February 2nd, 2012

Required Return Calculation Methodologies

By Kurt Schuldes, CFA, CAIA, Content Specialist

The following are several different examples of how to perform the required return
calculation for an individual investor based on recent exam questions. Keep in mind
that even though there are only a few examples here, and it seems like an infinite
number of scenarios can be presented on the real exam, there is a methodology to
approaching these problems allowing you to quickly narrow down the possible
outcomes. In the following examples we'll cover calculating a pre-tax 1 year return
calculation given after-tax data, an after-tax 1 year return given after-tax data, and
three different time value of money calculations.
I. Pre-tax required return given after-tax data based on the 2009 CFA exam question.
This question is regarding a Canadian couple who will retire in one year at which time
they will make a withdrawal from their portfolio to pay off their mortgage. You are
asked to calculate the required return at the time of their retirement in 1 year given
the values of their expenses and income at that time.
A. Pertinent data given:
1. Husband and wife age 59 and 1 year away from retiring.
2. When they retire in 1 year their portfolio will be worth 1.1 million Canadian dollars
(CAD) but they will withdraw CAD 100,000 to pay off their mortgage.
3. Inflation is projected to be 4% and they pay 20% in taxes.
4. In 1 year their expenses are projected to be CAD 125,000 per year with a total
after-tax pension income of CAD 80,000.
B. Question: calculate the pre-tax nominal rate of return required in the first year of
retirement:
After-tax yearly income in 1 year given as:

80,000

- Yearly expenses in 1 year given as: 125,000

- 45,000 = liquidity needs
After-tax required return = 45,000 / 1,000,000 = 4.5%

Note: 100,000 was withdrawn from asset base to pay off mortgage
Pre-tax real return = after-tax return / (1 - tax rate)
= 4.5% / (1 - .2) = 5.625% pre-tax real return + 4% inflation = 9.625% pre-tax
nominal rate of return or (1.05625)(1.04) - 1 = 9.85%
C. Notes:
1. This is a good example of when the income from pension, salaries, etc. does not
cover the spending needs thus the portfolio must make up the difference and cover a
portion of the spending needs.
2. This is also a good example of given after-tax liquidity needs but asked to
calculate the pre-tax required nominal rate of return.
3. You are given the portfolio value, income, and expenses at the time of retirement
1 year from today instead of having to project these values forward 1 year.
4. To calculate the pre-tax nominal return you must gross up the after-tax real return
and then add inflation.
II. After-tax required return given after-tax data based on a past exam question. This
is a two part question involving a young couple living in Brazil in which the main
objective in the first part is determining the 1 year required return after purchasing
and financing a new home. The second part of the question continues with the same
couple 25 years later but now with different goals and the question is now a time
value of money problem.
A. Pertinent data given:
1. Husband and wife both age 30
2. Combined after tax salaries = 120,000 Brazilian reais (BRL)
3. Salaries equal living expenses and both will increase at the rate of inflation which
is 4%
4. Trust fund = BRL 1,500,000; receive half now (750,000) tax free and the second
half in 10 years
5. BRL 500,000 in other investable assets
6. Buying a house costing BRL 850,000 with 30% down payment coming from the
trust distributions, down payment = 850,000 X .3 = BRL 255,000
7. BRL 55,000 after-tax fixed mortgage payment for 30 years, first payment due in
1 year
8. Immediate goal for the portfolio is to cover the mortgage payment and maintain
the inflation adjusted value of the portfolio

B. Question: calculate the nominal after-tax rate of return for next year.
Asset base current year:
750,000 from Trust
-255,000 down payment
495,000
+500,000 investable assets
995,000 total investable assets
55,000 fixed payment due in 1 year, after-tax real required return:
55,000 / 995,000 = 5.53% + 4% inflation = 9.53% after-tax nominal required return
or (1.0553)(1.04) - 1 = 9.75%
C. Notes:
1. There is no adjustment for taxes. All the data is given on an after-tax basis and
you are asked for the nominal after-tax return. If you were instead given pre-tax
income and asked for the after-tax return you would have to subtract taxes from the
couple's income and factor that into their after-tax income needs.
2. You are asked to calculate the nominal return for the next year. In other words
you are asked to calculate the return as of today (at time 0) that will produce the
required income to cover the mortgage payment of 55,000 over the coming
year. This is significant because many times in these questions you could instead be
asked to perform the required return one year from today. For example if a couple is
going to retire in 1 year you may be asked to calculate their required return during
their first year of retirement 1 year from today. This would require projecting all
income and expenses forward 1 year.
3. One of the unique things about this question is the payment amount is given as a
fixed payment due in 1 year. Normally ongoing future payments to meet liquidity
needs would need to be increased by the rate of inflation which is not the case in this
question.
4. Their salaries cover their expenses and both increase at the same rate of
inflation therefore they cancel each other out.
D. Question continued and it is now 25 years later:
1. The couple has 5 years left to pay on their house with yearly payments of BRL
55,000.
2. Their investment portfolio is now valued at BRL 10,200,000.
3. They need BRL 15,000,000 at retirement in 5 years to support retirement needs
and future charitable donations and bequests.

4. The question asks you to calculate the after-tax nominal rate of return.
5. This is now a time value of money problem where:
PV = -10,200,000 N = 5 PMT = 55,000 FV = 15,000,000 Compute I = 8.48%
Alternatively the calculation could be performed as: PV = 10,200,000 N = 5 PMT =
-55,000 FV = -15,000,000 Compute I = 8.48%
E. Notes:
1. Inflation is not added to the return calculation because the question simply states
that the couple needs 15,000,000 in 5 years thus this amount is already adjusted for
inflation. There is no mention of the future value as being equivalent to today's value
or needing to be adjusted for inflation.
2. Their salaries cover their expenses and both increase at the same rate of inflation
therefore they cancel each other out.
III. Time value of money problem based on the 2010 CFA exam question. This
question is regarding a young widow living in a country which uses U.S. dollars as the
currency. She has some savings, is contributing regularly to a tax deferred annuity,
and is saving for retirement in 25 years from now.
A. Pertinent data given:
1. 35 year old widow
2. Income tax rate = 25%
3. $140,000 pretax salary with annual living expenses equaling $96,000
4. Invests $12,000 per year pretax into a tax deferred annuity (TDA)
5. Current value of the TDA = $225,000
6. At age 60 she will receive $1,000,000 pretax from company pension plan
7. Needs $3,000,000 at age 60 to purchase a life annuity
B. Question: calculate the required average annual pretax nominal rate of return until
retirement in 25 years.
1. Perform the calculation as a time value of money (TVM) problem because you are
given the desired future value of the portfolio and 4 of the 5 variables needed to
calculate a TVM problem.
2. Calculation: PV = -225,000 FV = 3,000,000 - 1,000,000 = 2,000,000
PMT = -12,000 N = 25 Compute I = 7.05% Nominal pretax return

3. Note that it is very important to put the negative sign in front of both the PV and
PMT values otherwise the computed return will be incorrect. One way to determine
the correct sign on a value is to assign a positive sign to any cash inflows and a
negative sign to any cash outflows. The FV can be seen as a future lump sum cash
inflow at retirement needed to purchase the annuity thus it gets a positive sign. Both
the PV and PMT values can be viewed as cash outflows because they are cash
needed to invest into the portfolio thus they are cash outflows resulting in the
negative signs.
4. Note that since all values are on a pretax basis and the future value needed of
$2,000,000 is already in nominal terms there is no need to adjust for taxes or add
inflation because it is already factored into the final answer. We know the $2 million is
in nominal terms because it does NOT state in the question the $2 million is in
"today's" dollars. If it had said that then the computed value would have represented
a "real" return and inflation would need to be added to determine the "nominal"
required return.
IV. Time value of money problem based on a past exam question. This question
pertains to a relatively young Canadian couple who has recently retired. They plan to
live off their portfolio with the first distribution occurring immediately. Upon their
death they plan on leaving gifts in a specified amount to their son and a local charity.
The gifts are to maintain the same purchasing power as of today. This means you are
calculating the "real" return and if you are asked for the "nominal" return then
inflation would need to be added to get the nominal return.
A. Pertinent data given:
1. Recently retired couple age 50
2. Assets in Canadian dollars:
a. 1,000,000 in publicly traded company stock
b. 2,400,000 inheritance in small cap equities in after-tax dollars
c. 800,000 bonds
d. 1,250,000 value of house
3. Pretax income needs equals 200,000 per year, couple expects this amount to
remain constant with an inflation adjustment.
4. Inflation projected at 2.5% per year
5. First 200,000 distribution is to be made immediately
6. Time horizon equals 35 years
7. Upon their death the couple wants to leave gifts to their son and a charity valued
at 2,000,000 and 1,000,000 respectively in today's dollars (Future Value = 2,000,000
+ 1,000,000 = 3,000,000). This means that if you are asked for the "nominal" return

then the 3 million in today's dollars would need to be adjusted upward for inflation to
maintain the same purchasing power as today.
B. Question: calculate the nominal pre-tax return objective:
1. Perform the calculation as a time value of money (TVM) problem because you are
given the desired future value of the portfolio and 4 of the 5 variables needed to
calculate a TVM problem.
2. Asset base present value (PV) = (1,000,000 in company stock) + (2,400,000
inheritance) + (800,000 bonds) - (200,000 first year's withdrawal) = 4,000,000. The
first year's withdrawal of 200,000 is subtracted from the asset base because the first
distribution was made immediately. The primary residence is never included in the
asset base.
3. The next payment (PMT) needs to be adjusted for inflation: PMT = 200,000 x
1.025 = 205,000
4. Calculation: PV = -4,000,000 FV = 3,000,000 PMT = 205,000 N = 35
Compute I = 4.84%. Alternatively the calculation could be performed as: PV =
4,000,000 FV = -3,000,000 PMT = -205,000 Compute I = 4.84%. To adjust the
future value so it equals the 3 million in today's dollars we add inflation so the
nominal pre-tax required return equals 4.84% real return + 2.5% inflation = 7.34% or
alternatively geometrically linking the real required return and inflation: 1.048 x
1.025 - 1 = 7.46% nominal pretax required return.
C. Notes:
1. The couple has recently retired and you are asked to calculate their required
return as of today instead of at some point in the future.
2. You are asked to calculate the nominal return, versus the real return, the nominal
return requires adding inflation to the real return. You are also asked to perform the
calculation in today's dollars which is another way of saying to adjust the return
calculation upward for inflation.
3. You are asked to calculate the pre-tax required return and the liquidity needs are
given on a pre-tax basis thus there is no adjustment for taxes. If you were instead
given after-tax liquidity needs but asked for the pre-tax nominal required return you
would need to first calculate the real required return on an after-tax basis, gross up
the after-tax real return so it is now a pre-tax real return (divide the after-tax real
return by 1- tax rate) and then add inflation to get the pre-tax nominal return.
4. The desired future value (amount bequeathed) is in today's dollars meaning that
in 35 years the couple wants the portfolio to equal what would be equivalent to
3,000,000 today after taking inflation into consideration. This means the future value
of 3,000,000 must be adjusted upward for inflation which is why inflation is added to
the real required return to get the nominal required return.
5. Subtract the first payment from the asset base because it was distributed
immediately.

6. Adjust the payment (PMT) for inflation as stated in the question the couple's
income needs must keep pace with inflation.
7. Don't include the house in the asset base. Only investable assets are included in
the asset base and primary residences are not considered to be investable assets.
8. This is a time value of money calculation because you are given a future value of
the portfolio and the other 4 TVM variables needed to compute the required return
(interest rate) over a multiple year time period. A required return calculation that is
not a time value of money problem is a single year calculation where the real
required return is calculated by dividing the liquidity needs by the asset base and you
are not given a future value of the portfolio.
V. Final Comments
A. As previously mentioned, even though there can literally be what seems like an
endless number of ways a required return question can be asked there are ways to
quickly narrow down the possibilities to a small number of outcomes. The following
are important questions to ask yourself as you read through the vignette and must be
answered before you can begin to perform the required return calculation:
1. Is it a time value of money problem (a multi-year return)?
2. Is the data given before or after-tax or a combination of both?
3. Are you asked for the pre-tax or after-tax nominal or real return?
4. Are you asked to perform the calculation as of today or at some point in the
future?
5. There is a high probability that you will be dealing with a foreign currency and
you may not be very familiar with it. In this situation there is no need to panic and
you can perform the calculation correctly by simply ignoring the currency and
perform the calculation based solely on the numbers given. This will result in the
correct required return being calculated regardless of what currency you're using.
B. Liquidity needs are usually given on an after-tax basis unless otherwise stated. If
you are given after-tax liquidity needs but asked for the pre-tax nominal return,
perform the calculation using the following steps:
1. First calculate the real after-tax return: after-tax liquidity needs / asset base =
after-tax real required return.
2. Then divide by 1- tax rate to gross up the return so it is now on a pre-tax basis:
after-tax real return / (1 - tax rate) = pre-tax real required return.
3. Lastly, add or geometrically link inflation to get the nominal pre-tax required
return:
pre-tax required return + inflation = nominal pre-tax return or
(1 + pre-tax required return)(1 + inflation) - 1 = nominal pre-tax return.

C. Other things to be aware of:

1. Usually there is extraneous data that is not used and can very easily mislead you.
Watch out for that and don't get swayed into thinking that you need to use every
piece of information given!
2. You are usually never asked to calculate the real return and almost always asked
for the nominal return requiring you to calculate the real return first then add inflation
to determine the nominal return.
3. There is usually never an invasion of principal in other words the liquidity needs
are met by the capital gains and income generated by the asset base which is almost
always never used (spent down) to meet the liquidity needs. It is usually assumed or
specified that the asset base must keep pace with inflation and therefore must grow
by at least that rate.
Private Wealth Management: Risk Tolerance

By Dr. Bruce Kuhlman, CFA, CAIA

In a morning case for an individual, you may be asked to determine the individuals
ability or willingness to tolerate risk or even determine the individuals overall risk
tolerance using the combination of willingness and ability. Here are a few guidelines
to help you get full credit:
Willingness to tolerate risk
An individuals willingness to tolerate risk is determined by psychological factors (i.e.,
subjective factors). For example, the individual might feel their portfolio is large
(e.g., perception of wealth). They might feel they are better than others at
interpreting market or firm information (e.g., overconfidence). Alternatively, they
might want to get on board a rising market (e.g., representativeness, correlating
emotions with the market). Other people are just naturally risk takers. In other
words, the individual may know little or a lot about investing but his or her
psychological makeup overrules any attempts at rational expectations (i.e.,
traditional finance measures).
Statements. In determining willingness, you should look for statements by the
individual but you should not rely on them alone. For example, there was a question
on a previous Level III exam in which the client stated he had average risk tolerance.
If you had stopped reading there and determined the clients willingness solely on
that statement, you would have missed the individuals history of making risky
investments. International equities (especially emerging markets), commodities,
derivatives, venture capital, hedge funds, etc, are usually considered risky
investments by individuals.

Notice that the individual did not specifically mention

willingness to tolerate risk, just risk tolerance. When a client
makes statements about risk tolerance, you should interpret the
statements as indicators of willingness, not ability, to tolerate
risk.
Actions. Always look at what the client does. For example investments as well as
other actions in life in general may be better indicators of the clients willingness to
tolerate risk. In the previous example the clients actions spoke much louder than his
words. The client was a wealthy surgeon and he apparently measured his willingness
against his peers. To him he seemed to have average risk tolerance, but to others he
would be considered above average.
Ability to Tolerate Risk
The clients ability to tolerate risk is jointly determined by the size of the portfolio
(not the clients perception of the size of the portfolio), the clients time horizon, and
the clients spending (i.e., liquidity) needs. I sometimes think its best to think in
terms of the portfolios ability to tolerate risk. Whatever it takes to make yourself do
it, you must focus on objective measures in determining ability to tolerate risk.
Rules
1.
2.
3.

of thumb:
As the size of the portfolio increases ability increases (positive relationship).
As the time horizon increases ability increases (positive relationship).
As liquidity needs increase ability decreases (negative relationship).

Remember that these spending needs are only those that will be met out of the
portfolio return (i.e., met by the portfolio), not the individuals salary or other income.
Another consideration is the size of the spending needs relative to the portfolio. In
some cases very large spending needs will be met by a very large portfolio and the
result is above average ability. In another case the large spending needs translate to
average or even below average ability. For example, if the client must depend upon
the portfolio to meet all living expenses it will generally be translated as below
average ability. This is the case with retirees.
Overall Risk Tolerance
Willingness. In deciding both the individuals willingness and ability, I always start
the individual at average. I then look for reasons to increase or lower. If the
individual makes statements about avoiding certain risky investments, for example,
I reduce their willingness to below average. If on the other hand they say they are
not concerned with volatility over the holding period, I increase willingness to above
average. Usually a clients specific reference to risk is reason enough to reduce their
willingness to below average. If there are no statements one way or the other, I stick
with average willingness.
Ability. The final decision on ability is usually fairly straight forward. Try not to read
too much into the question, however. If the client has a multi-million dollar portfolio, a
high salary, a long time horizon, and no need to draw on the portfolio for near term
spending needs, go with above average ability to tolerate risk. Dont start
questioning yourself as to exactly what constitutes a large portfolio or long time
horizon. That can only lead to confusion and uncertainty. Go with your gut. If
given the facts of the case you feel the clients ability to tolerate risk is above

average, go with it. If you feel the client has below average ability to tolerate risk, go
with that. Indecision on your part can only eat valuable time.
Rules of thumb:
1.
If willingness > ability honor ability recommend counseling to reconcile
the difference.
2.
If willingness < ability honor willingness recommend counseling to
reconcile the difference.
3.
If willingness < ability and the client is extremely wealthy average the two
and recommend counseling to reconcile the difference.
The last rule of thumb is based on a client who has below average willingness but
above average ability due to an extremely large portfolio relative to spending needs.
You can see an example of this scenario in a sample case in the 2012 Level III
curriculum, Volume 2, page 190.

Portfolio Management for Private Wealth Clients (Individuals):

By Dr. Bruce Kuhlman, CFA, CAIA

To help you develop your plan of attack, I have compiled a list of recommendations
for answering a portfolio management case for a private wealth client:
1.

Candidates have often been asked to recommend an individual allocation (a

portfolio) from a list of alternative portfolio allocations. Be sure your selection is
consistent with the IPS. That is, the recommended portfolio allocation must
meet the IPS objectives of return and risk, as well as constraints relating to
liquidity, legal and regulatory concerns, taxation, time horizon, and unique
circumstances. Be sure to take note of any specific client instructions, like
avoiding certain classes of investments.

2.

Return. You will probably need to determine the clients required return based
upon consumption (i.e., spending) needs and wealth (i.e., portfolio size).
Always look to see if there is a difference between after-tax salary(ies) and
spending needs to determine whether there is a spending deficit that must be
met by the portfolio. Remember, whenever the portfolio must be called upon to
help meet living expenses, the client loses a notch in ability to tolerate risk,
regardless of the clients willingness to tolerate risk.

3.

The process for calculating the required return will most likely follow this
pattern:
a.

Start by adjusting each future spending need for inflation (if it is stated
that it will increase with inflation).
b.
Total spending needs and divide by the value of the portfolio to determine
the required after-tax return necessary to meet spending needs (including

the shortfall between living expenses and salary). Be sure to use the net
amount of the portfolio. That means the value of the portfolio after
deducting any personal residences or planned, short-term major outlays
(see #6 below).
c.
Divide the after-tax required return by (1 t) to gross it up for taxes (i.e.,
put it on a before-tax basis.
d.
Add inflation to protect the nominal value of the portfolio.
The first inflation adjustment is very straight forward; it covers the nominal
values of the future spending needs. The second adjustment is for the nominal
value of the portfolio itself. This assumes that the portion of the return that
protects the principal from inflation is unrecognized (for taxes) capital gains.
(Thats why we dont gross it up for taxes.)
Note: Unless specifically stated otherwise always assume you are required to
protect the portfolio principal.
4.

Assume a total return approach. It is OK to assume that the client will liquidate
a portion of the portfolio to meet spending needs, as long as the client spends
only from annual returns (capital gains or cash flows). In that way the real value
of the portfolio never declines. (Note that the portfolio value increases each
period by the rate of inflation, thus maintaining its real value. Also, the only
capital gains recognized and taxed are those resulting from selling portfolio
assets to meet spending needs.)

5.

Risk tolerance. You may have to resolve differences between the clients
willingness and ability to tolerate risk. Remember that you usually always select
the lower of the two. (See the blog on investor risk tolerance.)

6.

Liquidity needs. Include only those expenditures that must be met by the
portfolio. For a working client this could include a portion of living expenses,
kids college funding, paying for a loved ones medical care, or any other
specified expenditures. For a retired client, the portfolio will typically have to
meet all living expenses.

7.

If there is a planned (large) outlay within the coming year, you should deduct
that amount from the portfolio. You then allocate the rest of the portfolio
according to the IPS.

8.

Unique circumstances. This will include anything that jumps out at you as
specific (unique) to the investor and will include things like disallowed
securities, large holdings of an individual asset, planned charitable gifts,
presence of or the desire to establish a trust, etc. (PS - If the client wants to
establish a trust, be sure to state that legal counsel is recommended).
Required expenditures (e.g., living expenses, college education) should be met
but desired expenditures (e.g., second home, large bequests) should be met
only if feasible. For example, on one prior exam a client wanted to leave $1
million to each of her two children. As it turned out, she had insufficient assets
to do so without jeopardizing her retirement needs. The bequests were ignored
in determining her IPS and portfolio allocation. The unfulfilled request was then
noted under special circumstances.

9.

Time horizon. The end of one time horizon and the beginning of another is
indicated by the need to rewrite the IPS and reallocate the portfolio. This is

nearly always caused by retirement and could be caused by sending a kid or

kids to college. The underlying cause is usually a significant change in risk
tolerance or liquidity needs.
Identify multiple time horizons if present. For an individual there will probably be
at least two, pre-retirement and retirement. Remember, once the client dies and
the assets are transferred to beneficiaries (whether loved ones or charities), the
assets will be managed according to the beneficiarys IPS.
10.

Legal and regulatory. This constraint is usually insignificant for an individual

and is usually not required on the exam.

11.

Taxes. Individuals are taxed on income. Be sure you consider the clients tax
status in your allocation recommendation. For example to minimize tax
impacts, the client who does not require cash flows from the portfolio to meet
annual liquidity needs should have a portfolio weighted heavily toward growth
(capital gains).

12.

Recommending an allocation. Use the Sharpe ratio, Roys safety-first

measure, or the safety-first measure provided in the vignette to support the
final allocation recommendation. On previous exams the client has at times
specified a maximum annual loss and instructions in the case told candidates to
use a two-standard deviation rule to facilitate the clients wishes. In that case
you subtract two standard deviations from the portfolios expected return and
the resulting return (i.e., loss) must be less than or equal to the clients
specified maximum loss. In any case, be sure your final recommendation (if one
is requested) meets the clients desired aversion to shortfall.
Portfolio choices should be narrowed down on the basis of return, risk,
diversification, disallowed securities, and liquidity. For example, if the client will
have to liquidate parts of the portfolio to meet regular spending needs, he or
she will probably not want large holdings of illiquid real estate, such as raw
land.

13.

IPS questions for individuals often leave a lot of room for interpretation, but you
should stick to the facts of the case as much as possible. Dont make
assumptions unless its absolutely necessary. If the client has stated a specific
goal, assume it must be met, unless the clients wealth and income simply
arent sufficient.

14.

As I have stated on numerous occasions, the key to doing well on the Level III
exam is integration of material across study sessions. Youre in the big
leagues nowyou are expected to apply what you have learned, not just
regurgitate facts, formulas, and definitions.