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Bajtelsmit, Personal Finance: Skills for Life © John Wiley & Sons 2006
Chapter 15
Saving for Distant Goals: Retirement & Education Funding
15-2 Bajtelsmit, Personal Finance: Skills for Life © John Wiley & Sons 2006
Chapter Preview
Determining retirement income needs Estimating retirement income from employer
plans and Social Security Calculating target wealth and savings Understanding retirement payout options Planning for your children’s education costs
15-3 Bajtelsmit, Personal Finance: Skills for Life © John Wiley & Sons 2006
…applying the planning process
15-4 Bajtelsmit, Personal Finance: Skills for Life © John Wiley & Sons 2006
Where Does This Fit in Your Comprehensive Financial Plan
Establish a firm foundation: Evaluate your finances, acquire tools and skills, set goals, develop a budget (Chapters 1 - 4)
Secure basic needs: Liquidity, consumer purchases and credit decisions, insurance, employee benefits (Chapters 5-10)
Build wealth: Save and invest to meet short-term and long-term goals (Chapters 11-15)
Protection: Plan for death and incapacity (Chapters 16-17)
15-5 Bajtelsmit, Personal Finance: Skills for Life © John Wiley & Sons 2006
Retirement Planning Steps1. Estimate before-tax income needs2. Estimate annual retirement income from
employer pension plans3. Estimate annual retirement income from
Social Security4. Calculate retirement income shortfall5. Estimate total retirement wealth needed6. Establish retirement savings goal7. Calculate monthly savings required
15-6 Bajtelsmit, Personal Finance: Skills for Life © John Wiley & Sons 2006
How much will you need? Replacement ratio method
Forecast your future income Retirement needs = X% * Future Income X% = replacement ratio
Adjusted expense method Consider each expense category and adjust for
changes that you expect in retirement Example: Mortgage paid off, higher healthcare
costs, no childcare expense, etc. Adjust for inflation to future dollars and taxes
15-7 Bajtelsmit, Personal Finance: Skills for Life © John Wiley & Sons 2006
Adjusting to Future Dollars
Your current income $30,000 (age 25) If wages increase at an average rate of 4
percent, how much will you be earning in 42 years (age 67)?
FV = PV x (1+i)n
15-8 Bajtelsmit, Personal Finance: Skills for Life © John Wiley & Sons 2006
Adjusting to Future Dollars
Your current income $30,000 (age 25) If wages increase at an average rate of 4
percent, how much will you be earning in 42 years (age 67)?
FV = PV x (1+i)n = $30,000 x (1.04)42
=$155,783
15-9 Bajtelsmit, Personal Finance: Skills for Life © John Wiley & Sons 2006
Income from Employer-Sponsored Retirement Plans
Defined Benefit (DB) plan Benefit is based on a formula that usually
includes years of employment and final salary Example: Benefit = 1% of final 2-year average
salary for every year of service If your final two years of salary are $78,000 and
$82,000 and you worked at the employer for 40 years benefit = 40 x 1% x $80K = $32K
15-10 Bajtelsmit, Personal Finance: Skills for Life © John Wiley & Sons 2006
Three-legged Stool Analogy
Sources of retirement income are like the legs on a three-legged stool Employer-sponsored retirement plans Social Security Own savings
If one or two legs are two short, then the stool topples over
15-11 Bajtelsmit, Personal Finance: Skills for Life © John Wiley & Sons 2006
Three-legged Stool Analogy
15-12 Bajtelsmit, Personal Finance: Skills for Life © John Wiley & Sons 2006
Income from Employer-Sponsored Retirement Plans
Defined Contribution Plan Benefit will depend on the amount in the
account at retirement No benefit promise In planning, consider:
Current plan balance future accumulated wealth Contributions to plan offset your required savings
15-13 Bajtelsmit, Personal Finance: Skills for Life © John Wiley & Sons 2006
Social Security Defined benefit program Every covered worker and their employer
pays 6.2% + 1.45% payroll tax (total 15.3%) Retirement plan Survivors insurance Disability insurance Health insurance (Medicare)
15-14 Bajtelsmit, Personal Finance: Skills for Life © John Wiley & Sons 2006
Social Security Benefits Fully insured status: 40 quarters (10 years) Retirement at age 65 – 67 years old Early retirement at reduced benefits age 62
Reduced because you will contribute for fewer years and collect for more years
Benefit based on your Average Indexed Monthly Earnings (AIME) Top 35 years earnings in today’s dollars
15-15 Bajtelsmit, Personal Finance: Skills for Life © John Wiley & Sons 2006
Social Security Benefits
Primary Insurance Amount (PIA) Amount of benefit to be received Formula replaces higher percentage of lower
earnings
Exhibit 15-5—estimate of benefits if you have average income growth
Example: Current salary $30,000, age 25
15-16 Bajtelsmit, Personal Finance: Skills for Life © John Wiley & Sons 2006
Estimated Social Security Benefits
15-17 Bajtelsmit, Personal Finance: Skills for Life © John Wiley & Sons 2006
Social Security Benefits Example: Current salary $30,000, age 25
Social Security benefit = $62,772 per year at age 67.
15-18 Bajtelsmit, Personal Finance: Skills for Life © John Wiley & Sons 2006
Likelihood of Social Security Being There When Your Retire? Currently not enough assets to pay future
benefit promises Why? Assets are not invested—they are spent Government IOUs to Social Security will have to
be repaid in the future Demographic shifts
more old people; fewer children; living longer Bush Proposal:
Add individual saving accounts to social security
15-19 Bajtelsmit, Personal Finance: Skills for Life © John Wiley & Sons 2006
What is your Shortfall? Total Before-tax Income Needs Minus: Projected income from employer plan Minus: Projected Social Security benefit Equals: Retirement Income Shortfall
15-20 Bajtelsmit, Personal Finance: Skills for Life © John Wiley & Sons 2006
How much to save to meet shortfall?
Use time value of money PMT = amount of annual income you need I = average return (annual or monthly) you can
earn on investment N = number of years you will be retired Solve for PV = amount you need to have saved
up by the date of retirement
15-21 Bajtelsmit, Personal Finance: Skills for Life © John Wiley & Sons 2006
What about inflation?
Previous calculation assumed income would be constant
If you want your income to grow with inflation while you are retired, then you need to calculate an inflation adjusted annuity
Use Exhibit 15-6 (for 4% assumed inflation) or you can calculate with appropriate formula
15-22 Bajtelsmit, Personal Finance: Skills for Life © John Wiley & Sons 2006
Inflation adjusted annuity
RetirementSavings Goal =
PMT = Income Shortfall y = Years in retirement r = average return i = average inflation
y
r
i
ir
PMT
1
11*
)(
15-23 Bajtelsmit, Personal Finance: Skills for Life © John Wiley & Sons 2006
Inflation adjusted annuity
Example: You estimate that you need $50,000 in first year of retirement; your will be retired 25 years; 4% inflation; 10% return
How much do you need to have saved by the time you retire?
15-24 Bajtelsmit, Personal Finance: Skills for Life © John Wiley & Sons 2006
Inflation adjusted annuity
Example: You estimate that you need $50,000 in first year of retirement; you will be retired 25 years; 4% inflation; 10% return
How much do you need to have saved by the time you retire?
At retirement you will need to have saved$50,000 x 12.5659 (from Exh 15-6) = $628,295
15-25 Bajtelsmit, Personal Finance: Skills for Life © John Wiley & Sons 2006
Amount to save each month until retirement 42 years from now: Straightforward TVM problem Use the payment table (Exhibit A-5)
or a calculator
15-26 Bajtelsmit, Personal Finance: Skills for Life © John Wiley & Sons 2006
Straightforward TVM problem Use the payment table (Exhibit A-5)
or a calculator FV = 628,295; I=8; N=42: PMT = $2,065/year
Amount to save each month until retirement 42 years from now:
15-27 Bajtelsmit, Personal Finance: Skills for Life © John Wiley & Sons 2006
Importance of starting early Suppose in previous example, you did not
start saving until 10 years later PMT = $4,681 per year for 32 years
(instead of $2,065/yr for 42 years)
15-28 Bajtelsmit, Personal Finance: Skills for Life © John Wiley & Sons 2006
If you already have some savings?
Problem: You estimate you need $2 million by the time you retire in 45 years. You currently have $50,000 saved in an IRA.
Calculate the annual savings required to meet your goal
15-29 Bajtelsmit, Personal Finance: Skills for Life © John Wiley & Sons 2006
If you already have some savings?
Problem: You estimate you need $2 million by the time you retire in 45 years. You currently have $50,000 saved in an IRA.
Calculate the annual savings required to meet your goal if you earn 8 percent
PV = -50,000; N = 45; FV = $2 million; I = 8 Solve for PMT=$1,045.20
15-30 Bajtelsmit, Personal Finance: Skills for Life © John Wiley & Sons 2006
Retirement Payout Options Annuity for a specific term Life annuity Joint and Survivor annuity Lump sum
15-31 Bajtelsmit, Personal Finance: Skills for Life © John Wiley & Sons 2006
Education Funding Calculate your Target College Funding Goal
How much will it cost to send your kids to college? Uncertainty of tuition inflation Uncertainty of type of institution
How much should you save to meet the target? Use Time Value of Money
15-32 Bajtelsmit, Personal Finance: Skills for Life © John Wiley & Sons 2006
Sample Problem Your child is just born (18 years to save) Calculate the expected total cost
Use Exhibit 15-7 to estimate future costs 4 year public school = 38,534 x 4 = $154,136
15-33 Bajtelsmit, Personal Finance: Skills for Life © John Wiley & Sons 2006
Estimating Future Education Costs
15-34 Bajtelsmit, Personal Finance: Skills for Life © John Wiley & Sons 2006
Sample Problem Calculate the annual savings required to
meet the goal assuming you can earn 6% on your investments: FV =$154,136; N=18; I=6% Solve for payment = $4,987/year
If invest at 8%? If invest at 10%?
15-35 Bajtelsmit, Personal Finance: Skills for Life © John Wiley & Sons 2006
Tax Programs to Help You Save for Education Expenses
Section 529 Prepaid Tuition Plans Allow you to buy tuition credits which can be
exchanged for tuition in the future Example: 100 credits equals one year’s tuition at
a state institution
Section 529 Savings Plans Allow you to invest in mutual funds that are
targeted for payment of college expenses
15-36 Bajtelsmit, Personal Finance: Skills for Life © John Wiley & Sons 2006
Tax Programs to Help You Save for Education Expenses Coverdell Education Savings Accounts
(formerly called Education IRAs) After-tax contributions No tax on withdrawal
Hope Scholarship Credit 100% of $1000 plus 50% of $1000 (total $1500)
of college expenses for first 2 years Lifetime Learning Credit
20% of first $5000 (max $1000) per dependent for undergraduate and graduate education