the fact that you need to make the portfolio > return grow for all of inflation, not just part Can you elaborate on that? Lets do it with an example: I am very tired so I am going to use very simple things like apples… Apple costs $1 today inflation if 15% and thus apple will cost 1.15 1 years from now… Keep the cost in real dollars the same (hedge it) if your tax rate is 40% Your portfolio return is going to be taxed at 40% and thus the real return will be (if you match it exactly) 15%*(1-40%) = 9% and thus you fall short of keeping up with inflation… if on the other hand your port returned 15%/.60 then you would have 15% left over in real dollars after the govt got its cut That makes sense to me

Maybe youre right…this is a tricky one. Example…my portfolio is $100, I spend $5 a year for living (5%) and inflation is 3% and my tax rate is 30% All i know for sure is at the end of the year i better have $103 in my portfolio so it keeps its real value. I would need 11.42% return. I make $11.42, tax it by 30% which brings it down to $8, then I take 5 that I needed to spend to live. I have $103 left. This is a little tricky. I think they will have questions where it is all before tax calculation so a tax rate shouldnt get in the way too much…you would just need to tax income once or something. Otherwise I think they would take either method…

Thanks for the confirmation guys. It is just real frustrating when something like calculating a return should be straightforward, but winds up being inconsistent throughout the materials.

exactly… it is either they will need to eliminate the tax issue altogether or accept either one… You know which one I will be using either way it lays out (make sense in the real world). ;o) 2 mice fall into a bucket of cream… one mouse…

I have a hypothetical question: If I will be making a charitable donation of say $10 mn 8 years from now, how would we deal with this in the IPS? Thanks guys!

Another question: Can shortfall risk for a portfolio be calculated from pre-tax returns or do we use only after-tax returns? Thanks!

For charitable donation that far out, I would defintitely list it under unique concerns. The only way I would list it under legal is if I were setting up a CRT or a CLT. If you were, I would say consult legal advice in setting this up.

And how do we incorporate it into the the return requirement? IMO, it definitely cannot be stated in the liquidity constraint. Any thoughts?

YOu wouldn’t. It’s 8 years out.

I feel like setting up a CULT. Who needs a CFA Charter when you can have lots of adoring followers who give you all their assets.