Value of Money: A Retirement

¶ … 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. Sensitivity This analysis relies on many assumptions about what will happen over the next 30 years.

There are many factors that could influence inflation rates and returns on the Smith's investments. Many of these factors are due to general trends and macroeconomic factors. The current rates that have been used to calculate retirement are based on assumptions and current economic trends. Life is not a straight path and there are certain to be bends in the road. As time goes on, the Smiths will have to re-evaluate their strategy from time to time.

They may have to devise a plan in order to cope with factors such as higher than expected interest rates, or to take advantage of an opportunity that presents itself. The global economy has been around for many years. However, advances in communications have changed the face of the global economy in recent years like never before. A world that used to be only for the large corporation has now opened up to become a part of the world of the small and medium business.

This will have many effects on the macro economy including increased competition, greater access to substitute goods and many other factors that may have an impact on the U.S. inflation rate. In regards to the sensitivity of the assumptions of this report, a change of 1-2% would not change these results drastically. However, a change of 4-5% in either direction could mean the need to alter the plan significantly.

As the economy reacts to shocks, the size and duration of the shock determine the effect that it have on interest rates. The same can be said of shocks that are experienced by the Smiths themselves. There are a number of things that could happen which could interfere with this plan. The loss of a job or long-term illness that is not covered by insurance could have a drastic effect the outcome of the plan.

The severity and length of the shock will be the determining factor in whether it affects the outcome or not. A shock can be positive or negative. However, for the most part one is concerned about negative shocks. The lower interest accounts would be more sensitive to shocks than higher interest ones. Even a small shock could place the smaller interest account into an even situation, where it loses as compared to inflation. The key to retirement savings is to make gains that are greater than the inflationary index.

It may appear as if an account is increasing astronomically if one considers it at the current inflation rate. However, when one considers that the cost of living goes up with the increases in salary then it soon becomes apparent that it is possible to lose money even if the account continues to rise. If other items have risen at the same rate as salaries, then no gain in real terms has been made.

This is the key to understanding retirement savings, it is not simply a matter of putting money into accounts, and it is a matter of beating the inflationary index and the many factors that can affect it. The following shows movement of the Prime Rate over time. Source: MOneycafe.com (2006) In general, 401(k) plans and other retirement plans do only slightly better than inflation. In many cases they only keep pace, which means that at least one does not lose money in the long run.

However, 401(k) plans are not the answer to wealth in the golden years. They are considered a conservative move for those that are adversarial to risk and that may not be suited for riskier, but higher return investments. Roth and traditional IRAs tend to perform better than 401 (k) plans, typically twice the rate. However, one has to be careful that the earnings from these investments do not get consumed in taxes, whether it now or in the future.

The plans chosen by the Smiths in this case study represent the types of investments that are utilized by a majority of Americans. They are safe and one at least knows that they will not lose money in the end. However, as we saw in this case study, these low risk investments are also low yield as well. In some of the scenarios depicted in this study the Smiths actually ended up broke as soon as they retired.

In other cases, they were able to live comfortably in their golden years and their children will be quite spoiled by the trusts that they left them. 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.