Chapter 11

Both types of IRAS include:

- have a annual contribution limit of the lesser of 6,000 or earned income per person - persons over age 50 are allowed an extra 1,000"catch-up"contribution - allow tax deferral on all income and gains earned as long as funds are not withdrawn

effects of changes in retirement "risk variables" on periodic work life retirement investment contributions required to meet a retirement need (decreases)

- inflation rate, down - investment return rate, up - work life expectancy, down - retirement life expectancy, down - retirement lifestyle, down

Qualifying for benefits S/S

two conditions: 1) have the appropriate "insured" status and - funded by FICA and self-employment taxes - benefits vary from retirement to survivor 2) have a qualifying life event -survivorship benefits= is the death of the individual - disability = the person must be declared disabled by a state government agency - retirement = is reaching a retirement age. - between 62 -67.

effects of changes in retirement "risk variables" on periodic work life retirement investment contributions required to meet a retirement need (increases)

- inflation rate, up - investment return rate, down - work life expectancy, down - retirement life expectancy, up - retirement lifestyle, up

Define retirement annuities

- is a type of life insurance product that provides a periodic retirement payment as long as the retiree lives - the insurance company (annuity provider) bears the risk that the annuitant will live longer than expected

Retirement planning Phases:

- is divided into two time phases: 1) Accumulation period - is the working life, pre-retirement. Presumably, during this time, the individual is saving and investing toward retirement, participating in an employer retirement plan, and/or paying into social security 2) Distribution period - is the period after retirement date. During this period the individual is collecting retirement benefits and drawing down retirement savings to fiance living expenses. the retiree may or may not be working part-time for compensation - 65 is historically retirement age

Purchasing power preservation model

- is even more conservative than the capital preservation model - assumes that the purchasing power of the accumulated fund balance necessary under the annuity model is preserved until life expectancy - requires that additional funds are accumulated by retirement so that the purchasing power of the original needs are maintained until life expectancy - annual savings under this model are greater than what is required under annuity and capital models

The serial payment approach

- method of funding the necessary retirement accumulation is to increase the savings amount each year, which often correlates to typical salary increases over a career - can be equal to inflation or can equal any other reasonable assumption

Social security basics

- provides retirement, disability, and survivor (death) benefits to qualified individuals - there is much uncertainty about the future of s/s beyond the year 2033

Wage replacement ratio

- represents the % of pre-retirement working income that is necessary in retirement - 80% rule BOGUS - formula = expenses in retirement / pre-retirement income

expenses that may decrease during retirement

- savings is no longer necessary at retirement - FICA payments are eliminated - mortgage payments may end - lower income means lower taxes - auto costs are lower due to less driving - insurance, may be reduced - work related expenses

Bottom - up (budget) approach

- to determining the WRR - because it determines total expenses in the same manner that is used to build a budget - used by people who are close to retirement

retirement needs analysis

- to find the amount of money needed at the beginning of retirement, and/or the PV now of that needed. from there can estimate a required monthly or annual savings amount - only need about 80% of your pre-retirement income to maintain a similar standard of living - the rule is BOGUS

Expenses that may increase during retirement

- vacation and travel costs - hobby costs - costs for a second home - lifestyle changes - health care and medical costs - costs of supporting adult children - higher costs due to inflation - gifts to family members

example of Annuity taxation

-Example: Bill retires and pays $500,000 for an annuity that will pay $32,000 per year as long as bill lives. Bill's retirement life expectancy is 25 years. -Bill expects to receive a total of 25 x $32,000 = $800,000. -He paid $500,000, so 5/8 of each payment is considered return of capital and not taxed. -3/8 of each payment is considered as taxable income.

Example of Needs analysis

-Roger is 30 years old and plans to retire at age 65. He has a 20 year retirement life expectancy. -Roger's wage now is $56,000 annually, and his wage replacement ratio is 85%. He expects to receive a social security benefit equal to $11,000 (today's dollars) annually in retirement. -The expected inflation rate is 2%, and Roger can invest at an average rate of 6%. -What is the present value of Roger's retirement need? -Use the unequal cash flow registers: ´ CF0 = 0; CF1=0; F01=34 (Roger wants first payment at age 65) ´ CF2 = 56000*0.85 - 11000 = 36600; F02=20. ´ real i = 3.9216% (= [1.06/1.02] - 1) ´ NPV = 135435.66 -Roger can compare this number to the value of his investments to see if he is on track.

when must required minimum distribution begin for traditional IRA, Roth IRA, Qualified plan

-Traditional IRA= age 70.5 - Roth IRA= never - Qualified plan- later of 70.5 or separation from service

Capital Preservation Model

-assumes that the accumulated fund balance necessary under the annuity model is preserved until life expectancy

Stages of retirement benefits of S/S

-retiring at your normal retirement age entitles you to a monthly benefit equal to 100% of your PIA - your PIA will increase, if continue working til 70 Early retirement - can begin as soon as age 62 - permanently reduced % of PIA Dependent and spousal benefits - additional benefits for the spouse and certain dependents - spouse can choose the higher of her own retirement benefit or the spouse based retired spouse benefits - there is a family max

Annuity taxation

-when a retiree receives an annuity payment, that payment is treated as part taxable income (ordinary income) and part return of capital (not taxed)

Retirement savings needs personal and economic factors:

1) Present and desired lifestyle 2) Length of accumulation and distribution periods - work life expectancy (WLE) refers to the length of time we plan to work - retirement life expectancy (RLE) refers to the length of time we plan to be in retirement 3) Inflation rates - when inflation is high, retirement income needs increase. 4) Rates of return on investments - the higher the investment return, the less saving required. greater returner = to greater risk

Employer retirement plans

1) Qualified plans - offer maximum tax advantages for employer and employee, they are highly regulated by government

three major lines of defense against the risk of superannuation:

1) Social security 2) employer-sponsored retirement plans 3) personal savings - in order to ensure adequate retirement funding, an individual should have all three- main is personal savings

Taxation and Planning S/S

1) Taxation of benefits - for low income persons (mfj 33,000), benefits are excluded from taxable income - income increases ,benefits are taxable on a sliding scale, with up to 85% of benefits subject to tax - is someone takes early retirement benefits and continues to work, their retirement benefit will be reduced based on how much money was earned from work that year 2) Planning - www.ssa.gov

What are the major risks in employer-sponsored retirement plans? who bears these risks in DB versus DC plans?

Risks include: longer than expected longevity, lower than expected investment returns, higher than expected inflation -In a DB plan, the employer bears these risks, the only risk the employee bears is counter party risk - In a DC plan, the employee bears all risks

what factors legitimately can be considered in reducing a wage replacement ratio

Present savings rate towards retirement, FICA tax rate

Individual retirement accounts

- (IRA) are a tax-advantaged vehicle for individual investment toward retirement - - is a way of designating a bank account, brokerage account, mutual fund account or other eligible investment that gives significant tax advantages to the investor

Primary Insurance Amount (PIA)

- S/S benefit based formula that considers the person's length of work life, money earned and FICA/SE paid, and the average national wage over that time period - base monthly retirement benefits

retirement funding defined

- also called capital needs ananlysis - is a process of determining how much money

The amount of the periodic retirement benefit received is a function of:

- amount of money paid by the annuitant to fund the annuity - applicable interest rates or rates of return - the annuitant's life expectancy

top-down approach

- begins with 100% of pre-retirement income and adjusts the % up or down depending on expenses that may be eliminated or added - more then a few years to retirement - used to compute expenses for WRR

Survivor and disability benefits

- can be used in planning disability and life insurance needs during the accumulation period 1) Disability -must meet strict definition of disability - provides monthly benefits = 100% PIA, plus additional spouse and dependent benefits 2) Survivorship - pays benefits to the survivors of the insured person - without minor children must wait until retirement age- the "blackout period"

Earnings rate and inflation accurate assumptions when computing payments for retirement

- earnings rate should take into account the expected return rate of an individuals portfolio, based on the portfolios asset allocations - inflation rates should be based on historical trends - if the difference between the two are higher than the historical real rates of return, then it is an indication that either the estimate for inflation is too low or the expected return is too high

Defined benefit/Defined contribution

1) benefit plans - promise to pay a given benefit to the retired employee in retirement. - based on a formula that considers the employees age, years of service and average income earned - employer is making a long term, uncertain promise and bearing inflation, longevity and investment risk 2) Defined Contribution plans - pay a stated amount into the employees retirement plan now and make no promises about the future - the employee is bearing inflation, longevity and investment risks - younger workers get more benefit from this - because of increased economic and market uncertainly, most employers use contribution plans

Factors affecting retirement planning

1) education (0-18) *school years - there is a direct correlation between the amount of education and the average income earned during one's lifetime - more years of education means a delay entering the workforce 2) Work life expectancy (WLE) *Working Years (18-25) start - key factors before retirement - saving amount and rate, timing of the savings, investment earnings rate, inflation rate and years until retirement 3) Retirement Life Expectancy (RLE) (62-65 to death) * retirement years - key factors - annual retirement needs - wage replacement ratio - Longevity - life expectancy - investment earnings rate - inflation rate

Annuity types

1) fixed annuity - pays a fixed dollar amount monthly or annually as long as the annuitant lives. - the annuitant bears inflation risk and premature death risk 2) period certain annuity - guarantees to pay a minimum number of payments, even if the annuitant dies before that time - annuitant avoids some premature death risk 3) joint and survivor annuity - insures two lives and pays until the second death - the payment may or may not be reduced at the first death 4) variable annuity - investments with the intent of earning returns that allow an increasing payment (this helps offset inflation risk)

Popular defined contribution plans

1) profit-sharing plans - not related to firm profit 2) Section 401-k plans - works like profit sharing, expect: - employee makes payroll deduction contributions to the plan - these deductions reduce the employees w2 income and current income tax 3)Employee stock ownership plans (ESOP) - in all these plans no contributions are taxed until receieved

Qualified plans advantages:

1) tax-deferral on contributions to the plan - employee pays no tax on this compensation at the time of contribution 2) tax deferral on income and gains to the plan - while working, funds in the retirement plan are invested for gain - until the employee actually takes money distributions from the plan there is no income tax - the benefits received are taxed to the retired employee as ordinary income

Two types of IRA'S

1) traditional IRA - the gains/income part of withdrawals is taxed at the retirees ordinary income tax rate - required to begin taking distributions at age 70.5 - contributions may be subtracted from income as an adjustment (this adjustment phases out for workers who are in a employer plan and who are above a certain income level) - no income limit to being able to make non-deductible contributions 2) Roth IRA - at retirement, the gains/income part of withdrawals is not taxed - never required to take distributions - contributions are made with after tax income - enjoys tax deferral and tax-free income at retirement - phases out at upper income levels - early withdrawals are more flexible, possible to take early withdrawals without tax or penalty - very much like the coverdell ESA

Qualified plan regulation

1) vesting requirements - vested means the employee owns a right to retirement assets or benefits by 7th year or shorter work year 2) Distributions - for taking out before age 59.5 there is a substantial penalty (income tax plus an additional 10%) some exceptions applies

what are the differences between an employer defined-benefit plan and a defined contribution plan?

DB: promises pmt@ retire, ER bears inflation, investment and longevity risks, favors older EE DC: promises pmt now, EE bears inflation, investment and longevity risks, favors younger EE

Superannuation

living longer than your money at retirement

name five retirement "stressors" that can affect newly or about to retirees

location, activity, sense of worth, medical, family, asset disposition

Example of wage replacement ratio

retirement income is not subject to FICA tax so someone can maintain the same standard of living in retirement with 92.35% (1 - .0765) of their pre-retirement wage. Also, in retirement there is still a need to save, but not a need to save for retirement. So, if someone has contributed 10% of her wage annually to a 401-k, she can manage in retirement without that 10% gross. - then substract S/S and defined benefit payments

name three different categories of social security benefits and what is the tax treatment of social security benefits received

retirement, disability, and survivor. - up to 85% of SS benefits received may be considered taxable income

Try it yourself - Retirement

´Bill presently earns $45,000 per year. He wants to retire in 30 years, and he plans to live 25 years in retirement. He can invest at 6.5% and inflation is expected to be 3%. He wants a WRR = 90%. What is the present value of Bill's retirement need? ´ ´Beck just retired today with retirement savings = $2.5 million. He can invest at 5%, and the inflation rate is expected to be 3%. If Beck expects to live 28 years in retirement, what annual payment can he take annually with constant purchasing power?

Try it yourself Solutions

´Bill: ´Income need = 0.90(45000) = $40,500; real i= 1.065/1.03 - 1 = 3.40%. ´Go to your CF registers: C01 = 0; C02 = 0, F02 = 29; C03 = $40,500, F03 = 25. [2nd][Quit] ´ [NPV] input i= 3.40 [enter][↓][cpt] → PV = $631,183. ´ ´Beck: ´This is the growing payment annuity problem. Real i= 1.05/1.03 - 1 = 1.94%. ´PV = -2500000; n= 28; i= 1.94. Compute PMTDUE = $114,345. This will be the dollar amount of his first withdrawal. ´

Example 2 of Needs analysis

´Here is another approach. This time we want to know the amount needed at the beginning of retirement. Let's use the same data as before with Roger. -How much money does Roger need at age 65? =1 - Find FV of inflated replaced wage. PV=36600; i=2; n=35; ´ FV=73196. ´2 - Find PVAdue of pmt=73196; n=20; i=3.9216; PV = 942848. -Roger needs to have $1,040,981 in his investments at age 65.

Try it yourself: Annuity Taxation

´Meghan just retired and bought a fixed annuity for $800,000. The annuity contract promises a $3,000 monthly payment to Meghan as long as she lives. As of now Meghan's life expectancy = 27 years. How much of each of the $3,000 payments is considered taxable income? -Alyson retired and bought a fixed annuity for $450,000. The annuity will pay $2,000 per month for the rest of Alyson's life, which is expected to last another 20 years. How much of each $2,000 payment is considered taxable income?

Try it yourself Solutions

´Meghan: ´Amount expected to be collected = 27 × 12 × $3,000 = $972,000. ´Exclusion ratio = $800,000 / $972,000 = 0.82. ´Taxable amount of each payment = (1 - 0.82)( $3,000 ) = $540. -Alyson: ´Amount expected to be collected = 20 × 12 × $2,000 = $480,000. ´Exclusion ratio = $450,000 / $480,000 = 0.94. ´Taxable amount of each payment = (1 - 0.94)( $2,000 ) = $120.

Example #4 Needs analysis

´Sometimes people want to leave an inheritance in real purchasing power terms. We can plan for this with what's called the purchase power preservation approach. Let's go back to Roger. -We saw that Roger needs $942,848 at retirement. Suppose he wants to leave this amount as an inheritance, but in real purchasing power. How much money does Roger need at age 65? -Find the PV of: FV =$942,848; n=20; real i = 3.9216. PV = 436842 -Add this to 942848 to get 1379690 -Roger needs to have $1379690 in his investments at age 65. He can enjoy retirement and leave almost $950k inheritance in real terms.

Example #3 needs analysis

´Sometimes people want to leave an inheritance. We can plan for this with what's called the capital preservation approach. Let's go back to Roger. -We saw that Roger needs $942,848 at retirement. Suppose he wants to leave this amount as an inheritance. How much money does Roger need at age 65? -Find the PV of: FV =$942,848; n=20;i = 6. PV = 293984 -Add this to 942848 to get 1236832 -Roger needs to have $1,236,832 in his investments at age 65. He can enjoy retirement and leave almost $950k inheritance.