When answering the constraints portion of IPS questions, the CFAI’s treatment of retirement income appears vague. My understanding is ‘liquidity’ should ONLY contain near - term, 1 - time and/or infrequent items (e.g. emergency reserves, money to buy home, etc.). However, the answer to one question included retirement income as one of the liquidity constraints.
Schweser instructs candidates to include retirement income in the ‘return’ section ONLY, which adds to the confusion. How about some feedback?
In retirement , ( Sum required for Living Needs *(1+Inflation ) ) drives the required return from the portfolio in absence of income. Naturally any retirement income could be subtracted from the numerator .
inflation will eat the priinciple , so we do the (1+inflation) compounding twice to grow the portfolio at the rate of inflaton.
Now if the individual has not yet retired , her goal might be a certain target principal at retirement as advised by the investment adviser or actuary. Since she is working , she may only need to satisfy her pr-retirement living needs , and save the rest towards retirement.
Liquidity is always considered as sums needed to be set aside from the portfolio . This could come about in pre-retirement such as 1-time or annual requirement for college expenses for children or in post retirement for example expenses for a holiday trip . This sum is usally too large to be satisfied from the income portion an requires the principal to be invaded. To me this was the distinguishing factor :
Can the expense be classified as regular , living expense or some other “normal” ( nominal?) expense ? The phrases in the question are usually explicit in this regard
OR
Is the expense too obviously large to be classified as above? i.e. is capital invasion required ? That will alter the denominator of the return equation obviously so has to be carefully segregated.
Having said this : I have written Lvl III 3 times and ALWAYS got failing marks in the IPS section , so I am not sure I am a good guide , and others should chime in