IPS - living expense inflation adjustment

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FrankCFA

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Jack has portoflio 1million USD, retired.
Living expense (pre-tax): 20k USD, inflation rate 2%
Estimate living time horizon: 10 years
Plan to donate 1 million USD after he dies.
Calculate nominal pre-tax required return.
* Assume living expense change is in line with inflation rate.
 
Good question. My thoughts are, if it’s nominal the inflation should not be included and the calculation is simple: 20,000/1,000,000 = 2% nominal return…. I’d be interested in knowing if this is correct. Also, I’d be interested in knowing where this guy lives that he can sustain himself on 20k a year.
 
I believe you find the return at 20k and then add (or times) the inflation component afterwards. So the required return is 4%..
 
pokhim wrote:
I believe you find the return at 20k and then add (or times) the inflation component afterwards. So the required return is 4%..
Click to expand...
So PMT use 20k?
 
I might be overcomplicting this but a few observations:
  • ending balance of 1m is fixed, the question doesn’t state that it’s adjusted for inflation
  • Need a return that covers the 20k + 20k * inflation
If you compute the PV of the future cashflow liabilities you end up with a gross return of 218,994, which is about 2.19% per year
218,994/1,000,000^1/10 = 2.19%
 
Galli wrote:
I might be overcomplicting this but a few observations:
  • ending balance of 1m is fixed, the question doesn’t state that it’s adjusted for inflation
  • Need a return that covers the 20k + 20k * inflation
If you compute the PV of the future cashflow liabilities you end up with a gross return of 218,994, which is about 2.19% per year
218,994/1,000,000^1/10 = 2.19%
Click to expand...
This makes more sense. Oh man i’m screwed
 
Galli wrote:
I might be overcomplicting this but a few observations:
  • ending balance of 1m is fixed, the question doesn’t state that it’s adjusted for inflation
  • Need a return that covers the 20k + 20k * inflation
If you compute the PV of the future cashflow liabilities you end up with a gross return of 218,994, which is about 2.19% per year
218,994/1,000,000^1/10 = 2.19%
Click to expand...
Why $20k + $20k *1.02? I don’t understand…
I think this question needs more detail to answer really, but the 2.19% sounds about right given he’s just trying to cover his living expenses, and the 4% answer would = the $20k + $20 *1.02
 
I’m confused by the “$20k + $20 *1.02” as well. The question asks for nominal pre-tax required return without the tax information, I would think it’s just 20k per year. 20k * 1.02 would be to cover expenses adjusted for inflation or real return, and the second 20k would adjust the portfolio for inflation, which is not asked for… as I’m typing this I’m realizing this question is missing a lot of key information and would never be asked on the exam….
 
JSobes wrote:
Galli wrote:
I might be overcomplicting this but a few observations:
  • ending balance of 1m is fixed, the question doesn’t state that it’s adjusted for inflation
  • Need a return that covers the 20k + 20k * inflation
If you compute the PV of the future cashflow liabilities you end up with a gross return of 218,994, which is about 2.19% per year
218,994/1,000,000^1/10 = 2.19%
Click to expand...
Why $20k + $20k *1.02? I don’t understand…
I think this question needs more detail to answer really, but the 2.19% sounds about right given he’s just trying to cover his living expenses, and the 4% answer would = the $20k + $20 *1.02
Click to expand...
To clarify, it’s 20k + 20k *.02. The second peice of the equation is just the adjustment to the base cost of living.
Year 1 pmt is 20,000
Year 2 pmt is year1*1.02
Year 3 pmt is year 2*1.02
etc etc
———————————————————
In your calculator try this:
PV = 0
PMT = -20,000
i = 2%
N = 10
FV = 218,994
—————————————————
Annualized = (218,994/1,000,000)^1/10 = 2.19%
I hope this is right!
 
Galli wrote:
JSobes wrote:
Galli wrote:
I might be overcomplicting this but a few observations:
  • ending balance of 1m is fixed, the question doesn’t state that it’s adjusted for inflation
  • Need a return that covers the 20k + 20k * inflation
If you compute the PV of the future cashflow liabilities you end up with a gross return of 218,994, which is about 2.19% per year
218,994/1,000,000^1/10 = 2.19%
Click to expand...
Why $20k + $20k *1.02? I don’t understand…
I think this question needs more detail to answer really, but the 2.19% sounds about right given he’s just trying to cover his living expenses, and the 4% answer would = the $20k + $20 *1.02
Click to expand...
To clarify, it’s 20k + 20k *.02. The second peice of the equation is just the adjustment to the base cost of living.
Year 1 pmt is 20,000
Year 2 pmt is year1*1.02
Year 3 pmt is year 2*1.02
etc etc
———————————————————
In your calculator try this:
PV = 0
PMT = -20,000
i = 2%
N = 10
FV = 218,994
—————————————————
Annualized = (218,994/1,000,000)^1/10 = 2.19%
I hope this is right!
Click to expand...
Thanks. It makes sense for the required real pretax return.
Nominal pretax just add the 2% up? (I’m thinking if it’s duplicated?) So it should be 4.19%.
 
^ no, that won’t be pre-tax… that will be after-tax. You haven’t given us a tax rate to gross it up by.
 
Frank - Is there an actual answer to this question or did you make up the inputs to it?
 
Can someone confirm real pretax is 2.19 and nominal pretax is 4.19% please? That is my understanding, I don’t typically do the calculator but write out the expenses since we usually will need to show our calculations…
 
Would You Look at That wrote:
^how are you getting a pre-tax number if the tax rate hasn’t been provided?
Click to expand...
Sorry I meant after tax
 
JSobes wrote:
Would You Look at That wrote:
^how are you getting a pre-tax number if the tax rate hasn’t been provided?
Click to expand...
Sorry I meant after tax
Click to expand...


You are right, the question should add it’s pre-tax income need. (Adjust the question)
 
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