Time value of money in retirement and college planning

¶ … Value of Money: a Retirement Planning Case Study

Financial Planning (TVM Applications)

On September 15, 2006 Mr. And Mrs. Smith came to me for advice in planning for their retirement. Both of them are currently 35 years old. They have two children, ages 3 and newborn. They plan to retire at age 65 and expect a retirement horizon of 25 years. Their goals are two fold. The first is to pay help pay for college for both of their children. The second is to be able to live comfortably their retirement years and to be able to leave some inheritance to their children.

The Smiths own their own home and have excellent medical coverage, which means that there is little to interfere with their plans. They have a combined income of $60,000 and are both paid at the end of each month. In accordance with current government estimates it can be expected that they will receive an annual average increase of 4% annually until they retire. Each of them Deposit 12% of each paycheck into a 401(K) which is expected to receive an annual rate of return of 9%, compounded daily. In addition, their employers match their contribution with an additional 3% of their annual salary. Over a 25-year period, this will result in a combined total of $35,298 at the end of 25 years.

The Smiths have additional income in bonuses that they receive at the end of the year. Their bonuses equate 20% of their salary. The Smiths wish to deposit $10,000 of their bonus money into a 529 plan to help pay for their children' college expenses. Any amount remaining from this bonus check they wish to deposit into a Roth IRA that is expected to generate an 8% annual rate of return, compounded daily.

Current expenses for college are approximately $30,000 per year, per student. These are expected to increase at a rate of approximately 6% a year. The average program takes five years to complete. The Smiths expect their children to be able to pay for 20% of their college expenses on their own. The Smiths plan to use the 529 plan to help pay for the rest and will dip into the Roth IRA if needed. They will not use any of their 401K for this purpose.

It is assumed that both children will enter college at age 18 and that they will complete their degree in the allotted five-year time period. The first child is 3 now, which means that the Smiths have 15 years to save before they have to start paying for child number one. Three years after the first child begins college, the second one will begin. There are two years where the Smiths will have two children in college at the same time.

Calculate at the current rate, this means that the total college expenses for Child 1 will total $229,429 which breaks down into $45,885 per year for the full five-year duration. For child 2 the amount needed for college are slightly higher due to expected increases over the time between college entrances for the two children. For child 2 it is expected to take $329,174.27 for the entire five years. This breaks down into $65,834 per year. The Smiths expect their children to save 20% of their college expenses.

This means that the children will have to save $45,885 and $65,834 respectively.

For the first child the Smiths will still have to come up with $183,543.40. For the second child they will want to come up with $263,339.42 for the second child. The makes the amount needed by the Smiths to $446,882. The amount of contributions to the 529 plus the interest earned on them will total $323,356. This means that they will have to dip into the Roth IRA, which will only have $64,671 at the time to cover the remaining amount. Under this plan they will not be able to pay for college.

It appears that the savings plan for the childrens' college will be able to pay for the needed expenses at that time if both children are able to save the remaining 20% needed. If the children are able to save nothing, then the Smiths will have to come up with an additional $111,719. They would still be able to pay for their children's college and would still have $160,203 for their own retirement. Even under the worst case scenario it appears that the Smiths will be able to pay for their children's college and still have money left over. This is assuming that college expenses will rise at the predicted rate.

Retirement Living

The Smiths not only wanted to put their children through college, but wanted to have enough for their own needs in when they retired as well. After the children have gone to college, the Smiths will use their 401(k) and the remainder of the Roth IRA to fund their retirement. It is expected that the Smiths will need 90% of their retirement at the time just prior to their retirement. The Smiths have indicated that they realistically expect to retire in 30 years at age 65, rather than at 50. This gives them an additional five years to save.

If the inflationary rates and expected increases in pay go as planned, then the Smiths will be making a combined income of $194, 603 per year. This means that they will need $175,142 each year to live at their current lifestyle. It is expected that social security benefits will cover 20% of these expenses and that pensions will cover another 10%. The Smiths will still have to cover $122,600 from their own investments.

When they retire the Smiths plan to roll over all of their savings from the 401(k) and the Roth IRA to an account that will generate an expected return of 6% annually. Assuming that the Smith children will be able to save their allotted 20% for school and that they will have $271,922 left over for retirement, when combined with the $40,838 generated from their retirement accounts, they will have $312,760 to invest. If they earn 6% annually, that will generate $18,765 per year, not nearly enough for them to survive the first few months by these estimates.

Discussion and Recommendations

There are many factors that will affect the results of this exercise. The Smiths did something right in that they chose to start saving earlier rather than later in their working years. Earlier would always be better, but at least they started saving before the age of 40. They have two young children and this may place a damper on being able to save extra early on. Not enough information is available in the case to determine if the Smiths are able to save any additional monies other than their bonuses and the 401 (k) contributions. It is assumed that because other contributions are not mentioned that this means the Smiths do not have significant descressionary income to devote to additional savings.

The savings that the Smiths generated will be able to provide their children a good college education, but they will not be able to survive when they retire. This leaves several options. The first is to hope that the children become professionals that are able and willing to provide for their mom and dad in their golden years. However, barring this, let us see if the children paying for their own college would be enough. If the Smiths do not have to contribute to their childrens' college, then they would have $471,406 in addition to the $40,838 in their retirement. If they are able to invest this $512,244 at 6% then they will have an annual income of $30,734 annually to live on after retirement. This is still not enough for even the first year.

They still do not have enough to survive on the investments alone. If they then started using the principle amount to pay for their monthly expenses, then they would run out of money at approximately age 70. However, there is one major factor that was left out of this analysis. It is assumed that the Smiths will need approximately 90% of their annual salaries. However, one major event will occur before they retire that will significantly impact the amount of money needed after retirement.

They probably have a 30-year mortgage on their house. This means at some time they will have the house paid off and will have additional income to invest in retirement. Even if they only bought the house in recent years, then they will still have it paid off right before they retired and would not need as much in retirement income as they would if they rented or did not have the house paid off. The only expenses that they would have are utilities, groceries and other such recurring expenses.

The amount of the Smiths' mortgage has a significant impact on the outcome of this analysis. If they are living within their means then they may be able to sock away additional monies. However, if they are strapped every month then this scenario may be the best that they can do. This creates a dismal retirement for the Smiths. Therefore, let us examine some financial planning strategies that will help the Smiths to achieve their goals.

When one examines the Smiths' investments, they are only relying on what is available from their employers as the basis for their savings. The 401 (k) is not considered to be an aggressive investment strategy. They typically only manage to match or slightly outperform inflation by 1-2%. This means that using a 401(k) as a sole means of retirement income will only yield a little more or less than one year's salary at the beginning of the retirement. This is hardly better than a passbook savings account, and in some cases is less. However, the real advantage to the 401 (k) is the matching contribution from the employer. This adds money that they otherwise would not have had access to. One should never look a gift in the mouth and should use their 401(k) to their best advantage, but they should not count on it as a sole means of retirement income.

The Roth IRA and 529 plan are more aggressive than the 401 (k), but as we saw they still were not able to generate enough so that the Smiths could live comfortably. The Smiths combined income was only able to help them achieve one of their goals, putting their kids through college. Let us examine some ways that the Smiths may be able to use to achieve both of their goals.

For the first scenario, we will assume that the calculation is correct and that the Smiths will need 90% of their pre-retirement income to live. If this is the case, then, as we determined previously, they will need to generate $175,142 annually to live at their current lifestyle. If they wished to devise a plan to live entirely off of investments then they would need to invest approximately $3,000,000. This would generate a passive income of $180,000 per year and they could live comfortably on passive income and have a $3,000,000 income to pass on to their children. If the children were smart they would use this to generate passive income as well. However, three million dollars is a large chunk of money and without some aggressive strategies, it is unlikely that the Smiths will be able to achieve this.

The other way to look at this problem is that the mortgage will be paid off and the Smiths will have a much lower income needed to survive. In order to do this we will have to make some basic assumptions about the mortgage. We will assume that they mortgage is 60% of the Smith's annual income. If this is true, then if we eliminate this expense at retirement the Smiths only need $52,542 per month to live. Let us assume as in the previous scenario that social security and pensions will cover an additional 30% then they will only need $31,525 to live.

Under their current plan they will have an income of $30,734. That is reasonably close and is probably correct considering that our inflationary indices and other factors may be off. If the Smiths can find additional ways to cut back then they can probably make this budget work for them. They now can live on the passive income and have about $312,760 to pass onto their children.

Using this strategy, the Smiths will be able to leave their children a nest egg of $312,760. They wish to devise a plan to help their kids manage their money successfully. Therefore they have decided to set up a trust that distributes quarterly payments. The trust is expected to generate an annual return of 9%, compounded monthly. Their children will receive $7,035 per quarter for the rest of their lives.

Alternative Investment Opportunities

401(k) plans are an excellent way to protect savings. However, as we have seen in recent years, there have been cases where 401(K) plans have been plundered by unscrupulous upper managers. People have lost their retirement savings and had to start over at a time when they were in no position to do so. IRAs are fairly safe, but tax rates on them tend to change with Presidential administrations. These types of investments should not be avoided and they provide a nice stable base for other investments.

Many like the sense of security that 401 (k) and IRAs have to offer. They are afraid of riskier investments and fear losing their hard earned money. However, if they wish to truly experience independence in their retirement years, they need to consider other types of investments. For instance, they might consider CDs for a portion of their money. Let us see what would happen if the Smiths place one $10,000 allotment of their yearly bonuses into a CD instead of the 529 plan.

If the Smiths took one 10,000 dollar allotment and placed it in a 12-month CD, that was earning 5% interest, they would have $500 extra dollars. However, they still did not outpace the 8% earned on their 529 plan. Currently CDs are relatively low (4.5-5.25%), compared to rates several years ago. However, when CD rates rise, it may be a wise decision to place a little money into them. If the amount is rolled over, it could amount to quite a substantial nest egg. The only drawback is that if the money is needed before the CD matures then there could be considerable penalties. A savvy investor would watch the rates and when banks offer a good deal be prepared to jump on it. At this time there may not be any good CD deals out there, but they should stay abreast of the situation for the future.

In general savings accounts and Money Market Accounts are not the answer either. In some cases they perform well below the inflationary index. Over time they lose money against inflation. As the dollar loses purchasing power, the savings account or money market account becomes a less attractive option. At the current time, it is possible to lose money in the savings account and money market account market (Bankrate.com, 2006).

Let us take a look at how prime rates have fluctuated in the past. Bankrates.com tracks rates historically and has good data available to realistically see how rates can change over time. The Smiths are investing over a long time frame and it is important to understand that what is decided as the best strategy for today is not always the best strategy for tomorrow.

Key interest rates

Oct. 25, 1995 through Dec. 13, 2005

Source: Bankrate.com, 2006

This chart provides valuable insight into the relationships of various lending and investment instruments. There may be things that the Smiths are doing which are sabotaging their savings and ability to meet their goals. For instance, the chart indicates that credit card rates are almost 10% higher than savings rates. If the Smiths tend to keep a lot of credit card debt, then they will have less to save for retirement. If they pay off high interest credit cards and place the money saved into retirement savings then they can reach their goals faster and earn substantially more in after-retirement investments.

Source: Moneycafe.com (2006)

The chart tells us that the best one can wish to do on a savings, CD, or other similar account is around 6% return. These are the safest investments, but do not have any guarantees, and they do not help reach one's goals quickly. According to Bankrate.com the long-term prospects indicate that savings related rates are expected to go down, rather than up. This could put a kink in the Smith's investment plans.

Other types of investments, such as stocks, or mutual funds have high rates of return. However, they also carry a substantial amount of risk as well. One has to weigh the amount of risk involved with each type of transaction. In general, mutual funds are much less risky than single stock purchases. However, there are options, such as combining low risk investments with higher risk investments in an attempt to balance risk with return. The type of investment depends on the level of risk that the customer is comfortable with.

Judging from the investment strategy presented by the Smiths in the case study, it appears that they are not great risk takers. They tend to want something that is relatively guaranteed, and are willing to accept lower returns as a result. However, it appears that the one of their greatest fears is that they will not be able to fund the childrens' college, or that they will not have enough to leave them as an inheritance. The Smiths are not considered high income winners, but are on the high/average end of the economic ladder. They have a little left over and if they watch their debt carefully, they can reach their goals. However, they do not have a lot of margin for error.

It would not be advisable for the Smiths to engage in placing a high amount of their investment in high yield/high risk investments, such as single stocks. However, it would be wise to set aside an amount that they feel comfortable risking to be able to place in higher yield investments, such as well-researched mutual funds. Let us see if they tried several different high yield investments. Let us assume that they will use a portion of their $12,000 a year bonus to do this. According to Yahoo Finance (2006) there are some funds out there that are medium risk and carry a return of around 11-12%. Let us assume that the Smiths find one of these attractive.

If they take $1,000 of the 10000 in the 529 plan and place it in a mutual fund that earns 12%, compounded quarterly and continue to roll it over, at the end of 28 years they will have $175,595 at the end of 25 years. This is compared to the same $1,000 dollars in the 529 plan, which would equal $87,120 compounded monthly at 8% over the same time period. If they placed $2,000 in the Mutual Fund and $8,000 in the 529 plan then they would have $351,190 from the mutual fund and $696,965 from the 529 at the end of 25 years.

As one can see, placing a small amount into a higher yield type of account can make a big difference over time. With any investment, one has to watch out for hidden fees that may result in a risk and lower the amount of return. This is especially true when dealing with a broker. However, if one shops around it is possible to find a higher yielding fund that had no or few hidden fees attached. They will have to be careful about higher risk investments, but at the current time it appears that the Smiths need a more aggressive plan for savings than they have devised at this time.

In conclusion, the Smiths presented a typical scenario that demonstrated a lack of knowledge of investing savvy. They have a major part of their investments in a plan that will barely beat inflation over time. This will not help them meet their goals and provide a solid future for themselves or their children. There is no single answer to the question of how to meet financial goals. The answer is different for each and every person. It is dependent upon the horizon and amount of risk that the person feels comfortable with. A thirty year horizon is a long time and there are certainly many things that could change. The Smiths need to constantly re-evaluate their position to meet their needs.