Financial life-cycle stage analysis and net worth assessment for Jay and Rebecca

Personal Finance

Define which stage of the live-cycle are Jay and Rebecca in today. What important financial planning issues characterize this stage?

According to Modigliani and Brumberg (1954) there are six potential stages that an individual or couple may experience: Individual supported by parents, young single, young couple- no children, couple or individual with children, empty nesters, and retired (Personal Finance. N.D.P.1). Based on the data presented Jay and Rebecca fall into the couple or individual with children category which is characterized by: income approximately equal to expenditures, potential upgrade of house, purchase children's toys, clothing, and supplies, purchase life insurance, college tuition expenses, and debt management (Personal Finance. N.D.P.1). Financial planning should consist of saving for retirement, investing, securing adequate insurance coverage, saving for child's tuition, and estate planning.

Construct the Balance Sheet and Income Statement for the Bennett's (information is presented both as background and as listed Assets, Debt and Expenses in the table). Do Jay and Rebecca have a positive or negative net worth?

Assets: Cash-Checking $6,700

Savings in Securities $26,500

Life Insurance Cash Value $1,700

Vehicles #1, #2 $20,300

Personal Property $17,000

Total Assets $72,200

Liabilities: Car Loan #1 $7,500

Student Loan $10,500

Furniture Loan $4,600

Credit Card $2,000

Total Liabilities $24,600

Net Worth $47,600

Income Statement

Revenues Salaries $107,000 Annual- $8,916.67 Monthly

Expenses- Annual $74,610 -- Monthly $4,250.83

Debt Expense- $1,145

Rent $1,500

Life Insurance $54.17

3. Using information from the Balance Sheet and Income Statement calculate:

Current ratio- Current (liquid) Assets / Current Liabilities

33,200 (cash, savings, and investments) / 24,600 (current debts paid on= 1.35

Monthly living expense covered ratio- Current Assets / Monthly Living

Expenses: $33,200/$6,950 (all monthly expenses from data provided)=4.78

Debt Ratio- Total Liabilities / Total Assets

$24,600 / $72,200= .34

Long-term debt coverage ratio- Monthly Living Expenses / Monthly Debt Payments

$6,950 / $1,145= 6.07

Savings ratio- Total Savings / Net Income

33,200/$83,400= 40%

4. Use the information provided by the ratios and recommended ratio limits from the textbook to assess the Bennett's financial health.

The current ratio of 1.35 is below the recommended value of 2. "It is also important to track the trend of this ratio; an upward trend is recommended" (Pocket Financial Planner. N.D.P.1.). The value is above 1 however, which is satisfactory.

The monthly living expense covered ratio referred to "as the emergency fund ratio should ideally be between 3 and 6 depending on the volatility of your job" (Pocket Financial Planner. N.D.P.1.). Jay and Rebecca have a 4.78 ration which again is satisfactory.

A debt ratio "above 1 means a negative net worth; the closer the ratio is to zero, the better. When the ratio hits zero, you are debt free" (Pocket Financial Planner. N.D.P.1.). The .34 ratio suggests that the debt load is manageable and not overwhelming.

"The long-term debt coverage ratio tells you how many times over you could pay debt obligations-based your monthly living expenses. A higher ratio indicates that you could cover debt payments for a longer period of time if you had a loss of income" (Pocket Financial Planner. N.D.P.1.). The 6.07 ratio for Jay and Rebecca is quite solid and indicates financial health.

For the savings ratio "good rule of thumb is to keep these ratios above 10%

and preferably above 15%. The higher the ratio the better" (Pocket

Financial Planner. N.D.P.1.).. Jay and Rebecca

at 40% have a healthy ratio.

5. Do they have an emergency fund? How much would you recommend that they have in it?

Currently, Jay and Rebecca have no emergency fund however; they could easily allocate $1,000 for that purpose. A recommended emergency fun consists of a "cash reserve which is as liquid as possible (a high-yield online savings account is just about perfect) and should contain at least $1,000 (at first) and eventually six to twelve months of your household's take-home salary (eventually)" (the Simple Dollar. January 3, 2007. P.1.)

6. Recall that the Bennett's already have a house savings fund for a future down payment (FMV of $23,000). How much will this house-savings fund be worth in 3, 5, and 10 years assuming an annual growth rate of 5%. How much will the fund be worth if they could achieve a 10% nominal rate of return for the same 3, 5 and 10 years?

At 5%

At 10%

3

$26,642.80

3

$30,613

5

$29,354.90

5

$37,041.50

10

$37,464.70

10

$59,655.10

7. How much will Jay and Rebecca have to save at the beginning of each year to accumulate $50,000 for Emily to attend university if they can earn 9% per annum, assuming she enrolls at the age of 19? If the Bennett's had to accumulate $100,000 to fund Emily's educational expenses, how much would they need to save at the beginning of each year, assuming the same rate of return? If they could earn 12% per year on their investments, how much would they need to save at the end of each year to meet the $100,000 target?

Assuming Emily just turned 3 the Bennett's would have 16 years to save $50,000. According to the future value of an annuity due formula; $1,390.05 per year. To save $100,000 earning 9% the couple would need to save $2,780.09. To save $100,000 at 12% with investment at the end of each period the future value of an ordinary annuity provides a value of $2,339.18 each year.

8. Assuming an 8% return for the current year from Jay's ETF, and a 33% marginal tax rate, how much will the Bennett's pay in taxes on their investment, either from their savings or current income this year? By how much, after taxes will their account grow this year?

$3,500* 1.08=$3,780. Gain = $2,780*.33= $917.40 taxes. $2,780- $917.40= $1,862.60 in after tax gain.

9. Calculate the amount of CPP and EI taxes withheld from Jay's and Rebecca's pay based on their current income? Total taxes annually $23,600 equals $1,966.67 monthly withheld

PART II: Cash Management

10. Jay has been on the Internet researching various investment alternatives. He has learned about T-bills and is wondering if they are an appropriate vehicle to put Bennett's savings for a house? Treasury or T-bills are short-term investments issued by national governments. "Government of Canada Treasury Bills offer attractive interest rates and are fully guaranteed by the federal government. They are available for terms of one month to one year and are essentially risk-free if held to maturity" (Canada Trust. T-Bills. N.D.P.1.). The safety of this investment would be ideal for Jay and Rebecca's house fund, although the rate of 1.32% on a one year bill does not offer a stellar return.

11. He also read about Canada Saving Bonds. How appropriate are these bonds as a saving vehicle for the same purposes? From a safety perspective these bonds offer a similar advantage to T-bills however, the rate of .65 does not offer a quality return (Government of Canda. N.D.P.1).

12. What recommendation would you give to the Bennett's with respect to their down-payment savings: hold as is or change? What investment vehicle would you recommend? For house savings I would recommend the t-bill approach or perhaps a money market account which pays a higher rate and would offer a safe and guaranteed return on investment. The key point is that this money cannot be placed at risk of loss of principal.

13. Bennett's have heard about "pay yourself first" concept. Rebecca is not sure how to do this. Give her advice about the ways to automate her savings. The "pay yourself first" concept simply means allocating income to savings prior to paying out other expenses. The simplest method to do this is a transfer of 1- 20% of paycheck income to a designated savings account. Jay and Rebecca have disposable income of $6,950 monthly and from this amount $695.00 should be automatically transferred to a separate account. The account can be a traditional savings account or perhaps an investment account. An alternative to this approach would be to save through a Canadian "registered Retirement Savings Plan (RSP) an investment account designed primarily for saving toward your retirement years" (Canada Trust. RSP. N.D.P.1).

14. The family's total monthly real disposable income (after taxes) is approximately $6,950/mth. Calculate Bennett's current monthly debt payments. Calculate and interpret their debt limit ratio.

Monthly bills:

Car Pmt $485

Student Loan $150

Furniture Loan $260

Credit Card $250

$1,145 monthly debt

PART III: Investments

21. Based on the Bennett's stage in the lifecycle, what type of investment asset allocation would be appropriate, assuming they want to establish a retirement savings fund? What types of stocks should they consider for the equity portion of their asset allocation? What type of bonds would be appropriate for the fixed income portion of their portfolio? (List the bond maturity, rating and type of issuer). Please provide your asset allocation recommendation (use of charts and tables is recommended). As a couple that is relatively young and has time to save for retirement they can afford to have more of their investments in equities. The most simple investment option is the use of mutual funds or index funds. A mutual fund "is nothing more than a collection of stocks and/or bonds. You can think of a mutual fund as a company that brings together a group of people and invests their money in stocks, bonds, and other securities. Each investor owns shares, which represent a portion of the holdings of the fund" (Investopedia- Mutual fund. N.D.P.1.). An index fund is "a type of mutual fund with a portfolio constructed to match or track the components of a market index, such as the Standard & Poor's 500 Index (S&P 500). An index mutual fund is said to provide broad market exposure, low operating expenses and low portfolio turnover" (Investopedia- Index Funds. N.D.P.1.). Choosing specific stocks can be time consuming and may not adequately diversify a portfolio. Jay and Rebecca should consider being more aggressive though in their portfolio which could follow this program. "The old rule of thumb used to be that you should subtract your age from 100 - and that's the percentage of your portfolio that you should keep in stocks. For example, if you're 30, you should keep 70% of your portfolio in stocks. If you're 70, you should keep 30% of your portfolio in stocks" (CNNMoney.com. N.D.P.1.). The Bennett's should have 70% investment in equities. Their fixed income portfolio could also be a bond fund such as PIMCO Total Return which invests in a mix of corporate, treasury, municipal and foreign bonds. These bonds are typically rated AAA and AA.

(Carther, S.N.D.P.1)

22. What investment risks should be of primary concern to the Bennett's when choosing a savings or investment account for their emergency fund? What account would be most appropriate? Why? Loss of principal is the primary concern for the emergency fund. The account should be parked in a safe investment such as CD or high yield money market account to ensure security of principal.

23. Rebecca's parents recently gave the Bennett's $25,000 to start education fund for Emily. An investment advisor has recommended that they include a 10-year corporate bond in the education saving fund. The bond currently yields 6.75% per year and sells for $1,000. If interest rates increase by 2 percentage points and the bond is sold, how much will the bond sell for at that time? Calculate the bond price if rates fall 1%. What investing rule has this proved? If the rate increases to 8.75% the bond would be sold for $867. If rates fell by 1% the bond would sell for $1,076. This investment rule indicates that interest rates and bond values move in the opposite direction. An investor must be concerned not only with return but also valuation of the bond.

24. The same advisor who recommended a bond for Emily's education fund also recommended to include a preferred stock paying a $5 annual dividend, currently selling for $53/share. If the Bennett's required rate of return is 10%, how much should the preferred stock sell for? The stock based on a $100 par value should sell at $50 (Business Finance Online. N.D.P.1.).

where

Pp = the preferred stock price,

Dp = the preferred dividend, and r = the required return on the stock

25. The Bennett's, in the 33% marginal tax bracket, are concerned about the taxes paid on investment earnings. Show the calculations to answer the following questions:

a. A money market mutual fund is currently yielding 1.5%. Should Jay and Rebecca move their savings into this fund or keep their money in a savings account at the bank paying 1%. "Equivalent taxable yield is calculated by dividing the available tax-exempt yield by one minus the investor's marginal tax rate" (Investor Glossary. N.D.P.1.). In this case .015/.67= 2% required return to make up for taxes so the Bennett's should not move their money.

b. A Government of Canada bond is currently yielding 4.2%. What is the minimum yield that the Bennett's must receive in order to obtain an equivalent return on a pure equity mutual fund with about 75% of its returns in capital gains and 25% in dividends from Canadian companies?

"Equivalent taxable yield is calculated by dividing the available tax-exempt yield by one minus the investor's marginal tax rate" (Investor Glossary. N.D.P.1.). In this case the required return would be .042 / .67= 6.0%

PART IV: Life cycle planning

26. Jay and Rebecca plan to retire in 35 years. They estimate their living expenses at approximately $60,000/year after taxes when they retire.

a. How much before-tax income will they need to retire on, assuming an average tax rate of 19% during their retirement? The couple will need approximately $74,000 in pre-tax annual income.

b. Assume that through a combination of savings, government benefits and pension distributions Jay and Rebecca can earn $50,000 annually in retirement. Determine their retirement income shortfall. Assuming a 3% long-term inflation rate and 35 years until retirement, calculate their inflation-adjusted shortfall. The shortfall is $10,000 a year. The inflation adjusted shortfall $10,000 * Future value of a single amount 35 -- %= $10,000* 2.8139= $28,139

c. If Jay and Rebecca can earn a 5% inflation-adjusted return, determine how much they must accumulate in savings over the 35 years to fund the annual inflation-adjusted shortfall as previously-calculated. Savings necessary is $28,139/.05= $562,780 / Future value factor for ordinary annuity @5% 35 years= 90.3203= $6,230.94 Annual savings necessary.

d. How much do the Bennett's need to start saving each year for the next 35 years at 7% annual return to meet their savings accumulation goal as calculated in part (c)? As before annual inflation adjusted shortfall is $28,139 / .07= $401,986 / Future value factor for ordinary annuity @7% for 35 years= 138.2369= $2,907.95 in annual savings needed.

27. if, for 35 years, Jay and Rebecca invested $3,000 at the end of every year in a tax-sheltered RRSP account, what would be the future value of the account if they earned 9% annually? If instead they first paid taxes (marginal tax rate of 33%) and then made the investment, how much would the account be worth at the end of 35 years? Based on these calculations, what advice would you give to Jay and Rebecca regarding their retirement savings? Using the future value factor for an ordinary annuity at 9% for 35 years which is 215.7108, the value of the account would be $647,132. The alternative would mean investing $2,010 for 35 years at 9% which would be $433,578. I would recommend that they invest the $3,000 in the RRSP account because their future tax burden will likely be lower than their current 33%.

28. Rebecca has considered offering accounting services to small businesses. She has obtained a business license and plans to work out of her home. Would she qualify for a retirement plan? If so, what should she consider? Yes, in Canada she could utilize a RSP plan which allows Contributions to an RSP by individuals with "earned income" taxable in Canada, which includes salaries, and self-employment income" (Canada Trust. RSP. N.D.P.1.).

29. At retirement, what expected and unexpected changes should the Bennett's monitor to safeguard their future? Retirement concerns for the Bennett's would include the value of their investment portfolio and the potential for drops in the stock market for the 30% of dollars they have invested in equities. An unexpected health related incident might force them to deplete their savings more quickly. Long-term care insurance may be an option which they would consider. A surge in the inflation rate might entail that they will have to spend more savings then previously calculated.

30. At this stage of their life cycle, which of the five objectives of estate planning are the most important to the Bennett's household? Preparation of what two estate planning documents would enable them to accomplish these objectives? "To provide for a young widow/widower and children, and to provide adequately for you and your spouse, if married, during retirement years" (the Ohio State University. N.D.P.1.). Of the five following documents: "a will, a durable power of attorney, a health care proxy, a living will and medical release or HIPAA release (Health Insurance Portability and Accountability Act)" (Chan, a. May 25, 2010. P.1.); the Bennett's would be advised to draft a will and durable power of attorney.

31. The Bennett's have always considered a trust to be a financial tool of the wealthy, but they do want to learn more about estate planning. Provide a simple explanation of how both living and testamentary trusts, which by definition are quite different, can accomplish the same purpose of reducing estate taxes. The fundamental difference between the two trusts is that the testamentary trust is formed after the individual's death, while a living trust is formed during one's life. "A testamentary trust is created by a will, which begins its existence upon the death of the person making the will, when property is transferred from the decedent's estate" (IRS.gov. N.D.P.1.). The advantage of a testamentary trust "is the favorable tax treatment they receive under the Income Tax Act. Unlike other trusts, testamentary trusts pay tax using the graduated rates in the Income Tax Act on income retained in the trust, although they do not receive the personal deductions available to individuals" (Professional Referrals CA. N.D.P.1.). Yet living trusts can also reduce tax liability because the top marginal tax rate for an individual will likely be lower in retirement years then during working years.