CH-13-15 Investing in Mutual Funds – Personal Finance : Book Guide

This Document Contains Chapters 13 to 15 13 INVESTING IN MUTUAL FUNDS CHAPTER OVERVIEW This chapter describes mutual funds as an investment alternative. We begin our discussion by considering why investors purchase mutual funds. Then, we examine the characteristics of closed-end mutual funds and open-end mutual funds. The differences between load funds and no-load funds are explained. We describe the major categories of mutual funds in terms of the types of securities they invest in. Finally, methods that can be used to evaluate mutual fund investments and the mechanics of mutual fund transactions are presented. LEARNING OBJECTIVES CHAPTER SUMMARY After studying this chapter, students will be able to: Obj. 1 Describe the characteristics of mutual fund investments. The major reasons why investors choose mutual funds are professional management and diversification. Mutual funds are also a convenient way to invest money. There are two types of mutual funds. A closed-end fund is a mutual fund whose shares are issued only when the fund is organized. An open-end fund is a mutual fund whose shares are sold and redeemed by the investment company at the net asset value (NAV) at the request of investors. Mutual funds are also classified as load and no-load funds. A load fund charges a commission every time an investor purchases shares. No commission is charged to purchase shares in a no-load fund. Mutual funds can also be front load or back load. Possible fees include management fees and contingent deferred sales loads. Obj. 2 Classify mutual funds by investment objective. The managers of mutual funds tailor their investment portfolios to the investment objectives of their customers. The major fund categories includes money market funds, mortgage funds, bond funds, dividend funds, balanced and asset allocation funds, equity or common stock funds, specialty funds, international or global funds, real estate funds, ethical funds, segregated funds, and labour sponsored venture capital corporations (LSVCCs). Today, many investment companies use a family of funds concept, which allows shareholders to switch their investments among funds as different funds offer more potential, financial reward, or security. LEARNING OBJECTIVES CHAPTER SUMMARY Obj. 3 Evaluate mutual funds for investment purposes. The responsibility for choosing the “right” mutual fund rests with you—the investor. The information in newspapers, the financial objectives of the fund, the information in the prospectus and annual reports, financial publications, professional advisory services, and the Internet can all help you evaluate a mutual fund. Obj. 4 Describe how and why mutual funds are bought and sold. The advantages and disadvantages of mutual funds have made mutual funds the investment of choice for many investors. For $250 to $2,500, you can open an account and begin investing. The shares of a closed-end fund are bought and sold on organized stock exchanges. The shares of an open-end fund may be purchased through a salesperson that is authorized to sell them, through an account executive of a brokerage firm, from a mutual fund supermarket, or from the investment company that sponsors the fund. The shares in an open-end fund can be sold to the investment company that sponsors the fund. Shareholders of mutual funds can receive a return in one of three ways: income dividends, capital gain distributions when the fund buys and sells securities in the fund’s portfolio at a profit, and capital gains when shares in the mutual fund are sold at a higher price than the price paid. There are a number of purchase and withdrawal options. INTRODUCTORY ACTIVITIES • Ask students to comment on the opening case for the chapter (p. 393). • Point out the learning objectives (p. 393) in an effort to highlight the key points in the chapter. • Ask students to express opinions they may have about investing in mutual funds. • Discuss how different investment objectives can be achieved with various types of mutual funds. • Ask if investors need to evaluate mutual funds since they are professionally managed. CHAPTER 13 OUTLINE I. Why Investors Purchase Mutual Funds A. Characteristics of Mutual Funds B. Management Fees and Other Charges C. Special Fees II. Classifications of Mutual Funds III. How to Make a Decision to Buy or Sell Mutual Funds A. How to Read the Mutual Funds Section in the Newspaper B. Financial Objectives—Again C. Mutual Fund Prospectus D. Mutual Fund Annual Report E. Financial Publications F. The Internet IV. The Mechanics of a Mutual Fund Transaction A. Return on Investment B. Taxes and Mutual Funds C. Purchase Options D. Withdrawal Options CHAPTER 13 LECTURE OUTLINE • A mutual fund is an investment alternative chosen by individuals who pool their money to buy stocks, bonds, and other securities selected by professional managers who work for an investment company. Instructional Suggestions • Discussion Question: Why would an investor choose mutual funds for investment purposes? • Current Example: Professional fund managers base their decisions on market conditions, interest rates, inflation, individual companies, business periodicals, government reports, and conversations with business executives. • Text Highlight: Exhibit 13-1(p. 396) illustrates the type of securities contained in the portfolio of the Royal Canadian Equity Fund. • Text Highlight: According to the Investment Funds Institute of Canada (IFIC), member firms managed $679 billion in assets. • Discussion Question: What is the difference between a closedend fund and open-end fund? • Discussion Question: What is the difference between a load and no-load mutual fund? WHY INVESTORS PURCHASE MUTUAL FUNDS (p. 394) • • • The major reasons why investors purchase mutual funds are professional management and diversification, or investment in a wide variety of securities. But be warned—even the best portfolio managers make mistakes. As an investor, you have to evaluate an investment in mutual funds just as you would evaluate any other potential investment. The diversification of mutual funds spells safety, because an occasional loss incurred with one investment is usually offset by gains from other investments. Characteristics of Mutual Funds (p. 395) • • • An investment company is a firm that, for a management fee, invests the pooled funds of small investors in securities appropriate to its stated investment objectives. There are two ways to invest in the mutual funds offered by investment companies. 1. A closed-end fund is a fund of finite size whose shares are issued by an investment company only when the fund is organized. Shares of closed-end funds are traded on the floor of stock exchanges. 2. The majority of mutual funds are classified as open-end funds. An open-end fund is a mutual fund whose shares are issued and redeemed by the investment company at the request of investors. Investors are free to buy and sell shares at the net asset value plus a small commission. The net asset value (NAV) per share is equal to the current market value of the mutual fund’s portfolio minus the mutual fund’s liabilities divided by the number of shares outstanding. The investor should compare the cost of investing in a mutual fund with the cost of other investment alternatives. • • • • • With regard to cost, mutual funds are classified as 1. Load funds. 2. No-load funds. The commission charge for load funds may be as high as 8 1/2 percent of the purchase price for investments under $10,000. No-load funds don’t charge commissions when you buy shares because they have no salespeople. Since no-load funds offer the same investment opportunities that load funds offer, you should investigate them further before deciding which type of mutual fund is best for you. Some mutual funds charge a management fee that ranges from 0.5 to 4 percent per year. Some mutual funds charge a contingent deferred sales load of 1 to 6 percent that shareholders pay when they withdraw their investment from a mutual fund. These fees depend on how long the investor owns the fund. Management Fees and Other Charges (p. 399) • The management expense ratio is the management fee and direct costs the fund pays each year. You may also have to pay special fees such as RRSP trustee fees. • Text Highlight: A sample mutual fund report on the BMO Canadian Equity Class fund is illustrated in Exhibit 13-2 (p. 400). • Concept Check 13-1 (p. 402) CLASSIFICATIONS OF MUTUAL FUNDS (p. 402) • • • • The managers of mutual funds tailor their investment portfolios to the investment objectives of their customers. The major categories of mutual funds, in terms of the types of securities they invest in, are as follows: money market funds, mortgage funds, bond funds, dividend funds, balanced and asset allocation funds, equity or common stock funds, specialty funds, international or global funds, real estate funds, ethical funds, segregated funds, and labour sponsored venture capital corporations (LSVCCs). A family of funds exists when one investment company manages a group of mutual funds. Each fund has a different financial objective. And most investment companies offer exchange privileges that enable shareholders to readily switch among the mutual funds in a fund family. A MAP is a program that allows investors to invest in a portfolio consisting f several mutual funds To improve financial performance, some investors use a market timer. A market timer is an individual who helps investors decide when to switch their investment from one fund to another fund, usually within the same family of funds. • Text Reference: You may want to discuss Life Situation Case, “The Wrong Mutual Fund” at this point in your lecture. (p. 417) • Text Highlight: You may want to discuss the objectives of the Fundamental Investors Mutual Fund described in this section. • Concept Check 13-2 (p. 404) • Text Highlight: You may want to discuss the material on how to read newspaper quotations for mutual funds (Exhibit 13-5) at this point in your lecture. (p. 406) HOW TO MAKE A DECISION TO BUY OR SELL MUTUAL FUNDS (p. 404) • The responsibility for choosing the right mutual funds rests with the individual investor. After all, they are the only ones who know how a particular mutual fund can help them achieve their financial objectives. How to Read the Mutual Funds Section in the Newspaper (p. 405) • • • Most local newspapers, The Financial Post, and The Globe and Mail provide information about mutual funds. The net asset value, offer price, and change in net asset value are reported in tables. The letters beside the name of a specific fund can be very informative. You can find out what they mean by looking at the footnotes that accompany the newspaper’s mutual fund quotations. Generally, 1. “N” means no load. 2. “F” means front load, or fee. 3. “B” means front- and back-end fees. 4. “U” means U.S. currency. Financial Objectives—Again (p. 405) • Evaluate the relationship between your financial objectives and the financial objectives of a mutual fund. Now your aim is to find a mutual fund whose investment objectives match your own. Mutual Fund Prospectus (p. 406) • An investment company sponsoring a mutual fund must give potential investors a prospectus. Mutual Fund Annual Report (p. 407) • Once you are a shareholder, the investment company will send you annual reports. Financial Publications (p. 407) • Another source of information about mutual funds is investment-oriented magazines like Canadian Business, and Report on Business, and other financeor consumer-oriented magazines and financial guidebooks. • Text Highlight: An online fund card for All-Canadian Capital Fund is presented in Exhibit 136. (p.408) • Concept Check 13-3 (p. 409) • Discussion Question: How can an investor make money on a mutual fund investment? • Text Highlight: You may want to discuss the material on calculating total shareholder return for mutual funds presented in the “Financial Planning Calculations” boxed feature. (p. 411) The Internet (p. 407) • It is also possible to use the Internet to obtain information about mutual funds. Not only is it possible to obtain current market values, you can also access home pages of the investment company sponsoring the mutual fund and different professional advisory services. THE MECHANICS OF A MUTUAL FUND TRANSACTION (p. 409) • In this section, we discuss three important topics. 1. We examine how shareholders can make money by investing in closed-end or open-end mutual funds. 2. We look at the options that can be used to purchase shares in a mutual fund. 3. We look at the options that can be used to withdraw shares from a mutual fund. Return on Investment (p. 409) • • As with other investments, the purpose of investing in a closed-end or an open-end fund is to earn a financial return. Shareholders in such funds can receive a return in one of two ways. 1. Both types of funds pay income dividends, capital gain distributions, or both. a. Income dividends are the earnings that a fund pays to shareholders after it has deducted expenses from its dividend and interest income. b. Capital gain distributions are the payments made to a fund’s shareholders that result from the sale of securities in the fund’s portfolio. 2. As with stock investments, it is possible to buy shares in both types of funds at a low price and then to sell them after the price has increased. The profit that results from an increase in value is referred to as a capital gain. Of course, if the price of a fund’s shares goes down, the shareholder incurs a loss. Taxes and Mutual Funds (p. 410) • • • • Income dividends, capital gain distributions, and financial gains and losses from the sale of closed-end or open-end funds are subject to taxation. At the end of each year, investment companies are required to send each shareholder a statement specifying how much he or she received in dividends and capital gain distributions. Be sure you understand the difference between capital gains distributions and capital gains. Be sure to keep accurate records for tax purposes. Purchase Options (p. 412) • • • The shares of a closed-end fund are traded on various stock exchanges, or in the OTC market. The shares of an open-end fund may be purchased through a salesperson that is authorized to sell them, through an account executive of a brokerage firm, or directly from the investment company that sponsors the fund. All four purchase options (regular accounts, voluntary savings plans, contractual savings plans, and reinvestment plans) allow investors to buy shares over a long period of time. As a result, they can use the principle of dollar cost averaging. • Caution: Many investors and government regulatory agencies are critical of contractual savings plans because of penalties that the fund imposes on investors who do not fulfill the contractual requirements. Withdrawal Options (p. 413) • • • Because closed-end funds are listed on securities exchanges, it is possible to sell shares in such a fund to another investor. Shares in an open-end fund can be sold on any business day to the investment company that sponsors the fund. In this case, shares are redeemed at their net asset value. In addition to just selling shares, the investor may use at least four options to systematically withdraw money from an open-end mutual fund. 1. Most funds have a provision that allows investors with a minimum share value of at least $5,000 to systematically withdraw a specified, fixed dollar amount of money each investment period. (Normally, an investment period is three months.) 2. A second option allows the investor to liquidate or “sell off” a certain number of shares each investment period. 3. A third option allows investors to withdraw a fixed percentage of asset growth. 4. A final option allows the investor to withdraw all income that results from income, dividends, and capital gains earned by the fund during an investment period. • Discussion Question: What methods can be used to withdraw money from a mutual fund? • Concept Check 13-4 (p. 413) CONCLUDING ACTIVITIES • Point out the chapter summary (p. 414) and key terms in the text margin. • Discuss selected end-of-chapter Financial Planning Problems, Financial Planning Activities, and Life Situation Case. • Use the Chapter Quiz in the Instructor’s Manual. CHAPTER 13 QUIZ ANSWERS True-False 1. T 2. F 3. T 4. T 5. T 6. T 7. F 8. T Multiple Choice 9. B 10. A 11. D 12. A 13. B 14. B 15. C 16. D Name ________________________________________ Date____________________________ CHAPTER 13 QUIZ TRUE-FALSE _____1. _____2. _____3. _____4. _____5. The major reasons why investors purchase mutual funds are professional management and diversification. A closed-end mutual fund is a fund whose shares are issued and redeemed by the investment company at the request of issuers. Typically, the management fee for a mutual fund ranges between 0.5 and 4 percent of the fund’s asset value. A family of funds exists when one investment company manages a group of mutual funds. _____6. Generally, there are a number of purchase options and withdrawal options for investors that purchase mutual funds. A market timer helps you decided when to switch funds. _____7. A no-load mutual fund charges lower commissions than a front-load mutual fund. _____8. Mutual funds have higher management expenses than Exchange Traded Funds. MULTIPLE CHOICE _____9. A mutual fund in which new shares are issued and redeemed by the investment company at the request of investors is called a(n) ____________ fund. a. closed end b. open-end c. load d. no-load _____10. If your fund made a return of 10 percent and the MER was 2.5 percent, what would be the reported return for the year? a. 7.5 percent b. 10 percent c. 12.5 percent d. The 10 percent return already includes the MER _____11. An investor who wants a tax-free investment would choose a. a balanced fund b. an income fund c. a municipal bond d. there are no such funds _____12. A contingent deferred sales load fund is also known as a _________ fund. a. back-end load b. no-load c. front-end load d. none of the above _____13. Payments made to a fund’s shareholders that result from the sales of securities in the fund’s portfolio are called a. income dividends. b. capital gain distributions. c. tax-free income. d. none of the above. _____14. A(n) ___________ is a company that for a management fee invests the pooled money of small investors in securities that fit the stated investment goals of the fund. a. Utility company b. Investment company c. Corporation d. Pool company _____15. ________ seek to achieve a high level of income and liquidity through investment in short-term money market instruments. a. Dividend funds b. Mortgage funds c. Money market funds d. Specialty funds _____16. A document that prospective mutual fund investors receive is called a(n)___________. a. SEC report. b. load fund report. c. index fund report. d. prospectus. SUPPLEMENTARY LECTURE This lecture should help students understand the importance of reading the fine print in a contractual savings plan agreement that is often used in connection with mutual fund investments. Introduction On June 14, 2000, Mike Dobson signed an agreement to buy shares in XYZ mutual fund. As part of the contract, Mike agreed to make monthly purchases in the amount of $200 for the next 10 years. The sales representative for XYZ told Mike that the company insisted on the contractual savings plan arrangement because it helped individual investors “discipline” themselves to make regular purchases. The Problem After three years, Mike got tired of making $200 monthly installments. Besides, his total three-year investment in the mutual fund—over $7,000—had a current market value of less than the total of his contributions. He contacted the salesperson who had signed him up and told him that he wanted to withdraw his money. The salesperson told him that he could “cash in” his investment, but that he would be “hit” with heavy withdrawal penalties. The salesperson also pointed out that during the first three years of the contract, most of his monthly investments had gone to pay the up-front commissions. If he were to cash in his investment now, he would receive only about $4,000. Finally, the salesperson told him that he should stick it out and continue to make monthly purchases. At this point, you may want to ask students the following questions. 1. What would you do if you were Mike Dobson? 2. Does it seem fair that most of the commissions are charged in the first three years? Final Note Many financial planners and government regulatory agencies are critical of contractual savings plans. As a result, new regulations have been imposed on investment companies offering contractual savings plans. ANSWERS TO CONCEPT QUESTIONS, OPENING CASE QUESTIONS, FINANCIAL PLANNING PROBLEMS, FINANCIAL PLANNING ACTIVITIES, AND LIFE SITUATION CASE CONCEPT QUESTIONS Concept Check 13-1 (p. 402) 1. What type of information about a mutual fund can be found on the Internet? Today, a great deal of information about mutual funds can be found on the Internet. Most investment companies sponsoring a mutual fund have a home page which provides general information and financial performance data about their funds. It is also possible to obtain detailed financial information about mutual funds that is provided by professional advisory services by accessing their Web sites. 2. What are two major reasons investors purchase mutual funds? The major reasons why investors purchase mutual funds are professional management and diversification. 3. How do a closed-end fund and an open-end fund differ? A closed-end fund is a fund of finite size whose shares are issued by an investment company only when the fund is organized. After all the shares originally issued have been sold, an investor can purchase shares only from another investor who is willing to sell them. These shares are traded on organized exchanges. An open-end fund is a mutual fund whose shares are issued and redeemed by the investment company at the request of investors. Investors are free to buy and sell shares at the net asset value. Some investment companies do charge a small commission in addition to the net asset value. 4. What are the typical fees charged for a load and no-load mutual fund? Fees for a load fund may be as high as 8 1/2 percent. A no-load fund is a mutual fund in which no sales charge is paid by the individual investor. 5. What are the typical management fees, and front and back load fees? The typical annual management fee for a mutual fund is a fixed percentage of the fund’s asset value and ranges between 0.5 and 4 percent per year. Contingent deferred sales load fees range from 1 to 6 percent. A fee is used to defer the costs of marketing, administration and management. Concept Check 13-2 (p. 404) 1. How important is the investment objective as stated in the fund’s prospectus? The managers of mutual funds tailor their investment portfolios to the investment objectives of their customers. As such, investors must make sure that their objectives and a prospective mutual fund’s objectives match. 2. Why do you think fund managers offer so many different kinds of funds? Fund managers know that investors have different objectives, and therefore, offer funds to match those objectives. 3. What is a family of funds? How is it related to shareholder exchanges? A family of funds exists when one investment company manages a group of mutual funds. Each fund within the family has a different financial objective. Generally, investors may give instructions to switch from one fund to another within the same family. 4. How does a market timer help people manage their mutual fund investments? A market timer is an individual who helps investors decide when to switch their investment from one fund to another fund—usually within the same family of funds. Concept Check 13-3 (p. 409) 1. Many financial experts say that purchasing a mutual fund is “too easy.” Do you think this statement is true or false? Explain. Certainly, investment companies do make it easy for investors to purchase shares in a mutual fund. Yet, it is still the investor’s money, and there is no substitute for conducting research when purchasing shares in a mutual fund. Simply put: the best investors are the ones who research their investments. 2. How can the following help you evaluate a mutual fund? a. b. c. d. e. f. Newspapers The fund’s objective The prospectus The annual report Financial publications The Internet Newspapers provide current information about a mutual fund’s net asset value, offer price, and change in net asset value. The fund’s objective should be described in the fund’s prospectus. Investors should make sure that there is a match between their objectives and the fund’s objectives. The prospectus contains a summary of the fund and information about fees, past financial performance, and the fund’s management. The annual report also contains detailed financial information on the fund’s assets and liabilities, statement of operations, and statement of changes in net asset value. The annual report also contains a schedule of investments and a letter from the fund’s independent auditors. Financial publications provide investors with another detailed source of information about mutual funds. The Internet can provide investors with current market values, information about the fund provided by the investment company sponsoring the fund, and by professional advisory services. Concept Check 13-4 (p. 413) 1. How can you make money when investing in mutual funds? Closed-end funds and open-end funds pay both income dividends and capital gain distributions. Also, it is possible to buy shares in both types of funds at a low price and then to sell them after the price has increased. The profit that results from this type of transaction is referred to as a capital gain. 2. What is the difference among income dividends, capital gains distributions, and capital gains? Income dividends are the earnings a fund pays to shareholders after it has deducted expenses from its dividend and interest income. Capital gain distributions are the payments made to a fund’s shareholders that result from the sale of securities in the fund’s portfolio. A capital gain results when a shareholder decides to sell shares in a mutual fund at a price that is higher than the price paid for the shares. 3. How are income dividends, capital gains distributions, and capital gains reported on your federal tax return? Income dividends are taxed in a special way. You receive a dividend tax credit that is calculated by “grossing up” the actual dividend by a certain percentage. Capital gains distributions and capital gains are taxed as regular income on your tax return. 4. Whom would you contact to purchase a closed-end fund? An open-end fund? Shares of a closed-end fund are traded through various stock exchanges, or in the over-the-counter market. You can purchase shares of an open-end fund through a salesperson, an account executive, or directly from the investment company that sponsors the fund. 5. What options can you use to purchase shares in a mutual fund from an investment company? The shares of a closed-end fund are traded on various stock exchanges. The shares of an open-end fund may be purchased through a salesperson that is authorized to sell them, through an account executive, or directly from the investment company. To purchase shares, investors may use these options: regular account transactions, voluntary savings plans, contractual savings plans, and reinvestment plans. 6. What options can you use to withdraw money from a mutual fund? Because closed-end funds are listed on securities exchanges, it is possible to sell shares in such a fund to another investor. Shares in an open-end fund can be sold on any business day to the investment company that sponsors the fund. Investors may also use these options to withdraw funds: (1) withdraw a specified, fixed dollar amount each investment period; (2) liquidate a certain number of shares each investment period; (3) withdraw a fixed percentage of asset growth; and (4) withdraw all income that results from income, dividends, and capital gains earned by the fund during an investment period. OPENING CASE QUESTIONS p. 393 1. Based on the information provided, do you think Sally made a good choice? Was her research adequate? Based on her objectives of low risk and moderate growth, her choice is fine. However, she should have researched other investment companies as well to compare their rates of return for mutual funds of the same asset class. 2 What other factors should she have taken into consideration before making her investment? The qualifications of the fund managers, the number of years they have been running the fund, the MER, commission charges (if any), special fees and the fund’s distribution policy should have been taken into consideration as well. FINANCIAL PLANNING PROBLEMS p. 415 1. Given the information below, calculate the net asset value for the Altamira Bond mutual fund. Total assets Total liabilities Total number of shares $225,000,000 5,000,000 4,400,000 The net asset value per share is equal to the current market value of the mutual fund’s portfolio minus the mutual fund’s liabilities divided by the number of shares outstanding. For the above information, the net asset value is $50 as calculated below. Net asset value = 225,000,000 - 5,000,000 = $50 per share 4,400,000 2. Given the information below, calculate the net asset value for the New Empire small cap mutual fund. Total assets Total liabilities Total number of shares $350,000,000 10,000,000 17,000,000 The net asset value per share is equal to the current market value of the mutual fund’s portfolio minus the mutual fund’s liabilities divided by the number of shares outstanding. For the above information, the net asset value is $20 as calculated below. Net asset value = 350,000,000 - 10,000,000 = $20 per share 17,000,000 3. Jane Tong invested $15,000 in the ADA Diversified Futures Mutual Fund. The fund charges a 5.50 percent commission when shares are purchased. Calculate the amount of commission that Jane must pay. Jane must pay $825 for commissions as illustrated below. $825 Commission = $15,000 x 0.055 4. Tony Matteo invested $9,800 in the CI Harbor growth and income fund. The fund charges 5.3 percent commission when shares are purchased. Calculate the amount of commission Tony must pay. Tony must pay $519.40 for commissions as illustrated below. $519.40 = $9,800 × 0.053 5. Chris Lavigne invested a total of $8,500 in AIC Diversified Canadian Mutual Fund. The management fee for this particular fund is 2.38 percent of the total investment amount. Calculate the management fee that Chris must pay this year. $8,500 total investment × 0.0238 = $202.30 management fee 6. Mary Canfield purchased the All-Canadian Compound bond fund. While this fund doesn’t charge a front-end load, it does charge a contingent deferred sales fee of 4 percent for any withdrawals for the first five years. If Mary withdraws $6,000 during the second year, how much is the contingent deferred sales load? Ms. Canfield must pay a $240 contingent deferred sales fee, as illustrated below. $240 = $6,000 × 0.04 7. This chapter classified mutual funds into different categories based on the nature of their investments. Using the following information, pick a mutual fund category that you consider suitable for each of the investors described below and justify your choice. (pp. 400-402) a. A 25-year-old single investor with a new job that pays $30,000 a year. Mutual fund category ___________________________________________________________ Why _________________________________________________________________________ b. A single parent with two children who has just received a $100,000 divorce settlement, has no job, and has not worked outside the home for the past five years. Mutual fund category ____________________________________________________________ Why _________________________________________________________________________ c. A husband and wife who are both in their early 60s and retired. Mutual fund category ___________________________________________________________ Why _________________________________________________________________________ a. Because this investor is young (25), has a job that pays $30,000 a year, and there is no mention of family responsibilities, a mutual fund that stresses growth potential is a good choice. Growth funds invest in the common stocks of well-managed, rapidly growing corporations. b. Because this investor is a single parent with two children, no job, and hasn’t worked outside of the home for the past five years, a mutual fund that stresses growth and income is a good choice. Growth and income funds invest in stocks that provide for increases in value and dividend growth. (Note: Because of this investor’s situation, safety and preservation of capital are additional concerns.) c. Because these investors are in their 60s and retired, a mutual fund that stresses both safety and income is a good choice. Mutual funds in this category include some balanced funds, some corporate bond funds, some growth and income funds, and municipal bond funds. Today, many financial experts would recommend that a small portion of this couple’s portfolio be invested in growth funds. 8. Over a four-year period, Matt Ewing purchased shares in the Barreau du Quebec Canadian Equity Fund. Using the information below, answer the following questions. You may want to review the concept of dollar-cost averaging in Chapter 11 before completing this problem. Year 2004 2005 2006 2007 Investment Amount $3,000 $3,000 $3,000 $3,000 Price per share $40 per share $50 per share $60 per share $45 per share a. At the end of four years, what is the total amount invested? At the end of four years, Mr. Ewing has invested a total of $12,000 ($3,000 x 4 years = $12,000). b. At the end of four years, what is the total number of mutual fund shares purchased? At the end of four years, Mr. Ewing owns 251.7 shares, as illustrated below. 2004 = 2005 = 2006 = 2007 = $3,000 ÷ 40 $3,000 ÷ 50 $3,000 ÷ 60 $3,000 ÷ 45 = = = = 75.0 shares 60.0 shares 50.0 shares 66.7 shares 251.7 shares c. At the end of four years, what is the average cost for each mutual fund share? At the end of four years, the average cost for each mutual fund share is $47.68, as illustrated below. $12,000 ÷ 251.7 shares = $47.68 FINANCIAL PLANNING ACTIVITIES p. 415 1. Assume that you are 35, are divorced, and have just received a $120,000 legal settlement. Prepare a two-page report on the major reasons you want to invest in mutual funds. The major reasons why investors purchase mutual funds are professional management and diversification. It is also easy to invest in mutual funds. The major disadvantage of a mutual fund investment is that fund managers do make mistakes. Therefore, it is the investors’ responsibility to evaluate any mutual fund investment. When responding to this question, students should take into consideration that this investor is 35 and divorced. These two factors may indicate that the investor should consider mutual funds that are more conservative. 2. Using recent newspapers, magazines, mutual fund reports, or the Internet, find examples of the following concepts. a. b. c. d. e. The net asset value of a mutual fund An example of a load fund An example of a no-load fun The management fee for a specific mutual fund A fund that charges a contingent deferred sales load Student answers for this question will vary depending on the source of their information and the funds they choose. 3. Assume that you are single, 28 years old, and have decided to invest $8,000 in mutual funds. a. Prepare a chart that shows the typical charges for load funds, no-load funds, and management fees. Student answers for this question should include the information presented in Exhibit 13-3. b. Calculate the following fees for your $8,000 mutual fund investment: (1) a 5 percent load charge, (2) an annual 0.50 percent management fee. The following fees would apply to the original $8,000 investment 1. $8,000 × 0.05 = $400 load charge 2. $8,000 × 0.005 = $40 annual management fee 4. This chapter explored a number of different classifications of mutual funds. a. Based on your age and current financial situation, which type of mutual fund seems appropriate for your investment needs? Explain your answer. Student answers will vary depending on their age and investment philosophy. For someone in their twenties, investments should provide the type of long-term growth possibilities that will enable them to grow their retirement nest egg over a long period of time. b. As people get closer to retirement their investment goals often change. Assume that you are now 45 years old and have accumulated $110,000 in a retirement account. In this situation, what type of mutual fund would you choose? Why? As people get older, they tend to choose investments that are more conservative. Since most people don’t retire until they are 60 to 65, you still have a number of years for your investments to appreciate. Perhaps conservative mutual funds that emphasize both growth and income could be chosen. c. Assume that you are now 60 years of age and have accumulated $400,000 in a retirement account. Also, assume you would like to retire when you are 65. What type of mutual funds would you choose to help you reach your investment goals? Why? The fact that you are now 60 should be taken into consideration. More conservative mutual funds that emphasize preservation of capital and predictable sources of income are a wise choice for people who are near retirement age. While it is still desirable to have some growth component in their portfolio, investors tend to be concerned with safety. 5. Obtain specific information on either the Fidelity Disciplined Equity Class mutual fund or the Fidelity Canadian Short Term Bond-A fund. Then describe how each source of information could help you evaluate a mutual fund. a. b. c. d. e. f. g. Newspapers The fund’s investment objective The fund’s prospectus The fund’s annual report Financial publications The Internet After researching one of the Fidelity funds, would you invest in the fund? Why or why not? a. Newspapers report current information on a mutual fund’s net asset value, offer price, and change in net asset value on a daily basis. Many newspapers also offer information on a fund’s past performance. b. The fund’s objective for a mutual fund should match the personal objectives of the investor. c. The fund’s prospectus for a mutual fund is available to prospective investors and contains a fee table and other information that can be used to evaluate a mutual fund investment. d. The fund’s annual report contains detailed financial information on the fund’s assets and liabilities, statement of operations, and statement of changes in net asset value. It should also include a schedule of investments and a letter from the fund’s independent auditors. e. Financial publications like Canadian Business, Report on Business and other investor-oriented magazines provide information on the performance of many mutual funds. f. The Internet can provide current market values for mutual funds and access to the home page provided by the investment company sponsoring a mutual fund, and online research reports provided by professional advisory services. g. Student answers will vary. 6. Choose one of the following mutual funds and use information from newspapers, magazines, mutual fund reports, or the Internet to complete the mutual fund evaluation form presented in the “Financial Planning Calculations feature”. Then answer the questions below. Name of the fund AIM Canadian Premier Altimara Health Sciences Dynamic APEX Balances BMO Emerging Markets AIC Diversified Canada Type of fund Large-cap equity Specialty Balanced Emerging markets Canadian equity a. Which fund did you choose? b. Why did you choose this fund? c. Do you think that fund could help you achieve your investment objectives? Explain your answer. Student answers will vary for each of the three questions depending on which fund they chose and the information they obtained about the fund. You may want to point out that if they were not satisfied with one of the above funds, there are other mutual funds that might meet their investment objectives. 7. In a one-page report, explain how the concept of dollar-cost averaging applies to the options used to purchase mutual funds. Dollar-cost averaging allows the investor to average many individual purchase prices over a long period of time. Thus, the investor avoids the problem of buying high and selling low. Investors who use dollar cost averaging can make money if they sell their mutual fund shares at a price higher than their average purchase price. 8. Obtain a mutual fund prospectus to determine the options you can use to purchase and redeem shares. Then prepare a chart that illustrates which options can be used to purchase and redeem shares in the fund, and answer the following two questions. a. Which purchase options would appeal to you? b. Assuming that you are now of retirement age, which of the withdrawal options would appeal to you? Answers for the above questions will vary depending on the mutual fund chosen by the student. And yet, most mutual funds offer the following options for purchasing shares: regular accounts, voluntary savings plans, contractual savings plans, and reinvestment plans. Most mutual funds also offer the following withdrawal options: withdraw a specified, fixed dollar amount each investment period, liquidate or sell off a certain number of shares each investment period, withdraw a fixed percent of asset growth each investment period, or withdraw all income that results from interest, dividends, and capital gains. LIFE SITUATION CASE The Wrong Mutual Fund? (p. 417) 1. Often investors indicate that diversification and professional management are the two main reasons they choose mutual fund investments. How important do you consider these two factors? Why? Diversification and professional management are very good reasons why investors purchase mutual funds. And although diversification provides a measure of safety and fund managers are professionals, investors still need to evaluate mutual funds like they would any other investment. 2. According to the Racines, everybody was investing in mutual funds – indeed, it seemed almost fashionable to invest in mutual funds. In your own words, what did the Racines do wrong? The Racines admitted that they invested in the All-Canadian Resource Mutual Fund without researching their investment. They made their choice because they heard a “high-powered” financial planner on a radio show talk about gold as the ultimate safe investment. In fact, the Racines would have purchased the gold coins the talk show host was selling, but Mike lost the 800 phone number. For lack of some other way to invest in gold, they decided to purchase shares in a gold mutual fund. 3. Obtain information about a reputable mutual fund at the library or via the Internet. Then complete a mutual fund evaluation form (see the “Financial Planning Calculations” feature on page 409 ) for this fund and answer the following questions. a. b. c. d. What sources of information did you use to evaluate the fund? What fees must investors pay to invest in the fund? What is the investment objective for the fund? How would you describe the fund’s financial performance over the past 12 months? The past three years? The past five years? e. How would you rate the risk associated with the fund? f. Would you invest your money in this fund? Justify your answer. Although student answers will vary, they should be prepared to defend their decision to invest or not in their fund. It would be possible for student to use any of the sources described in this chapter to evaluate their fund. COMMENTS ON CONTINUOUS CASE FOR PART 4 (p. 418) Building an Investment Program 1. How would you rate the Mortimers’ financial condition at this stage in their lives? The Mortimers are only 20 years away from retirement. The current value of Isaac’s retirement program is $110,000. They also have about $36,000 invested in conservative stocks and mutual funds. And they have accumulated enough money to pay for their children’s education. Finally, they have established a $5,000 emergency fund. While the Mortimers could be in worse shape, they must work hard, make wise financial decisions, and invest wisely to ensure that they have enough money to do the things they want to when Isaac does retire. 2. Given the fact that Pamela is 43 and Isaac is 45 and they have three children who will soon begin their post-secondary education, what investment goals would be most appropriate for this middleaged couple? Given their current financial condition, the Mortimers must develop goals that provide for their retirement. The fact that it will be 20 years before they retire is significant. Because they have this much time for their investments to grow, they can choose more conservative investments that are not as speculative. 3. According to Pamela, “We both know we should have started our investment program sooner, but we always seemed to have ‘emergencies’ that took what ‘extra’ money we had.” Many investors feel the same way and, to compensate for a late start, often invest in highly speculative investments that promise large returns. Would you recommend such investments to a couple like the Mortimers? Explain your answer. While student answers may vary, get-rich-quick schemes and highly speculative investments are usually wrong for a couple like the Mortimers. This couple has already established an investment program, and they are aware of the need for long-range retirement planning. They should resist the temptation to trade their conservative investments for highly speculative investments. 4. Describe the investment portfolio that you would recommend for the Mortimers. Be sure to include specific types of investments (stocks, bonds, mutual funds, etc.) as well as information about the risk factor(s) associated with each investment alternative. While student answers may vary, it is important to stress the fact that the Mortimers are approximately 20 years away from retirement. Currently, they already have a retirement program and have established a small investment program. Therefore, conservative investments should be used to reduce risk and provide steady growth over the next 20 years. 14 RETIREMENT PLANNING CHAPTER OVERVIEW As increasing numbers of Canadians join the 65-and-over ranks, Canada faces a serious question—is this country prepared to meet the demands of a growing elderly population? The evidence that Canada is growing older is clear. In the last two decades, the 65-and-over population grew twice as fast as the rest of the population. We begin this chapter by recognizing the importance of retirement planning. We show how individuals can analyze their current assets and liabilities to make sure they are suitable for retirement. Then, we suggest that individuals estimate their needs by considering changes in spending patterns and where and how they live. Next, we describe various types of housing suitable for retirees. In estimating retirement expenses, we emphasize that expenses should be adjusted for inflation. Once expenses are estimated, we then turn to the importance of evaluating planned retirement income. Income from the Canada Pension Plan, Quebec Pension Plan, other public pension plans, employer pensions plans, and personal retirement plans. Finally, we stress the need for living on retirement income and balancing the retirement budget. LEARNING OBJECTIVES CHAPTER SUMMARY After studying this chapter, students will be able to: Obj. 1 Recognize the importance of retirement planning. Retirement planning is important because you will probably spend many years in retirement; public pensions and a private pension may be insufficient to cover the cost of living; and inflation may erode the purchasing power of your retirement savings. Many young people are reluctant to think about retirement, but they should start retirement planning now, before they reach age 40. Obj. 2 Analyze your current assets and liabilities for retirement. Analyze your current assets (everything you own) and your current liabilities (everything you owe). The difference between your assets and your liabilities is your net worth. Review your assets to make ensure they are sufficient for retirement. Obj. 3 Estimate your retirement spending needs. Since the spending patterns of retirees change, it is impossible to predict the exact amount of money you will need in retirement. However, you can estimate your expenses. Some of those expenses will increase; others will decrease. The expenses that are likely to be lower or eliminated are work-related expenses, clothing, housing expenses, federal income taxes, and community expenses. LEARNING OBJECTIVES CHAPTER SUMMARY Obj. 4 Identify your retirement housing needs. Where you live in retirement can influence your financial needs. You are the only one who can determine the location and housing that are best for you. Would you like to live in your present home or move to a new location? Consider the social aspects of moving. Obj. 5 Determine your planned retirement income. Estimate your retirement expenses, and adjust those expenses for inflation using the appropriate inflation factor. Your possible sources of income during retirement include the CPP, other public pension plans, employer pension plans, and personal retirement plans. Obj. 6 Develop a balanced budget based on your retirement income. Compare your total estimated retirement income with your total inflated retirement expenses. If your income approximates your expenses, you are in good shape; if not, determine additional income needs and sources. INTRODUCTORY ACTIVITIES • Ask students to comment on the opening case for the chapter (p. 420). • Point out the learning objectives for the chapter (p. 420). • Ask students to share various attitudes toward retirement planning. • Discuss the methods that can be used to easily build a retirement fund. CHAPTER 14 OUTLINE I. Why Retirement Planning? A. Tackling the Trade-Offs B. The Importance of Starting Early C. The Basics of Retirement Planning II. Conducting a Financial Analysis A. Review Your Assets III. Retirement Living Expenses A. Adjust Your Expenses for Inflation IV. Planning Your Retirement Housing A. Type of Housing B. Avoiding Retirement Housing Traps V. Planning Your Retirement Income A. Public Pensions B. Employer Pension Plans C. Personal Retirement Plans D. Will You Have Enough Money during Retirement? VI. Living on Your Retirement Income A. Tax Advantages B. Working during Retirement C. Investing for Retirement D. Dipping into Your Nest Egg CHAPTER 14 LECTURE OUTLINE Instructional Suggestions WHY RETIREMENT PLANNING (p. 421) • • Retirement can be a rewarding phase of your life, but you must plan ahead for it. While it is never too late to begin sound financial planning, you can avoid many unnecessary and serious difficulties by starting this planning early. • Discussion Question: What financial and personal difficulties are associated with inadequate retirement planning? • Supplementary Resource: Find the tools you need to see if you’re on track using Web sites in Exhibit 14-2 (p. 423). • Exercise: Have students suggest actions that can be taken at different stages of the adult life cycle to have a financially successful retirement. • Assignment: Have students talk to retired persons to obtain information on areas that are frequently overlooked when doing retirement planning. • Exercise: Create a list of nonfinancial actions that a person can take to plan for a fulfilling retirement. • Concept Check 14-1 (p. 423) • Concept Check 14-2 (p. 425) Tackling the Trade-Offs (p. 422) • • “You can’t have your cake and eat it too” is particularly true in planning for your retirement. Only saving now and curtailing current spending can ensure comfortable retirement later. The Importance of Starting Early (p. 422) • • Start early, but don’t let your 45th birthday roll by without a comprehensive retirement plan. Financial planning for retirement is critical for several reasons: ∗ You can expect to live in retirement for many years. ∗ Government benefits and a private pension may be insufficient to cover the cost of living. ∗ Inflation may diminish the purchasing power of your retirement savings. The Basics of Retirement Planning (p. 423) • • The first step is to analyze your current assets and liabilities. Then estimate spending needs and adjust them for inflation. Finally, evaluate your planned retirement income and increase it if necessary. CONDUCTING A FINANCIAL ANALYSIS (p. 423) • The difference between your assets and your liabilities is your net worth. Use Exhibit 14-3 (p. 425) to calculate your net worth now and at retirement. Review Your Assets (p. 424) • • • • Housing: If you own your house, it is probably your biggest single asset. Life Insurance: You may want to convert some of this asset into cash or income (an annuity). Other Investments: Evaluate any other investments you may have. A Reverse Annuity Mortgage (RAM) is a loan based on the equity in a home that provides elderly CHAPTER 14 LECTURE OUTLINE Instructional Suggestions home-owners with tax-free income and is paid back with interest when the homeowner dies. RETIREMENT LIVING EXPENSES (p. 425) • Exercise: Create a list of factors that influence the spending patterns of retired individuals. • Text Highlight: Exhibit 14-4 (p. 426) shows how an average household, 65 years and over, spends its money. • Text Highlight: Use the worksheet in Exhibit 14-5 (p. 429) to list your present expenses and estimate what these expenses would be if you were retired. • Text Highlight: Use the inflation factor in the “Financial Planning Calculations” feature to estimate what your monthly and annual expenses will be when you retire. (p. 429) • Concept Check 14-3 (p. 428) PLANNING YOUR RETIREMENT HOUSING (p. 429) • • Discussion Question: What factors influence the type of housing selected by individuals? • Exercise: Debate the issue of a retired person continuing to live in the same area as opposed to moving to a different geographic area. • Discussion Question: What actions should be taken by federal and state government agencies to protect people from deceptive land sales and fraudulent housing developments? • Concept Check 14-4 (p. 431) • Discussion Question: What types of retirement income should be the main emphasis of a retirement program? • • Your spending patterns will probably change. The following expenses may be lowered or eliminated: ∗ Work expenses ∗ Clothing expenses ∗ Housing expenses ∗ Federal income taxes Some of the following expenses may increase: ∗ Insurance ∗ Medical expenses ∗ Expenses for leisure activities ∗ Gifts and contributions Adjust Your Expenses for Inflation (p. 428) • The possible loss of buying power due to inflation is what makes planning ahead so important. Where you live in retirement can influence your financial needs. Type of Housing (p. 429) • Caveat Emptor: If you buy land for a retirement home, be sure you know what you are doing. Avoid Retirement Housing Traps (p. 430) • You have to do the proper research before making the move. Get economic profile and property tax information, subscribe to a local newspaper, call an accountant to see if taxes are rising, check to estimate energy costs, rent for a while instead of buying immediately. PLANNING YOUR RETIREMENT INCOME (p. 431) • Possible sources of income are public pension plans, CHAPTER 14 LECTURE OUTLINE employer pension plans, personal retirement plans, and annuities. Instructional Suggestions • Assignment: Survey retired individuals or people close to retirement to obtain information on their main sources of retirement income. • Discussion Question: What actions might be appropriate by government and individuals to guarantee the continuing financial stability of the CPP? • Text Highlight: Point out Exhibit 14-6 (p. 431) to show Canada Pension Plan payment rates from January to December 2008. • Text Reference: Contrast the difference between a defined contribution plan and a defined benefit plan • Text Highlight: Point out Exhibit 14-8: “Know Your Pension Plan Checklist” (p.435) • Assignment: Survey local businesses to determine the types of retirement plans available to employees. • Text Highlight: Exhibit 14-9 shows the power of tax-deferred compounding of earnings. (p. 435) Public Pensions (p. 431) • • • Federal programs are the major source of public retirement pensions, but most provinces and the territories also provide income supplements for residents in financial need. Canada’s retirement income system has three levels: OAS (Old Age Security), CPP (Canadian Pension Plan), QPP (Quebec Pension Plan), SPA (Spouse’s Allowance), and GIS (Guaranteed Income Supplement). Although government programs are the most widely used source of retirement income, they should not be the only source. Employer Pension Plans (p. 434) • • • • • Most employer plans are defined-benefit or definedcontribution plans. ∗ A defined-contribution plan has an individual account for each employee; therefore, these plans are sometimes called money-purchase pension plans. In a defined-benefit plan, the plan document specifies the benefits promised to the employee at the normal retirement age. A Deferred Profit Sharing Plan (DPSP) is a form of retirement saving set up for contributions from the employer only. The contribution made to a DPSP is subtracted from your allowable RRSP contribution. A Group RRSP is set up for a particular company’s employees. Although its advantage lies in its liquidity, it may provide smaller returns than would a company pension plan. Recent legislation has enforced pension portability, allowing employees to transfer their pension credits from one employer to another. Personal Retirement Plans (p. 436) • • The most popular personal retirement plan is an RRSP. An RRSP is an investment vehicle that allows you to shelter your savings from income taxes. The principal motive behind RRSPs is to defer your income taxes to a time when your marginal rate of taxation will be less. CHAPTER 14 LECTURE OUTLINE • • • • • • Canada’s federal Income Tax Act allows you to register only certain specified investments as RRSPs. Other restrictions include contribution limits and early withdrawal penalties. Qualified investments can be divided into three categories. Guaranteed funds ensure the return of your principal plus a guaranteed rate of return. Mutual funds have no guarantee regarding rate of return or safety of principal. Life insurance and life annuity products can only be purchased from life insurance companies, as opposed to the previous two, which are available at most financial institutions. There are several types of RRSPs. The most commonly held is a regular RRSP. The second main type is a self-directed RRSP, and another type is a spousal RRSP. If you have earned income in a given year you can contribute to your RRSP, but the amount allowable is subject to a maximum set by the government. In the event that you are unable to make your full contribution to the plan, you are allowed to “carry forward” the full amount of unpaid contribution to a later year. Your RRSP must be deregistered by the end of the year of your 71st birthday. At that point, you will have six choices as to what to do with your funds. ∗ Withdraw the funds and pay the income tax. ∗ Purchase a single-payment life annuity. ∗ Purchase a fixed-term annuity. ∗ Set up a Registered Retirement Income Fund (RRIF) ∗ Set up a Life Income Fund (LIF). ∗ Set up a segregated fund. Will You Have Enough Money During Retirement? (p. 443) • Instructional Suggestions Estimate what your annual retirement income will be. Now compare your total estimated retirement income with your total inflated retirement expenses. If your estimated income exceeds your estimated expenses and a large portion of your planned income will automatically increase with the cost of living during your retirement, you are in good shape. • Assignment: Have students suggest the best investment vehicles for an individual retirement account. • Assignment: Have students talk to representatives of various financial institutions to determine their suggestions for RRSP investments. • Concept Check 14-5 (p. 443) • Supplementary Resource: Have students contact Human LIVING ON YOUR RETIREMENT INCOME (p. 443) l You may find your actual expenses at retirement CHAPTER 14 LECTURE OUTLINE l l l l higher than anticipated. There are several ways of stretching your retirement income to make sure you are receiving all of the income to which you are entitled. You should be sure to take full advantage of all the tax savings available to retirees. You may want to work part-time or start a new parttime career after you retire. You should therefore be aware of how your earnings will affect your public pension income. The guaranteed-income part of your retirement fund consists of money paid into lower-yield very safe investments. To offset inflation, your retirement assets must earn enough to keep up with, and even exceed, the rate of inflation. Your savings may be large enough to allow you to live comfortably on the interest alone. If not, you may need to make regular withdrawals to help finance your retirement. Although dipping into your savings is not wrong, you must do so with caution. Instructional Suggestions Resources and Development Canada at www.hrdc-drhc.gc.ca for additional information on available options. • Text Highlight: To determine how long your savings would last by withdrawing monthly amounts, refer to Exhibit 14-11. (p. 439) • Text Highlight: Exhibit 14-12 summarizes major sources or retirement income and their advantages and disadvantages. (p. 442) • Concept Check 14-6 (p. 445) CONCLUDING ACTIVITIES • Point out the chapter summary (pp. 446-447) and key terms in text margin. • Discuss selected end-of-chapter Financial Planning Problems, Financial Planning Activities, and Life Situation Case. • Use the Chapter Quiz in the Instructor’s Manual. CHAPTER 14 QUIZ ANSWERS True-False 1. F 2. T 3. T 4. F 5. T 6. T 7. T 8. T Multiple Choice 9. D 10. C 11. D 12. C 13. C 14. B 15. C 16. C Name ________________________________________ Date____________________________ CHAPTER 14 QUIZ TRUE-FALSE _____1. “You can have your cake and eat it too” is particularly true in planning for retirement. _____2. _____3. A CHIP lifetime reverse mortgage is designed exclusively for homeowners age 60 and over. Public pensions are the most widely used source of retirement income. _____4. At age 65, CPP benefits are paid automatically. _____5. Most employer plans are defined-contribution or defined-benefit plans. _____6. RRSP is an investment vehicle that allows you to shelter your savings from income taxes. _____7. When estimating your annual retirement income, it is important to include inflation. _____8. Survivor allowance gives benefits that are payable to widows, widowers and the spouses of OAS beneficiaries who are between 60-65 years old. MULTIPLE CHOICE _____9. Which of the following is not a retirement planning misconception? a. My expenses will drop when I retire b. My retirement will only last 15 years c. My pension benefits will increase to keep up with inflation d. I can’t depend on the government to help me. _____10. What is considered the critical age to begin financial planning for retirement? a. 25 b. 35 c. 45 d. 55 _____11. The first step in retirement planning is to a. Estimate your spending needs. b. Estimate the inflation rate. c. Evaluate your planned retirement income. d. Analyze your current assets and liabilities. _____12. At retirement, the following expenses may decrease a. expenses for leisure activities b. medical expenses c. federal income taxes d. insurance _____13. Vesting is the most important aspects of which plan? a. CPP b. OAS c. Defined-contribution d. New Seniors Benefit _____14. When you are about to turn 70 years old and own RRSPs, which of the following is NOT an option? a. Withdraw the funds and pay income tax. b. Keep the funds in the RRSP. c. Purchase a single-payment life annuity. d. Set up a segregated fund. _____15. How long can you expect to live in retirement? a. 5 years b. 10 years c. 20 years d. 25 years _____16. Which of the following is not a good tip to avoid falling into retirement housing traps? a. Get an economic profile on the area b. Find out if taxes are rising c. Buy immediately d. Estimate energy costs SUPPLEMENTARY CASE Jim Monitz, 52, plans to retire at age 65. To supplement his income at retirement, he starts to save $100 at the beginning of each month. Assuming that his annual return on savings is eight percent, what amount will Jim have accumulated at age 65? How big will the nest egg be if Jim could earn an annual return of 10 percent? Use the table here to find the amounts. Building Your Nest Egg This table shows how much you’ll have at the end of a period of year if you save or invest $100 a month, assuming various annual returns. Other amounts can be calculated as fractions or multiples of $100. (Table assumes $100 is saved at the beginning of each month.) Year 5.5% 7% 8% 9% 10% 12% 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 1,236 2,542 3,922 5,380 6,920 8,546 10,265 12,080 13,998 16,024 18,164 20,425 22,814 25,337 28,002 30,818 33,793 1,246 2,583 4,016 5,553 7,201 8,968 10,863 12,895 15,073 17,409 19,914 22,601 25,481 28,569 31,881 35,432 39,240 1,253 2,611 4,018 5,673 7,397 9,264 11,286 13,476 15,848 18,417 21,198 24,211 27,474 31,008 34,835 38,979 43,468 1,260 2,638 4,146 5,795 7,599 9,572 11,730 14,091 16,672 19,497 22,586 25,964 29,660 33,703 38,124 42,961 48,251 1,267 2,667 4,213 5,921 7,808 9,893 12,196 14,740 17,550 20,655 24,085 27,874 32,060 36,684 41,792 47,436 53,670 1,281 2,724 4,351 6,183 8,249 10,576 13,198 16,153 19,482 23,234 27,461 32,225 37,593 43,642 50,458 58,138 66,792 18 19 20 21 22 23 24 25 26 27 28 29 30 36,936 40,255 43,762 47,467 51,381 55,516 59,884 64,498 69,373 74,522 79,962 85,709 91,780 43,323 47,702 52,397 57,431 62,829 68,617 74,824 81,480 88,616 96,269 104,475 113,274 122,709 48,329 53,593 59,295 65,469 72,157 79,399 87,242 95,737 104,936 114,899 125,689 137,374 150,030 54,037 60,367 67,290 74,862 83,145 92,204 102,114 112,953 124,809 137,777 151,962 167,477 184,447 60,557 68,165 76,570 85,855 96,122 107,443 199,961 133,789 149,066 165,942 184,585 205,180 227,933 76,544 87,533 99,915 113,867 129,590 147,306 167,269 189,764 215,111 243,674 275,858 312,125 352,991 Answers: Jim has 13 years to retirement. At eight percent, the nest egg will be $27,474 in 13 years. At 10 percent, the amount will be $32,060. ANSWERS TO CONCEPT QUESTIONS, OPENING CASE QUESTIONS, FINANCIAL PLANNING PROBLEMS, FINANCIAL PLANNING ACTIVITIES, AND LIFE SITUATION CASE CONCEPT QUESTIONS Concept Check 14-1 (p. 423) 1. Why is retirement planning important? Financial planning for retirement is vitally important for several reasons. You can expect to live in retirement for many years. Public and private pensions may be insufficient to cover the cost of living, and inflation may erode the purchasing power of your retirement savings. 2. What are the four basic steps of retirement planning? The first step is to analyze your current assets and liabilities. Then estimate your spending needs and adjust them for inflation. Next, evaluate your planned retirement income. Finally, increase your income if necessary. Concept Check 14-2 (p. 425) 1. How can you calculate your net worth now and at retirement? As you learned in Chapter 4, your current assets include everything you own that has value: cash on hand and in checking and savings accounts; the current value of your stocks, bonds, and other investments; the current value of your house, car, jewelry, and furnishings; and the current value of your life insurance and pensions. Your current liabilities are everything you owe: your mortgage, car payments, credit-card balances, taxes due, and so forth. The difference between the two totals is your net worth, a figure that you should increase each year as you move toward retirement. Use Exhibit 14-3 to calculate your net worth now and at retirement. Concept Check 14-3 (p. 428) 1. How can you estimate the amount of money you’ll need during retirement? The exact amount of money you will need in retirement is impossible to predict. However, you can estimate the amount you will need by considering the changes you plan to make in your spending patterns and in where and how you live. Exhibit 14-5 can help you in anticipating your own future spending patterns. 2. What expenses are likely to increase or decrease during retirement? The expenses that are likely to be lower or eliminated are work related expenses, clothing expenses, housing expenses, and federal income taxes. Insurance, medical expenses, expenses for leisure activities, and gifts and contributions are likely to increase. The spending pattern changes because your mode of living during retirement changes. 3. How might you adjust your expenses to inflation? By using the inflation factor in the Financial Planning Calculations feature, you can estimate what your monthly and annual expenses will be when you retire. Concept Check 14-4 (p. 431) 1. What are some housing options for retirees? Everyone has particular needs and preferences; you are the only one who can determine what location and housing are best for you. 2. How can retirees avoid retirement housing traps? Too many people make the move without doing enough research. Refer to page 430 for a list of tips from retirement specialists on how to uncover hidden taxes and other costs. Concept Check 14-5 (p. 443) 1. What are possible sources of income for retirees? Various sources of retirement income are public pensions, employer pension plans, and personal retirement plans. Public pensions are the most widely used source of retirement income for most Canadians. 2. How do defined-contribution plans differ from defined-benefit plans? In a defined-benefit plan, the plan document specifies the benefit promised to the employee at the normal retirement age. A defined-contribution plan has an individual account for each employee; therefore, these plans are sometimes called money purchased pension plans. 3. What options do you have for deregistering your retirement investments? The options available are to withdraw the funds and pay income tax, purchase a single-payment life annuity, purchase a fixed-term annuity, set up a RRIF, a LIF, or a segregated fund. Concept Check 14-6 (p. 445) 1. What’s the first step in stretching your retirement income? The first step in stretching your retirement income is to make sure you are receiving all of the income to which you are entitled. Examine the possible sources of retirement income mentioned earlier to see whether there are more programs or additional benefits that you could qualify for. What assets or valuables could you use as a cash or income source? 2. How should you invest to obtain retirement income? To offset inflation, your retirement assets must earn enough to keep up with, and exceed, the rate of inflation. OPENING CASE QUESTIONS (p. 420) 1. What were Meg Hansen’s and Andrew Belanger’s concerns about retirement income? Meg and Andrew discovered that they would have to play catch-up to have a comfortable retirement. 2. Why did they close their home-renovation business? Meg and Andrew wanted careers that would provide steadier incomes. 3. What document served as the couple’s wake-up call? The couple was awaken by their CPP statement of contributions. 4. How can the Internet assist you in retirement planning? Visit www.ccra-adrc.gc.ca. The students’ answers will vary. FINANCIAL PLANNING PROBLEMS (p. 446) 1. Prepare your net worth statement using the guidelines presented in Exhibit 14-3. The purpose of this activity is to review one’s assets to make sure they are suitable for retirement. After thoroughly reviewing assets, one can estimate spending needs during the retirement years. 2. How will your spending patterns change during your retirement years? Compare your spending patterns with those shown in Exhibit 14-4. Spending patterns will probably change. Statistics Canada offers information on how families spend money. Retired families use a greater share for food, housing, and medical care than nonretired families. Refer students to Exhibit 14-4. 3. Jean and Dan Sladek both work. Each earns a salary of $30,000, but only Jean is a member of a registered pension plan. Both she and her employer contribute 2% of her gross salary to a defined contribution pension plan. Dan has $15,000 of unused contribution room carried forward since 1991. Calculate the maximum RRSP contribution that each can make. (Obj. 5) Jean = [0.18][$30,000] – [(2)(0.02)($30,000)] = $5,400 - $1,200 = $4,200 Dan = [0.18][$30,000] + $15,000 = $5,400 + $15,000 = $20,400 4. Assume that your gross pay per pay period is $2,000 and that you are in the 26 percent tax bracket (ignore provincial taxes). Calculate your net pay and spendable income in the following situations: a. You save $200 per pay period after paying income tax on $2,000. b. You save $200 per pay period in a RRSP. a. After-tax saving method: 5. Taxable Pay Tax $2,000 $520 b. Tax-sheltered method: Net Pay $1,480 Savings $200 Spendable Income $1,280 Taxable Pay $1,800 = $2,000 $200 Net Pay $1,332 Savings $200 Spendable Income $1,132 Tax $468 Your grandfather is turning 71 and he must deregister his remaining RRSP funds of $200,000 this year. Both your grandparents are in good health and they have enough income from your grandfather’s current monthly RRIF payments to meet their expenses. He would like to minimize the tax burden of this withdrawal, and enjoy some growth potential while keeping the principal safe. He would also like to have some liquidity in the event of an emergency. He knows you are taking a personal finance course and asks for your advice. How would you advise him? Explain your rationale. Although he could buy an annuity, which would be tax-free, the entire amount of each annuity received would be taxed. While this solution is simple, his income preference suggests some growth potential, which the annuity would not provide. He would be better advised to consider buying a segregated fund, which will not attract tax on transfer, but depending on his tolerance for risk provide growth potential while keeping his principal safe. 6. You have $50,000 in your retirement fund that is earning 5.5 percent per year, compounded quarterly. How many dollars in withdrawals per month would reduce this nest egg to zero in 20 years? How many dollars per month can you indefinitely and still leave this nest egg intact? Referring to Exhibit 14-11, students will find that at a withdrawal rate of $340 a month, the nest egg of $50,000 will be reduced to zero in 20 years. But at 5.5 percent interest, compounded quarterly, one can take $230 a month indefinitely and still leave the $50,000 nest egg intact. FINANCIAL PLANNING ACTIVITIES (p. 447) 1. Survey friends, relatives, and other people to get their views on retirement planning. Prepare a written report of your findings. Views on retirement planning will vary among the individuals surveyed. Many young professionals would rather spend money today than save for retirement. Prosperous and educated people want the good life now. Many interviewees probably have not yet begun to save seriously for retirement. 2. Obtain consumer information about reverse mortgages in the Royal Bank’s Your Money Matters, available in all Royal Bank branches or online at www.royalbank.com. Evaluate the information. How might a reverse mortgage help you or a member of your family? The information on reverse mortgages will show the money available at various ages. The money available will depend on a person’s age, the value of the person’s home, and prevailing interest rates. 3. Read newspaper or magazine articles to determine what expenses are likely to increase and decrease during retirement. How might this information affect your retirement planning decisions? The expenses that are likely to be lower or eliminated are work related expenses, clothing expenses, housing expenses, and federal income taxes. Insurance, medical expenses, expenses for leisure activities, and gifts and contributions are likely to increase. The spending pattern changes because your mode of living during retirement changes. 4. Which type of housing will best meet your retirement needs? Is such housing available in your community? Make a checklist of the advantages and disadvantages of your housing choice. Students’ responses will vary, according to their taste. They may select to live in their present home or weigh out the different alternatives. 5. Outline the steps you must take to live on your retirement income and balance your retirement budget. As you planned your retirement, you estimated a budget or spending plan. Now you may find your actual expenses at retirement are higher than you anticipated. The first step in stretching your retirement income is to make sure you are receiving all of the income to which you are entitled. Examine the possible sources of retirement income mentioned earlier to see whether you could qualify for more programs or additional benefits. What assets or valuables could you use as a cash or income source? To stay within your income, you may also need to make some changes in your spending plans. For example, you can use your skills and time instead of your money. There are probably many things you can do yourself instead of paying someone else to do them. Take advantage of free and low-cost recreation, such as walks, picnics, public parks, lectures, museums, libraries, art galleries, art fairs, gardening, and church and club programs. LIFE SITUATION CASE To Be Young, Thrifty, and in the Black: The Importance of Starting Early (p. 448) 1. What did Ann Farrell learn when she attended a seminar on retirement? Ann learned that if you started early saving for retirement, the payoff is huge. 2. How much money did Farrell originally commit to her company pension plan? In what funds did she invest her money? Farrell originally committed eight percent of her paycheck into the two most aggressive stock funds offered (retirement growth and asset manager). 3. What is the maximum contribution Farrell can make to her RRSP? The maximum contribution Farrell can make is 18 percent of her salary or $20,000 in 2008 (whichever is lower). Assuming her salary is still $28,000, she could contribute $5,040. However, since she is already contributing 13 percent to her company’s pension plan and her company is contributing another 5 percent on her behalf, she is already at her maximum contribution limit. 4. After how long and when did Farrell become fully vested in her RPP plan? Farrell . 15 ESTATE PLANNING CHAPTER OVERVIEW We begin this chapter with the importance of estate planning. Its goal is to assure that the estate’s assets go to the rightful heirs, not the taxman. Next, we present personal aspects of estate planning noting that if you are married, estate planning involves the interest of at least two people. But never having been married does not eliminate the need to organize your papers. Then, we discuss the legal aspects of estate planning. We offer tips in writing a will, selecting an executor, and altering or rewriting a will. Next, we differentiate among living trust, testamentary trust, and spousal trust. We conclude the chapter with an explanation of how estates are settled and the associated costs. LEARNING OBJECTIVES CHAPTER SUMMARY After studying this chapter, students will be able to: Obj. 1 Analyze the personal aspects of estate planning. Estate planning is an essential part of retirement planning and an integral part of financial planning. The first part of estate planning consists of building your estate; the second part consists of transferring your estate, at your death, in the manner you have specified. The personal aspects of estate planning depend on whether you are single or married. If you are married, your estate planning involves the interests of at least two people—more if there are children. Never having been married does not eliminate the need to organize your papers. Obj. 2 Assess the legal aspects of estate planning. In case of death, proof of claims must be produced, or the claims will not be processed. Among the papers needed are birth certificates, marriage certificates, legal name changes, and military service records. Every adult should have a written will, which is the legal declaration of a person’s wishes as to the disposition of his or her property after death. Thus, a will is a way to transfer your property according to your wishes after you die. Obj. 3 Distinguish among formats of wills. The two formats for wills are holographic and formal. A holographic will is handwritten and requires no witness, but is a poor choice for most people and some provinces will not recognize it. A formal will is a typed document signed by you and witnessed by two individuals who must not be the beneficiaries or the spouses of beneficiaries. A lawyer is usually employed to draft a formal will. Obj. 4 Appraise various types of trusts and estates. Establishing a trust can be an excellent way to manage your estate. Popular forms of trusts include living trusts, testamentary trusts, and spousal trusts. An attorney’s help is needed to establish a trust. INTRODUCTORY ACTIVITIES • Ask students to comment on the opening case for the chapter (p. 449). • Point out the learning objectives (p. 449) in an effort to highlight the key points in the chapter. • Ask students to give their opinions regarding estate planning aspects of financial planning. • Discuss the problems that can occur without appropriate estate planning. CHAPTER 15 OUTLINE I. Why Estate Planning? A. What Is Estate Planning? B. Provincial Family Law C. The Opportunity Cost of Rationalizing II. Legal Aspects of Estate Planning A. Wills III. Types and Formats of Wills A. Writing Your Will B. Altering or Rewriting Your Will C. A Living Will D. Power of Attorney E. Letter of Last Instruction IV. Types of Trusts and Estates A. Types of Trusts B. Estates C. Estate Assets Not Distributed by a Will D. Settling Your Estate CHAPTER 15 LECTURE OUTLINE • This chapter discusses a subject most people would rather avoid: death—your own or that of your spouse. Instructional Suggestions • Discussion Question: Why is estate a frequently overlooked aspect of financial planning? • Exercise: Have students suggest factors that will influence various estate planning activities. • Assignment: Have students talk to several individuals about the actions they have taken in the area of estate planning. • Supplementary Resource: Talk to a lawyer, accountant, and other financial planning experts to obtain information on their suggested actions related to estate planning. • Supplementary Resource: Visit the Canadian Financial Planning Group’s Web site for a review of estate planning. • Concept Check 15-1 (p. 452) • Text Reference: Use Exhibit 15-1 to show the contents of a basic will (p. 454) WHY ESTATE PLANNING? (p. 450) • Most people now live long lives. They think about and plan for the future. Yet a large percentage of people do little or nothing to provide for those who will survive them. What Is Estate Planning? (p. 450) • • • Estate planning is a definite plan for the administration and disposition of one’s property during one’s lifetime and at one’s death. Estate planning is an essential part of retirement planning and an integral part of financial planning. An estate plan is usually implemented by a will and one or more trust agreements. Provincial Family Law (p. 451) • • Provincial family law can have a significant impact on your estate planning. The particular nature and scope of the laws vary from province to province. The motive behind these is to protect those who have traditionally needed to depend on you and to ensure a just distribution of your estate. The Opportunity Cost of Rationalizing (p. 451) • Morticians, clergy, lawyers, insurance agents, clerks of federal government agencies, and so on, will be sympathetic, courteous and helpful, but disinterested strangers. And your bereaved beneficiary may find it difficult to reveal confidences to them. LEGAL ASPECTS OF ESTATE PLANNING (p. 452) • In case of death, proof of claims must be produced or the claims will not be processed. Some important needed papers are: * Birth certificates * Marriage certificates * Legal name changes * Military service records Wills (p. 453) • • A will is the legal declaration of a person’s mind as to the disposition of his or her property after his or her death. If you intestate—without a valid will—the province’s law of descent and distribution becomes your will. CHAPTER 15 LECTURE OUTLINE • • Changes in your marital status can affect the validity of your will. Legal fees for drafting a will vary with the complexities of your estate and family situation. A standard will costs between $200 and $300. TYPES AND FORMATS OF WILLS (p. 455) • • • • • • • • • A holographic will is a handwritten will that you prepare. It should not be witnessed. Some states do not recognize a holographic will. A formal will is usually prepared with an attorney’s assistance. You must sign in the presence of two witnesses A notarial will is made in the presence of a notary and at least one witness, and that does not require probate. Available only in Quebec. Writing Your Will (p. 455) The way to transfer your property according to your wishes is to write a will specifying those wishes. An executor will have many important tasks, one of which is to obtain probate from court. Probate is the legal procedure of providing a valid or invalid will. Selecting an executor. Select an executor who is both willing and able to carry out the complicated tasks associated with the job. Your executor can be a family member, a friend, an attorney, an accountant, or the trust department of a bank. Selecting a guardian: A guardian is a person who assumes the responsibilities of providing the children with personal care and of managing the estate for them. A trustee is a person or an institution that holds or generally manages property for the benefit of someone else under a trust agreement. Instructional Suggestions • Concept Check 15-2 (p. 455) • Exercise: Have students create a list of items that they believe would be desirable to include in a will. • Supplementary Resource: Talk to one or more lawyers about the format, content, and type of will recommended in certain situations. • Assignment: Have students obtain the cost of a will from a number of different lawyers. • Text Reference: Exhibit 15-4 summarizes typical duties of an executor. (p. 458) • Discussion Question: Is it necessary to use the services of an attorney in preparing a will? • Discussion Question: How should a person select a guardian for minor children? • Exercise: Have students create situations in which a will would need to be revised. • Discussion Question: Is it prudent to write a prenuptial agreement in case one remarries? Altering or Rewriting Your Will (p. 459) • • • If you have a will, you should review it if: ∗ You move to a different province ∗ You have sold property mentioned in the will ∗ The size and composition of your estate has changed ∗ You have married, divorced, or remarried ∗ New potential heirs have died or been born. If only a few changes are needed in your will, adding a codicil may be the best choice. A codicil is a document that modifies provisions in an existing will. If you are rewriting a will because of a remarriage, CHAPTER 15 LECTURE OUTLINE Instructional Suggestions consider drafting a prenuptial agreement. It is a documentary agreement between spouses before marriage. A Living Will (p. 460) • A living will provides for your wishes being followed if you become so physically or mentally disabled that you are unable to act on your own behalf. • Text Highlight: Use Exhibit 15-5 to explain the purpose of a living will. (p. 460) • Concept Check 15-3 (p. 462) • Assignment: Talk to legal and financial planning experts to contrast the cost and benefits of wills and trusts. Power of Attorney (p. 461) • A power of attorney is a legal document authorizing someone to act on your behalf. Letter of Last Instruction (p. 461) • This document, though not legally enforced, can provide your heirs with important information. It should contain the details of your funeral arrangements, the names of the persons who are to be notified of your death, and locations of your bank accounts, safe-deposit box, and other important items. TYPES OF TRUSTS AND ESTATES (p. 462) • l A trust is a legal arrangement through which your assets are held by a trustee for your benefit or that of your beneficiaries. The settlor is the creator of a trust. There are several reasons for setting up a trust. Furthermore, trustee services are commonly provided by trust companies and, in some circumstances, by life insurance companies. Types of Trusts (p. 462) l l l A living, or inter-vivos trust is a property management arrangement that you establish while you are alive. A testamentary trust is established by your will and becomes effective upon your death. You can create a spousal trust under certain conditions. This trust can actually be classified as either a living or testamentary trust. Estates (p. 464) • Your estate is everything you own. It includes all of your property—tangible and intangible. CHAPTER 15 LECTURE OUTLINE Instructional Suggestions Estate Assets Not Distributed by a Will (p. 465) l l l l By law, there are two situations in which your assets will go directly to a beneficiary, independently of your will. The first one in which your assets already have a named beneficiary. The second occurs when you have assets held in joint tenancy, which confers the right of survivorship. Life insurance proceeds and employee benefits are free of income tax and excluded from probate. There are a number of lifetime gifts and trusts that can be made with significant tax benefits. Settling Your Estate (p. 465) • • • If you have a will, your executor will carry out your wishes in due time. If you have not named an executor, the probate court will appoint an administrator to carry out the instructions in your will. Administration costs may run 3 to 5 percent of your estate and usually decrease as the size of the estate increases. Probate fees on the other hand tend to rise with the size of the estate. The exact costs, payable to the court, are paid out of the proceeds of your estate and are set by the court. • Concept Check 15-4 (p. 467) CONCLUDING ACTIVITIES • Point out the chapter summary (p. 467) and key terms in the text margin. • Discuss selected end-of-chapter Financial Planning Problems, Financial Planning Activities, and Life Situation Case. • Use the Chapter Quiz in the Instructor’s Manual. CHAPTER 15 QUIZ ANSWERS True-False 1. T 2. T 3. F 4. T 5. F 6. T 7. F 8. F Multiple Choice 9. D 10. A 11. A 12. D 13. A 14. C 15. C 16. A Name ________________________________________ Date____________________________ CHAPTER 15 QUIZ TRUE-FALSE _____1. Every adult should have a written will. _____2. If you die intestate, the province’s law of descent and distribution becomes your copy of the will. An executor cannot be a family member or a friend. _____3. _____4. _____5. A guardian is a person who assumes the responsibilities of providing the children with personal care and managing the estate for them. A living trust is a trust established by your will that becomes effective upon your death. _____6. A codicil is a document that modifies provisions in an existing will. _____7. Upon your death, only those assets that have a named beneficiary are transferred to your estate. An ethical will is a legally binding document. _____8. MULTIPLE CHOICE _____9. When death occurs, which is not an important document to provide as proof for the claims? a. Birth certificates b Marriage certificates c. Military services records d. Drivers license _____10. A handwritten will that you prepare yourself is called a ____________ will. a. holographic b. formal c. statutory d. beneficiary _____11. Trusts can be a. Revocable or irrevocable. b. Callable or noncallable. c. Cumulative or noncumulative. d. Participative or nonparticipative. _____12. Which of the following is NOT a characteristic of a testamentary trust? a. Asset management. b. Financial bookkeeping. c. Reduced taxes. d. Unprotected from beneficiary’s creditors. _____13. Probate and administration costs of your estate may run between __________ percent of your estate. a. 3 to 5 b. 6 to 8 c. 9 to 12 d. 15 to 20 _____14. A(n) ___________ is a legal document that allows someone else to act on your behalf. a. Trustee b. Guardian c. Power of attorney d. Will _____15. One situation where your assets will go directly to a beneficiary, independently of your will is when assets are held in _________ a. Tenancy in common b. Common holding c. Joint tenancy d. Union tenancy _____16. A document that explains, adds or deletes provisions in your existing will is a a. Codicil b. Power of attorney c. Will d. Pre-nuptial agreement SUPPLEMENTARY CASE Lyn and Larry are graduate students, both in their mid 20s. They are about to marry, and even though they have almost no assets, they write a will. Their marriage will be an equal partnership—each will balance individual and career decisions with the other. Lyn and Larry will be jointly responsible for all expenses and debt. Furthermore, they will share income and assets equally, regardless of who acquires them. Fifteen years later, they decide to divorce. Lyn, having earned more money than Larry, seeks a larger share of the property settlement. But the court upholds the original agreement because the contract was “properly drawn and freely entered.” Questions: 1. Should Lyn appeal the judge’s decision? 2. Are prenuptial agreements legally binding? 3. Will you consider such a marriage contract? Explain. ANSWERS TO CONCEPT QUESTIONS, OPENING CASE QUESTIONS, FINANCIAL PLANNING PROBLEMS, FINANCIAL PLANNING ACTIVITIES, AND LIFE SITUATION CASE CONCEPT QUESTIONS Concept Check 15-1 (p. 452) 1. If you needed information about estate planning, would you go to the library or the Internet? Why? Students’ answers will vary. 2. Why is estate planning an important component of financial planning? Estate planning is an essential part of retirement planning and an integral part of financial planning. It has two parts. The first consists of building your estate through savings, investments, and insurance. The second consists of transferring your estate, at your death, in the manner you have specified. Nearly every adult is involved with financial decision making and must keep important records. Whatever your status—single or married; male or female; Ph.D. professor; taxi driver, corporate executive, farmer, rancher, or sports champion—you must make financial decisions that are important to you. Those decisions may be even more important to others in your family. Knowledge in certain areas and good record keeping can simplify those decisions. There are things you should know—and do—to protect your interests and those of your heirs. 3. Why is estate planning important for single as well as for married individuals? If you are married, your estate planning involves the interests of at least two people—more if there are children. Legal requirements and responsibilities can create for married people problems that are entirely different form the problems of single persons. Situations become more complex. Possessions accumulate. The need for orderliness and clarity becomes greater. Never having been married does not eliminate the need to organize your papers. For persons who live alone, as for married people, it is essential that important documents and personal information be consolidated and accessible. Remember that in the event of your death, difficult questions and situations are going to confront some person at a time of severe emotional strain. That person may not be prepared to face them objectively. Concept Check 15-2 (p. 455) 1. What are the legal aspects of estate planning? In case of death, proof of claims must be produced or the claims will not be processed. If no thought was given to gathering the necessary documents beforehand (with a sufficient number of copies), a period of financial hardship may follow until proof is obtained. If needed documentation cannot be located, there may be irretrievable loss of funds. Your heirs may experience emotionally painful delays until their rights have been established. 2. What is a will? Why is it an important estate planning tool? A will is the legal declaration of a person’s mind as to the disposition of his or her property after his or her death. Thus, a will is a way to transfer your property according to your wishes after you die. Whether you prepare a will before you die or neglect to take that sensible step, you have a will. If you fail to prepare your own will, the state in which you legally reside steps in and controls the distribution of your estate without regard for wishes that you may have had but that you failed to define in legal form. Thus, if you die intestate—without a valid will—the state’s law of descent and distribution becomes your will, as shown in Exhibit 15-1. 3. How does marriage or divorce affect a will? If you already have a will and you are about to be married or divorced, review your will with an attorney for necessary changes. Upon divorce, only provisions favoring a former spouse are automatically revoked; provisions favoring family members of your ex-spouse—such as stepchildren, nieces, nephews, in-laws—are not affected. If you marry after you have made a will, the will is revoked automatically unless certain conditions are met. Concept Check 15-3 (p. 462) 1. What are the three formats of wills? Wills may be holographic or formal. A holographic will is a handwritten will that you prepare. It should be written, dated, and signed entirely in your handwriting—no printed or typed information should be on its pages. It should not be witnessed. Some states may not recognize a holographic will. A formal will is usually prepared with an attorney’s assistance. It may be either typed or in a preprinted form. You must sign the will and acknowledge it as your will in the presence of two witnesses, neither of whom is a beneficiary (a person you have named to receive property under the will). The witnesses must then sign the will in your presence. A notarial will is made in the presence of a notary and at least one witness, and that does not require probate. Available only in Quebec. 2. What are the steps in writing your will? Selecting an Executor. Select an executor who is both willing and able to carry out the complicated tasks associated with the job. These tasks are preparing an inventory of assets, collecting any money due, paying off any debts, preparing and filing all income and estate tax returns, liquidating and reinvesting other assets to pay off debts and provide income for your family while the estate is being administered, distributing the estate, and making a final accounting to your beneficiaries and to the probate court. Selecting a Guardian. In addition to disposing of your estate, your will should name a guardian and/or trustee to care for minor children if both parents die at the same time, such as in an automobile accident or a plane crash. A guardian is a person who assumes the responsibilities of providing the children with personal care and of managing the estate for them. 3. What is a power of attorney? A power of attorney is a legal document authorizing someone to act on your behalf. At some point in your life, you may become ill or incapacitated. You may then wish to have someone attend to your needs and your personal affairs. You can assign a power of attorney to anyone you choose. (p. 461) 4. What is a letter of last instruction? In addition to your will, you should prepare a letter of last instruction. This document, though not legally enforced, can provide your heirs with important information. It should contain the details of your funeral arrangements. It should also contain the names of the persons who are to be notified of your death and the locations of your bank accounts, safe-deposit box, and other important items. (p. 462) Concept Check 15-4 (p. 467) 1. Differentiate among the types of trusts. Living or Inter Vivos Trusts. A living trust is a property management arrangement that you establish while you are alive. You simply transfer some property to a trustee, giving him or her instructions regarding its management and disposition while you are alive and after your death. Testamentary Trusts. A testamentary trust is a trust established by your will that becomes effective upon your death. Such a trust can be valuable if your beneficiaries are inexperienced in financial matters or if the potential estate tax is substantial. Like a living trust, a testamentary trust provides the benefits of asset management, financial bookkeeping, protection of the beneficiaries, and minimizing of estate taxes. Spousal Trusts. Subject to certain conditions, you can create a trust for a spouse (or common-law spouse). The principal conditions are that (1) all of the income of the trust must be paid to the spouse during the spouse’s lifetime, and (2) that none of the capital can be distributed to anyone else during your spouse’s lifetime. This trust can actually be classified as either an inter vivos or testamentary trust. Capital gains on property are taxed only when the trust disposes of the property or when your spouse dies. 2. What is included in an estate? Your estate is everything you own. It includes all of your property—tangible and intangible, however acquired or owned, whether inside or outside the country. It may include jointly owned property, life insurance and employee benefits, and property you no longer own. Thus, an important step in estate planning is taking inventory of everything you own. 3. What are the two types of joint ownership? In joint tenancy with the right of survivorship, the property is considered owned 50-50 for estate tax purposes and will automatically pass to your spouse at your death. In tenancy in common, each of the tenants in common is considered to own a proportionate share for tax purposes, and only your share is included in your estate. Tenancy by the entirety is limited to married couples. Both spouses own the property; when one spouse dies, the other gets it automatically. Depending on your circumstances, any one of the above ownerships can serve your needs. OPENING CASE QUESTIONS (p. 449) 1. How can you protect your wishes and your peace of mind with a living will? A living will is not a substitute for a traditional will. It enables an individual to express how you want to be cared for should you become terminally ill. 2. Would you want to be kept on life support? Why or why not? Students’ responses will vary. 3. In your opinion, who should have the right to make life-and-death decisions? Students’ responses will vary. 4. Should you keep your living will in a safety deposit box? Why, or why not? A living will is a legal document that should not be kept in your savings deposit box. Give copies to your lawyer, your doctor, and your adult children, and take one to the hospital on your next visit. FINANCIAL PLANNING ACTIVITIES (p. 468) 1. Prepare a written record of personal information that would be helpful to you and your heirs. Make sure to include the location of family records, your military service file, and other important papers; medical records; bank accounts; charge accounts; the location of your safety deposit box; Canada savings bonds; stocks, bonds, and other securities; property owned; life insurance; annuities; and government benefits information. The purpose of this activity is to organize important information before it is needed. 2. Develop a list of specific long-term estate planning goals with your family. Discuss how those goals could be achieved even if one spouse died unexpectedly. Long-term estate planning goals should include your personal aspects (married or single), proper type of will, executor, trustee, a living will, letter of last instruction, an applicable trust, and estate and trusts taxes. 3. Draft your will, using the Exhibit 15-1 as a guideline. Whom will you appoint as a trustee or guardian for your minor children? Why? The answers will vary; students may choose a family member, a friend, an attorney, an accountant, or the trust department of a bank to be an executor or a guardian. 4. Contact several lawyers in your area to find out how much they would charge to prepare your simple will. Are their fees about the same? The answers will vary depending upon where the students live—city lawyers generally will demand higher fees than those in rural areas. 5. Visit Metropolitan Life Insurance Company’s Web page at www.lifeadvice.com. Using this information, prepare a report on the following: (a) Who needs a will? (b) What are the elements of a will (naming a guardian, naming an executor, preparing a will, updating a will, estate taxes, where to keep your will, living will, etc)? (c) How is this report helpful in preparing your own will? Students’ responses will vary. 6. Prepare your own letter of last instruction. The students’ responses will vary. 7. Make a list of the criteria that will use in deciding who will be the guardian of your minor children if you and your spouse die at the same time. You should take great care in selecting a guardian for your children. You want a guardian whose philosophy on raising children is similar to yours and who is willing to accept the responsibility. 8. Discuss with your attorney the possibility of establishing a trust as a means of managing your estate. Students’ responses will vary. LIFE SITUATION CASE Don’t Let Your Windfall Blow Away (p. 469) 1. What did Warren do with his 1.4 million inheritance? Warren invested all of his inheritance. 2. What do smart people do with sudden wealth? Smart people decide not to blow it. COMMENTS ON CONTINUOUS CASE FOR PART 5 (p. 470) Planning for Tomorrow 1. How would you rate the Mortimer’s financial condition at this stage in their lives? The Mortimer’s realized a number of years ago that they must begin planning for retirement. As a result, they began investing in conservative stocks and mutual funds. The current value of these investments is about $62,000. As mentioned in this case, Isaac’s retirement fund is smaller than he might like. Its current value is just over $115,000. Since this couple is approximately 15 years away from retirement, they still have time for conservative investments to grow and provide the financial foundation they need for retirement. 2. Given the fact that Pamela is 48 and Isaac is 50, what should be their major priorities as they continue planning for retirement? The number one priority for the Mortimers should be preparation for retirement. Given the current financial status of the Mortimers, they should continue to do what they have done for the past 8 years. Since Pamela is 48 and Isaac is 50, they will have approximately 15 years until Isaac retires. This 15-year window allows the Mortimers to continue to choose conservative investments. They should also increase their contributions to Isaac’s retirement fund (if possible). They should avoid the temptation to try and get-rich quick with speculative investments. For the Mortimers, patience should pay excellent dividends. 3. What types of estate planning, if any, should the Mortimers consider at this time? The importance of estate planning is obvious—to assure that dependents, family members, friends, or organizations receive intended care and financial well-being. While most people think that estate planning means having an up-to-date will, there are many other aspects that are often overlooked. The “Financial Planning in Life’s Situations” boxed insert entitled “Estate Planning Checklist” lists a number of questions that can help individuals organize their estate. Also, you may want to review the material on the Legal Aspects of Estate Planning as you discuss this question with your students. Finally, you may want to review the material on Types of Trusts and Estates. Solution Manual for Personal Finance Jack Kapoor, Les Dlabay, Robert J. Hughes, Arshad Ahmad 9780071320597, 9781259453144