Taxes, Inflation, and Investment Strategy

1. Taxes, Inflation, and Investment Strategy 21 Bodie, Kane, and Marcus Essentials of Investments, 9th Edition

2. 21.1 Saving for the Long Run • Basic Considerations in Developing Plan • Time until retirement • Life expectancy • Rate of return • Allocation of income to savings • Retirement annuity • Stream of level cash flows available for consumption during retirement

3. Spreadsheet 21.1 Savings Plan

4. 21.2 Accounting for Inflation • Inflation erodes real value of purchasing power • Real consumption = Nominal consumption/ Price Deflator • What is the real rate of return if inflation = 6% and nominal ROR is 6% annually?

5. 21.2 Accounting for Inflation • The investor in the example is 30 years old. What is the size of the price deflator with 3% inflation at age 35? • By age 65?

6. Accounting for Inflation • Overcoming inflation requires either higher savings or higher ROR on investment or both • Because taxes are paid out of nominal returns, inflation further reduces after-tax ROR

7. Spreadsheet 21.2 Real Retirement Plan

8. Spreadsheet 21.3 Backloading Real Savings Plan

9. 21.2 Accounting for Inflation • Another Problem with Inflation • Inflation continues after retirement • Level annuity equals declining standard of living • Purchasing power of the $192,244 at age 65: • Purchasing power of the $192,244 at age 90:

10. 21.3 Accounting for Taxes • Flat Tax • Taxes all income above exemption at fixed rate • Taxes further reduce retirement benefits available • Overcoming taxes’ impact requires larger allocations to savings or higher returns on investments

11. Spreadsheet 21.4 Saving with Simple Tax Code

12. 21.4 Economics of Tax Shelters • Potential Benefits • Postponing payment of tax • Additional earnings on investment of postponed payments • Effectiveness of Shelter • Depends on investment performance, how tax rates change

13. Spreadsheet 21.5 Saving with Flat Tax and IRA

14. Spreadsheet 21.6 Saving with Progressive Tax

15. Spreadsheet 21.7 Benchmark Tax Shelter with Progressive Tax Code

16. 21.5 Menu of Tax Shelters • Tax-Sheltered Accounts • Individual Retirement Accounts (IRAs) • Currently allow investors to contribute up to $5,000/year to retirement account • Individuals 50/older may contribute another $1,000/year • 10% tax penalty for withdrawal of funds prior to age 59½ • Must begin withdrawals by age 70½

17. 21.5 Menu of Tax Shelters • Types of IRAs • Traditional • Contributions may be tax deductible; earnings tax deferred until withdrawn • Roth • Contributions not tax deductible; earnings on account not taxed when withdrawn

18. Spreadsheet 21.8 Roth IRA with Progressive Tax

19. Table 21.2 Traditional versus Roth IRA under Progressive Tax Code

20. 21.5 Menu of Tax Shelters • Defined Benefit Plans • Employer promises to pay defined benefit to employees when they retire • Typically percentage of salary based on years of service • Employer must fund pension obligation • Pension Benefit Guaranty Corporation (PBGC) guarantees pension benefits in event of corporate bankruptcy

21. 21.5 Menu of Tax Shelters • Defined Contribution Plans • 401k and 403b Plans are examples • Employee and employer contribute set amounts to investment plan; employee’s retirement benefit depends on investment performance • Employees typically given choice of mutual funds managed by fund family • Because of employer contributions these are attractive to employees

22. Spreadsheet 21.9 Saving with No-Dividend Stocks under Progressive Tax

23. Table 21.3 Investing Roth Plan Contributions in Stocks and Bonds *Since the retirement annuity is similar in both plans, taxes on this annuity are ignored.

24. Table 21.4 Investing in Traditional Plans *Since the retirement annuity is similar in both plans, taxes on this annuity are ignored.

25. 21.6 Social Security • Federal pension plan established to provide minimum retirement benefits to all workers • Unfunded, although in surplus on current-year basis; projected to go into red around 2016 • You pay 6.2% of income to SS, plus 1.45% toward Medicare; employer matches contribution • SS is means of redistributing income; in dollar terms, taxes are regressive

26. 21.6 Social Security • What You Earn • You pay in every working year but only top 35 years of earnings and contributions count for determining benefits • Lifetime real annuity paid in full if you retire at age 67; reduced amount if you retire earlier (62) or larger benefit if you retire later (70)

27. 21.6 Social Security • What You Earn • Four steps to calculate benefits • The series of your taxed annual earnings is compiled • Indexing factor series • All past earnings converted to today’s dollars using average wage index (AWI) • Average Indexed Monthly Earnings (AIME) • 35 highest annual indexed contributions summed and then divided by (35 x 12) = 420

28. 21.6 Social Security • What You Earn • Four steps to calculate benefits • Primary insurance amount (PIA) • Annuity value received each year • Income replacement rate is percentage of working income received in retirement; substantially higher for low-income individuals • Benefits may be taxed if household income > $32,000

29. Table 21.5 Calculation of Retirement Annuity of Representative Retirees if 2012, Age 66 a Income is above the maximum taxable, and income replacement cannot be calculated. b 2008 PIA parameters (bend points) are used. 2008 is the year of eligibility, that is, the year in which the retiree attains age 62. c COLA adjustment for years 2008–2011: 5.8%, 0.0%, 0.0%, 3.6%. d Internal rate of return.

30. 21.7–10 Additional Considerations • Financing Child’s Education • Same procedure as funding retirement • Rent-or-Buy Decision • No equity created by renting • Equity is safeguard for tough times • Don’t try to buy too much house • Houses are illiquid investments whose value does not always increase

31. 21.7–10 Additional Considerations • Uncertain Longevity • Life annuity versus fixed-term annuity • Payment received on life annuity reduced due to adverse selection

32. 21.7-10 Additional Considerations • Marriage, bequests and intergenerational transfers • Marriage increases motivation for saving for old age • Dependents increase need to save • Desire for bequests increases need to save • 75% of intergenerational transfers are involuntary (due to earlier than planned demise or under-spending in retirement)