return requirement

so let’s say you have 2mm in assets, you want to end up with 5mm in 20 years. your living expenses are 100K your after tax income is 130K when you are calculating the return you need to get 5mm in 20 years, why do you not add the 30K extra income per year as a PMT in the calculation? what do you do with that 30K? just ignore it because it’s not in the portfolio?

I would ignore it for the same reason as he wants the portfolio to grow to 5 mm and doesn’t specify that the additonal 30K savings will be added each year to grow the asset base

Is this a hypothetical question or are you getting it from somewhere? Wasn’t the Individual IPS question in 2007 like this? There was another question several years back like this on the exam. I would say you count the 30K as an inflow to the portfolio over the 20 years. That’s a lot of money to not designate it for anything. What about inflation and salary raises? If they offset each other, then add the 30K straight up. If they don’t, this gets messy.

not made up, although i changed up the situation and numbers a bit… not in the 2007 test. i honestly don’t remember this in that test, but i could certainly be wrong. anyhow, the answer just left it out. the amounts were different, but it was still significant. maybe i misread the question, but i’m in agreement that i thought i would have to assume reinvestment.

That’s pretty weird. To have a surplus every year that just goes away doesn’t seem to keep with what CFAI teaches. It certainly doesn’t go with the total return approach. I don’t have it in front of me but there was a similar question in '03, '04 or '05 I think. Did they do the same thing?

ins’t this an inflow? so you input it in the calculator as PMT=-30? this is killing me. i saw this crap in Book 7 of Schweser. I was quite certain you need to input the savings. An more important, they do tell us in the curriculum that savings are reinvested, thus increasing return. look in individual IPS, i believe is one way to mitigate earnings risk.

i’ve done all the past CFAi exams going back to 2003 + schweser exam book 1 - and can’t recall seeing it. - but my memory is playing tricks these days (!). If inflation in earnings is expected to keep pace with inflation in living expenses, and it is a clear surplus to requirements and no other cashflow needs - then I would add it to investments each year - so make pmt = -30k. so the required return drops from 4.69% to 3.70% pa. This would be a real return requirement if the $5m target is in today’s dollars. This is ok because the $30k surplus would also be growing assuming income inflation was the same as cost inflation.

there is a problem in book 7… but i will not give any spoilers. in any case, i included the savings as PMT, they didn’t. so crap.

does anyone has any clue on how to handle this issue? so savings in PMT or not? please advise, as IPS is a very hefty part of the AM.

has anyone seen any examples that contradict this question? i have not.

one IPS in book 7 Schweser ignores the savings (3 AM) and the main problem is that the asset allocation problem that follows gives portfolio alternatives with returns at the border of the calculated return with/without savings…

I can’t see why you would not include the inflow as PMT. This helps increase the portfolio value in 20 years and reduce your required return. Part D of the 2008 exam had the same situation but with an outflow for PMT instead of an inflow and is factored into the calculation.

I would not include it in the return requirement, unless they specify that the savings are reinvested. I would make reference to an increased ability to take risk within the IPS, since they could theoretically up their contributions from the surplus if things went bad in the portfolio.

I would include it in the answer. Don’t see how CFAI can say that’s wrong so I expect they won’t.

maybe the investor has a 30k a year raging coke habit. but seriously, if you show your work, i got to think they will give you credit either way. or you would hope. the only place i saw this situation was in that book 7 question, so hopefully we don’t see it on the test.

You are making an assumption which is generally not a good idea.

I would include the residual in the portfolio unless they gave me a very clear reason not to.

I did include the residual and it told me i was wrong. i would hope the cfai would address something like that more explicitly in one of their questions…

The 2004 exam had a similar problem although in that instance, the investor had a shortfall each year that the portfolio needed to provide. Obviously this is an outflow from the portfolio each year. I would think the converse would hold true in that the investor would either reinvest the surplus back into the portfolio or at least invest it in some sort of risk-free asset. I don’t see how you could just ignore that amount of money each year considering it would add up to $600K in 20 years with 0% return. That is 20% of the $3M you are trying to accumulate and it would reduce your req’d return by almost 1% annually. If this were ever on the exam, there is no way CFAI would ignore it. If anyone is taking one of Schweser’s seminars, the instructor should have provided his/her email. I would email them and ask their opinion. Personally, I would reinvest it back in the portfolio and calculate the return like this: PV = -2M PMT = -30K N = 20 FV = +5M I/Y = 3.70%

I would like to see exactly how it was worded. People spend money on more than just “basic living expenses”. That could be the key. Those of you that have done a bunch of these,is living expenses used as a proxy for total spending?