There is an extremely disturbing discrepancy in the way CFAI calculates Pre-tax nominal return between an example in their reading and a question in their 2009 morning session exam.
The Susan Fairfax example in the CFAI Text, Page 190 of Book 2, Chapter 10 (Managing Individual Investor Portfolios) implies to take after-tax return (3% in example), add inflation (4%), then divide by (1 - T) [here (1-T) = 0.65] to get the pre-tax nominal return requirement of 10.8%.
In the CFAI 2009 morning section, the after-tax return would be 45,000 / 1,000,000 = 4.5%. Following the same methodology as Fairfax, adding the 4% inflation = 8.5%, then dividing by (1 - 0.20) = 10.625%. But the answer key doesn’t follow the same methodology as Fairfax. Instead, it first divides the 4.5% by (1 - 0.20) to get 5.625%, then adds inflation of 4% to get 9.625%.
Which methodology should be used? This is making me so nervous because I don’t know which way their answer key will do it!
I have seen other posts on this forum about the Fairfax example, and others about the surrounding question I have here, but none of them addresses this discrepancy.
Thank you in advance. Hopefully this post helps out more than one person here.
In the 2009 exam, they were explicit about taxes only being on withdrawals from the account. I think the default assumption is that all gains from the account are taxed though (so thus inflation would also need to be grossed up for taxes).
I don’t have the current CFA Institute text, but in the 2009 morning session, question 1, it is explicit that only the withdrawals from the Tracys’ account are taxable ; thus, the inflation component that will remain in the account is not taxed.
I’ve written this time and again: read the vignette. It will tell you whether inflation is taxed or not. You needn’t guess about which approach to take.