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Chapter 14 Planning for Retirement How Will This Affect Me? While almost everyone understands that planning for retirement is important, far too few people actually implement a comprehensive plan, much less set aside enough savings to fund their retirement adequately. This chapter discusses the importance of retirement planning and encourages action by identifying the major pitfalls that you must overcome. In order to make the process more concrete and accessible, the steps for estimating your retirement income needs and the income that your investments will support are explained. Eligibility requirements to receive Social Security benefits and their amounts are detailed, as well as the key aspects of supplemental employer-sponsored pension plans and the potential benefits of self-directed retirement programs like traditional and Roth individual retirement accounts (IRAs). In addition, the usefulness of various annuity products in retirement planning is evaluated. After reading this chapter, you should understand how to develop and implement a financial plan that will help you achieve your long-term retirement objectives. Learning Objectives 14-1 Recognize the importance of retirement planning, and identify the three biggest pitfalls to good planning. If your school or community will allow it, I suggest you take a branding iron and brand the student’s forehead with the words: ”Plan NOW”. Planning for retirement needs to begin when you take the first job. It stops when you are dead. Consider the following: Investing $2,000 per year @ 6% from age 25 to 45, FV(6%,20,2000) = $73,571 Keep the amount invested at 6% for another 20 years yields (1 + .06)^20 * 73,571 = $235,953 Versus Investing $5,000 per year at 6% from age 45 to 65, FV(6%,20,5000) =$183,928 By starting young and keep the amount invested, you will have 28% more for retirement. Of course, if you can invest more, you will have more. You really need to start young, that is NOW!!!! 14-2 Estimate your income needs in retirement and the level of retirement income you’ve estimated from various sources. Worksheet 14.1 does this and I suggest you go over the worksheet and assign Financial Planning Exercise 3 to have the students compute the retirement needs. 14-3 Explain the eligibility requirements and benefits of the Social Security program. I suggest just using the power points to cover this. 14-4 Differentiate among the types of basic and supplemental employer sponsored pension plans. The basic plans are defined benefit and defined contribution plans. More common today are defined contribution plans. The students should know the basic terms vesting and matching, and what they mean to the ability to build a retirement fund. 401(k) plans are very common and deserve to be discussed. Key is the ability to control the type of investments made by the fund. That is, can you do a portfolio or must it all be in the company’s stock. 14-5 Describe the various types of self-directed retirement plans. Traditional and ROTH IRAs are discussed. The features of these plans should be discussed including that it is common to move all plans into one IRA at retirement in order to reduce the management time during retirement. Financial Planning Exercise problem 8 will be useful for this discussion. 14-6 Choose the right type of annuity for your retirement plan. Annuities have a place, especially for the risk adverse person who want a fixed sum for retirement and does not trust a financial planner to manage their funds. But to do so they have to trust the insurance company. Annuities have a place. Financial Facts or Fantasies? These may be used as “teasers” to get the students on the right page with you. Also, they may be used as quizzes after you covered the material or as “pre-test questions” to get their attention. • The first step in retirement planning is to set your retirement goals. Fact: In order to provide direction to your retirement plans, you should begin by defining your goals. These include what you want to do in retirement, the standard of living you want to maintain, and the level of income you would like. • In order to receive maximum social security retirement benefits, a worker must retire before his or her 66th birthday. Fantasy: To qualify for maximum benefits, a worker must be full retirement age and have career earnings (prior to retirement) that were equal to or greater than the maximum social security tax base for at least 10 years. • Social security retirement benefits should be sufficient to provide retired workers and their spouses with a comfortable standard of living. Fantasy: Social security is intended to be only a foundation for retirement income. By itself, these benefits will likely permit retirees only a small fraction of their pre-retirement standard of living. • Because participation in a company’s defined benefit pension plan is mandatory, you’re entitled to immediate vesting of all contributions. Fantasy: While the employer may offer immediate vesting, that’s usually not the case. By law, the employee is entitled to full vesting rights within a maximum of five to seven years, depending on whether the company is using cliff or graded vesting procedures. • Your contributions to an IRA account may or may not be tax deductible, depending in part on your level of income. Fact: Whether or not your traditional IRA contributions are fully deductible depends to a large extent on your adjusted gross income. And it also depends on whether you and/or a spouse are covered by a retirement plan at work. • Since an annuity is only as good as the insurance company that stands behind it, you should check the company’s financial rating before buying an annuity. Fact: Because it’s a life insurance company that guarantees the payout of the policy during the distribution period, it’s a good idea to see how the company’s financial strength is rated in Best’s Insurance Reports. And if you’re looking for maximum protection, stick with companies that are rated A+ or A. Financial Facts or Fantasies? These may be used as a quiz or as a pre-test to get the students interested. 1. True False The first step in retirement planning is to set your retirement goals. 2. True False In order to receive maximum social security retirement benefits, a worker must retire before his or her 66th birthday. 3. True False Social security retirement benefits should be sufficient to provide retired workers and their spouses with a comfortable standard of living. 4. True False Because participation in a company’s defined benefit pension plan is mandatory, you’re entitled to immediate vesting of all contributions. 5. True False Your contributions to an IRA account may or may not be tax deductible, depending in part on your level of income. 6. True False Since an annuity is only as good as the insurance company that stands behind it, you should check the company’s financial rating before buying an annuity. Answers: 1. True 2. False 3. False 4. False 5. True 6. True YOU CAN DO IT NOW The “You Can Do It Now” cases may be assigned to the students as short cases or problems. They will help make the topic more real or relevant to the students. In most cases, it will only take about ten minutes to do, that is, until the student starts looking around at the web site. But they will learn by doing so. YOU CAN DO IT NOW Get a Rough Estimate of Your Future Social Security Benefits It’s easy to get a rough estimate of your future Social Security benefits. While the Quick Calculator doesn’t access your actual earnings history, it does provide a useful rough estimate: Remember that this estimate does not consider that future Social Security benefits could be reduced somewhat. YOU CAN DO IT NOW Calculating the Benefits of a Traditional IRA If you want to estimate the potential value of a traditional IRA at retirement, try the calculator at You can do it now. YOU CAN DO IT NOW What Do Annuities Cost? Want to get a sense of what an annuity costs? Representative quotes based on state, age, and gender can be found at You can do it now. Financial Impact of Personal Choices Read and think about the choices being made. Do you agree or not? Ask the students to discuss the choices being made. Hannah and Elizabeth’s Different Approaches to a Traditional IRA Hannah Bennett and Elizabeth Cruz, both 30 years old, are good friends who work together at a management consulting firm. They both take advantage of their firm’s 401(k) plan. But they differ in how they set aside money in a traditional IRA. Hannah has just started setting aside $5,500 a year in an IRA that he expects to earn 5 percent per year until he plans to retire at age 66. In contrast, while Elizabeth also expects to retire at age 66, she believes it’s too early in her career to bother investing in an IRA because it won’t have that much impact in the long term. She consequently plans to wait five years before following Hannah’s example. At age 66 the pre-tax value of Hannah’s IRA should be about $553,455 while the value of Elizabeth’s account should be about $408,644. Hannah invested $27,500 more than Elizabeth but ended up with $144,811 more in her IRA account! That’s because the IRA sheltered the earnings on Hannah’s investments from taxes and she also benefited handsomely from the compounding of returns on her money. There’s a moral here: invest early, often, and consider the impact of taxes on your investments. Financial Planning Exercises 1. Retirement planning pitfalls. Explain the three most common pitfalls in retirement planning. The three most common pitfalls in retirement planning are: Starting too late Putting away too little Investing too conservatively The most serious of the three is starting too late. If you wait until you are 50 to start building your retirement fund, you will not have time to accumulate the amount you will need. With life expectancy of 80 years, if you retire at age 70, you still have ten years during which you have to provide all your retirement needs. And if you live to be 90, that is 20 years. 2. Calculating amount available at retirement. Molly Lincoln, a 25-year-old personal loan officer at First National Bank, understands the importance of starting early when it comes to saving for retirement. She has designated $3,000 per year for her retirement fund and assumes that she’ll retire at age 65. a. How much will she have if she invests in CDs and similar money market instruments that earn 8 percent on average? Using the Appendix B, the annuity factor for 8% for 40 years is 259.057. Thus, investing $3,000 per year will amount to $777,171 [$3,000 * 259.057 = $777,171]. Using a financial calculator, the key strokes are: b. Molly is urging her friend, Isaac Stein, to start his plan right away because he’s 35. What would his nest egg amount to if he invested in the same manner as Molly and he, too, retires at age 65? Comment on your findings. Funds earn 8%: Isaac will only be able to invest for 30 years. Using the Appendix B, the annuity factor for 8% for 30 years is 113.283. Thus, investing $3,000 per year will amount to $340,149 [$3,000 * 113.283= $340,149]. Using a financial calculator, the key strokes are: Fund earn 10%: Isaac will only be able to invest for 30 years. Using the Appendix B, the annuity factor for 10% for 30 years is 164.494. Thus, investing $3,000 per year will amount to $493,487 [$3,000 * 164.494= $493,487]. Using a financial calculator, the key strokes are: The ability to accumulate funds for retirement depends upon both the time available to build the fund and the return you can earn. Molly has an extra ten years more than Isaac, so she has a greater likelihood of building a larger retirement fund. 3. Calculating annual investment to meet retirement target. Use Worksheet 14.1 to help George and Jude Sullivan determine how much they need to retire early in about 20 years. Both have promising careers, and both make good money. As a result, they’re willing to put aside whatever is necessary to achieve a comfortable lifestyle in retirement. Their current level of household expenditures (excluding savings) is around $75,000 a year, and they expect to spend even more in retirement; they think they’ll need about 125 percent of that amount. (Note: 125 percent equals a multiplier factor of 1.25.) They estimate that their Social Security benefits will amount to $20,000 a year in today’s dollars and that they’ll receive another $35,000 annually from their company pension plans. George and Jude feel that future inflation will amount to about 3 percent a year, and they think they’ll be able to earn about 6 percent on their investments before retirement and about 4 percent afterward. Use Worksheet 14.1 to find out how big their investment nest egg will have to be and how much they’ll have to save annually to accumulate the needed amount within the next 20 years. 4. Average Social Security benefits and taxes. Use Exhibit 14.2 to estimate the average Social Security benefits for a retired couple. Assume that one spouse has a part-time job that pays $24,000 a year, and that this person also receives another $47,000 a year from a company pension. Based on current policies, would this couple be liable for any tax on their Social Security income? Average benefits for a retired couple are $2,340 per month or $28,080 per year. With the part-time job and company benefit, their income would be $71,000 without social security. Current tax law taxes 85% of social security for married taxpayers with income over $44,000. This couple would have to report 85% * 28,080 or $23,868 as income subject to tax. 5. Retirement Planning. At what age would you like to retire? Describe the type of lifestyle you envision—where you want to live, whether you want to work part-time, and so on. Discuss the steps you think you should take to realize this goal. I personally think you should be able to retire at 25 for a 5-year period, and then work until you are 70 so you can truly enjoy 5 years of retirement. Most people these days are working past 65 to at least full retirement age of 66 or 67. Some are working longer. Many retired people like to work part-time and do so either for money or as a volunteer. For planning, it is best to not plan on money from a part-time job. Look at what it will take to live your current life style adjust for inflation to the year you will retire and use Worksheet 14.1 to determine how much you need to save to retire. Then, any part-time income provides some extra “mad money”. 6. Comparing Retirement Plans. Millie Russell has just graduated from college and is considering job offers from two companies. Although the salary and insurance benefits are similar, the retirement programs are not. One firm offers a 401(k) plan that matches employee contributions with 25 cents for every dollar contributed by the employee, up to a $10,000 limit. The other firm has a contributory plan that allows employees to contribute up to 10 percent of their annual salary through payroll deduction and matches it dollar for dollar; this plan vests fully after five years. Because Millie is unfamiliar with these plans, explain the features of each so Millie can make an informed decision. Under the first plan, the maximum contribution would be $10,000 by Millie plus $2,500 by employer, total contribution of $12,500. The contribution vests immediately to Millie and it looks like she can pick the investments. The second plan has the employer matching contributions dollar for dollar, thus if Millie contributed $10,000 the employer would contribute $10,000. But there is a five-year vesting before the funds are locked it for her. For Millie to be able to contribute $10,000, her salary would have to be $100,000 which most likely it is not. Also, most likely, the dollar for dollar contributory plan of the second company is managed by the company and the company selects the investments. The first plan would add $12,500 per year or after four years it would total $50,000 before considering investment returns. If Millie stays for five years the plan would amount to $62,500, before investment returns. The second plan would amount to $40,000 if Millie leaves after four years. If Millie stays for five years, at the end of five years her contributions would amount to $50,000 and the company’s contribution would be another $50,000 for a total of $100,000 before investment returns. The deciding question becomes what is the chance that Millie will still be with the company after five years. If she thinks that she will still be with the company, go with the second company, all other things being equal. 7. Effective after-tax cost of 401(k) contribution. Luis Gomez is an operations manager for a large manufacturer. He earned $68,500 in 2016 and plans to contribute the maximum allowed to the firm’s 401(k) plan. Assuming that Brad is in the 24 percent tax bracket, calculate his taxable income and the amount of his tax savings. How much did it actually cost Luis on an after-tax basis to make this retirement plan contribution? The 401(k) maximum is $18,000 in 2016. The limit for 2018 is $18,500 and for 2019 the limit is $19,000. Luis’s after-tax cost of his $18,000 contribution to 401(k) is 18,000 * (1 - .24)) = $13,680, 8. Deciding between traditional and Roth IRAs. Elijah James is in his early 30s and is thinking about opening an IRA. He can’t decide whether to open a traditional/deductible IRA or a Roth IRA, so he turns to you for help. a. To support your explanation, you decide to run some comparative numbers on the two types of accounts; for starters, use a 25-year period to show Elijah what contributions of $5,500 per year will amount to (after 25 years), given that he can earn, say, 10 percent on his money. Will the type of account he opens have any impact on this amount? Explain. The following table is used for both a and b.
Traditional Roth
Amount available to contribute $5,500 $4,290 [tax rate is 22%]
Time money invested 25 years 25 years
Return on the investment 10% 10%
Balance before distribution 98.347 * 5,500 = $540,908 98.347 * 4,290= $421,909
Distribution received after tax of 22% $421,908 $421,909
b. Assuming that Elijah is in the 22 percent tax bracket (and will remain there for the next 25 years), determine the annual and total (over 25 years) tax savings that he’ll enjoy from the $5,5,000-a-year contributions to his IRA; contrast the (annual and total) tax savings he’d generate from a traditional IRA with those from a Roth IRA. If the tax rate at the time of contribution and at the time of distribution is the same, it makes no difference with a Roth or a Traditional account. With a Roth, you pay the tax up front; with a traditional IRA, you pay the tax on the back end when it is distributed. c. Now, fast-forward 25 years. Given the size of Elijah’s account in 25 years (as computed in part a), assume that he takes it all out in one lump sum. If he’s now in the 40 percent tax bracket, how much will he have, after taxes, with a traditional IRA, as compared with a Roth IRA? How do the taxes computed here compare with those computed in part b? Comment on your findings. If the tax rate goes from 22% at the time of contribution to 40% at the time of distribution, the ROTH IRA will be better. With a traditional IRA, the after-tax distribution will be 60% * $540,908 = $324,545, a difference of $97,364 less than the after-tax distribution if a ROTH IRA is used. Note the difference is the change in tax rate. The tax paid upon contribution to a ROTH IRA is 22% and the tax paid on the distribution from a traditional IRA is 40%, a difference of 18%. 18% * 540,908 is $97,364. d. Based on the numbers you have computed as well as any other factors, what kind of IRA would you recommend to Elijah? Explain. Would knowing that maximum contributions are scheduled to increase to $7,000 per year make any difference in your analysis? Explain. Since I believe that the tax rates later will not be higher for Elijah, I still think that at Traditional IRA is better than a ROTH. There is some chance that Elijah will die and therefore his heirs will receive the IRA funds and they may have a lower tax rate. Elijah may decide to contribute the IRA to a charity and never have to pay the taxes. The maximum contribution amount will be the same for both, thus not an issue. Of course, the limit on the amount contributed to a ROTH is the after-tax amount. If the limit on contributions is $7,000 and the tax rate is 30%, it will take $10,000 before tax dollars to make a $7,000 contribution to the ROTH. It will only take $7,000 to make the contribution to the traditional IRA. The other $3,000 available would have to be invested in a tax deferred account in order to have equivalent results between the ROTH and Traditional. 9. Deciding whether to convert a traditional IRA to a ROTH IRA. Explain the circumstances in which it makes sense to convert a traditional IRA to a ROTH IRA. It is all about you estimated tax rate in the future. If you think the rate when you will withdraw the IRA funds will be higher than the current tax rate, it may be sensible to convert traditional IRA to a ROTH and pay the tax at the current rate. Another possible reason to convert is the ability of the beneficiary of the IRA if you should die. If the beneficiary does not have the ability to manage money, it may be sensible to pay the tax now so that the beneficiary does not have to do so later. Your estimate of future tax rates is the key reason to convert. 10. Comparing variable annuities and mutual funds. Explain how buying a variable annuity is much like investing in a mutual fund. Do you, as a buyer, have any control over the amount of investment risk to which you’re exposed in a variable annuity contract? Explain. With a mutual fund, the investor gives money to the mutual fund that uses that money to buy and sale stocks and other securities. The investor pays taxes on the gains, dividends, or interest each year. The gains and dividends are taxed as capital gains; the interest as ordinary income. With a variable annuity, the investor gives money to an insurance company which uses that money to purchase stocks and other securities. The annual income is not subject to tax until amounts are paid out. At that time, the portion received that are attributable to the amount invested is not subject to tax. The earnings from an annuity are taxed as ordinary income when received. The investor in a variable annuity may be able to select the mutual funds the amounts are invested in by the insurance company. The amount received is determined by the market. 11. Fixed vs. variable annuities. What are the main differences between fixed and variable annuities? Which type is more appropriate for someone who is 60 years old and close to retirement? Fixed-rate annuities grow at a minimum fixed rate set by the insurance company, which is usually fairly low. Fixed annuity assets are commingled with the assets of the insurance company and hence are subject to the claims of the company’s creditors. Variable annuities are much like an investment in mutual funds, because the variable annuities offer a collection of securities, usually mutual funds managed by the insurance company. You decide how your investment will be allocated among the various choices, and the return on a variable annuity depends on the investment choices made. Typically, the assets of variable annuities are in separate accounts and not commingled with company assets and therefore not subject to the claims of the company’s creditors. For someone age 60 and close to retirement, a fixed annuity would probably be the better choice. Even though the variable annuity offers greater growth potential, it could also suffer a loss, something that is more difficult for someone close to retirement to bear. However, for someone who has other assets to live off of in retirement, the variable annuity might be attractive. Also, Life expectancy is about 80. So, a 60-year old is looking at a 20 year window. To settle for a fixed annuity at this point, may be premature. Of course if you think the market is due a correction, go fixed. Test Yourself 14-1 Discuss the relationship of retirement planning to financial planning. Do investment and tax planning have a role in retirement planning? The financial planning process would be incomplete without retirement planning. Certainly no financial goal is more important than achieving a comfortable standard of living in retirement. In many respects, retirement planning captures the very essence of financial planning. Once you know what you want out of retirement, the next step is to establish the size of the nest egg that you’re going to need to achieve your retirement goals. In other words, at this point, you’ll want to formulate an investment program that enables you to build up your required nest egg. This usually involves (1) creating a systematic savings plan in which you put away a certain amount of money each year and (2) identifying the types of investment vehicles that will best meet your retirement needs. This phase of your retirement program is closely related to investment and tax planning. Tax planning is involved because the Congress has enacted several tax provisions to subsidize retirement funds. 14-2 Identify and briefly discuss the three biggest mistakes people tend to make when setting up retirement programs. When it comes to retirement planning, people tend to make three big mistakes: • Starting too late. Many people in their 20s, or even their 30s, find it hard to put money away for retirement. Most often that’s because they have other, more pressing financial concerns— such as buying a house, paying off a student loan, or paying for child care. The net result is that they put off retirement planning until later in life—in many cases, until they’re in their late 30s or 40s. • Putting away too little. Even worse, once people start a retirement program, they tend to put away too little. Although this may also be due to pressing financial needs, all too often it boils down to lifestyle choices. They’d rather spend today than save for tomorrow. • Investing too conservatively. On top of all this, many people tend to be far too conservative in the way they invest their retirement money. The fact is, they place way too much of their retirement money into low-yielding, fixed-income securities such as CDs and Treasury notes. 14-3 How do income needs fit into the retirement planning process? Both your personal budget and the general state of the economy will change over time which makes accurate forecasting of retirement needs difficult at best. Two ways to approach the forecasting problem. One is to state your retirement income objectives as a percentage of your present earnings. A second approach is to formulate the level of income that you’d like to receive in retirement, along with the amount of funds you must amass to achieve that desired standard of living. Then develop a plan to build savings to provide that amount. 14-4 What are the most important sources of retirement income? Two basic sources of retirement income are Social Security and employer-sponsored pension plans. 14-5 What benefits are provided under the Social Security Act, and who is covered? There are three basic benefits: Disability income: If you become disable you can receive social security benefits in the same amount that you would receive if you retired. Retirement income: You receive a monthly benefit based upon the amount of earnings for the highest ten years of your working career up to a maximum. Spousal retirement income: Your spouse can receive a monthly benefit based upon your contributions to social security during your career. 14-6 What is the earnings test, and how does it affect Social Security retirement benefits? Social Security benefits are based upon the level of income on which you paid taxes. The maximum salary subject to tax for 2015 is $118,500. The maximum level changes each year. As the level you pay taxes on increases, the future benefits you will receive increases also. Also, if you are under the full retirement age and receive social security benefits, you may not earned more than a specified amount. The limit for 2015 was $15,720. Your social security benefits are reduced $2 for every $1 earned over that amount. Thus, if you earned $16,000, you would lose 2 * $280 or $560 in social security. If you are over the full retirement age [66 o4 67 depending on date of birth], there is no limit on what you can earned. 14-7 Does Social Security coverage relieve you of the need to do some retirement planning on your own? Social Security was designed to be a supplement to other retirement income. If all you receive is Social Security benefits, you will not be able to maintain your pre-retirement standard of living. You need to do retirement planning to provide sufficient funds to maintain you standard of living. 14-8 Which basic features of employer-sponsored pension plans should you be familiar with? An employee should be familiar with the following features of an employer-sponsored pension plan: a. Participation requirements are the eligibility criteria for participation. Most common are requirements relating to years of service, minimum age, level of earnings, and employee classification. b. Contributory obligations specify who pays into the plan. In a noncontributory pension plan, the employer pays the total cost of the benefits. Under a contributory pension plan, the employee must bear a portion of this cost. Most pensions established by corporations used to be noncontributory, but today the trend is toward contributory plans. c. The vesting rights of the pension are the criteria the employee must meet before he or she can obtain a nonforfeitable right to pension assets accumulated in his or her name. Once these nonforfeitable rights are secured by the employee, they are said to be vested in the plan. The law sets down the rules for vesting and partial vesting. d. Retirement age is also an important feature of the plan. Most pensions specify a retirement age, but there may provision for early retirement. Also, find out if the pension benefits are portable—can you take them with you if you change jobs? e. The method of computing benefits is spelled out in every retirement plan. A defined benefit plan provides a formula for computing benefits that is stipulated in the plan provisions. This type of plan allows employees to determine before retirement how much their monthly retirement income will be. The formula is frequently based on number of years of service and average annual salary, although other formulas are possible. In contrast, a defined contribution plan specifies, how much the employer and/or employees are to contribute to the plan, but says nothing about what the plan benefits will be. That depends on how much the pension plan administrators are able to earn on the plan's investments. f. Finally, you should get a full run-down on what, if any, voluntary supplemental programs the company offers, such as a 401(k) salary reduction plan. 14-9 Under which procedure will you become fully vested most quickly—cliff or graded vesting? Cliff vesting, requires full vesting after no more than three years of service—but you obtain no vesting privileges until then. Graded schedule, vesting takes place gradually over the first six years of employment. At the minimum, after two years you’d have a non-forfeiture right to at least 20 percent of the benefits, with an additional 20 percent each year thereafter until your 100 percent vested after six years. The cliff vesting will provide the best benefit to the employee. 14-10 What is the difference between a profit-sharing plan and a salary reduction, or 401(k), plan? A profit-sharing plan may be qualified under the IRS and become eligible for essentially the same tax treatment as other types of pension plans. An argument supporting the use of profit-sharing plans is that they encourage employees to work harder because the employees benefit when the firm prospers. From the firm’s perspective, a big advantage of profit-sharing plans is that they impose no specific levels of contribution or benefits by the employer. When profits are low, the firm makes smaller contributions to the plan, and when profits are high, it pays more. A 401(k) plan basically gives employees the option to divert part of their salary to a company-sponsored, tax-sheltered savings account. The employer may match some or all of the contribution. The employee selects the amount to contribute up to a maximum of $18,000 in 2015 [the maximum changes with the Consumer Price Index. Depending upon the plan, the funds may be investment in the company’s stock or a family of mutual funds, which is the more common plan. Under both plans the contributions are tax deferred [not taxed when contributed; taxed when distributed] and they are generally invested in mutual funds. The employer may provide both plans and the employee may decide to contribute to the 401(k) plan or not. With a profit sharing plan, all the funds contributed are the employer’s; the employee does not contribute. With a 401(k) plan, the employee contributes their money to the plan. 14-11 Why is it important to evaluate and become familiar with the pension plans and retirement benefits offered by your employer? When participating in a company-sponsored pension plan, you’re entitled to certain benefits in return for meeting certain conditions of membership—which may or may not include making contributions to the plan. Whether your participation is limited to the firm’s basic plan or includes one or more of the supplemental programs, it’s vital that you take the time to acquaint yourself with the various benefits and provisions of these retirement plans. You may have to elect options or take action to qualify for an option. 14-12 Briefly describe the tax provisions of 401(k) plans and Keogh plans. The tax law generally treats qualified plans the same. The basic feature is the contributions to the plan are not subject to tax, that is either they are excluded if contributed by the employer or deductible if contributed by the employee. The distributions from the plans are taxed when received which could be several years after the contributions. The Roth plans are just the opposite: Contributions are after-tax and distributions are not taxed. Note that in both cases, the distributions include the amount that was contributed plus any earnings on the contributions. 14-13 Describe and differentiate between Keogh plans and individual retirement arrangements. What’s the difference between a nondeductible IRA and a Roth IRA? Keogh and IRAs are very similar. The major difference is the limit on the amount that may be contributed to the plan. Keoghs are limited to $53,000 or 25% of income in 2015 [limit changes yearly]. IRAs are limited to $5,500 per year [for taxpayers under 50; $6,500 over 50]. Nondeductible IRA and Roth IRA are similar as to the contributions. Both are made with after-tax contributions. The distributions are taxed differently. With a nondeductible IRA, the distributions traced to the earnings are tax; those traced to the contributions are not taxed. With a Roth IRA, both the distributions of contributions and the distributions of earnings are tax-free—the tax was paid at time of contribution. Another difference is the income limit that qualifies the taxpayer to make contributions to the plan. Nondeductible IRAs have no income limit for contributions; anyone who has earned income can make contributions. The ROTH IRAs limit the amount of income the contributor can make to $193,000 if taxpayer files a joint return; $131,00 for a single return. 14-14 Under what circumstances would it make sense to convert your traditional IRA to a Roth IRA? The ability to convert is not available if your Adjusted Gross Income is over $100,000. So for many taxpayers it is not an issue. For those can convert, the current tax rate is compared to the estimated future tax rate. If the rate in the future is expected to be higher than the current tax rate, then convert. Otherwise that is no advantage to conversion. If you have a windfall of cash, such as an inheritance, and you qualify, conversion may be a good use of those funds. The return on the use of the funds for conversion will be the future tax you save. 14-15 What is an annuity? Briefly explain how an annuity works and how it differs from a life insurance policy. An annuity is the systematic liquidation of an estate in such a way that it provides protection against the economic difficulties that could result from outliving personal financial resources. That is assuming you sign a life annuity contract rather than a term certain contract. Also, the contract is with an insurance company [typically] and it could be subjected to economic difficulties that leads to bankruptcy. In that unlikely case, you may get nothing. Annuitant, you, give a lump sum of money to an entity, typically an insurance company, and in return, the entity will pay you a periodic [month for example] amount for either a term certain or for life depending on the contract. A life insurance contract does not give you anything, but it pays your heirs a lump sum at your death. The life insurance payout is tax free; the income portion of the annuity payment is taxable as ordinary income. 14-16 Which one of the annuity distribution procedures will result in the highest monthly benefit payment? The three options are life annuity, life annuity with refund, and annuity certain. The largest monthly payout would be the annuity certain; it is payout for a specified number of years. Of course at the end of the term, you do not receive any additional payment. 14-17 What is a fixed-rate annuity, and how does it differ from a variable annuity? A fixed rate annuity is an annuity in which the insurance company safeguards your principal and agrees to pay a guaranteed rate of interest on your money. In addition, the (minimum) monthly benefit is set by contract. With a variable annuity, the monthly income provided by the policy varies according to the actual investment experience of the insurer. Does the type of contract (fixed or variable) have any bearing on the amount of money you’ll receive at the time of distribution? Yes. In periods when the market is bullish, the variable annuity will payout more than the fixed annuity. But with a fixed annuity, you know in advance the payout you will receive each month. Not so with a variable annuity. With a variable rate annuity, the amount that is ultimately paid out each month varies with the investment results of the insurance company. Nothing is guaranteed. 14-18 Which type of contract (fixed or variable) might be most suitable for someone who wants a minimum amount of risk exposure? The fixed annuity is less risky than a variable annuity. 14-19 How do variable annuity returns generally compare to mutual fund returns? Can you explain why there would be any difference in returns? The average returns on variable annuities are usually lower than the average returns on mutual funds. The major cause of such differences in performance is the much higher costs associated with variable annuities. Not only are there load charges (commissions) which mutual funds may or may not have, there are insurance fees, contract charges, and/or maintenance fees on variable annuities that, every year, come right off the top of any earnings (or push investment losses down even further). Typically, a variable annuity will have a front-end load (commissions charged on every contribution), a back-end load for several years (charges on every withdrawal), and yearly maintenance fees which include an insurance (mortality) expense of an extra 1-2%, making the total yearly expenses in many cases close to 3%. Obviously, these fees and charges can drag down returns. On the plus side, the returns on variable annuities are tax sheltered (tax-deferred), whereas they would not be with mutual funds, unless the mutual funds are held in a tax-sheltered retirement account. Criterial Thinking Cases 14.1 Comparing Pension Plan Features Linda Calloway and Meredith Perdue are neighbors in Charleston. Linda works as a software engineer for Progressive Apps Corporation, while Sherry works as an executive for Industrial Container Company. Both are married, have two children, and are well paid. Linda and Meredith are interested in better understanding their pension and retirement plans. Progressive Apps Corporation, the company where Linda works, has a contributory plan in which 5 percent of the employees’ annual wages is deducted to meet the cost of the benefits. The firm contributes an amount equal to the employee contribution. The plan uses a five-year graded vesting procedure; it has a normal retirement age of 60 for all employees, and the benefits at retirement are paid according to a defined contribution plan. Industrial container, where Sherry works, has a minimum retirement age of 60. Employees (fulltime, hourly, or salaried) must meet participation requirements. Further, in contrast to the Progressive Apps plan, the Industrial Container program has a noncontributory feature. Annual retirement benefits are computed according to the following formula: 2 percent of the employee’s final annual salary for each year of service with the company is paid upon retirement. The plan vests immediately. Critical Thinking Questions 1. Discuss and contrast the features of the retirement plans offered by Progressive Apps and Industrial Container.
Plan feature Progressive Apps - Linda Industrial Container - Sherry
Type of Plan Defined Contribution Define Benefit
Contribution by employer 5% Fully funded by employer
Contribution by employee 5% none
Vesting 5-year graded Immediate vesting
Benefits Depends upon market results 2% of final salary for each year of service to company
Assumed salary $100,000, Years in service 30 Market return 6% $10,000 per year contributed Amount to 79.085 * 10,000 =$790,850 2% * 30 = 60% of salary Amount to $60,000 per year PV if live 20 years, earn 6%, 11.470 * 60,000 = $688,200.
The plans are examples of the two major types of plans. If make assumptions in last row of table above, the plans will yield very similar benefits. The defined benefit plan has a larger present value, but there is more risk to the employee. If the market does not perform at the 6% level, the amount available for retirement will be less. 2. Which plan do you think is more desirable? Consider the features, retirement age, and benefit computations just described. Which plan do you think could be subject to a conversion to a cash balance plan sometime in the future? Explain. Include in your answer the implications for the employee’s future retirement benefits. As above, the defined contribution plan has a larger present value and a greater risk. The option to convert to a cash balance will give the plan portability, so that if the employee leaves the employer they will be able to take some future benefits with them. The defined benefit plan is less risky to the employee, the market risk to borne by the employer. 3. Explain how you would use each of these plans in developing your own retirement program. The defined contribution gives the employee more control over their benefits along with more risk. When you are 50 years old and have a balance of $500,000 in a retirement plan, if the market drops 10%, it is likely that you will be concerned and have more stress in your life. With a defined benefit plan, you need only worry about doing your job and the employer not going bankrupt. Thus, less stress. A combination of a defined benefit plan funded by employer and an additional defined contribution [IRA or 401(k)] funded by the employee, will give the employee more retirement funds with less overall stress. 4. What role, if any, could annuities play in these retirement programs? Discuss the pros and cons of using annuities as a part of retirement planning. Most likely when employee reaches retirement age, the retirement funds will be converted to an annuity funded by the balance in the defined contribution plan or by the employer for the defined benefit plan. The annuity reduces the market stress for the retired employee and provides a stable retirement. Of course, the employee may enjoy the market and prefer to keep managing their funds. 14.2 Evaluating Maria Sepulveda’s Retirement Prospects Maria Sepulveda is 57 years old and has been widowed for 13 years. Never remarried, she has worked full-time since her husband died 13 years ago—in addition to raising her two children, the youngest of whom is now finishing college. After being forced to go back to work in her 40s, Maria’s first job was in a fast-food restaurant. Eventually, she upgraded her skills sufficiently to obtain a supervisory position in the personnel department of a major corporation, where she’s now earning $58,000 a year. Although her financial focus for the past 13 years has, of necessity, been on meeting living expenses and getting her kids through college, she feels that now she can turn her attention to her retirement needs. Actually, Maria hasn’t done too badly in that area, either. By carefully investing the proceeds from her husband’s life insurance policy, Maria has accumulated the following investment assets: Money market securities, stocks, and bonds $72,600 IRA and 401(k) plans $47,400 Other than the mortgage on her condo, the only other debt she has is $7,000 in college loans. Maria would like to retire in eight years, and she recently hired a financial planner to help her come up with an effective retirement program. She has estimated that, for her to live comfortably in retirement, she’ll need about $37,500 a year (in today’s dollars) in retirement income. Critical Thinking Questions 1. After taking into account the income that Maria will receive from Social Security and her company-sponsored pension plan, the financial planner has estimated that her investment assets will need to provide her with about $15,000 a year to meet the balance of her retirement income needs. Assuming a 6 percent after-tax return on her investments, how big a nest egg will Maria need to earn that kind of income? To fund $15,000 per year, assuming a 6% return on her investment will require: 6% of X = $15,000; X = $15,000 / .06 = $250,000 2. Suppose she can invest the money market securities, stocks, and bonds (the $72,600) at 5 percent after taxes and can invest the $47,400 accumulated in her tax-sheltered IRA and 401(k) at 7 percent. How much will Maria’s investment assets be worth in eight years, when she retires? Future Value of $1 at 5% for 8 years from Appendix A = 1.477; for $72,600 * 1.477 = $107,230 Future Value of $1 at 7% for 8 years from Appendix A = 1.718; for $47,400 * 1.718 = $81,433 3. Maria’s employer matches her 401(k) contributions dollar for dollar, up to a maximum of $3,000 a year. If she continues to put $3,000 a year into that program, how much more will she have in eight years, given a 9 percent rate of return? $3,000 by Maria plus $3,000 by employer, $6,000 per year, 9%, 8 years, From Appendix B, Future Value of annuity of 1, at 9%, for 8 years = 11.028 * $6,000 = $66,168 4. What would you advise Maria about her ability to retire in eight years, as she hopes to? From sum of amounts in part 2 and 3, she will have a nest egg of $107,230 + $81,433 + 66,168 = $254,831. From 1 above, we determined that she needs $250,000. So she will be able to retire in 8 years if all of the assumptions hold true. Terms Found in the Chapter
accumulation period The period during which premiums are paid for the purchase of an annuity.
annuity An investment product created by life insurance companies that provides a series of payments over time.
annuity certain An annuity that provides a specified monthly income for a stated number of years without consideration of any life contingency.
cash-balance plan An employer-sponsored retirement program that combines features of defined contribution and defined benefit plans and is well suited for a mobile workforce.
contributory pension plan A pension plan in which the employee bears part of the cost of the benefits
deferred annuity An annuity in which benefit payments are deferred for a certain number of years.
defined benefit plan A pension plan in which the formula for computing benefits is stipulated in its provisions.
distribution period The period during which annuity payments are made to an annuitant.
Employee Retirement Income Security Act (ERISA) A law passed in 1974 to ensure that workers eligible for pensions actually receive such benefits; also permits uncovered workers to establish individual tax sheltered retirement plans.
fixed-rate annuity . An annuity in which the insurance company agrees to pay a guaranteed rate of interest on your money.
Guaranteed- minimum annuity (life annuity with refund) An annuity that provides a guaranteed minimum distribution of benefits.
immediate annuity An annuity in which the annuitant begins receiving monthly benefits immediately.
individual retirement account (IRA) A retirement plan, open to any working American, to which a person may contribute a specified amount each year.
installment premium annuity contract An annuity contract purchased through periodic payments made over time.
Keogh plan An account to which self-employed persons may make specified payments that may be deducted from taxable income; earnings also accrue on a tax-deferred basis.
life annuity, period certain A type of guaranteed-minimum annuity that guarantees the annuitant a stated amount of monthly income for life; the insurer agrees to pay for a minimum number of years.
life annuity with no refund (pure life) An option under which an annuitant receives a specified amount of income for life, regardless of the length of the distribution period.
noncontributory pension plan A pension plan in which the employer pays the total cost of the benefits.
Pension Protection Act A federal law passed in 2006 intended to shore up the financial integrity of private traditional (defined benefit) plans and, at the same time, to encourage employees to make greater use of salary reduction (defined contribution) plans.
profit-sharing plan An arrangement in which the employees of a firm participate in the company’s earnings.
qualified pension plan A pension plan that meets specified criteria established by the Internal Revenue Code.
refund annuity A guaranteed-minimum annuity that, on the annuitant’s death, makes monthly payments to the beneficiary until the total price of the annuity is refunded.
salary reduction, or 401(k), plan An agreement by which part of a covered employee’s pay is withheld and invested in some form of investment; taxes on the contributions and the account earnings are deferred until the funds are withdrawn.
single premium annuity contract An annuity contract purchased with a lump sum payment
survivorship benefit On an annuity, the portion of premiums and interest that has not been returned to the annuitant before his or her death.
thrift and savings plan A plan to supplement pension and other fringe benefits; the firm contributes an amount equal to a set proportion of the employee’s contribution.
variable annuity An annuity in which the monthly income provided by the policy varies as a function of the insurer’s actual investment experience.
vested rights Employees’ non-forfeitable rights to receive benefits in a pension plan based on their own and their employer’s contributions.
Planning for Retirement Chapter Outline Learning Goals I. An Overview of Retirement Planning A. Role of Retirement Planning in Personal Financial Planning B. The Three Biggest Pitfalls to Sound Retirement Planning 1. Compounding the Errors C. Estimating Income Needs 1. Determining Future Retirement Needs 2. Estimating Retirement Income 3. Funding a Projected Shortfall D. Online Retirement Planning E. Sources of Retirement Income II. Social Security A. Coverage B. Social Security Payroll Taxes C. Social Security Retirement Benefits 1. Old-Age Benefits 2. Survivor's Benefits D. How Much Are Monthly Social Security Benefits? 1. Range of Benefits 2. Taxes on Benefits III. Pension Plans and Retirement Programs A. Employer-Sponsored Programs: Basic Plans 1. Participation Requirements 2. What's Your Contribution? 3. Defined Contributions or Defined Benefits 4. Cash-Balance Plans 5. Qualified Pension Plans B. Employer-Sponsored Programs: Supplemental Plans 1. Profit-Sharing Plans 2. Thrift and Savings Plans 3. Salary Reduction Plans C. Evaluating Employer-Sponsored Pension Plans D. Self-Directed Retirement Programs 1. Keogh and SEP Plans 2. Individual Retirement Account (IRAs) 3. Self-Directed Accounts and Their Investment Vehicles IV. Annuities A. Classification of Annuities 1. Single Premium or Installments 2. Disposition of Proceeds 3. Fixed versus Variable Annuity B. Sources and Costs of Annuities C. Investment and Income Properties of Annuities Solution Manual for Personal Finance Michael Joehnk , Randall Billingsley , Lawrence Gitman 9780357033609

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