10 - Chapter 10 Retirement Planning Accumulations and...

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Unformatted text preview: Chapter 10 Retirement Planning Accumulations and Distributions Copyright© 2011 Money Education, LLC Chapter 10 Remaining Work Life Expectancy (RWLE) 2 Work life expectancy (WLE) is the period of time a person is expected to be in the work force. The remaining work life expectancy (RWLE) is the work period that remains at a given point in time before retirement. Copyright© 2011 Money Education, LLC Chapter 10 Retirement Life Expectancy (RLE) 3 Retirement life expectancy (RLE) is the time period beginning at retirement and extending until death. Proper planning is needed because if the retired individual lives longer than he and his financial planner prepared for, there is a risk of running out of money. Chapter 10 Copyright© 2011 Money Education, LLC Savings and Investment Issues 4 The Savings Amount • If individuals do not begin saving at an early age, then they must save a greater amount of their gross earnings to compensate for the missed years of contributions and compounding of investment returns. Copyright© 2011 Money Education, LLC Chapter 10 Benchmark for Investment Assets as a Percentage of Gross Pay 5 Age Investment Assets as a Ratio to Gross Pay Needed at Varying Ages 25 0.20 : 1 30 0.6 – 0.8 : 1 35 1.6 – 1.8 : 1 45 3–4:1 55 8 – 10 : 1 65 16 – 20 : 1 Copyright© 2011 Money Education, LLC Chapter 10 Savings Rate 6 The savings rate identifies the average savings amount in the U.S. based on consumption. It is a percentage of disposable personal income. Chapter 10 Copyright© 2011 Money Education, LLC Timing of Savings 7 The earlier a person saves, the greater the number of future compounding periods available prior to retirement. Time / Savings Example (Accumulation at Age 65, Ordinary Annuity) Sheila Justin Total Invested (10 years) $25,000 $77,500 (30 years) Balance at Age 65 $393,588 $308,365 8% 8% Earnings Rate Copyright© 2011 Money Education, LLC Chapter 10 Investment Decisions 8 It is important to have a historical perspective of investment returns and risks for a wide variety of asset classes. Historical Returns, Inflation-Adjusted Returns, & Standard Deviation of Asset Classes (1932-2006) Standard Deviation Real Return After-Tax & Inflation 10% 33% 6.1% 7% 20% 4% 6% 3% 9% 1.2% 5.5% 2.5% 5.5% 0.9% 3% N/A 3.1% N/A Historical Returns InflationAdjusted Returns Small-Capitalization Stocks 13% Small-Capitalization Stocks 10% Fixed-Income Securities (Corporate) Asset Class Treasury Consumer Price Index (CPI) Copyright© 2011 Money Education, LLC Chapter 10 Managing Retirement Distribution 9 There are several approaches that can be utilized to reduce the risks of outliving retirement accumulation. Two of the more common are: • 1. 4% per year approach: Limit withdrawals from the capital accumulation to four percent per year. • 2. Money-for-life approach: Divide capital into unequal strata with each strata representing five years of retirement. Invest each strata in varying asset classes expected to produce inflation adjusted retirement income of about 5 to 5½ percent per year of initial capital. Chapter 10 Copyright© 2011 Money Education, LLC Retirement Needs Analysis 10 Copyright© 2011 Money Education, LLC Chapter 10 Planning for Retirement Pretax or After-Tax 11 Most financial planners who are not certified public accountants (CPAs) plan in pretax dollars believing that a pretax approach is what their clients best understand. Planning can be effective either way as long as the client and the planner understand the planning choice. Throughout this course we generally use a pretax approach. Copyright© 2011 Money Education, LLC Chapter 10 Wage Replacement Ratio (WRR) 12 The wage replacement ratio (WRR) is an estimate of the percent of annual income needed during retirement compared to income earned prior to retirement. For example, if a client in the last year of work (prior to retirement) makes $100,000, and that client needs $80,000 in the first retirement year to maintain the same preretirement lifestyle, the wage replacement ratio (WRR) is 80 percent ($80,000 ÷ $100,000). Chapter 10 Copyright© 2011 Money Education, LLC Calculating the Wage Replacement Ratio 13 There are two alternative methods used to calculate the wage replacement ratio: • Top-Down Approach The top-down approach is frequently used with younger clients where income and expenditure patterns are unlikely to remain constant. $50,000 = 100.00% Of salary in % terms ($5,000) = (10.00%) Less: current savings in % terms ($3,825) = $41,175 = (7.65%) less: payroll taxes in % terms (not paid in retirement) 82.35% wage replacement ratio in % terms Bottom-Up (Budgeting) Approach The bottom-up approach is also called the budgeting approach and is often used with older clients. This approach allows the planner to determine a wage replacement ratio with greater precision than the top-down approach of estimating retirement needs. Many expert financial planners conclude that most clients need approximately 70 to 80 percent of their pre-retirement current income to retire and maintain their pre-retirement lifestyle. Copyright© 2011 Money Education, LLC Chapter 10 Adjustments from Pre-Retirement Income to Retirement Income Needs 14 Copyright© 2011 Money Education, LLC Chapter 10 Sources of Retirement Income 15 Social Security • Social Security provides a foundation of retirement income. • Social Security is an adequate wage replacement for lower wage earners, but is clearly inadequate to provide sufficient replacement income for middle-to-higherwage earners. Private pension and company-sponsored retirement plans • Private pension plans are the second source of retirement income. Personal assets and savings • Personal assets and savings is the one source that traditionally is the most influenced by the individual. Chapter 10 Copyright© 2011 Money Education, LLC Qualitative Factors in Retirement Advising Clients 16 Qualitative factors associated with retirement may be more important than the financial or quantitative factors. Qualitative factors include: involuntary versus voluntary retirement; emotional and psychological factors, such as loss of esteem with loss of job and boredom in retirement; and the decision to relocate or to do things that were postponed during the work life (i.e., travel or pursue another vocation). Voluntary retirement, even when well-planned, means change, and change is difficult. Copyright© 2011 Money Education, LLC Chapter 10 Qualitative Factors in Retirement Advising Clients 17 Capital needs analysis is the process of calculating the amount of investment capital needed at retirement to maintain the pre-retirement lifestyle and mitigate the impact of inflation during the retirement years. It uses both objective and subjective criteria to determine retirement income needs. There are three methods for analyzing capital needs: • The basic annuity method • The capital preservation model • The purchasing power preservation model Copyright© 2011 Money Education, LLC Chapter 10 Accurate Assumptions 18 Assumptions are made for the wage replacement ratio, work life expectancy, retirement life expectancy, inflation, earnings, Social Security, and any other benefits. If these assumptions are inaccurate, the projection using those assumptions will be flawed. Chapter 10 Copyright© 2011 Money Education, LLC Basic Planning Capital Needs Analysis/Annuity Method 19 The annuity method is the simplest way to determine retirement needs. • Calculate the WRR. • Determine the gross dollar needs. • Determine the net dollar needs. • Calculate the inflated pre-retirement dollar needs. • Calculate the capital needed at retirement age. Copyright© 2011 Money Education, LLC Chapter 10 Example (1 of 3) 20 Sherry, age 42, currently makes $70,000. Her wage replacement ratio is determined to be 80 percent. She expects that inflation will average 3 percent for her entire life expectancy. She expects to earn 9.5 percent on her investments and retire at age 62, possibly living to age 90. She has sent for and received her Social Security benefit statement, which indicated that her Social Security retirement benefit in today’s dollars adjusted for early retirement is $15,000 per year. It is reasonable to subtract the Social Security benefit from today’s needs because it is inflation adjusted. Copyright© 2011 Money Education, LLC Chapter 10 21 Chapter 10 - 21 - Copyright© 2011 Money Education, LLC Example (3 of 3) 22 Chapter 10 - 22 - Copyright© 2011 Money Education, LLC Advanced Financial Planning Capital Preservation Model (CP) 23 The capital preservation model assumes that at life expectancy, as estimated in the annuity model, the client has exactly the same account balance as he started with at retirement. The purchasing power preservation model assumes that the client will have a capital balance of equal purchasing power at life expectancy as he did at retirement. Recall that the amount needed for Sherry at age 62 calculated from Example 10.5 was $1,022,625.84. If we discount that amount at the expected earnings rate of 9.5 percent, we can determine the additional amount of capital necessary to leave an estate of exactly $1,022,625.84 at life expectancy. Copyright© 2011 Money Education, LLC Chapter 10 Advanced Planning Purchasing Power Preservation Model (PPP) 24 This model essentially maintains the purchasing power of the original capital balance at retirement. Chapter 10 Copyright© 2011 Money Education, LLC Range Estimates & Sensitivity Analysis 25 Range Estimates • Using range estimates allows the planner to project what outcome will occur if we use a range of assumptions (e.g., 2.5% to 3.5% inflation) for a variable as opposed to a single mean expectation (three percent inflation). Sensitivity Analysis • Sensitivity analysis consists of rotating each variable assumption toward the undesirable side of the risk. Small deviations in one variable may significantly impact the entire plan. For example: One additional year of employment Small changes in the spread between the earnings rate and the inflation rate A small increase in inflation Copyright© 2011 Money Education, LLC Chapter 10 Range Estimates & Sensitivity Analysis 26 Copyright© 2011 Money Education, LLC Chapter 10 Simulations and Monte Carlo Analysis 27 A Monte Carlo Analysis is a mathematical tool that can be used to illustrate the unpredictability of the “real” world and its effects on an individual’s retirement plan. Monte Carlo Analysis helps the planner to understand the possibilities and probabilities. Monte Carlo Analysis cannot predict particular events. Monte Carlo Analysis is a valuable tool and an interesting exercise. It should not be used in a vacuum. Chapter 10 Copyright© 2011 Money Education, LLC ...
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This note was uploaded on 02/27/2012 for the course FIN 132 taught by Professor Afda during the Spring '12 term at Centenary College New Jersey.

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