page 151 of Book 2 CFAI curriculum It shows that muellers pension income is 100K and expenses 180K (8% short) and portfolio is 1million. They have trust of 2 more million but do not wish to withdraw income or principal so hence not considered. Now they are selecting portfolio A with 4.2% return which doesn’t making sense as they at least need 8% plus inflation. Can someone help please?
You can eliminate portfolios B and D because of no cash reserves right off the bat. Note that the returns are nominal and after-tax. We know that they will need a relatively stable, low risk portfolio. That already points to A over C. The 8% shortfall is partially covered by the portfolio return, and the remainder comes directly from the principal value (point three on page 151). They’re 63 years old, and they’re not expected to live more than 10 years. A ~4% cannibalization of the portfolio over 10 years is not too important. When you take into account: 1) the fact that they can invade the principal to pay some expenses 2) They are not concerned with growing or maintaining principal (again, point three on page 151, so they do not need 8%/year) 3) Portfolio C is much more risky A is the better choice.
Last bullet pt: “Not concerned with growing or maintaining principal… income deficit may be met with both investment income and by invading principal” So in this unique case, where principal deterioration is ok, don’t need to earn return equal to the deficit…
Cubemonkey, v. good explanation… I forgot about this problem, helpful example