1 (of 23) fin 200: personal finance topic 22–retirement lawrence schrenk, instructor
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FIN 200: Personal Finance
Topic 22–Retirement Lawrence Schrenk, Instructor
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Learning Objectives
1. Explain the importance of longevity risk. ▪
2. Discuss the ways of saving for retirement.
3. Calculate the savings needed to ensure a specified retirement lifestyle. ▪
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
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70 75 80 84 89 94
83% 72% 56% 41% 21% 7%
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) ???
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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.
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Why Do Companies Set Up Retirement Plans?
Competition Tax Shelters Personal Retirement for the Owners Personal Retirement for the Employees
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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
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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
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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
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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
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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.
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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
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Individual: Roth IRA
Not tax deductible, but earnings accumulate with distributions tax free after age 59½
Traditional versus Roth Marginal Tax Rate Calculator
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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
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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.
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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
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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
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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
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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
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Asset Allocation: Worry Free Approach Risk Free, Inflation Proof Investments
TIPS I-Bonds Inflation Adjusted Annuities
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Zvi Bodie and Michael J. Clowes. Worry Free Investing: A Safe Approach to Achieving Your Lifetime Financial Goals.
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.
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Simplified Example (cont’d)
Time 50 years 20 years
Return 8% Return 7% Inflation 4% Inflation 4%Now Retirement Death
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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?
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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 = 12PMT = -$5,000N = 20 x 12 = 240I/Y = 7% - 4% = 3%CPT, PV = $901,554.57
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Simplified Example (cont’d)
How much do you need to save monthly? P/Y = 12N = 50 x 12 = 600I/Y = 8% - 4% = 4%FV = -$901,554.57PMT = $472.18
