Chapter 1: The Preretirement MarketRetirement Market Segment: The retirement market has two segments:A) Retail Segment: The retail segment includes individuals and families looking for solutions to their retirement needs. Product Providers: The companies that create and market financial products for retirement. Advisors: Professionals who help customers evaluate and select retirement strategies and products. Customers: The individuals that purchase and use retirement products.B) Institutional Segment: The institutional segment includes the businesses and other groups that buy retirement products, plans, and services for the benefit of their employees or members. Plan Providers: The companies that offer group retirement plans. Consultants/Advisors/Brokers: Parties that are compensated for helping plan sponsors evaluate and select retirement plans. Plan Sponsors: The businesses and other groups that buy retirement plans for the benefit of their employees or members. Plan Participants: The individuals covered by a group retirement plan.
Pre-Retirement Market: Retirement is typically defined by age and employment status: Past retirement market - people age 65 or older who had left the work force. Past pre-retirement market - people under age 65 who, with the exception of disabled individuals and spouses who didn't work for pay, were actively employedGoals of Pre Retirement Market: People in the pre-retirement market tend to share a common goal To make sure they have enough money to cover their financial needs. Achievement of this goal depends on two primary factors: Their available resources Their expensesLife Stage: Youth Young Adults 25 to 45 years before retirement Mid Life Adults 10 to 25 years before retirement Pre Retirees 5 to 10 years before retirement RetireesThe resources can include: Wages Property Employer-sponsored retirement plans Personal savings InvestmentsYoung Adults 25 to 45 years before retirement Primarily depend on wages to cover their financial needs Lower end of wage scale: Relatively new to work force and work at entry or mid-level Upper end of wage scale: More established , likely to part of two income households and hence more affluentLike 25% of peers, young adults expect to start saving by the time they reach age 25Mid Life Adults 10 to 25 years before retirement Established careers with high income Apart from wages, other resources include:
Property: Most mid-life adults are homeowners and, for many, the equity they have in their homes represents a significant financial resource. Many mid-life adults also own other residential and non-residential real estateEmployer-sponsored retirement plans: Although contributions are voluntary, most mid-life adults have at least some funds in employer-sponsored retirement plans or pension accounts.Personal savings and investments: Most mid-life adults have money in personal savings accounts. Some also own life insurance, certificates of deposit (CDs), and investments such as stocks, bonds, and mutual funds.Most of them are actively saving or paying for higher education for their kidsPre Retirees 5 to 10 years before retirement In the United States, Baby Boomers- those people born between 1946 and 1964- represent the largest segment of the population. Many of them have already retired and the nearly 50 million Boomers between the ages of 55 and 70 who are still working are getting ready to retire. Pre-retirees have been in the workforce for half their lives or more and many have increased their incomes dramatically. Like mid-life adults, a large number of pre-retirees have also accumulated considerable liquid assets and retirement savings.More than half of them own their own homes.Mass market: Traditionally US households dived into three income-based categories Low income households-$0 to $24,999 Middle income households-$25,000 to 74,999 High income households-$75,000 to $100,000Affluent Market: Created by the shift from income to total liquid household assets Mass affluent households-$100,000 to $1 million High Net Worth households-$1 million to $24.9 million Ultra High Net Worth households-$25 million or more Summary of the life stages of the pre-retirement market:
Pre-retirement expenses: The costs of raising children can be significant, but child-rearing is only one of the many expenses that compete for resources during preretirement years. Most people also need to cover Living expenses Education expenses Health care expenses DebtLiving expenses - expenses associated with everyday life: Food Transportation (gas, car maintenance) Clothing Insurance (homeowners, automobile, life) Housing (mortgage, rent, furnishings, repairs) Entertainment Utilities (gas, electricity, water, garbage) TravelActual amount paid towards living expenses depend upon Geographic location Family Size Standard of LivingEducation Expenses: Providing post-secondary education for children can increase household expenses by $20,000 per year or more, depending on The colleges children attend Whether they live at home or on campus Whether they receive any financial aid And that amount increases every year. In fact, the cost of post-secondary education has increased at a faster rate than most other expenses.Tax Advantaged College Saving Plans: Families in the U.S. can choose from two types of tax-advantaged programs:Coverdell Education Savings Account (ESA): A federal education savings plan that allows people to contribute up to a specified amount per year into an education account on behalf of a named beneficiary who is under age 18 or has special needs. 529 College Savings Plan: A state-based education savings plan that allows people to deposit funds into an education account on behalf of a named beneficiary
Employer Sponsored Health Plans: The majority of full-time workers in the United States receive health care coverage through employer-sponsored group plans. In the past, most employers offered employees a choice of: Traditional medical expense insurance provided benefits for routine and major medical expenses A managed health care plan - integrates the financing and delivery of health care services to manage the cost of care.Although health care costs are reduced for plan participants, there are some participants' expenses. Premium Deductible Coinsurance / CopaymentPremium Deducted from wagesDeductible A flat dollar amount of eligible expenses that an insured must pay before the insurer begins making any benefit payments under an insurance policy. In medical expense insurance policies, the deductible usually applies to the total of eligible medical expenses incurred during a period of time, such as a yearCoinsurance / Copayment A specified, fixed amount that managed health care plan members must pay for specified medical services at the time the services are receivedHealth Savings Accounts (HSAs): Today, many employees in the United States are managing their own health care costs by establishing Health Savings Accounts (HSAs). The amount that employees and employers can contribute to HSAs is specified by the Internal Revenue Service (IRS).Example: Most HSAs include a high-deductible health plan (HDHP) that provides benefits for qualified medical expenses. Owners can choose the deductible amount and coinsurance amount for the HDHP as long as deductible and total out-of-pocket expense amounts satisfy regulatory requirements.HSA funds can be used to pay the HDHP deductible and/or eligible expenses not covered by the HDHP. If an employee's medical expenses exceed the amount in the account, the employee must pay the excess costs out of pocket until costs reach the established maximum.Benefits of HSAs: HSAs offer benefits over traditional health care options. For example: Because of the high deductible, monthly premiums for HDHPs are typically lower than premiums for traditional medical expense insurance or managed care plans. Contributions to a qualified HSA can be made with pre-tax dollars. Any unused funds in the account at the end of the year roll over to the following year. HSAs are portable, so money remains with the individual if she changes jobs or leaves the work force. HSA contributions are invested in money market accounts, CDs, and mutual funds. Investment earnings are not taxable until withdrawn. Funds withdrawn from the HSA to cover qualified medical expenses are tax free. However, funds used for non-qualified expenses are generally subject to a 20% penalty tax and income taxesDebt: Another expense for pre-retirees is debt, which arises when people use credit, or borrowed money, to buy products and services. Debt most often comes in the form of outstanding balances on Home mortgages Home equity loans Car loans Personal education loans Credit cardsInstallment Debt: Financial services companies classify most loans as installment debt because they require regular payments over a specified period of time.Revolving Debt: In contrast, financial services companies classify credit card debt as revolving debt because payments can extend indefinitely. Card owners can add new charges before paying off existing charges.Advantages of Using Credit: Buying on credit provides a way for people to Buy products and services they otherwise couldn't afford Cover emergencies Avoid carrying large amounts of cash Establish a credit historyDisadvantages of Using Credit: Buying on credit may also cause people to: Pay more for credit purchases than they do for cash purchases due to Interest charges on unpaid balances Damage their credit history by carrying too much debt
Retirement Savings: Saving for retirement is essential, and the earlier people start saving, the more funds they will have at retirement. Contributing small amounts to retirement plans over a long period of time can produce a higher account balance than contributing large amounts over a short period of time.There are 3 popular savings options: Employer sponsored retirement plans Bank based savings InvestmentsEmployer Sponsored Retirement Plans: Employer sponsored retirement plans can be structured in 2 ways: Defined benefit plans-Specify the amount of the retirement benefit Defined contribution plans-Specify the level of contributions to the planDefined benefit plan: A retirement plan structured using a defined benefit formula that specifies the amount of the benefit a plan participant will receive at retirement.What does the plan promiseThe benefit amount a participant receives at retirement
How are contributions determinedThe plan sponsor must provide enough assets to the plan to provide the promised benefits
Who contributesPlan sponsors. Plan participants typically don't contribute
How are benefits paidMost defined benefit plans are structured as pension plans that provide life time benefits beginning at retirement
Defined contribution plan:A retirement plan structured using a defined contribution formula that specifies the level of contributions that the plan sponsor promises to make to the plan on behalf of participating employees.What does the plan promiseThe amount the plan sponsor would contribute to the plan on behalf of the plan participant.
How are benefits determinedBenefit amounts are based on the total amount in the participant's account at retirement
Who contributesUsually, both plan sponsors and plan participants can contribute. Each can deduct the contributions they make from their taxable income
How are benefits paidTypically in a lump sum, although some plans offer additional payout options
The plan structure determines if plan sponsor contributions are mandatory or voluntary if plan participants make contributions how benefits are paidType of PlanSponsor ContributionsParticipant ContributionsBenefits
Traditional Profit Sharing PlanVoluntary - based on and payable from Employer's profitsUsually not allowedLump sum or monthly annuity benefits
Stock Bonus PlanVoluntary - based on Company's profitsNoneBenefits paid in company stock
401(k), 403(b), 457(b) plansVoluntary - Sponsor's match participant contribution up to specified percentage of participant's salaryVoluntary - usually a fixed percentage of annual salaryLump sum, Installments or monthly annuity benefits
Individual Retirement Arrangements (IRAs): An individual retirement arrangement (IRA) allows a person with taxable compensation to deposit a specified amount in a savings arrangement that receives favorable federal tax treatment.IRAs can be funded by financial products including annuities, mutual funds, and certificates of deposit (CDs). Two forms of IRAs include:
Traditional IRAs: A type of an IRA into which a person with earned income can make annual tax deductible contributions. Contributions are generally tax deductible Earnings grow on a tax-deferred basis Withdrawals must begin by age 70 1/2 and must meet minimum distribution requirements Withdrawals are taxable as income Nonqualified withdrawals (made before she reaches age 59%) are subject to an additional 10% tax penalty Exceptions: Penalty taxes on withdrawals are waived if the withdrawal is Made at the owners death or disability Used to buy or rebuild a first home (up to a $10,000 limit) Used to pay for qualified education expenses Used to pay unreimbursed medical expenses exceeding a specified percentage of adjusted gross income Used for health care Insurance payments If the owner Is unemployed and has received unemployment compensation for 12 consecutive months One of a series of substantially equal periodic paymentsRoth IRAs: A type of an IRA that permits people within certain income limits to make nondeductible contributions and to withdraw money on tax free basis. Contributions are made with after-tax money Earnings accrue on a tax-deferred basis Withdrawals aren't subject to age and minimum amount requirements Qualified withdrawals are tax free Nonqualified withdrawals may be taxable and, if made before he reaches age 59%, are also subject to a 10% tax penaltyFor a distribution to be qualified:1) The account must have been in effect for 5 years and2) Payment must be made to: an owner who has reached age 59%, become disabled, or withdrawn funds to buy or rebuild a first home, or a named beneficiary after the owner's deathBank Based Savings Options: Banks in the United States offer two types of savings options: Savings Account: An interest-earning deposit account that pays compound interest on deposited funds, typically from the day of deposit to the day of withdrawal Certificate of Deposit: A contractual agreement issued by a bank or other depository institution that returns the owner's principal with interest on a specified dateBank-based savings options don't offer substantial tax advantages, except when they are used to fund an IRA. The money paid into bank-based savings options can't be deducted from taxable income at the time of payment. Earnings are taxable as they are earned.
Securities: Security is a financial asset that represents either:A) Debt Security: An obligation of indebtedness owed by a business, a government or an agencyB) Equity Security: An ownership interestInvesting in securities is an alternative method of accumulating assets. Although the value of securities varies widely, they tend to increase in value over the long term.The basic types of securities are:Stock: An equity security representing a share of ownership in a corporationBonds: A debt instrument under which the entity that sells the bond promises to pay the owner of the bond a stated rate of interest over a specified period of time and to repay the original amount of borrowed money at end of the specified period.Mutual fund: An investment account that pools the funds of multiple customers and uses the funds to purchase shares in diversified portfolios of securitiesVariable Annuity: An annuity contract under which the amount of the accumulation value and periodic income payments fluctuate in accordance with the performance of one or more specified investment fundsStocks: An equity security representing a share of ownership in a corporation Typically bought and sold by consumers through stock exchanges or over-the-counter markets
Generate income through Capital appreciation, which results when stocks sell for more than their original purchase price, and Dividends payable to shareholders out of company earnings Historically have provided a better return on investment than fixed-rate products and over the long term usually result in gains
Involve greater risk than fixed-rate productsBonds: A debt instrument under which the entity that sells the bond promises to pay the owner of the bond a stated rate of interest over a specified period of time and to repay the original amount of borrowed money at end of the specified period. The issuing company pays a stated rate of interest over a specified period of time At the end of the period, the issuing company repays the face value of the bond to the owner Safer than stocks, but tend to provide lower returnsTypes of bonds include: Corporate bonds Treasury bonds Agency bonds Municipal bondsMutual fund: An investment account that pools the funds of multiple customers and uses the funds to purchase shares in diversified portfolios of securities Offer high liquidity and diversification Have low minimum investment requirements Offer professional management servicesVariable Annuity: An annuity contract under which the amount of the accumulation value and periodic income payments fluctuate in accordance with the performance of one or more specified investment funds Generally less liquid than other investments Offer owners a wide range of payout options Can be customized to meet owners needs Individual Investment Accounts:Although people can buy securities directly from the issuing companies or government agencies and in open markets, many people prefer to handle investments through a financial advisorBrokerage Accounts: Help with buying and selling securities Personalized investment adviceBrokerage accounts are investment accounts established through securities broker-dealers that specialize in the purchase and sale of stocks, bonds, and other financial instruments. Discount Broker Dealers: Execute customers' orders to buy and sell securities Full service broker dealers: Complete requested transactions and provide personalized investment advice Online Brokerage Accounts: Usually offer fewer services than traditional brokerage accountsIn exchange for these services, customers usually pay either commission on sales, transaction fees, and/or management fees.Brokerage accounts usually take one of two primary forms:Cash Account Transactions are handled on a cash basis Transactions are usually completed within three days after an investor places a buy or sell order Most accounts require investors to make a small initial deposit-usually $50-to open the account and additional cash payments to cover transaction costsMargin Account Transactions can be funded with a combination of investor deposits and money borrowed from the brokerage firm. Investor is usually required to make a substantial initial deposit either in cash or securities-usually at least 50% of the value of the buy-sell order If the value of an investment made with borrowed funds falls below a specified percentage of its current value (at least 25%), the brokerage firm can issue a margin call, which is notice to the investor that additional cash or securities must be deposited into the account.Managed Accounts Active management of investment portfolio to achieve specific objectives Personalized advice on selection, diversification, and allocation of assetsManaged accounts are customized investment portfolios established to achieve specific objectives, such as current income or long-term growth. Managed accounts usually require a high minimum deposit, such as $100,000, and advisers typically charge an amount each year to cover advisory services, management activities, and transaction costs.
Chapter 2: The Retirement MarketRetirement Resources: Before they retire, many people receive most of their financial resources from wages.After they retire, they rely on the three resources. Employer sponsored retirement plans Personal Savings and Investments Government sponsored retirement plansSocial Security: It is a United States federal program that provides specified benefits such as retirement benefits, survivors insurance and disability benefits to eligible individualsSocial Security Funding Details Tax rate 12.4% of earned income. Who pays? Employer half, employee half. Taxable wage baseThe maximum income taxed in a given yearYear of BirthFull (Normal) retirement age
1937 or earlier65
193865 and 2 months
193965 and 4 months
194065 and 6 months
194165 and 8 months
194265 and 10 months
1943 - 195466
195566 and 2 months
195666 and 4 months
195766 and 6 months
195866 and 8 months
195966 and 10 months
1960 or later67
Taking benefits before retirement age: Anne was born on February 1, 1950, and has made contributions to Social Security for 40 years. She is trying to decide if she will need to continue working until she reaches age 66 or if she can retire at age 62.Analysis: If Anne retires at age 66 (in 2016), she will be eligible for full Social Security retirement benefits. If she chooses to retire at age 62, which is the earliest age she can file for benefits, her benefit will be reduced by 25%. For example, if Anne's full benefit is $1,000, then her benefit at age 62 will be $750 ($1,000- $250).Taking benefits with less than 35 years of earnings: Charlie retired in 2010 at age 65. When he retired, he had 30 years of Social Security earnings totaling $1,650,000. His average earnings over those 30 years equaled $55,000 ($1,650,000 / 30).He has no plans to work again before he reaches his full retirement age of 66.Analysis: Because Charlie has fewer than 35 years of Social Security earnings, the Social Security administration will include five years with $0 earnings when it calculates his average earnings. As a result, his average earnings will decrease to approximately $47,143 ($1,650,000 / 35), and his monthly Social Security benefit will be reduced.Retiring Late: Under current rules, people earn a credit for each year they delay benefits, up to age 70, when benefits reach a maximum.What is a credit worth? It depends on when the retiree was born. Credit amounts range from A minimum of 3% (for people born in 1924) to A maximum of 8% (for people born in 1943 or later)These credits apply whether a person stops working at the normal age or continues working until delayed benefit payments begin. Cost of living adjustments, if any, also apply.Example: Ronald was born after 1943, his benefit will increase by 8% each year he defers payments until he reaches age 70. If he delays payment for 1 year, he will receive 108% of his scheduled monthly benefit. If he delays payments for 4 years, he'll receive 132% of his scheduled benefit.Other social security benefits: In addition to primary workers' benefits, Social Security also pays retirement benefits to the spouses and survivors of eligible workers. Benefits are calculated as a percentage of the primary worker's benefit.Disabled individuals may also be eligible for benefits.Taxes on social security: Although many may assume that Social Security benefits are tax free, that's not always the case. The first step in determining whether Social Security benefits are taxable is to calculate the person's or couple's combined incomeAdjusted Gross Income (This is a persons income from all sources minus amounts for specified expenses) + Any Tax-Exempt Income (E.g. Interest from Municipal Bonds) + Half of Social Security Benefits for the Year= Combined IncomeNext, determine whether the social security benefits are taxable from this table
Combined incomeTaxable amount
Single, head of householdMarried, filing jointly
Less than $25,000Less than $32,0000% of social security benefits
$25,000 to $34,000$32,000 to $44,000Upto 50% of social security benefits
Over $34,000Over $44,000Upto 80% of social security benefits
Social Security Penalties: People who start receiving Social Security benefits early and continue to work may be subject to an earned income penalty if their earnings are too high. The limits are set by the Social Security Administration.The penalty is equal to a $1 reduction in benefits for every $2 that earned income exceeds the established limit.The earned income penalty applies only to people who are younger than their normal retirement age. People who have passed retirement age are not subject to penalties. In the year in which a person reaches full retirement age, it's complicated, but we won't get into that.Withdrawing funds from employer plans:Retirees who leave the workforce typically have two options for receiving funds that have accumulated in their employer-sponsored retirement plans: Lump-sum Distribution: The retiree receives the full account balance in a single payment Annuitized Payments: The retiree receives a steady income stream for lifeLump Sum distributions: Most defined contribution plans provide benefits in a lump sum at retirement. At retirement, the participant can: Take personal possession of the money: In most cases, this is not the best choice because taxes are payable immediately on the entire taxable portion of the lump sum. Keep the money In the DC plan: The retiree still has access to the features and investment options of the group plan. He won't have to pay taxes until he makes withdrawals, and then he'll only pay taxes on the taxable amount he withdraws. Transfer the money to an IRA: If funds are transferred directly from the plan to a traditional IRA and not paid to the plan participant, the transfer qualifies as a rollover, which is not taxed. Taxes are payable on the taxable portion of any withdrawals taken from the IRA.Rollover: A tax-free distribution of cash from one retirement plan that the owner then contributes to another retirement plan within 60 days.Annuitized Payments: Pension plans automatically pay retirement benefits as an annuity, and some defined contribution plans offer an optional in-plan annuity. In addition, the participant can roll over a lump sum into an IRA and use it to purchase an annuity. Taxes on annualized payments are payable when the payments are received.
Advantages of Annuitized Payments The retiree receives payments for as long as she lives. She cannot outlive her income. If a retiree lives longer than expected, it's possible that she will receive more in benefits than was paid into the account. The retiree doesnt need to manage a large sum of money.Disadvantages of Annuitized Payments Fixed income payments lock retirees into a specific amount each month. Retirees can't choose a higher or lower payment according to their actual needs in a given month. If a person dies earlier than expected, it's possible that he will receive less in benefits than was paid into the account. When an account balance is annuitized, a retiree no longer has access to the funds. He can't withdraw a lump sum to pay for one-time or emergency expenses.Withdrawing from Stock Bonus Plans:Stock bonus plans present a special situation because benefits are paid in the form of company stock. The table below summarizes how distributions are taxed.When is it taxedTaxed as
Original value of stockAt distribution, whether or not stock is soldOrdinary income
Increases in the value of stockWhen stock is soldLong term capital gain
Withdrawing from Individual Retirement plans:RMD: Required Minimum Distribution sometimes called Minimum Required Distribution (MRD): Must take distributions by April 1 of the year after they reach age 70 and 1/2How large do the distributions need to be? The minimum amount an owner must withdraw from a traditional IRA each year-the RMD-is calculated by dividing the account balance at the end of the previous year by the owner's remaining life expectancy. How do I know what my life expectancy is? Life expectancies used to calculate RMDs are shown in tables provided by the IRSSuppose Rosy decided it would be a good idea to extend the amount of time her IRA would provide income payments, so she decided to take $7,500 in distributions rather than the $10,000 calculated using the IRS tables. Because contributions to traditional IRAs are most often made with pre-tax dollars and the taxes on earnings are deferred, Rosy will have to pay income taxes on the entire $7,500 she received as a distribution. Because she withdrew less than her minimum required distribution, she would also be subject to a tax penaltyPenalty for failing to take minimum required distribution: If an IRA owner withdraws less than the RMD, she must pay a penalty tax equal to 50% of the difference between the RMD and the amount taken.Rosys actual distribution in the earlier example is $2,500 less than the required distribution ($10,000 - $7,500), so she would be assessed a penalty tax of half that amount, or $1,250.Traditional IRARoth IRA
Most contributions made with pre-tax moneyContributions made with after tax money
Earnings accrue on a tax-deferred basisEarnings accrue on a tax-deferred basis
Pretax contributions and Investment earnings taxable on withdrawalQualified withdrawals are not taxable*
"Taxes are payable on the portion of any non-qualified withdrawal that represents investment earnings. A non-qualified withdrawal is one that is taken before the account is five years old or. with some exceptions. before the account owner is 59Y, years old.Personal savings and investments:: Retirees make deposits to savings accounts or COs with after-tax money and pay taxes on earnings in those accounts in the year they're credited to the account. As a result, retirees don't pay taxes when they withdraw money from the accounts.Retirees also buy securities with after-tax money, and they don't pay taxes on increases in the value of the securities as long as they hold the securities. Retirees pay taxes on any increases in value at the time the securities are sold. These increases in value, however, are taxed as capital gains and not as ordinary income, as long as the investment is held for more than one year (any income from dividends or interest is taxed as income in the year it is earned).Withdrawing from savings and investments:Buying an annuity: Cashing in savings accounts and investment accounts and using the money to buy an annuity takes the guesswork out of income planning because payments are designed to extend throughout the owner's lifetime.Laddering payouts: By staggering the payout dates of COs or bonds, a retiree can guarantee specified amounts at specified times.Taking systematic withdrawals: Under a systematic withdrawal plan (SWP), the retiree receives planned payout amounts at predetermined intervals for as long as the savings or investments last.Situations that can increase expense: Expenses can be higher than expected when retirees need to: Assimilate adult children into the household. Care for aging parents.In addition, the percentage of retirees who own their own home is decreasing. So, more people may face large amounts of debt during retirement.Health care expenses: Aging people become increasingly susceptible to illness and injury. As a result, health care expenses for retirees often increase dramatically.In the United States, health care coverage for retirees typically transfers from employer-sponsored plans to government-sponsored or personal insurance plans. The government provides health care coverage through two basic plans, Medicare and MedicaidMedicare: A U.S. federal government program established by the Old Age, Survivors, Disability and Health Insurance (OASDHI) Act that provides medical expense benefits to elderly and disabled persons.Medicaid: A joint state and federal program in the US, that provides basic medical expense and nursing home coverage to the low-income population and certain aged and disabled persons.Medicare Options:Part A: It covers basic inpatient hospital services, limited period of confinement in nursing and extended care facilities or home care after hospitalization, and hospice care.Enrollment in Part A is automatic when a person applies for Social Security; otherwise, individuals need to formally apply when they reach age 65Part B: It covers physicians' professional services and costs for diagnosing and treating illnesses or injuries.Part B is optional. People age 65 who are currently covered by an employer-sponsored health care plan usually don't need Part B. Those who don't have outside coverage must formally enroll for Part B.Part C: Also called Medicare Advantage, Part C combines Part A and Part B coverage and is available as a private fee-for-service plan, managed care plan, or Medicare medical savings plan.Many Medicare Advantage plans also cover prescription drugs.Prescription Drug Costs: As the costs of medical care grow year after year, one major cause-though by no means the only cause-is the rise in the costs of prescription drugsMedicare Part D provides benefits for prescription drugs, but not for the full costs of the drugs.Monthly Premium: The monthly premium for Medicare Part D varies by plan and is separate from the premium for Part B.Participants with income above a certain limit must pay an additional premium, which is deducted from Social Security benefits.Cost Sharing: Part D plans generally feature an annual deductible and a coinsurance charge for each prescription purchase.Plans offered by managed care organizations usually charge net copay for each prescription purchase instead of coinsurance.Medicare Part D plans include a temporary gap in coverage-the infamous "donut hole"- that begins after a participant's prescription costs have reached a specified level for the year. Above this level the participant is responsible for her own drug costs until she reaches the plan's out-of-pocket maximum, at which point plan coverage resumes. The good news is that, while in the coverage gap, participants receive price discounts from drug manufacturers. The other good news for Medicare participants is that, as a result of the Patient Protection and Affordable Care Act, the federal government provides subsidies to people in the donut hole.These subsidies reduced drug costs during the coverage gap by half in 2011, and the subsidies will increase gradually until 2020, when participants will pay the same percentage for prescription drugs in the donut hole as they pay before entering the donut hole.Government coverage for Long term care: Medicare provides limited coverage for long-term care2012 skilled nursing home care costs and Medicare benefitsMedian daily costMedicare benefit
Day 1-20$200$0
Day 21-100$200$148
Day 101+$200$0
Medicaid coverage for long-term care varies by states. States that do offer benefits usually offer coverage through community-based programs.Long Term Care (LTC): It is insurance providing benefits for medical and other services needed by individuals who, because of advanced age or the effects of serious illness or injury, need constant care at home, in an assisted living facility, or in a skilled nursing facility.Home Care: Most people's first choice for long-term care is the familiar environment of home. Many people also begin by receiving care from family or friends. However, because the emotional burden of providing care can be overwhelming for caregivers, they often tum to in-home assistance from an outside service provider. While reducing stress, this can be very expensive.
Assisted Living: It is for people who are unable to live by themselves but who don't require constant care. The services include: Medication management Housekeeping and laundry Meal preparation Assistance with bathing and toileting Transportation to doctor appointmentsSkilled Nursing Facility: Skilled nursing care 24 hours per day Hospital-like setting A last resort for most people Average length of stay about 2.5 yearsLong Term Care Insurance: Clearly, there is a gap between many people's likely long-term care needs and the coverage provided by the government. In order to navigate retirement successfully, retirees need either to set aside part of their retirement funds for long-term care expenses or to purchase commercial long-term careCharacteristics of most LTC policies
Benefit amountBetween $75 and $250 per day
Waiting PeriodUp to 100 days
ExclusionsSix month for pre-existing conditions disclosed in the application
Benefits paid if insuredIs cognitively impaired OR
Is unable to perform without assistance one or more of the six activities of daily living
Activities of daily living (ADLs): Bathing Continence Dressing Eating Toileting Walking
Social Security Concerns: Social Security was designed: To use revenues raised from workers To fund benefits for retiree With excess amounts placed into the Social Security FundIn reality, social security pays more than it collects, and the trust fund is growing smaller.Social Security Concerns: U.S. Congress has engaged in an ongoing debate over Social Security. Congress probably won't eliminate the system but is likely to modify it. Legislation has already been implemented to increase the age at which full Social Security retirement benefits will be payable and to encourage people to work longer. Other changes are also being considered. Proposals include tax increases, benefit reductions, new benefit structures, changes to the way COLAs are calculated, and program privatization.A COLA is a cost of living adjustment- an increase in the amount of Social Security benefits to account for rising prices.Proponents argue that the new method for calculating COLAs, which would be based on a combination of general price increases and spending patterns during periods of inflation, could reduce the strain on SS by $112 billion or more.Opponents contend that the change would create hardship for seniors because the proposed adjustments would not keep pace with increases in prescription drug costs.
Concerns about Retirement Plans: Shift to DC Plans - Effects:From a retirement planning point of view, defined benefit (DB) plans offer certain advantages. When they retire, DB plan participants know: The amount of income they will receive each month or year That their retirement income payments will last for the rest of their livesDefined contribution (DC) plans introduce more uncertainty into the planning process. Plan participants can calculate how much money goes into the plan, but they cant calculate how much monthly income they'll receive when they retire or how long their benefits will last.DC plans are built on the premise that over the long run, U.S. equities have always increased in value. Over the short run, values can increase or decrease. While funds are accumulating, periodic low return rates usually aren't a problem. However, when participants begin withdrawing money at retirement, they are subject to sequence of returns risk
Personal Savings: The U.S. government has taken a number of steps to encourage personal retirement savings by offering savers significant tax advantages, such as those available to people who establish traditional or Roth IRAs.Another example is the "Saver's Credit." Individuals who make contributions to IRAs, employer-sponsored retirement plans, and government-sponsored plans may also be eligible for the Retirement Savings Contributions Credit.Like other tax credits, the Saver's Credit is deducted from the amount of tax due on the individual's taxable income. The Saver's Credit is intended to benefit low- and moderate-income workers and so is only available to people who meet certain age and income requirements.
Retirement Savings Contributions Credit (Saver's credit): In the United States, a tax credit available to low- and moderate-income workers who contribute to an IRA or one of several types of workplace retirement plans. The Saver's Credit is available in addition to a plan's other tax advantages, but is often limited in amount and subject to various requirementsHowever, even with these incentives from the government, the overall savings rate is still fairly low and unstable People with poor saving patterns during employment are more likely to suffer from inadequate income during retirement.Financial status in Retirement: Researchers predict that nearly 70 percent of Americans will experience changes in financial status during retirement- either because of decreased resources or increased expenses. For example: Increases in household size-created by the need to assimilate children, grandchildren, or parents into the household-can increase expenses and affect how available resources are allocated. Decreases in household size when children move out can make the need for outside assistance for home care more likely. The loss of a spouse to death or divorce, and the loss of income and support from that spouse can make it difficult for the surviving spouse to maintain the same standard of living.Increasing Longevity: Longevity can also affect a person's financial status. Today, seniors often live additional20 years or more after retirement. People who retire before age 65 may well spend as many years in retirement as they spend working. Those extra years are likely to create significant mismatches between available retirement funds and actual retirement needs. Even those people who have planned for retirement face the very real possibility that they will outlive their funds. Therefore, a significant number of people are working beyond their "normal" retirement age on a part-time or full-time basis.Chapter 3: The Retirement IndustryThe Financial Services Industry: The companies that offer retirement savings and income options are part of the larger financial services industryPeople, businesses, and governments buy their products and services to help save, borrow, invest, and otherwise manage money.Customers trust financial institutions to act fairly and ethically and to put the customers' interests above company interestsFinancial services industry: The companies that offer products and services designed to help individuals, businesses, and governments meet certain financial goals, such as protecting against financial losses, accumulating and investing money or other assets, and managing debt and cash flows
Contractual savings institutions: Collect money from households, businesses, and governments Invest it in long-term financial assets Use accumulated assets to pay the benefits promised in a contractIn the United States, the two primary types of contractual savings institutions are Insurance companies- Offer insurance, protection for their customers against financial loss caused by specified events Pension funds -Pool contributions made to pension plans to provide plan participants with lifetime income benefits beginning at retirementInsurance companies: Two broad categories of Insurance Companies Include: Life and Health Insurance Companies: Offer protection against personal risk Property / Casualty Insurance Company: Offer protection against property damage risk and/or liability riskPersonal risk: It is the risk of economic loss that results from death, poor health, injuries, or outliving one's economic resources.Liability risk: It is the risk of loss from a person being held responsible for harming others or their property.Pension Funds: Pension funds pool the assets contributed to employer sponsored pension plans. Pension plans can be established: By private plan sponsors, such as employers on behalf of their employees By public sponsors, such as government agencies on behalf of citizens or public-sector employeesThe largest public pension plan in the United States is Social Security.Pension Benefit Guaranty Corporation (PBGC): A U.S. federal agency that guarantees the payment of part or all of the retirement benefits for participants in defined benefit retirement plans when those plans become financially unable to pay benefits. In the United States, pension plan participants are protected against loss of benefits by the Pension Benefit Guaranty Corporation (PBGC). In 2011, the maximum amount payable by PGBC to a 65 year-old participant in a financially impaired pension plan was $4,500 per month, or $54,000 per year. Plan sponsors are required to pay a premium every year to participate in this insurance program.Depository Institutions: It is a financial institution that specializes in accepting deposits and making loans.The primary activities of depository institutions include: Accepting deposits Making loans Offering checking accounts, savings accounts, and debit and credit cards Sometimes offering investment services, financial counseling services, and trust servicesTypes of Depository Institutions: The primary depository institutions in the United States include:Commercial banks: It is a depository institution that accepts deposits from people, businesses and government agencies and uses these deposits to make consumer and business loans. Make personal and commercial loans Accept savings account deposits from individuals and businesses Serve as distributors of mutual funds and insurance products Savings and Loan associations (S & Ls): It is a depository institution that pools the savings of people and makes residential mortgage loans. Make residential mortgage loans to consumers Accept savings account deposits Offer checking servicesCredit Unions: It is a nonprofit depository institution that does business only with its depositors called members- who traditionally shared a common bond, such as an employer or their industry Make consumer loans to members Accept deposits from members Function as non-profit cooperative organizations owned membersSavings banks (allowed only in certain states) Accept savings account deposits from individuals Make mortgage loans to individualsHow do depository institutions operate?Customers deposit funds with depository institutions. In exchange, the institution pays its depositors interest.The institution uses deposited funds to make investments or to make loans to other households, businesses, or government agencies, which pay interest to the institution for use of the funds.Interest: It is a fee that individuals and financial institutions pay (or charge) for the use of borrowed money.Depository institutions also invest deposited funds in financial markets.The interest the institution earns on loans and the earnings generated by the investments are the companys revenue.The difference between the interest the institution pays and the interest it earns is a large part of the institution's profitability.Federal Deposit Insurance Corporation (FDIC):The Federal Deposit Insurance Corporation (FDIC) insures deposits in member commercial banks for amounts up to a specified limit per depositor, per bank, based on account title.In 2013, the coverage limit was $250,000 per depositor per bank.The National Credit Union Share Insurance Fund (NCUSIF) provides similar protection for credit union deposits.National Credit Union Share Insurance Fund (NCUSIF)It is the insurance arm of the National Credit Union Administration that insures credit union accounts for up to $250,000.Our last key type of financial institution is investment institutions, which buy and sell securities.Securities represent either: An ownership interest in a business (stock) A debt owed by a business, government, or agency (bond)Investment institutions, which can market securities to both institutional and individual investors, fall into two categories:Broker-Dealers Investment Institution: It is a financial institution that engages primarily in investing and trading securities.Mutual Fund Company: It is a Type of investment institution that manages one or more mutual funds and sells shares in those funds to individual or organizational customers. Also called an investment company.Broker-Dealers: Broker-dealers act as brokers when they serve as intermediaries between buyers and sellers of securities, supervise the sales process, and provide information and advice to customers.Broker-dealers act as dealers when they maintain an inventory of securities and market those securities to customers.
Mutual fund companies: Mutual fund companies pool funds collected from investors to buy securities. The company then assembles the purchased securities into diversified investment portfolios called mutual funds. Individual investors own shares in the funds based on the amount of their investments.Example: Most mutual fund companies offer customers a choice of funds, each with its own risk profile and investment objectives. Investors can buy or sell fund shares at any time- either directly from the fund company or through a broker-dealer-and can switch from one fund to another.How do mutual fund companies generate revenue? Mutual fund companies generate revenue by collecting fees from investors or assessing sales charges for performing transactions.Two types of sales charges include: Front-end sales charge: a charge investors pay when they purchase mutual fund shares Back-end sales charge: a charge investors pay when they sell mutual fund sharesMost companies also assess maintenance charges or expense charges designed to cover their operating expenses.ProductsFeatures: A product is a bundle of physical, technical, and functional features.For example, an individual retirement arrangement (IRA) can be described in generic terms as a bundle of asset accumulation features, tax benefits, and payout optionsPurpose: For a customer, a product is a solution to a problem and a way to satisfy needs.For example, a retirement plan can be a means of providing financial security or protection against financial risk, a way to manage savings and taxes, evidence of the owner's concern for loved ones, or a legacy left by the owner to future generationsValue: The value of a product depends on how well it solves problems or satisfies customers' needs.Product Classification: Most products fall into one of two categories: goods and services Customers can see, touch, and sometimes smell, hear, and taste goods. Customers can only experience a service as it is performed or used. Although some products fit neatly into one category or the other, most have both tangible and intangible qualities. Goods and Services: We can divide goods and services into product classes, package or brand them, and sell them to individuals or to businesses. Product Class: Cars are often divided into classes such as luxury cars, economy cars, family cars, or sports cars according to their use and the image they foster. Joe and Mia's minivan would most likely be classified as a "family car" rather than a luxury car" or a sports car Branding: The minivan is branded because it carries the manufacturer's name. Individual/Business Because they bought the car for their personal use, it is an individual rather than a business purchase.Unique characteristics of financial products: Like other products, financial products can be Distinguished as goods or services Divided into categories Branded Sold to individuals or businessesHowever, financial products have two unique characteristics that set them apart from other products: their function and their structureProduct Function: The primary function of all goods and services is to satisfy customer needs Most tangible goods satisfy needs directly Most nonfinancial services satisfy needs directly Most financial services directly satisfy some psychological needs, but satisfy most other needs indirectly.Product Structure: Structurally, most financial products are augmented products that consist of two parts: A core product that meets needs A bundle of value-adding supplementary ServicesSupplementary Services:Facilitating service: Helps customers use product Information Services: Brad Worley calls Prime Financial Services {PFS) for information about the different investment options available through his 401{k).PFS provides Brad with detailed information on each option. Order Taking Services: Brad contacts PFS to make changes in his allocations and to request automatic investment rebalancing.Enhancing Service: It adds extra value to product Billing Services: PFS sends Brad a statement showing his transactions, fees, and account balances. Payment Services: Brad takes a loan from his account. PFS provides Brad with options for repaying
Types of Depository Institutions: Products offered in todays financial services marketplace can be divided into four core categories based on the needs they address. Here are the product categories and what they help customers to doCash Management: Pay bills Make purchases Store money short-term Transfer funds from one account to anotherAsset Protection: Manage risks and protect against financial lossesAsset Accumulation: Build wealth over timeAsset Distribution: Manage the distribution of accumulated wealthCash Management Products: Cash management products are designed primarily to satisfy short-term financial needs and obligations. Protection against loss: Since they live in the United States, Carol and Bill's bank-issued products are protected against loss, subject to certain limitations, by the Federal Deposit Insurance Corporation (FDIC). Easy Access to Funds (liquidity): Products such as checks and debit cards give Carol and Bill almost immediate access to their money. Convenience: Using checks or debit cards allows Bill and Carol to buy products and services quickly and easily, without having to carry large amounts of cash. Transaction cost: Bill and Carol don't pay fees for their checking and savings accounts. They do pay charges for withdrawals from their money-market account and for mutual fund purchases and sales, but these charges are fairly small. Wide Acceptance:Most businesses and individuals accept checks, debit cards, or credit cards as a form of payment for goods and services.Asset Accumulation Products: Asset accumulation products are designed to increase the amount or value of assets over time. Options in this category can help owners save for retirement, fund a child's education, or transfer assets to future generations.The particular product a customer purchases generally depends on the products ability to offer an acceptable level of: Earning potential Risk Liquidity CostEarning Potential: For the value of an asset to increase over time, the asset must generate returns, or earnings. Most asset accumulation options generate returns in the form of: Interest Dividends Capital AppreciationRisk: All asset accumulation options carry a certain amount of risk as a result of their exposure to unpredictable fluctuations in interest rates, market performance, or inflation rates.Because of the relationship between risk and return, options with higher risks typically produce higher potential returns and options with lower risks offer lower potential returnsLiquidity: Eventually, customers will need to convert accumulated assets into cash to meet their financial obligations. The more liquid the asset, the faster and more easily it can be converted to cash. Shares of stock and mutual funds are highly liquid because they can be sold at any time, without penalty (although such sales can result in sales charges in some cases). Under certain circumstances, certificates of deposit (COs), bonds, 401(k) accounts, or IRAs are also reasonably liquid. Real estate, business interests, and annuities still in the surrender period, on the other hand, have very low liquidity.
Cost: Cost asset accumulation options involve sales charges. Owners also commonly pay on-going maintenance fees or expense charges to cover the issuing company's or distributor's operating expenses.Insurance: Most asset protection products are forms of insurance, such as: Automobile insurance Disability income insurance Homeowners insurance Life Insurance Health InsuranceAsset Distribution Products: A financial product that enables owners to manage the distribution of assets to ensure that resources are available when needed. Most retirees have a significant need for a reliable stream of income that will cover everyday living expenses as well as expenses associated with disability or critical illness. Retirees also need a way to manage lump-sum payments, such as those received from certain retirement plans, inheritances, prizes or awards, and legal settlements. Asset distribution products can help retirees meet these needs.Asset distribution products usually include one of two distribution mechanisms: Managed payouts Systematic withdrawalsManaged Payouts: Managed payouts provide specified payment amounts on a specified schedule. For example, annuity owners can receive equal distributions throughout their lifetime, or they can receive account funds in payments of a fixed amount or for a fixed period of time. Most mutual funds also offer owners managed payouts that can be structured to distribute account funds by a specified date or to continue indefinitely. In addition, payouts can be linked to market interest rates or to historical returns.Systematic Withdrawals: Systematic withdrawals provide a payout at predetermined intervals, such as monthly, quarterly, semiannually, or annually. They are available under most IRAs and mutual funds. The amount of withdrawals can be fixed or variable. Systematic withdrawals allow retirees to:Access funds when neededKeep remaining funds in the account to generate earningsExample: Salona and Ray Manekar invested $100,000 in a mutual fund. They've set up a systematic withdrawal system that will give them $8,000 per year. When a payment is due, the mutual fund liquidates enough shares from the Manekars' account to provide the scheduled amount. The remaining shares in the account continue to generate earnings that will go toward future payments.Laddering: Investors can create a "ladder" of income payments by investing in vehicles with different maturity dates, such as certificates of deposit (COs) or bonds. Ladders provide a low-risk way to: Create a steady stream of income in the form of interest Increase liquidity because at least some COs mature each year Increase returns by reinvesting mature COs in longer term CDs with higher interest rates Extend investment period by annually reinvesting and buying back into the ladderInstitutional Market: The retirement market has two segments: the retail segment and the institutional segment. The retail segment includes individuals and families looking for solutions to their retirement needs. The institutional segment includes the businesses and other groups that buy retirement products, plans, and services for the benefit of their employees or membersThe Institutional Market: The institutional market consists of three primary groups:Plan Providers: Plan providers design, develop, and market retirement plans for businesses and organizations for the benefit of employees or members. Plan providers include insurance companies, banks, mutual fund companies, and broker dealers.Plan Sponsors: Plan sponsors purchase retirement plans for the benefit of their employees or members. Plan sponsors operate in two separate sectors. Public sector sponsors include federal, state, and local government agencies such as school systems, police and fire departments, and the military. Private sector sponsors include all for-profit businesses that are not owned or operated by federal, state, or local governments.Plan participants: Plan participants are employees or group members who elect to participate in retirement plans offered by plan sponsors.Additional participants: Additional participants in the institutional market include people and companies that provide specialized services to plan sponsors:Asset managers: Asset managers professionally manage plan retirement plan assets. They are involved primarily in large plans (those with more than $50 million in assets and more than 500 participants) and are prevalent in trustee-directed or defined benefit plans that don't offer participant-directed investment accounts.Consultants/ Advisers / Brokers: Consultants help large-plan sponsors and fiduciaries review and select plan investments and select advisors and other service providers. They typically work on a fee-for-service basis. Registered Investment Advisors (RIAs) and brokers typically focus on smaller plans and are usually compensated on a fee-for-service and/or commission basis.Plan administrators: Plan administrators perform regulatory and compliance functions for qualified plans. They usually also handle communications with plan participants. Small-plan sponsors typically use third-party administrators (TPAs) and outside record keepers to perform compliance and record-keeping activities. Large plans usually appoint an official Plan Administrator who serves as a plan fiduciary. The official Plan Administrator contracts with TPAs and record-keepers to perform compliance and record-keeping work, and oversees the activities of other service providers.Record keepers: Record keepers take receipt of plan contributions and pay out distributions to participants. They also track each individual participant's account balance, investment allocations and returns, distributions, and contributions- including the nature of each contribution (for example: employer contribution; tax-deductible employee contribution; after-tax employee contribution). In addition, they provide account statements to participants.Institutional Services Offered: Some plan providers offer services directly to plan sponsors. For example, insurance companies and mutual fund companies often serve as asset managers. Provider companies also offer bundled or unbundled compliance and record keeping services. In a bundled services arrangement, the provider company offers both compliance and record keeping services. In an unbundled services arrangement, the provider company offers record keeping services only and partners with local TPAs to perform compliance work.*Bundled Services: A combination of record-keeping and administrative services offered by provider companies to retirement plan sponsors.*Unbundled Services: Record-keeping services only, offered to retirement plan sponsors by provider companies. Providers then contract with local third-party administrators (TPAs) to provide administrative servicesConclusion: As you've learned, the financial services industry is made up of many different types of financial institutions. Each institution offers products that pre retirees and retirees can use to manage, accumulate, protect, and distribute their assets. You've also learned about the characteristics that distinguish financial products from other goods and services and the additional services companies can provide to increase customer satisfaction and build customer loyalty.Chapter no: 4 Personal RisksEmployment Risk: Risk is the possibility that things won't turn out as expected.Reasons for Voluntary Unemployment: To change jobs: Many people change jobs every few years to increase earnings, to advance their careers, or to pursue a different line of work. They may be unemployed between jobs. To start a business: Some people dream of owning their own company and being their own boss. Until a new business becomes profitable, however, their earnings will be interrupted. To pursue other goals: People often leave the workforce to obtain additional education, to focus on their families, to care for children, or simply because they want to stop working.Involuntary Unemployment:Severance Pay Two weeks of salary is common. Employers are sometimes willing to negotiate higher amounts, especially for long-serving employees. Severance pay is in addition to any other money the employer owes the employeeUnemployment compensation: Generally payable for a maximum of 26 weeksRecipient must: Have worked for a minimum number of weeks Have earned a specified amount in wages and benefits Be actively seeking employmentBenefit amounts: Vary by state Are based on income prior to unemployment Are taxable as incomeNot available to workers who: Leave the work force voluntarily Are dismissed for just causeUnemployment expenses: Potential Expenses during Unemployment: Job search expenses Taxes on retirement fund withdrawals Penalties for early distributions from retirement fundsMedical expense risk: Medical expenses for people with insurance: Deductibles Coinsurance Copays and drug copays (managed care) Any excluded expenses, such as most experimental treatmentsMedical expenses for people without insurance The full cost of careConsolidated Omnibus Budget Reconciliation Act (COBRA): An employee who loses health care coverage as a result of a qualifying event can continue group coverage following termination. Coverage continuation for employee: up to 18 months Coverage continuation for dependents: up to 36 monthsAn employee must pay the full cost of coverage, including any part of the premium that was previously paid by the employer.Affordable Care Act: also known as Patient Protection and Affordable Care Act, aka PPACA, Affordable Care Act, and ACA, Became in force beginning in 2014 Applies to people not eligible to obtain group coverage and not eligible to receive coverage through government programs such as MedicaidPatient Protection and Affordable Care Act Individuals and families whose income falls between 100% and 400% of the federal poverty line(FPL) receive tax credits based on their medical insurance premium. Tax credits are calculated using a sliding scale from 2% to 9.8%, depending on income. The law also limits participants' out-of-pocket costs to a specified amount, based on income. The PPACA imposes a penalty on qualified people who fail to maintain minimum essential coverage (unless excluded from coverage requirements). The law also allows enrollment by people who are eligible for employer-sponsored coverage if the cost of that coverage is greater than 9.8% of income or if the employer pays less than 60% of the premium.Income Interruption Risk:Workers' compensation programs State-based program Provides wage replacement benefits AND medical expense benefits Covers losses from work-related accidents or illnesses. Benefits are not payable if a person's disability is not work-related The federal government has similar programs covering federal employeesSupplemental Security Income (SSI) Pays periodic benefits to people with limited incomes who are disabled, blind, or age 65 or older. People do not have to pay a specified amount of Social Security tax in order to receive benefits.Social Security Disability Income (SSDI) SSDI pays benefits to people who are unable to work because of a physical or mental illness or injury that has lasted, or is expected to last, for at least one year, or that is expected to lead to the person's death. Workers under age 65 must pay a specified amount of Social Security tax for a prescribed number of years in order to receive benefits.Private Disability Income (DI) Insurance: Disability income (DI) insurance is available in two formsIndividual Disability Income (DI) Insurance: It is usually purchased and paid for by the insuredBenefits are usually: A flat amount based on the insured's income when the policy is purchased Payable after a specified waiting period Payable only if the insured meets the definition of "disability" included in the policy Payable for a maximum period of time Not reduced by other income benefits
Group Disability Income (DI) Insurance Provided by an employer, who pays all or part of premium Benefits are usually: Calculated as a specified percentage of a covered employee's pre-disability earnings Usually payable only after a specified waiting period Payable only if a disabled employee meets the definition of "disability" included in the policy Payable only for a specified period of time Reduced by income replacement benefits a covered employee receives from other sources (such as SSI or SSDI)Financial Risk: Let's look at some of the financial risks people face during their working years. One such risk is identity theft. Cleaning up the mess after an identity theft can be arduous, expensive, and stressful. Identity theft victims often have to deal with Creditors who extended credit to the identity thief and now seek repayment from the person whose identity was stolen Damage to their credit rating, which may make it difficult to obtain not only credit, but also potentially insurance, housing, and employment Reductions in retirement savings caused when income is diverted to cover losses in other areasPractices that can help prevent Identity theft: Shredding or destroying documents that include personal information such t:IS account numbers and Social Security numbers Using a locking mailbox or a post office box to receive mail Restricting access to information maintained in the folders or computer records Mailing personal documents from a post office rather than a home mailbox Refusing to provide personal information to unsecure online sites or in responses to emails from unknown sourcesCredit Card Debit Risk: Some options for easing the strain of credit card debt include: Negotiating a lower interest rate or obtaining credit counseling services from the credit card company Obtaining a debt-consolidation loan Initiating bankruptcy proceedings Re-establishing credit after a bankruptcy proceeding is difficult, so the decision to file should be made only as a last resort and only after consulting an advisorDeath of a Spouse: The death of a spouse usually results in at least some change in the remaining spouse's financial status. The amount of change and whether the change is positive or negative depends on How much the deceased spouse contributed to the family income How many people the couple support The amount of life insurance coverage on the spouse who diesIf the surviving spouse's income and life insurance proceeds aren't enough to cover expenses for the surviving family members, the loss can result not only in a reduction in retirement savings, but in the need to find a more modest residence, a better-paying job, or even a second job.Example: Before Susan Henry was widowed, her husband's salary was about twice as much as hers. When her husband died leaving her with three small children, she received a modest amount of group life insurance. She had to cut back on all her living expenses and stop her retirement plan contributions.Example: Abdul and Aaliyah Muhammad's salaries were similar. When Aaliyah passed away, Abdul received a sizeable life insurance benefit. Since his children had grown and were supporting themselves, he was able to maintain his living standards AND invest most of the life insurance benefit for retirementDivorce: During a divorce, property is often divided between the two parties as settlement of alimony, child support, or property rights. One important item of property that may be divided is either spouse's retirement or pension benefits.In the United States, division of retirement benefits is usually accomplished through a qualified domestic relations order (QDRO).
Example: When Thomas Ann got divorced from his wife, the court assigned half of Thomas's retirement savings to his wife.
Caring for Adult children or Siblings: We generally hope that our sons, daughters, sisters, and brothers will support themselves and live independently as adults, but this is not always the case. Circumstances such as unemployment or divorce can cause adults to seek help from parents or siblings. Adults with special needs may need support throughout their lives. After the parents die, the responsibility can fall to siblings.In the United States, physically or mentally disabled persons who meet specified requirements are eligible to receive health care and long-term nursing care benefits through government programs such as Medicare and Medicaid. Their parents can also provide additional funds to support such people, without causing them to lose their government benefits, by establishing a supplemental needs trust.Caring for Aged Parents: Because of increasing longevity, it's likely that a significant number of adults will be faced with the responsibility of supporting or caring for their parents. The expense of caring for parents is yet another risk to a retirement plan.Planning ahead and making sure that a parent's preferences for care are clearly communicated to family members can reduce financial surprises, reduce conflicts among caregivers, and provide more care options.Example: Planning ahead for the Care of an Aging Parent: Geraldine Parker is aging and her three children, Pamela, David, and Jemima, expect that she will eventually need to receive professional care and support. They're concerned, though, that Geraldine's assets won't cover the cost of professional care either at home or in a licensed institution. They've done some research and have identified three possible options: Having their mother move in with one child while the other children provide financial support Taking turns caring for their mother in their own homes Purchasing long-term care (LTC) insurance tor their mother and jointly paying the premiumsAnalysis: None of the children feels that having Geraldine move in with them on a permanent basis is feasible. They also feel that having her change locations is likely to create significant stress for their mother. Sharing the cost of long-term care insurance, however, will be feasible for all of the children. And the combination of Geraldine's financial assets and her LTC benefits should be adequate to provide her with the care she wants and needsMeasuring Inflation: To measure inflation, economists generally use price indexes including, in the United States and Canada, the consumer price index (CPI).Most of the products and services included in the market basket that makes up the CPI are items that are part of the general cost of living. However, the market basket also includes important financial and retirement values such as tax rates, Social Security benefits, some pension benefits, and retirement plan contributions.Retirees and Inflation: Although inflation can create problems for anyone, it's usually a greater risk for retirees. During working years, wages typically increase annually to account for inflation. During retirement, wages are replaced by Social Security benefits and withdrawals from personal retirement funds. These sources offer few, if any, guarantees. Social Security benefits have a built-in mechanism-the cost of living adjustment (COLA)-that provides a cushion against inflation. However, legislators may change COLA calculations to make them less generous. Most defined benefit retirement plans also provide guaranteed amounts at retirement, but those amounts are generally fixed. Retirees can't increase their benefit payments to adjust for inflation. Defined contribution retirement plans and personal savings and investments don't offer any guarantees. Retirees can adjust withdrawal amounts each year to account for inflation, but those increases ultimately reduce the total number of withdrawals they can makeOther Expense Risks in Retirement:Health Care Cost Increases: As people progress through retirement, their need for health care often increases. Unfortunately, when they move from the workforce into retirement, their health care coverage often decreases.Long-Term Care: The need for long-term care can increase health care costs even more. Long-term care insurance provides benefits that help reduce the costs of age-related care, but the cost of the insurance adds to retirees' expenses. Some retirees simply cannot afford the cost of LTC insurance.Longevity: People, before and during retirement, often don't think much about the potential impact of longevity risk because it's not as immediate a concern as health care or expense risks.They also generally underestimate how long they will actually live. One reason for poor estimates is that life expectancy estimates, based on mortality rates, are averages, so approximately half the people in a given age group will live longer than expected.
Public Policy Risk: Retirees and retirement savers face the risk that changes to government programs, laws, regulations, or taxes, will either increase their expenses or decrease their retirement benefits.Sometimes, such changes work in retirees' favor. An example is the PPACA's closing of the "donut hole" in Medicare Part D.However, given the concern over the long-term viability of Medicare and Social Security, most changes to those programs are designed to save the government money, which generally means that they will be less generous to recipients.
Future Medicare Premium and Deductible Increases: Legislators have also proposed gradually raising the eligibility age for Medicare benefits until it reaches 67 by 2027, bringing it in line with Social Security. This change would reduce the strain on Medicare funds, but it would have negative consequences for retirees and non-retirees. 65- and 66-year-olds would need to seek private insurance coverage. Removing younger, healthier people from the Medicare risk pool would drive up premiums for those remaining in Medicare. Adding 65- and 66-year olds to private risk pools could raise insurance premiums for the younger members of those pools.Public Policy Risk Social Security: Social Security has already been changed to increase the age at which full retirement benefits are payable. This change has helped reduce the current strain on program funds, but it hasn't solved the problem. As a result, additional remedies have been proposed. Social Security Tax Increases: Currently, the Social Security payroll tax in the United States Is 12.4% on the taxable wage base, half payable by the employee and the other half payable by the employer.Suggestions have been made to increase contributions by 2% to 3% annuallySocial Security Benefit Reductions: One change that's already been proposed is to change the way Social Security cost of living adjustments are calculated. Proponents argue that changes to COLA calculations could result in a $112 billion reduction of COLA benefits over the next 10 years. Opponents point out those changes to COLA calculations would have a disproportionate effect on seniors, whose spending patterns are often different than those of younger peopleSocial Security Privatization: Privatization would place more responsibility for securing retirement income on individuals by allowing individuals to deposit a percentage of current Social Security taxes into personal retirement accounts.At retirement, people would receive monthly payments from both Social Security and their personal accounts to bring their total benefit to an established guaranteed minimum amount.Shortfall Risk:Risk of Increased Expenses+Risk of Increased Longevity+Risk of Decreased Benefits------------------------------------------------------=Shortfall Risk (Risk of not having enough income during retirement to cover expenses)Evolving problems with Social Security and with private retirement plans threaten to make shortfall risk even worse for many retirees. Problems with Social Security: Social Security in the United States is already paying more in benefits each year than it receives in employer and employee contributions. Analysts predict that, if current trends continue, the Social Security trust fund will become insolvent by 2033. After that, the system will be able to pay out only 75% of promised benefitsProblems with private retirement plans: The majority of workers in the United States have access to employer-sponsored retirement plans, but less than half of workers contribute to those plans. Contribution levels from plan sponsors and plan participants are low. Some plan sponsors have responded to poor economic conditions over the past several years by eliminating their matching contributions, causing many plan participants to also reduce or stop their contributions. In 2010, the average pre-retiree in the US planning to retire within the next five years had only 43% of recommended savings in an employer-sponsored retirement plan. Persistent low market interest rates during recent years reduce returns on retirement savings and reduce the amount of annuity payments available for a given sum. Low market interest rates during the early years of withdrawals may also mean that accumulated funds won't last as long as expected because of sequence of returns risk.Techniques for managing personal risks: People cannot eliminate the personal and financial risks they face, but they can use some common risk management techniques to reduce the effects of these risks. Avoid Accept Control TransferAvoid: One way to manage risk is to avoid it.Risk: Getting struck by lightning How to avoid it: Stay inside during thunderstormsAlthough avoidance might be a viable approach to some risks, it's impossible to avoid all risk. When it comes to saving for retirement, it's not even desirable to avoid all risks; to earn a return on an investment; a person must accept some risk.Control: Another approach is controlling risk: that is, taking steps to prevent or reduce lossesJane Crowell just finished talking to her friend, Alison, who told Jane about the nightmare she had experienced after having her identity stolen.Alison persuaded Jane to take a number of steps to control her identity theft risk, including registering with a credit monitoring service, ordering new checks from the bank that do not show her Social Security number, and shredding all documents that show her account or Social Security number as well as all the credit card offers she receives in the mail.
Accept: Accepting risk involves assuming all financial responsibility for the risk. People accept risks every day-usually when the losses associated with the risk are insignificant, like losing an umbrella or breaking a dish or a lamp. Some people also consciously choose to accept more significant risks
Frank Manzoni has one more year before he reaches retirement age. He's been setting aside $100 each month for an emergency fund for years and now has about three months' worth of salary in the fundLast week, his employer announced that, if results don't improve, the company will need to lay off workers within one to two years. Some of Frank's co-workers decide to retire early or switch jobs, but Frank chooses to keep working at his current job as long as he can and accept the risk of getting laid offHe decides he can afford to take this risk because he can file for unemployment compensation and use the money in his emergency fund if necessary to cover his lost incomeTransferring Risk: A person or business can transfer financial responsibility for specific risks to another party by buying insuranceSarah and Paul Carmichael recently learned that, in nearly 75% of 65-year-old couples, one will outlive the other by 5 years or more. In 50% of couples, one will outlive the other by at least 10 years. They know that, when one of them dies, the surviving spouse will have fewer expenses than they had together, but they are worried that the survivor's income will fall by even more than expenses
Sarah and Paul can manage the financial risk each of them faces if the other one dies by transferring this risk to another party. One option would be to buy life insurance policies that would pay death bene fits to the surviving spouse. Another option would be to purchase a joint and survivor annuity that would provide income to both of them until one of them dies and then to the survivor until that person dies
Chapter 5 Investment Risk and ReturnsRisk and Return: A good start is to understand the relationship between financial risk and return. Risk is the possibility that things won't turn out as expected Return is the compensation people receive when they invest or lend moneyWith more risk comes the possibility of a larger return. It also works in the other direction-less risk usually carries a smaller potential return. This relationship is known as the risk-return tradeoff.Financial Risk for Retirement Products: Retirement investments are subject to several types of financial risk, including: Market risk Income risk Reinvestment risk Default riskSome risks affect ALL investments, but others only affect a specific type of investmentMarket Risk: Some types of risk are present in the marketplace.Market risk is the possibility that fluctuations in an entire market may result in losses or reduced investment returns.Certain factors tend to cause the prices of most investments of a certain type to rise or fall. For example, bad economic news generally causes the average price of stocks to fall.Interest Rate Risk: One specific type of market risk is interest rate risk. Interest rate risk affects many types of investments, including stocks and real estate, but it has the greatest effect on those that pay a fixed rate of interest, such as bonds. Inflation risk, the risk that prices will increase and purchasing power- the amount of goods and services a person can buy for every dollar he earns- will decrease. In other words, his money won't buy as much as it used to!Except in rare instances, there is always inflation. The question is, how does the rate of inflation compare to your rate of investment return?You may be happy with your investment returns, but, if your returns are only slightly higher than inflation, then your returns will only slightly increase your purchasing power.It is even possible for inflation to exceed investment returns.Another hazard of falling interest rates is reinvestment risk.The two main types of reinvestment risk: Maturity risk is the risk that market interest rates on products that mature at a stated time will be lower at maturity than they were when the products were purchased. For investors, this means they'll have to reinvest the money they receive on the investment at a lower rate than was formerly available. Call risk occurs when issuers of certain longer-term securities "call" or redeem their offers before they mature.Companies face the possibility of unexpectedly low profits, or even a loss. This business risk can also affect investors. For example, low profits or losses may prevent a company from paying dividends to its investors and/or cause its stock to lose value.Business Risk: A variety of factors can cause business risk: Low per-unit prices High operating costs Poor sales volume Competition Overall market performance Government regulations Corruption and fraud Poor managementDefault Risk: Entities that make loans face default risk.Banks and other businesses that make loans to individuals or other businesses face the risk that borrowers will fail to make required payments on loansIndividual investors face default risk when they buy bonds. A bond is a loan to the company or government agency that issues the bond. Even though most bonds are secure, an issuer that doesn't pay principal and interest when due is in default on the bond.Risk Measurement: Risk measurement usually involves studying how actual returns vary from expected returns. Because a particular investment, an asset class, or an investment portfolio can produce gains or losses, risk variance can be positive or negative.The main measure of risk is standard deviation, which is a measure of the distance between each individual return in a series of returns and the mean, or average, return for the series.General rule: The greater the standard deviation, the greater the potential variation of actual returns from expected returns and the greater the investment risk.* Standard deviation calculations assume that values in a data set follow a normal distribution pattern. Even though investment returns don't always follow a normal pattern, standard deviation calculations can still provide a fairly accurate estimate of investment risk.If you're calculating standard deviation, mathematicians assume that values in a data set follow a normal distribution pattern-which means the values are equally distributed on either side of the mean of the data set.Here's an example of what a normal curve looks like. Regardless of dimensions, all normal distributions have certain characteristics. The mean is at "0.
What shape do you see in the graph? You should see bells. When calculated results are plotted on a graph, they form a bell-shaped curve. The peak of the bell is at the mean value, which is the center value. It's marked at "0." Numbers to the left are all negative because they're less than the mean, and numbers to the right are all positive because they're greater than the mean. The portions of the curve that extend beyond three standard deviations from the mean on either side are called "tails." The values in the tails are near zero because in a true normal curve, the probability of a value being in one of the tails is extremely low.Investment Risk / Return Calculations:Martin Jones, age 54, is deciding whether to add large-cap common stocks or U.S. government bonds to his investment portfolio. He has published information on the performance of both investments over the last 10 years STOCK: Average annual return = 10% with Standard deviation of 18% BONDS: Average annual return = 6% with Standard deviation of 11%STOCK
