FIN 200: Personal Finance

1. FIN 200: Personal Finance Topic 22–Retirement Lawrence Schrenk, Instructor

2. Learning Objectives • Explain the importance of longevity risk. ▪ • Discuss the ways of saving for retirement. • Calculate the savings needed to ensure a specified retirement lifestyle. ▪

3. Life and Retirement Expectancy • Life Expectancy • 83 Years (at age 20) • Retirement Expectancy • 13 Retirement Years (retirement at age 70) ▪ • Probability of 20 Year Old Male Living to… ▪ • Calculator

4. Longevity Risk • Longevity Risk • Risk that you might live longer than expected • Risk that you might out-live your retirement savings • Women live longer–more longevity risk • Longevity risk will continue to increase • Now 13 years • In 50 years (when you retire) ???

5. Social Security • Most widely used source of retirement income, covering 97% of U.S. workers. • Part of retirement income, not sole source. • Earnings & Benefit Statement • Full benefits at 67, reduced at age 62. • See www.ssa.gov • In 2050 it is estimated there will be two workers per retiree.

6. Why Do Companies Set Up Retirement Plans? • Competition • Tax Shelters • Personal Retirement for the Owners • Personal Retirement for the Employees

7. DB versus DC, etc. • Defined Benefit Plan (DB) • The amount you receive after retirement is fixed. • Defined Contribution Plan (DC) • The amount your employer contributes to your retirement fund is fixed. • Alternatives • Portability

8. Defined Benefit Plan (DB) • Fixed Amount in Retirement • Percentage of Ending Salary • Firm Bears • Longevity Risk • Investment Risk • Underfunding • Diversification Concern • Incentive/Agency/Control Issues

9. Defined Contribution Plan (DC) • Fixed Contribution during Employment • Percentage of Salary • You Bear • Longevity Risk • Investment Risk • Types • Money-Purchase Pension Plans • Stock Bonus Plans • Profit-Sharing Plans

10. Tax Deferred Accounts • Employer Qualified Plans: • 401(k), Roth 401(k), 403(b), Roth 403(b), or 457 retirement plans for the employee • Individual and Small Business Retirement Accounts: • IRA’s (Roth and Traditional), Keoghs, SEP’s and SIMPLE’s for the self-employed

11. Employer: 401(k) Plan • Employer makes non-taxable contributions and reduces your salary by the same amount. • Employee contributions are tax-deferred. • Some employers match a portion of the funds you contribute.

12. Individual: Regular IRA • Contribute up to $5,000 • May be tax-deductible. • Interest accumulates tax free until you start taking it out. • You pay taxes on the money as you withdraw

13. Individual: Roth IRA • Not tax deductible, but earnings accumulate with distributions tax free after age 59½ • Traditional versus Roth • Marginal Tax Rate • Calculator

14. Annuities • Guaranteed Income for Life • Fixed or Variable Payments • Single Payment or Periodic Payments • With deferred annuities, income payments begin at some future date. Contributions, and the interest they earn, are tax-deferred until you begin drawing the money out. • High Fees

15. Longevity Insurance • Pros • Bigger payouts than alternatives, e.g., deferred annuities. • Payments come for the rest of your life. • Amount of the future payments is generally fixed • Cons • There's no death benefit. • You lose the ability to use the money you invest in this product for other investments.

16. Planning for Retirement • How long will you live? • What income do you need? • Remember inflation! • Do you have additional resources? • Social Security, House, Life Insurance, etc. • How much do you need to save? • Tax Implications • How should you invest this? • Risk Tolerance

17. Retirement Needs • Amount needed depends on • Age at Retirement • Health Status and Life Expectancy • Goals (e.g., Travel, Hobbies, Work in Retirement) • Lifestyle Decisions (e.g., Choice of Area/Housing) • Available Resources (e.g., Health Benefits) • Resources • Calculator • BLS Data

18. Retirement Needs • Some expenses may go down or stop • 401(k) Retirement Fund Contributions • Work, Clothing, and Housing Expenses • Other expenses may go up. • Life and health insurance unless your employer continues to pay them. • Medical Expenses • Expenses for Leisure Activities

19. Asset Allocation:Traditional Approach • Diversified Portfolio • Stock, Bond, Cash Mix • Shifting Allocations over Time • Factors • Use a diversified set of investments • Consider the number of years to retirement • Consider your level of risk tolerance

20. Asset Allocation:Traditional Approach

21. Asset Allocation: Worry Free Approach • Risk Free, Inflation Proof Investments • TIPS • I-Bonds • Inflation Adjusted Annuities • Zvi Bodie and Michael J. Clowes. Worry Free Investing: A Safe Approach to Achieving Your Lifetime Financial Goals.

22. Simplified Example • You hope to retire in 50 years and need $70,000 in pretax income to retire comfortably for 20 years. • Data • Expected Social Security $10,000/year (real) • Inflation 4% • Investment Return • 8% before retirement • 7% during retirement.

23. Simplified Example (cont’d) Time 50 years 20 years Return 8% Return 7% Inflation 4% Inflation 4% Now Retirement Death

24. Simplified Example (cont’d) • Two Stage Calculation • Stage One: • How much do I need at retirement? • Stage Two: • How much do I need to save until retirement?

25. Simplified Example (cont’d) • Calculate shortfall (before tax basis): The shortfall is $70,000 – $10,000 = $60,000 or $5,000 monthly • How much do you need at retirement? P/Y = 12 PMT = -$5,000 N = 20 x 12 = 240 I/Y = 7% - 4% = 3% CPT, PV = $901,554.57

26. Simplified Example (cont’d) • How much do you need to save monthly? P/Y = 12 N = 50 x 12 = 600 I/Y = 8% - 4% = 4% FV = -$901,554.57 PMT = $472.18

27. Project Note

28. Ethical Dilemma