I hate to add to this confusion but I was just doing the 2003 AM. Here is a summary of the problem: The Trust should provide for Bavier’s and Campbell’s annual living expenses, currently estimated to total $78,000 per year (after tax). The Trust portfolio should earn a return sufficient to cover the living expenses of Bavier and Campbell, taking taxes into consideration and allowing for both inflation (expected to be 2 percent annually) and modest growth (1 percent annually). Income and capital gains are taxed at 30 percent, and this tax treatment is not expected to change. Return Calculation provided: Return requirement reflects two major factors: the need to cover living expenses and the need to protect the portfolio from the adverse effects of inflation. Specifically, the Trust must generate a total before-tax return of at least 6.71 percent on an annual basis to meet the return requirements. The living expenses are estimated at $78,000 per year. However, because income and capital gains are taxed at 30 percent, the Trust will need to generate $111,429 before tax to meet the living expenses of Bavier and Campbell, which equals a 3.71 percent return on the $3,000,000 portfolio. Adding inflation and growth results in the total return of 6.71%, as follows: (($78,000 / (1 – 0.30)) / $3,000,000) + 2% inflation + 1% (minimum) for growth = ($111,429 / $3,000,000) + 2% inflation +1% (minimum) for growth = 3.71% + 2% + 1% = 6.71% So according to CFA: 1) Calculate before-tax return 2) Add inflation and growth rate Which seriously pisses me off because I thought its: 1) Calculate after-tax return 2) Calculate after-tax return included with inflation and growth = (1+after-tax return)*(1+inflation)*(1+growth) 3) Divide result by (1-tax rate) The latter is what I have noticed in the CFA books and EOC Qs. Why would you first calculate before-tax returns and THEN add inflation and growth? Doesn’t make sense.
sparty419 Wrote: > > (($78,000 / (1 – 0.30)) / $3,000,000) + 2% > inflation + 1% (minimum) for growth = > ($111,429 / $3,000,000) + 2% inflation +1% > (minimum) for growth = > 3.71% + 2% + 1% = 6.71% > > So according to CFA: > > 1) Calculate before-tax return > 2) Add inflation and growth rate > sparty419 I have not done the exam you are referring to, so I have to rely on the data you provide in the posting. According to that, the calculation is consistent with CFAI’s approach to 2009 exam as we discussed above, i.e., ignoring the tax one has to pay to get AFTER tax return needed for growth and inflation. I have argued that it is wrong calculation. > > Which seriously pisses me off because I thought > its: > > 1) Calculate after-tax return > 2) Calculate after-tax return included with > inflation and growth = (1+after-tax > return)*(1+inflation)*(1+growth) > 3) Divide result by (1-tax rate) > > > The latter is what I have noticed in the CFA books > and EOC Qs. Why would you first calculate > before-tax returns and THEN add inflation and > growth? Doesn’t make sense. This is what I have argued all along to be the right calculation, i.e., [[1+ (78 000/3 000 000)]* (1+2%)* (1+1%) -1 ]/(1-30%) =8.1 % or (less correctly) [(78 000/3 000 000)+ 2%+1%]/(1-30%) =8% As I mentioned, the difference between those two approaches is roughly (2%+ 1%)/(1-30%) - 2%-1% = or 1.3 % in additional return.
sparty419, Do you mean that it is calculated as ($111,429 / $3,000,000) + 2% inflation +1% (minimum) for growth = 3.71% + 2% + 1% = 6.71% in CFAI’s guideline answer ? And you think {[1+($78,000/ $3,000,000)] x (1+ 2%) x (1+1%) - 1]}/(1- 0.3) = 8.14% shall be the correct answer ? Where did you find this method in CFA books and EOC Qs ?
Let me see if I can come up with a different explanation. 1) Now if the problem says the person earns XYZ amount and has ABC expenses, then if there is any additional amount to be provided by the portfolio, that amount will be added to inflation and growth rate and THEN divided by (1-t) 2) If the problem just says the person needs XYZ amount after/before tax, then the before tax amount is taken and THEN added to inflation and growth. Anyone can confirm to this? Also, why literally add and not multiply the rates? AMC, I dont have the problems off the top of my head, but as far as I can recall, the second method in my previous post was how I remember them. Sorry about that.
> > 1) Now if the problem says the person earns XYZ > amount and has ABC expenses, then if there is any > additional amount to be provided by the portfolio, > that amount will be added to inflation and growth > rate and THEN divided by (1-t) > Yes. > 2) If the problem just says the person needs XYZ > amount after/before tax, then the before tax > amount is taken and THEN added to inflation and > growth. > > No sure what you mean here. > Anyone can confirm to this? Also, why literally > add and not multiply the rates? > Just a short cut. They should give similar numbers. Most correctly [(1+a) (1+b) -1] = a+b + ab. For most cases, ab is quite small (e.g., a= 2%, b= 1% --> 2%*1% ~0, so you just use a+b as an approximate number.
EL, The second point refers to a problem like the one I posted. The Trust should provide for Bavier’s and Campbell’s annual living expenses, currently estimated to total $78,000 per year (after tax). The Trust portfolio should earn a return sufficient to cover the living expenses of Bavier and Campbell, taking taxes into consideration and allowing for both inflation (expected to be 2 percent annually) and modest growth (1 percent annually). Income and capital gains are taxed at 30 percent, and this tax treatment is not expected to change. Here, there is no salary or income generation apart from the portfolio return. They have just given 78,000 as the amount needed. This could be after/before tax. But then we need to get to the before tax calculation and then follow up with the inflation and growth rate. Hope that was clear.
sparty419 Wrote: ------------------------------------------------------- > Let me see if I can come up with a different > explanation. > > 1) Now if the problem says the person earns XYZ > amount and has ABC expenses, then if there is any > additional amount to be provided by the portfolio, > that amount will be added to inflation and growth > rate and THEN divided by (1-t) Do you mean {[(ABC - XYZ)/$ of investable assets] + inflation + Growth (or managment fee)}/(1 - t) ? elcfa, I do believe your explanation. However, for exam. maybe the best way is to send inquiry to CFAI requeting them to clarify. Do you think so ?
sparty419 Wrote: ------------------------------------------------------- > EL, > > The second point refers to a problem like the one > I posted. > As I posted above, I believe the calculation should be the same as 1. It does not matter how much that person earns (as salary), what matters is how much he/she needs on a ongoing basis to withdraw from the portfolio.
I agree with you, but as you must have heard, there is the real world way and then there is the CFA way. Am just trying to see if there is a trend is the methodology here.
Hi guys, good morning and I’m back. elfca – Again, TYVM for your comments! It really helps to narrow down the main issues of this posting. AMC Wrote: > elcfa, > > I do believe your explanation. However, for exam. > maybe the best way is to send inquiry to CFAI > requeting them to clarify. Do you think so ? AMC – I agree with you. We should have the authority to answer this question directly. In addition, I think we may want to mention the CFA books and EOC Qs showing our method (if there is any). I haven’t started to look at CFA books yet on this issue (I has assumed I can get an answer here at AF). Can anyone refer to a specific pages/questions/examples of this calculation in CFA books, in case you have already go across? sparty419 Wrote: ------------------------------------------------------- > Let me see if I can come up with a different > explanation. > > 1) Now if the problem says the person earns XYZ > amount and has ABC expenses, then if there is any > additional amount to be provided by the portfolio, > that amount will be added to inflation and growth > rate and THEN divided by (1-t) > > 2) If the problem just says the person needs XYZ > amount after/before tax, then the before tax > amount is taken and THEN added to inflation and > growth. sparty419—I see your point. Personally I agree with elcfa that they should be the same. However, I really don’t have the exam answer. CFAI should have. Nevertheless, I really think it is just very wrong in CFA exam answer that these people don’t get taxed on their capital gain portion that battles the inflation. Maybe CFA question should state…Mr. Retiree XXX use a taxable amount to support his living and use a Roth IRA to hedge against inflation, which the Roth will be passed to his heir tax-free (JUST JOKING)….