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CHAPTER 16

RETIREMENT PLANNING

CHAPTER CONTEXT: THE BIG PICTURE

As the first chapter in “Part 5: Life Cycle Issues,” this chapter stresses the importance of establishing a sound, simple, retirement plan at the earliest stages in the financial life cycle. Within the broader context of financial planning, this section explains how concepts such as tax planning, insurance planning, and investment planning affect retirement and estate plans. Important student messages fundamental to this chapter are (1) begin saving for retirement now, no matter what your current age or income may be, and (2) take full advantage of tax-favored retirement plans to fund retirement.

CHAPTER SUMMARY

This chapter stresses the importance of starting early to plan for and fund retirement. A discussion of the Social Security system, including financing, eligibility, retirement benefits, and disability and survivor benefits is provided. Definitions and examples of employer-sponsored retirement plans, with comparisons of defined benefit, including cash balance plans, and defined contribution plans, are presented. The seven-step retirement planning process is explained and illustrated. Optional Individual Retirement Accounts (IRAs) are considered, as are plans for the self-employed or small business employees. Distribution and payout options are explained. The chapter concludes with tips on putting together and monitoring a plan.

LEARNING OBJECTIVES AND KEY TERMS

After reading this chapter, students should be able to accomplish the following objectives and define the associated terms:

1. Understand the changing nature of retirement planning.a. defined-benefit planb. noncontributory retirement planc. contributory retirement pland. portabilitye. vestedf. funded pension plang. unfunded pension planh. cash-balance plan

2. Set up a retirement plan.Copyright ©2010 Pearson Education, Inc. publishing as Prentice Hall

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a. defined-contribution planb. profit-sharing planc. money purchase pland. thrift and savings plane. employee stock ownership plan or ESOPf. 401(k) plang. 403(b) plan

3. Contribute to a tax-favored retirement plan to help fund your retirement.a. Keogh planb. simplified pension plan or SEP-IRAc. savings incentive match plan for employees or SIMPLE pland. individual retirement account or IRAe. Roth IRAf. Coverdell Education Savings Account or Education IRAg. 529 plans

4. Choose how your retirement benefits are paid out to you.a. single life annuityb. annuity for life or a “certain period”c. joint and survivor annuityd. lump-sum option

5. Put together a retirement plan and effectively monitor it.

CHAPTER OUTLINE

I. Social SecurityA. Financing Social SecurityB. EligibilityC. Retirement benefitsD. Disability and survivor benefits

II. Employer-Funded Pension PlansA. Defined benefit plansB. Cash-balance plans: the latest twist in defined-benefit plans

III. Plan Now, Retire LaterA. Step 1: Set goalsB. Step 2: Estimate how much you’ll needC. Step 3: Estimate income at retirementD. Step 4: Calculate the inflation-adjusted shortfallE. Step 5: Calculate the funds needed at retirement to cover this shortfallF. Step 6: Determine how much you must save annually between now and retirementG. Step 7: Put the plan in play and save

Copyright ©2010 Pearson Education, Inc. publishing as Prentice Hall

Retirement Planning 322

H. What is the best plan for you?

IV. Employer-Sponsored Retirement PlansA. Defined contribution plans

1. Profit-sharing plans2. Money-purchase plans3. Thrift and savings plans4. Employee stock ownership plan (ESOP)5. 401(k) plans6. How much can you contribute?

V. Retirement Plans for the Self-Employed and Small Business EmployeesA. Keogh plan or self-employed retirement planB. Simplified employee pension plan (SEP-IRA)C. Savings incentive match plan for employees (SIMPLE)

VI. Individual Retirement Accounts (IRAs)A. Traditional IRAs

1. Saver’s tax credit B. The Roth IRAsC. Traditional versus Roth IRA: Which is best for you?E. Saving for college: 529 plans

VII. Facing Retirement—The PayoutA. An annuity or lifetime payments

1. Single life annuity2. An annuity for life or a “certain period”3. Joint and survivor annuity

B. A lump-sum paymentC. Tax treatment of distributions

VIII. Putting a Plan Together and Monitoring ItA. Saving for retirement – Let’s postpone starting for one year

APPLICABLE PRINCIPLES

Principle 2: Nothing Happens Without a PlanSaving money is hard to do even in the best of circumstances. But when it comes to saving for retirement, an event that seems so far away, saving money is even harder. Although an elaborate, complicated plan might be an ideal way to force you to save, these types of plans seldom come to fruition. It is probably better to start off with a modest, uncomplicated


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retirement plan. Once the plan becomes part of your financial routine and your earnings increase, then you can modify and expand the plan.

Principle 4: Taxes Affect Personal Finance DecisionsTax-deferred retirement plans allow investment earnings to grow untaxed until you withdraw these earnings at retirement. The bottom line is that these plans allow you to put off paying taxes so that money that would have gone to the IRS can be invested now and continue growing for your future. In addition, some plans allow for initial contributions to be made on either a full or partial tax-deductible basis, making these plans even more attractive.

CLASSROOM APPLICATIONS

1. To encourage students to think about their future retirement needs, ask them to project their current, entry level salary 40 years into the future assuming a 3 percent rate of inflation and no other raises. Then, basing their post-retirement income needs on 80 percent of their pre-retirement income, have them calculate their total savings requirement to fund their retirement. They should assume a 30-year retirement period and a 3 percent inflation rate. Remind the students to calculate a 30-year annuity (PVIFA), not just the need for the first year (PVIF). How much would they need to fund their retirement, assuming that same first year out of college lifestyle? Use this example to illustrate the need to start saving early.

2. Ask students to discuss the advantages and disadvantages of using tax-deferred retirement plans for their savings. Make sure students consider: How someone can save more using a tax-deferred plan. The effects of tax-deferral on compounding. The impact of taxes and penalties on early distributions. The role that taxes play during retirement on the ultimate benefit of tax-deferred plans.

3. Financial planning experts, policy makers, and concerned citizens have suggested that the Social Security system should be privatized. Proponents of privatization argue that the current system is inefficient and will be bankrupt in the future. Opponents to privatization argue that Social Security provides a social safety net during retirement and that, if the system were privatized, many people would fail to save for retirement. Conduct a classroom debate on the issue of privatizing Social Security. (Note: Some have argued that a system that allows someone to opt out of Social Security is a good compromise. Ask students if this type of plan would be effective.)

4. Invite a benefits administrator from the college/university or a local corporation to discuss the types of retirement plans offered. Encourage students to inquire about rates of participation in each plan, the availability of matching contributions, or other questions they



would have as a new employee. Ask the students to select a retirement plan and defend their choice.

5. Have students discuss the types of retirement plans they have been offered in previous or current jobs. Identify the positive and negative aspects of these plans. Evaluate the different plans based on the strategies for promoting increased employee participation and responsibility, for helping employees save for retirement, for reducing employer plan maintenance costs, and other factors.

REVIEW QUESTION ANSWERS

1. Payroll deductions for Social Security go into the Social Security Trust Fund to purchase mandatory insurance that provides for you and your family in the event of death, disability, health problems, or retirement.

In 40 years the system may or may not function similarly to the one today. The greatest problem facing the system under the current “pay-as-you-go basis” is that 40 years ago 16 workers were paying for each retiree. Today that ratio has dwindled to 3-to-1, and in 40 years is projected to be 2-to-1.

2. To qualify for benefits, someone needs 40 credits. One credit is earned for each $1,050 in earnings in 2008, up to a maximum of four credits per year. Thus, it takes a minimum of 10 years to qualify for retirement, disability, and survivor benefits.

3. The amount of Social Security benefit received is determined by: Number of years of earnings Average level of earnings Adjustments for inflation

Social Security attempts to provide benefits that replace 42 percent of one's average earnings, with an adjustment upwards for those in lower income brackets and downwards for those in higher income brackets. For those born in 1960 or later, full retirement benefits will not be available until age 67. Retiring at age 62 will result in a permanent reduction to 70 percent of the full benefit amount.

4. Disability benefits provide protection for those who experience a physical or mental impairment that is expected to result in death or substantial work lost for at least one year. Survivor benefits are paid to families when the breadwinner dies. Payments include automatic one-time payments at the time of death to help pay for funeral costs, as well as monthly payments to the surviving spouse if he/she is over 60, over 50 if disabled, or any age if caring for a child either under 16 or disabled and receiving Social Security benefits.


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Children may also receive survivor benefits if they are under 18, or under 19 but still in elementary or secondary school, or if they are disabled. Parents may also qualify for survivor benefits from a deceased child if the parents were dependent on the child for at least half of their support.

For the purposes of collecting disability benefits the Social Security Administration’s definition of substantial work is anything that generates monthly earnings of $500 or more.

5. A pension plan is a defined benefit plan, and may be contributory or noncontributory. The contributory modifier describes whether or not an employee pays into the plan. A noncontributory plan is one where employees are not required to pay into the plan in order to receive future benefits. The retirement benefit, or payout, is based on a formula based on age at retirement, salary level, and years of service.

Pension Plan Advantages: Employer bears investment risk May not require employee contributions

Pension Plan Disadvantages: May change with little or no notice May pay only a small percentage of salary Lack of portability Lack of inflation-adjusted benefits (fixed benefit amount) May not be funded, increasing the risk of possible non-payment of benefits in the

future

A number of reasons explain why companies have dropped defined benefit plans, but most relate to cost. Low interest rates, poor stock market returns, sky-rocketing health-care costs, and longevity of retirees have forced many companies to abandon pensions in favor of less costly 401(k) and other defined contribution plans. In addition, younger companies never offered pension plans, so competition also has forced older companies to switch to defined contribution plans.

6. To be “vested” means that someone has worked for a company long enough to have the right to receive pension benefits in the future. Some pension plans offer immediate vesting, while others require as many as seven years of employment before becoming 100 percent vested. Should an employee leave the company prior to being fully vested, he/she will forfeit the pension benefit. This eliminates the responsibility of the employer to invest and hold pension funds until some date in the future; however, an employee who often switches jobs among companies that do not have portable plans will not be accumulating retirement funds. The method of vesting used and the likelihood of remaining with the company past the vesting period is an important consideration when comparing employment offers.



Similarly, the “dollar cost” of losing pension benefits due to a job change should be considered, particularly if the option to become fully vested is soon.

7. Accumulation of funds in a cash balance plan is based on a formula that considers two factors: a percentage of pay to be credited and a predetermined rate of return. The latter determines the growth in the account, regardless of the actual level of investment earnings. Employers, not employees, choose the investments and returns are often less than employees could have earned through wise investment choices. This is a significant disadvantage for the employee. Cash balance plans offer the advantages of ease and accuracy of tracking earnings, faster benefit accumulation for younger employees, and portability, or the availability of benefits whenever an employee leaves the company. Employers benefit from any earnings difference between the predetermined and actual rates of return. Employers also save from reduced future benefits for older workers.

8. The seven steps involved in retirement planning include:1. Setting goals: This first step requires figuring out just what you want to do when you

retire.2. Estimate how much you will need to meet goals: This step helps you turn goals into

estimated dollar figures. A key step is to determine basic retirement living expenses.3. Estimate income available at retirement: This step includes estimating Social Security

benefits and pension estimates from your employer.4. Calculate the annual inflation-adjusted shortfall: At this step, you compare your

retirement income with estimated living expenses. A deficit would indicate the need for additional savings.

5. Calculate the funds needed at retirement to cover any shortfall: This step helps you determine how much money you will need to come up with each year to support yourself in retirement.

6. Determine how much you must save annually between now and retirement: In step 5, you determine how much you need to support yourself in retirement. In this step, you determine how much money you need to save each year to meet your objective.

7. Put the plan in play and save: This is the hardest step of all. Once a need has been determined, it is essential that the developed plan be put into effect.

9. The two fundamental principles of a tax-deferred retirement plan are Principle 2: Nothing Happens without a Plan and Principle 4: Taxes Affect Personal Finance Decisions. To help with Principle 4, the IRS makes tax-deferred plans available to encourage individuals to save for their own retirement. The two primary advantages are 1) pre-tax or tax deductible contributions and 2) tax-deferred growth. These plans work by allowing investment earnings to go untaxed until earnings are needed at retirement. In some instances contributions to a retirement plan may even result in a tax credit. However, Principle 2 is up to the individual and this is where many Americans fall short. It is very easy to avoid thinking about an event that does not happen for 30 to 50 years, but the longer


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the plan and execution are delayed the harder it becomes to realize the goal. Many people do not start planning for retirement because it is “too complicated,” they “still have time” or they simply are not aware of the benefits.

10. A defined contribution plan can be thought of as a personal savings account for retirement offered by an employer. Typically, employees and employers make contributions to these plans. In contrast, only the employer funds a defined benefit plan.

While future earnings and payments from the plan are not guaranteed, most defined contribution plans allow employees to choose how assets in the account are invested. Future payments depend upon how well the retirement account performs. In contrast, employees are not given investment choices with a defined benefit plan; the employer agrees to pay a benefit based on a designated formula and is responsible for managing the funds to meet this obligation.

Employers like defined contribution plans because their responsibility ends with their contribution to the plan and bookkeeping functions. In effect, defined contribution plans pass the responsibility for retirement from the employer to the employee. Such plans also pass the risks of investing from employers to employees because the accounts are not insured and payments are not guaranteed.

The opportunity to choose investment options for retirement funds is an acknowledged advantage of defined contribution plans, but can be a disadvantage if the employee lacks the knowledge to make wise investment selections. The lack of employee funding, and the employer’s sole responsibility for meeting the designated formula payout are advantages of a defined benefit plan.

11. The five most common examples of a defined contribution retirement plan, and associated advantages and disadvantages, include: Profit sharing plan: Employer contribution is based on a designated percentage, often

with a specified minimum and maximum, of the employee’s salary. Contribution amounts may vary with the company’s performance and may not be guaranteed.

Money purchase plans: Similar to a profit-sharing plan as the employer contributes a designated percentage of salary, but the contribution is guaranteed regardless of company performance.

Thrift-and-savings plans: Employer matches a percentage of the employee’s contributions to their retirement accounts.

Employee stock ownership plan (ESOP): Riskiest of the five plans as all retirement contributions are made as company stock, which could fluctuate widely in value and offers no diversification.

401(k) plan: Increasingly popular retirement option with only the employee, or the employee and employer, making contributions. Employer contributions are typically a



percentage match of the employee’s contribution to a designated maximum. The employee is responsible for investment choices. Contributions and all earnings are tax-deferred until the time of withdrawal. Several investment options are typically offered.

12. A 401(k) plan is a tax-deferred retirement plan in which contributions from the employee and employer, if applicable, as well as the earnings on those contributions are not taxed until retirement when withdrawals are made. A 403(b) plan is essentially the same as a 401(k) plan except that it is available only for employees of schools and charitable organizations. Both plans offer a tax-deductible employee contribution and tax deferral until funds are withdrawn.

13. A “catch up” provision allows taxpayers over the age of 50 to make additional tax-deferred contributions to a retirement account or IRA to “catch up” their savings to a more appropriate level. The annual “catch up” amount is $5,000, indexed to inflation.

14. Anyone who owns/operates a small business with full- or part-time employment, works for a small business, or does freelance work on a part-time basis is eligible to participate in a tax-favored retirement plan such as a Keogh, SEP-IRA, or SIMPLE plan. Generally, the plans are self-directed by the employee. The specific eligibility requirements vary for each plan depending on the employment situation. All offer tax-sheltered growth and different options for employer or employee contributions. Yes, a teacher who operates a photography business part-time would be eligible to fund a SEP-IRA,

15. A Keogh, SEP-IRA, and SIMPLE are all self-directed, tax-deferred retirement plans for small businesses or the self-employed. They offer the benefit of other tax-deferred plans in that employee contributions are made with pre-tax dollars, thereby reducing taxable income in the current year. Catch-up provisions apply for those over 50. Keogh plans can be the most complex to establish. The employer or the employee may fund a Keogh. The employer funds a SEP-IRA, while the employee funds a SIMPLE with the possibility of matching funds from the employer.

16. A Keogh, SEP-IRA, and SIMPLE are all self-directed plans, meaning that the employee chooses and manages the securities. Keogh plan withdrawals prior to age 59½ are assessed a 10 percent penalty except in cases of serious illness, disability, or death.

17. Roth IRA contributions are not tax deductible. The account grows tax-free and all withdrawals of principal are tax-free if the funds have been deposited for 5 years. With a traditional IRA, the annual contribution may be fully tax-deductible, partially tax-deductible, or not tax-deductible, but the earnings grow tax-deferred. Withdrawals are taxed when the money is withdrawn, but the taxation on the contribution varies with the original tax status. For example, tax-deductible contributions and the earnings will be taxed when


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withdrawn. Contributions that were not tax-deductible will not be taxed a second time when withdrawn, but the earnings will be taxed.

Annual contribution limits of $5,000 in 2008, with subsequent inflationary increases in $500 increments, apply to both the Roth and traditional IRA. Annual contribution limits apply to one or both accounts in combination. Both accounts are self-directed, with few restrictions on the investment chosen. No taxes are paid on the growth of a traditional or Roth IRA while the funds are in the account. Both have options for penalty-free withdrawals prior to retirement, although different criteria apply.

18. Yes, there is a provision to allow a non-working spouse to make a deductible contribution to a traditional IRA even if the working spouse is covered by a qualified retirement plan or earns a high income. If the modified adjusted gross income (MAGI) on the tax return is below $159,000 the contribution is fully deductible and if MAGI is below $169,000 the contribution is partially deductible. Above that limit, no deduction applies, but the couple may still fund the IRA and benefit from the tax-deferred growth and other IRA features. MAGI is defined as adjusted gross income before any traditional IRA contributions are subtracted.

19. Withdrawals from a traditional IRA may avoid the 10 percent penalty if the account owner is 1) over 59½, 2) disabled 3) using the money for the purchase of a first home ($10,000 maximum), 4) covering medical expenses that exceed 7.5 percent of AGI, 5) unemployed and paying for medical insurance premiums, or 6) paying qualified education expenses.

20. Distributions from pension plans or other company retirement plans are often "rolled over." This means that, instead of paying taxes on a lump-sum distribution, the distribution can be placed into an IRA or other qualified retirement plan. Rolling over distributions is a way to avoid paying taxes on the distribution while the funds continue to grow tax-deferred. It is important to complete a “trustee-to-trustee transfer” to avoid 20 percent tax withholding on the account. The check should never be made payable to the individual; if the check is sent to you, be sure it is made payable to the IRA.

21. Self-directed means that the owner directs the types of investments to be held in the IRA and that the owner may change investment choice at any time without paying taxes. The only limitation to this freedom of choice is that life insurance and collectibles are not eligible to be purchased in an IRA, which means that stocks, bonds, mutual funds, real estate, and CDs are all available choices.

22. The Saver’s Tax Credit is an income tax credit, with a maximum benefit of $2,000 for couples ($1,000 for individuals), to offset part of the first $2,000 a worker contributes to an IRA, 401(k), or other workplace retirement plan. This credit is available for certain low to moderate income filers based on filing status, adjusted gross income, tax liability, and the



amount contributed to qualifying retirement programs. This is very beneficial to those who qualify, because this, like all tax credits, off-sets tax liability on a dollar-for-dollar basis.

23. Once the taxes are paid, money rolled from a traditional IRA to a Roth IRA has the following advantages that are unique to a Roth IRA: Contributions and earnings will be distributed tax free, if the account is open for at

least 5 years. Withdrawals up to the amount of the contributions can be withdrawn without a tax

penalty. No requirement that distributions begin by age 70 ½.

24. A Coverdell Education Savings Account, formerly called the Education IRA, functions similarly to a Roth IRA. Contributions are limited to $2,000 annually for each child younger than age 18. Earnings grow tax-free and withdrawals are tax-free if used for qualified education expenses, including certain elementary and secondary school costs. Income restrictions apply. 529 plans also offer tax-free growth of education funds limited to qualified college or graduate school expenses. Contribution limits are much higher, with some state plans allowing a maximum contribution of $250,000. Investment alternatives are limited to those in the 529 plan chosen, while the Coverdell Education Savings Account has few investment restrictions.

25. A 529 plan is tax-advantaged savings plans used only for college and graduate school. These plans allow for contributions as large as $250,000, which then grow tax-free. There are two plan types: prepaid college tuition plans and college savings plans. Most prepaid plans limit payment to public in-state colleges and universities, a restriction that may not fit your situation. The college savings plans offer choice of educational institution and choice of investments (offered within the plan) to better match the family’s needs. The funds are withdrawn tax-free if used for qualified education expenses. Some states also offer state tax deductions for some or all of the contribution.

Professional financial advice may be helpful when comparing plans. Be sure to compare the investment alternatives, plan flexibility, restrictions on use, and any applicable fees.

26. The main advantage of the 529 over the College Education Saving Account is the contribution limit is so much higher. The 529 plans allow as much as $250,000 as compared to the $2,000 annual contribution limit per child under 18 with the College Education Saving Account.

Yes a household may fund both plans in the same year; however, for withdrawal purposes the same expenses can not be claimed for distributions from both the 529 and the College


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Education Saving Account. Nor can the same expenses be claimed for the Hope or Lifetime learning tax credits.

27. An annuity provides a recipient with an annual payout. Single Life Annuity: receive a set monthly payment for your entire life. Annuity for Life or a Certain Period: payments are made for your entire life; however, if

you die before the end of a certain period of time (e.g., 10 years), payments will continue to be paid to your beneficiary. At the end of the certain period, all payments to your beneficiary will stop.

Joint and Survivor Annuity: this type of annuity provides payments over the life of both you and your spouse. You may typically choose from a 50 percent or 100 percent survivor benefit. In the case of the 50 percent survivor benefit, your spouse would receive one-half of the monthly payment if you died. A 100 percent annuity would continue to pay the full benefit to your spouse. The higher the survivor benefit, the lower the size of the initial annuity. If you are married and choose no survivor benefit, your spouse must sign a waiver giving you permission to accept the alternative.

28. Student answers may vary, depending on the features chosen, but the following is representative.

The advantages and disadvantages of an annuity and a lump-sum distribution can counter, or offset, each other. For example, a single life annuity insures that you will never “outlive” your money, a fear of many elderly and a possible outcome with a lump-sum payment. The individual must be careful with the management and investment of the funds, but there is still no guarantee that the funds won’t be exhausted. The annuity recipient will never run out of money, although dying early could mean little benefit is received.

A lump-sum distribution offers greater control over the distribution of assets to heirs. Unless an heir is identified as a beneficiary on a certain period annuity, distribution is not possible.

Annuities generally offer little or no inflation protection, while a lump-sum distribution prudently invested in equities could offer protection from the long-term loss of purchasing power. However, care must be taken to preserve and manage the lump-sum payout.

29. Timing is critical for successful retirement planning because the earlier an investor starts 1) the longer the time horizon maximizing the benefit of compound interest, 2) the more risk the investor should be willing to accept, 3) the greater the benefit of tax-deferred investing, and 4) the better the chance the investor has at achieving the goal with lower annual investment amounts.



PROBLEM AND ACTIVITY ANSWERS

1. Kristen will pay 6.2 percent of her salary to Social Security and 1.45 percent of her salary to Medicare. Therefore she will pay a total of $3,920.63 [$51,250 x (0.0620 + 0.0145)]. Kristen's employer will pay a matching amount.

2. Grady Zebrowski will need to save $7,049 per year to achieve his goal, but if he waits 5 years the annual savings amount will increase to $11,072. See the “fixed dollar amount” section in the Retirement Planner Calculator exhibit on page 343 for the details.

Grady is in a little better shape if he already has $10,000 saved. In this case he only needs to save $6,114 per year. See the “fixed dollar amount” section in the Retirement Planner Calculator exhibit on page 344 for the details.

3. Mr. Zebrowski’s total savings need to fund 30 years of retirement is $3,125,237. Under this assumption, Grady needs to save 9.33% (12.33% – 3.00% match) of his annual salary. See the “fixed percentage of salary” section in the Retirement Planner Calculator exhibit on page 345 for the details.

4. For income of $119,750 the following 2007 tax liabilities would be incurred: Social Security = $97,500 x 0.062 = $6,045.00 (2007 income cap is $97,500) Medicare = $119,750 x 0.0145 = $1,736.38 Total = Social Security + Medicare = $7,781.38

For income of $119,750 the following 2008 tax liabilities would be incurred: Social Security = $102,000 x 0.062 = $6,324.00 (2008 income cap is $102,000) Medicare = $119,750 x 0.0145 = $1,736.38 Total = Social Security + Medicare = $7,060.38

5. Answers for Anne-Marie and Yancey are:a. They have a projected need of $58,977.27.

Net need = (current living expenses x replacement ratio) + additional annual needs= ($67,000 x 0.70) + $5,000 = $46,900 + $5,000= $51,900.00Gross need = net need / (1 – average tax rate)= $51,900.00 / (1 – 0.12)= $51,900.00 / 0.88= $58,977.27


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b. They have a present value annual shortfall of $1,977.27.Present value shortfall = projected income need – projected income available= $58,977.27 – ($22,000 + $35,000)= $1,977.27

c. They have a future value annual shortfall of $8,545.59.Future value shortfall = present value shortfall x (FVIF 5%, 30 years)

Factor Table A solution Calculator solutionPV $1,977.27 PV -$1,977.27PMT n/a PMT $0

(FVIF5 %, 30) 4.322I/Y 5%N 30

FV $8,545.59 FV ?CPT FV $8,545.66

d. Step 1: Determine the total shortfall at retirementUsing Appendix D, they have a future value shortfall of $91,224.17 at retirement

Factor Table D solution Calculator solutionFV n/a PV ?PMT $8,545.59 PMT -$8,545.66

(PVIFA8%, 25) 10.675I/Y 8%N 25

PV $91,224.17 FV $0CPT PV $91,223.01

Step 2: Determine the annual payment needed to cover the shortfall at retirementUsing Appendix C determines the current fixed annual payment to be $1,247.83

Factor Table C solution Calculator solutionPV n/a PV $0PMT $2,275 PMT ?

(FVIFA8%, 25) 73.106I/Y 8%N 25

FV $1,247.83 FV $91,223.01CPT PMT $1,247.82

Alternative d. This alternative assumes that their retirement income would increase annually by the rate of inflation.



Step 1: Determine the total shortfall at retirementUsing Appendix D, they have a future value shortfall of $148,804.33 at retirement(Because the annual value of their withdrawal is assumed to increase, the rate of return for this calculation must be the inflation adjusted rate of 3% (8% – 5%).)


(PVIFA3%, 25) 17.413I/Y 3%N 20

PV $148,804.33 FV $0CPT PV $148,805.62

Step 2: Determine the annual payment needed to cover the shortfall at retirementUsing Appendix C determines the current fixed annual payment to be $1,313.57(Because the annual value of their payment is assumed to remain fixed, the rate of return for this calculation must be the nominal rate of 8 percent.)

Factor Table C solution Calculator solutionPV n/a PV $0PMT $1,313.57 PMT ?

(FVIFA8%, 30) 113.282I/Y 8%N 30

FV $148,804.33 FV $148,805.62CPT PMT $1,313.57

6. Russell and Charmin need $77,000 income in retirement. Net need = (current living expenses x replacement ratio) + additional annual needs

= $97,000 x 0.80 = $77,600 Gross need = net need / (1 – average tax rate)

= $77,600 / 0.80 = $97,000

7. These calculations are based on the commonly used formula for defined-benefit plans, as found on page 509; variations in the formula used by Anita’s company would determine the actual amounts.

Annual benefit = Average salary x years of service x 0.015= $37,000 x 25 x 0.015 = $13,875 (if Anita retires now.)

Annual benefit = Average salary x years of service x 0.015= $47,000 x 30 x 0.015 = $21,150 (if Anita accepts the promotion and retires later.)


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Unfortunately, most pensions do not adjust retirement benefits for inflation. In other words, the benefit level remains constant; therefore, the spending power of the pension benefit gets reduced over time by the erosive effects of inflation.

8. At ABC, Inc. the first year contribution invested for 30 years at 9 percent would be worth $88,225.55. Reece’s Contribution = $38,000 x 0.10 = $3,800 Company Match = $38,000 x 0.10 x 0.75 = $2,850 Total Contribution = $6,650

Factor Table A solution Calculator solutionPV $6,650 PV -$6,650PMT n/a PMT $0

(FVIF9 %, 30) 13.267I/Y 9%N 30

FV $88,225.55 FV ?CPT FV $88,230.06

At XYZ, Inc. the first year contribution invested for 30 years at 9 percent would be worth $97,512.45. Reece’s Contribution = $35,000 x 0.15 = $5,250 Company Match = $35,000 x 0.06 x 1.00 = $2,100 Total Contribution = $7,350


(FVIF9 %, 30) 13.267I/Y 9%N 30

FV $97,512.45 FV ?CPT FV $97,517.44

The two retirement plans offered by the company would result in a future value difference for the first year of employment of $9,286.90. However, Reece must consider that it is his contribution that is making the difference. Although he would come out ahead at retirement the ABC offer is more lucrative today. No only are they offering a salary that is $3,000 more, but they potential could contribute $750 per year more to his retirement plan.

9. Peter and Blair have a $27,000 ($86,000 - $61,000) per year present value shortfall. They need to save $816,622.40 ($7,208.76 per year) to meet their income needs projection.



Step 1: Calculate the annual future value shortfall at retirement

Factor Table A solution Calculator solutionPV $27,000.00 PV -$27,000PMT n/a PMT $0

(FVIF3%, ,30) 2.427I/Y 3%N 30

FV $65,529.00 FV ?CPT FV $65,536.09

Step 2: Calculate the total shortfall needed to be funded by retirement assuming that the desired annual retirement benefit continues to grow at the inflation rate. (Because the annual value of their withdrawal is assumed to increase, the rate of return for this calculation must be the inflation adjusted rate of 3% (8% – 5%).)


(PVIFA5%, 20) 12.462I/Y 5%N 20

PV $816,622.40 FV $0CPT PV $816,724.54

Step 3: Calculate the annual funding requirement to achieve the savings goal by the time of retirement.


(FVIFA8%, 30) 113.282I/Y 8%N 30

FV $816,622.40 FV $816,724.54CPT PMT $7,209.58


337 Chapter 16

10. Funding a 529 plan with $120,000 with earnings of 7 percent until the child reaches age 18 would yield approximately $405,600 for college expenses.


(FVIF7%, ,18) 3.380I/Y 7%N 18

FV $405,600 FV ?CPT FV $405,591.87

11. Annual contributions of $2,000 to a Coverdell Education Savings Account earning 7 percent would yield approximately $67,998 when the child is 18 and ready to enter college.

Factor Table C solution Calculator solutionPV n/a PV $0PMT $2,000 PMT $2,000

(FVIFA7%, 18) 33.999I/Y 7%N 18

FV $67,998.00 FV ?CPT FV $67,998.07

DISCUSSION CASE 1 ANSWERS

1. Yes, they both qualify for a Roth or traditional IRA, although the Roth offers the greatest benefits. They can contribute $4,000 each in 2007 and $5,000 each in 2008 into their Roth IRA accounts, and should seriously consider increasing their contributions as the limits continue to increase. Molly can also take advantage of a SEP-IRA or Keogh plan to defer some of her self-employment income. The SEP-IRA allows her to defer up to 25 percent of her income or $46,000, whichever is less, in 2008.

2. Although Bill should be funding both the Roth and his 403(b) to the greatest extent possible, fully funding the Roth typically offers the greatest advantage, assuming the same rate of return on the two accounts. Whereas both accounts grow tax-deferred, the Roth account will be withdrawn tax-free, whereas Bill will pay taxes on the contributions and the earnings in the 403(b) account. However, the tax consequences in the current year may also be considered. For every $1,000 Bill deposits in his 403(b), he saves $250 in tax liability for the current year. Without the 403(b) contribution, the $250 would have been paid the federal government. Conversely, Bill must earn $1,333 [($1,000 / (1 – 0.25) (ignoring Social Security and state taxes)] to have $1,000 after taxes to fund the Roth. In summary,



the simple answer is fund the tax-free account in the absence of a match for a tax-deferred account.

3. “Catch-up” contributions will apply to Bill and Molly when they are 50 years old or older, and will allow them to make additional $1,000 per person retirement contributions beyond the maximum annual limit. The provisions also apply to the 403(b) account, the Roth IRA, and the SEP-IRA or Keogh account for Molly’s self-employment income, although the “catch-up” amounts vary by retirement plan.

4. They need approximately $117,600.00 at their anticipated retirement date.Replacement need = $70,000 x 0.80 = $56,000 (using the 80 percent replacement rule)

According to Table 16.2 in the text, pretax income = replacement income / (1 – average tax rate)

= $56,000 / (1 – 0.14) = $65,116.28 pre-tax income

Now calculate the future value “inflation-adjusted” income need using Appendix A

Factor Table A solution Calculator solutionPV $65,116.28 PV -$65,116.28PMT n/a PMT $0

(FVIF3%, ,20) 1.806I/Y 3%N 20

FV $117,600.00 FV ?CPT FV $117,607.25

5. Step 1: The value of the portfolio at retirement is approximately $316,015.80.Total portfolio value today = IRA + 403(b) = $20,000 + $47,800 = $67,800


(FVIF8%, ,20) 4.661I/Y 8%N 20

FV $316,015.80 FV ?CPT FV $316,012.89


339 Chapter 16

Step 2: Their after-retirement annual income would be approximately $32,187.39; assuming no further contribution into either retirement account, and a fixed withdrawal rate.

Factor Table D solution Calculator solutionFV n/a PV -$316,012.89PMT $32,187.39 PMT ?

(PVIFA8%, 20) 9.818I/Y 8%N 20

PV $316,015.80 FV $0CPT PMT $32,186.61

Alternative Step 2: Their after-retirement first year income would be $25,358.12; assuming no further contribution into either retirement account, and a continued 3% rate of increase on withdrawals. (Remember to use the inflation adjusted return to approximate for a continued increase in their retirement withdrawal rate.)

Factor Table D solution Calculator solutionFV n/a PV $316,012.89PMT $25,358.35 PMT ?

(PVIFA5%, 20) 12.462I/Y 5%N 20

PV $316,015.80 FV $0CPT PMT $25,357.69

6. If the Hickoks want their retirement income to remain fixed over their retirement period then they need to invest $11,621.30 annual to cover their projected shortfall. Step 1: Calculate the annual shortfall assuming a fixed withdrawal rate as:

Annual shortfall = Projected annual income need – projected annual income available$54,213.00 = $117,600.00 – ($32,187.39 + $31,200.00)

Step 2: Solve for the total additional funding requirement needed as of retirement.


(PVIFA8%, 20) 9.818I/Y 8%N 20

PV $532,263.23 FV $0CPT PV $532,271.23



Step 3: Solve for the annual additional funding requirement to reach their income goal.


(FVIFA8%, 20) 45.762I/Y 8%N 20

FV $532,263.23 FV $532,271.23CPT PMT $11,631.30

If the Hickoks want their retirement income to increase annually by 3 percent then they need to invest $16,622.99 annually to cover their projected shortfall. Alternative Step 1: Calculate the annual shortfall assuming a growing withdrawal rate as:

Annual shortfall = Projected annual income need – projected annual income available$61,041.65 = $117,600.00 – ($25,358.35 + $31,200.00)

Alternative Step 2: Solve for the total additional funding requirement needed as of retirement. (Remember to use the inflation adjusted return to approximate for a continued increase in their retirement withdrawal rate.)


(PVIFA5%, 20) 12.462I/Y 5%N 20

PV $760,701.04 FV $0CPT PV $760,713.88

Alternative Step 3: Solve for the annual additional funding requirement to reach their income goal.


(FVIFA8%, 20) 45.762I/Y 8%N 20

FV $760,701.04 FV $760,713.88CPT PMT $16,623.28

Investments for retirement should always be made in a tax-deferred account if at all possible. The Hickoks should consider increasing their investment into his 403(b) and IRA accounts, as well as starting tax-advantaged accounts for Molly’s self-employment income.


341 Chapter 16

7. Currently the only Social Security survivor benefit available to Molly or Bill is the one-time payment at the time of death to help defray funeral costs. Neither is currently eligible for continued monthly payments because they do not have qualifying children and neither is over age 60 (or age 50 if disabled).

8. Student answer may vary; however, the following could be included: Molly should open one of the self-employed retirement plans (e.g., SEP-IRA) Molly should start an IRA Bill should increase his retirement plan contributions

DISCUSSION CASE 2 ANSWERS

1. Because Timur and Maurguerite are married, Timur is required by law to obtain Marguerite's waiver (by signature) of all future rights to annuity income.

2. The primary advantage associated with an annuity is that it can be set up in such a way that Timur and Maurguerite will continue to receive benefits; regardless of how long they live. In effect, an annuity relieves them from having to make investment decisions that might decrease the amount of future income.

The largest disadvantage is that it does not provide inflation protection. Although they will know exactly how much they will receive each month, their spending power will be continuously eroded by inflation. Further, annuities do not allow for flexible distributions in cases of emergency and, in general, it is impossible to leave proceeds to heirs.

3. A 100 percent joint and survivor annuity would be the most appropriate in their case. Their pension income accounts for 55 percent of their total income. If Timur were to pre-decease Maurguerite, she would need the greatest possible income in order to maintain her level of living.

4. A lump-sum payment would be appropriate in this case. The annuities guarantee an approximate rate of return equal to 4 percent, which is half of their projected rate of return. Timur and Maurguerite could be better off taking a lump-sum distribution and purchasing an insurance company annuity on their own, or investing the proceeds themselves. Given historical rates of return, they could expect to earn substantially more than 4 percent, even in a conservatively managed mutual fund.

Possible disadvantages include choosing an annuity from a poorly rated insurance company that could jeopardize the safety of the distribution. If they invest the distribution themselves in stocks, bonds, or mutual funds, they run the risk of making a bad investment and losing



the money they've saved. However, these disadvantages may be offset by the flexibility that a lump-sum distribution offers.

5. One way to reduce the impact of taxes on a lump-sum distribution is to have the distribution “rolled over” into an IRA. In this way, they would avoid paying taxes on the distribution while the funds continue to grow on a tax-deferred basis. The other way, should Timur desire to continue working, is to have him transfer his 401(k) balance to a qualified plan with his new employer.

6. Timur and Marguerite should consider the following strategies to help them monitor expenses and safeguard their retirement lifestyle: Adjust their investments, particularly in the 401(k) plan, to cover inflation and allow

their money to grow conservatively. Fixed income investments, like CDs and bonds, may be safe, but with a long time horizon during retirement, they must still beat inflation and have moderate growth to insure adequate funds for the future.

Monitor their investments and the overall health of their former employer. Insurance or other benefits, as well as the price of any company stock they own, could be affected by changes in the company. Changes in company benefits or their investment values could impact their retirement goals and require them to make adjustments.

Keep their insurance coverage up to date and the premiums paid. Don’t risk an uninsured loss.

Use computer programs or Internet sites to monitor their investment plan and see into the future. By carefully tracking their funds, they can meet their goals without fear of “outliving their money.”

7. College Savings Plans: More flexible funding options Not limited to in-state public schoolsPrepaid Tuition Plans: Fewer funding options Limited to in-state public schools

8. If all of the relatives contribute as planned then the grandson would have just over $231,900. At that rate he might be able to afford George Washington University, just barely.

Factor Table C solution Calculator solutionPV n/a PV $0PMT $6,500 PMT $6,500

(FVIFA7.5%, 18) 35.677I/Y 7.5%N 18

FV $231,900.50 FV ?


343 Chapter 16

CPT FV $231,903.02



Retirement Planning Calculator


Current Salary $50,000 Annual Anticipated Inflation Rate 3.50%

Years Until Age 65 40 Projected Salary at Age 65 $197,963

Equities 75.00% 0.104Bonds 20.00% 0.054Cash 5.00% 0.037

Expected Tax-Deferred Return 9.07%

* Returns are based on historical averages from 1926 to 2007. Past performance is no guarantee of future results.

Equities 40.00%Bonds 50.00%Cash 10.00%



Projected Salary Replacement 90% First Year Retirement Income $178,167

Social Security benefit at 65 $0 Retirement Income to Replace $178,167

Years in Retirement 20 Desired Annual Income Increase 3.50%

Total Savings Need at Retirement $2,423,713

Current Retirement Savings $0 Value at Retirement $0

You Are Currently Falling Short of Your Goal By $2,423,713

$507.83 or $7,049 per year

But, if you wait 5 years, you would need $810.49 or $11,072 per year

9.56% or $4,782 this year

But, if you wait 5 years, it increases to 12.97% or $7,703 that year

Shortfall Funding Solutions

Fixed Dollar Amount

Preretirement Allocation

Projected Salary at Retirement

Required Salary Deferral to Achieve Retirement GoalFixed Percentage of Salary

Average Tax-Deferred Monthly Savings to Achieve Goal

5: Growth

2: Conservative GrowthYour portfolio allocation is

Your portfolio allocation is

Postretirement Allocation

Projected Retirement Savings Need

75.00%

20.00%

5.00% Equities

Bonds

Cash

40.00%

50.00%

10.00% Equities

Bonds

Cash

345 Chapter 16















Current Retirement Savings $10,000 Value at Retirement $321,674


$440.43 or $6,114 per year

But, if you wait 5 years, you would need $702.93 or $9,602 per year

8.29% or $4,147 this year



Fixed Dollar Amount



Required Salary Deferral to Achieve Retirement GoalFixed Percentage of Salary

Average Tax-Deferred Monthly Savings to Achieve Goal

5: Growth

2: Conservative GrowthYour portfolio allocation is

Your portfolio allocation is



75.00%

20.00%

5.00% Equities

Bonds

Cash

40.00%

50.00%

10.00% Equities

Bonds

Cash
















Current Retirement Savings $0 Value at Retirement $0


$654.81 or $9,090 per year

But, if you wait years, you would need $654.81 or $9,090 per year

12.33% or $6,166 this year


Required Salary Deferral to Achieve Retirement Goal


Fixed Dollar AmountAverage Tax-Deferred Monthly Savings to Achieve Goal

Fixed Percentage of Salary


Your portfolio allocation is 2: Conservative Growth




Your portfolio allocation is 5: Growth75.00%

20.00%

5.00% Equities

Bonds

Cash

40.00%

50.00%

10.00% Equities

Bonds

Cash

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