Inflation adjustment for required return...HELP!!!

I am really confused now… From practice problem 13 in Chapter 14 (CFAI), I gathered that no inflation needs to be added to the required rate of return when living expenses are covered by income and both are expected to rise at the normal inflation rate. But now I just looked at the first question of the AM Session CFA Sample 2008, where it also states that living expenses are being covered by salary and both will increase with inflation, but the correct answer apparently is to adjust for inflation! Can anyone help???

Always adjust for inflation before determining the final requirement. I thought it was double counting, but after doing all these Stalla/Schweser/CFA IPS problems they all seem to have the same adjustment.

But seriously, look at Problem 13 in Chapter 14 of the CFAI…it explicitly says in the answer that “no inflation adjustment is necessary”!

kinstongal, you just have to be eirie 'mon and then everything will fall into place.

wake2000 Wrote: ------------------------------------------------------- > kinstongal, you just have to be eirie 'mon and > then everything will fall into place. its spelled irie

I don’t have the book with me, but if wages are covered then presumably the portfolio is meeting some other expenditure? And in that case, that expenditure probably needs inflation protection. Give me the numbers.

In the CFAI book, the case is a couple building a portfolio for retirement. Their income doesn’t quite cover living expenses, so they need to fund an extra 26,000 a year, which is the only spending requirement they have. Both their income and their spending grow at the inflation rate…and it says in the answer “no inflation adjustment is required in the return calculation because increases in living expenses will be offset in Christopher’s salary”. In the 2008 morning session exam, it’s similar…here the only spending requirement is a 55,000 mortgage which is fixed (!) and remains nominally stable over time. And here too it states that spending and income grow at the prevailing rate of inflation. In fact, in this case income fully covers expenses. I am starting to think that the answer to the Chapter 14 question must be wrong and that you always have to adjust for inflation…but I would rather be sure!

Hm…that is tricky. It says salary will cover inflation so they are covered, but only until retirement. After retirement the portfolio return requirement should incorporate inflation, but since they’re still working that can be adjusted later on.

Yah, i remember this from the 2008 now. I was trying to figure out how to incorporate inflation for just post retirement, but couldnt so just added it entirely (if i remember correctly). I think a work around would to give the answer in real return terms and state (real return required = “x”)… that way you can’t get dinged for not incorporating inflation. I haven’t seen it many times where they force you to give a nominal return requirement.

I think I figured it out! I think that they made in a mistake in the answer to problem 13 in Chapter 14…the problem states that there is a gap of $26,000 between salary and spending and that because both spending and salary increase at the prevailing inflation rate, they exclude inflation from the calculation…but think about it, if you had a starting salary of 100,000 and spending of 126,000 and both grow at 3%, then your additional spending requirement would be 26,800 in the first year. (not 26,000 indefinitely), so you would need the inflation adjustment.

It stated that “After-tax salary increase will offset any future increase in their living expense” in problem 13 in Chapter 14. Does it mean that the gap of 26000 will remain constant ? i.e., after-tax salary increase > future increase in their living expense ? It is ambiguous & tricky !

No…as I wrote above, when you calculate it, it doesn’t make sense. Same % increase in lower salary and a higher living expense will widen the gap. 100,000 - 126,000 = -26,000 100,000 x 1,03 - 126,000 x 1,03 = -26,780 = -26,000 x 1,03 So I think that because there is a gap they actually need to adjust for inflation…right??? I am getting totally confused with this now!

e.g., after-tax salary increase by 4% but future increase in their living expense is only 3%. i.e., after-tax salary increase() \> or = future increase in their living expense ()

What we need to concentrate on is the 2 mio USD needed in 18 years. This is future amount, defined (we dont know how), we can assume that expected inflation was taken into account. The objective is not to protect against inflation, the inflation is already included in this future value (2 mio USD), so you only calculate IRR.

I actually went through the 2008 problem today and adjusted for inflation AND taxes, go figure.

Maybe the best way is to send an inquiry to CFAI.