View
53
Download
4
Category
Preview:
DESCRIPTION
Chapter 5: Life-Cycle Financial Planning. Objective To analyze how much to save for retirement To determine whether to defer taxes or pay then now, and to get a professional degree, and to buy or rent an apartment. Analyze how much to save for retirement. - PowerPoint PPT Presentation
Citation preview
1
FinanceFinance School of Management School of Management
Chapter 5: Life-Cycle Financial Chapter 5: Life-Cycle Financial PlanningPlanning
Objective To analyze how much to save for retirement
To determine whether to defer taxes or pay then now, and to get a professional degree, and to buy or rent an apartment
2
FinanceFinance School of Management School of Management
Chapter 5 ContentsChapter 5 Contents
Analyze how much to save for retirement. Determine whether to defer taxes or pay them
now. Determine whether to get a professional degree. Determine whether to buy or rent an apartment.
3
FinanceFinance School of Management School of Management
Consumption over the Life CycleConsumption over the Life Cycle
You are currently 35 years old, expect to retire in 30 years at age 65, and then to live for 15 more years until age 80.
You current income is $30,000 per year, and you real labor income adjusted for inflation remains at $30,000 per year until age 65.
The real rate of interest is 3% per year. How much should you spend for consumption now and
how much should you save for retirement ?
4
FinanceFinance School of Management School of Management
Two ApproachesTwo Approaches
Aim for a target replacement rate of preretirement income.
Aim for maintaining the same level of consumption spending before and after retirement.
5
FinanceFinance School of Management School of Management
Target Replacement Rate of Target Replacement Rate of Preretirement IncomePreretirement Income
Recommendation: You should aim for a replacement rate equal to 75% of your preretirement income.
That is 0.75×$30,000 = $22,500.
n i PV FV PMT Result15 3% ? 0 -22,500 $268,604
n i PV FV PMT Result30 3% 0 $268,604 ? $5,646
6
FinanceFinance School of Management School of Management
Maintaining the Same Level of Maintaining the Same Level of ConsumptionConsumption
Assume you plan to consume a constant stream of the same amount in each of the next 45 years, denoted by C.
n i PV FV PMT Result
30 3% 0 ? 1 $47.58
n i PV FV PMT Result
15 3% ? 0 1 $11.94
7
FinanceFinance School of Management School of Management
CC 94.11)000,30(58.47
982,23$C — — Permanent Permanent incomeincome
— — Human capitalHuman capital
45
1
30
1 )1()1(t tt
tt i
Y
i
C
8
FinanceFinance School of Management School of Management
Labor Income and Consumption
-5000
0
5000
10000
15000
20000
25000
30000
35000
35 40 45 50 55 60 65 70 75 80
Age
Rea
l $ lab_incconsump
9
FinanceFinance School of Management School of Management
Human Capital and Wealth
-100000
0
100000
200000
300000
400000
500000
600000
700000
35 45 55 65 75
Age
Rea
l $
fundHumanCapCapital
10
FinanceFinance School of Management School of Management
The Intertemporal Budget ConstraintThe Intertemporal Budget Constraint
R
tt
tT
T
tt
t
i
YW
i
B
i
C
10
1 111
i = real interest rate
R = number of years to retirement
T = number of years of remaining life
W0 = initial wealth
B = bequest
11
FinanceFinance School of Management School of Management
The Effect of Changes in Real IncomeThe Effect of Changes in Real Income
Dr.Omar Ben Holim’s has just graduated from medical school at age 30 and has started training to be a surgeon.
His real salary for the next five years will be $25,000 per year.
After completing his residency, Omar expects to earn $300,000 per year in real terms until he retires at age 65.
Assume that the real interest rate is 3%. If he wants to maintain the same level of consumption
for the rest of his life and his life expectancy is 85 years, how much should he allocate his wealth?
12
FinanceFinance School of Management School of Management
-300,000
-200,000
-100,000
0
100,000
200,000
300,000
400,000
30 35 40 45 50 55 60 65 70 75 80
Age
Con
stan
at D
olla
rs
Salary Consumption Saving
13
FinanceFinance School of Management School of Management
Taking Account of Social SecurityTaking Account of Social Security
In many countries governments oblige citizens to participate in a mandatory retirement system called social security.– Pay a tax during their working years and in turn qualify
for a lifetime annuity in their old age.
– The influence of mandatory saving on voluntary saving.
14
FinanceFinance School of Management School of Management
The Influence of Mandatory Saving on The Influence of Mandatory Saving on Voluntary SavingVoluntary Saving
Suppose that social security benefits are equal to what you would have if– you had saved each year an amount equal to the amount you pay in
social security taxes, and – earned a real interest rate of 3% per year.
Suppose that you are required to pay $2,000 per year in social security taxes for 30 years.
n i PV FV PMT Result
30 3% 0 ? 2000 $95,151
n i PV FV PMT Result
15 3% 95,151 0 ? $7,970
15
FinanceFinance School of Management School of Management
Age Salary Consumption SavingHuman capital Cum. Saving
35 30,000 23,982 4018+2000 588,013 0
65 30,000 23,982 4018+2000 0 191,147+95,151
70 0 16012+7970 -23,982 0 204,573
80 0 16012+7970 -23,982 0 0
The real interest rate implied in social security account vs. that earned in your bank account.
Lifetime annuity implies that the longer you live, the higher your actual rate of return.
16
FinanceFinance School of Management School of Management
Deferring Taxes through Voluntary Deferring Taxes through Voluntary Retirement PlansRetirement Plans
In many countries governments encourage voluntary saving for retirement through provisions of the tax code.
Tax-advantage accounts: IRAs (Individual Retirement Accounts).– Contributions are deductible, and
– interest on the contributions is not taxed until the money is withdrawn.
17
FinanceFinance School of Management School of Management
The tax-deferred plan– You face a tax rate of 20%
and interest rate is 8%.
– You are 30 years before retirement and contribute $1000 to IRAs.
– Your total before-tax cum. account will be:
$1000×1.0830 =$10,063
– You will pay taxes:
0.2×$10,063=$2,012
– You will be left with $8,050.
The ordinary saving plan:– You have to pay $ 200 in
taxes.
– The remaining $800 goes into ordinary saving plan, and interest earnings will be taxed, so after-tax int. rate:
(1-0.2) ×8%=6.4%
– The cum. account will be
$800×1.06430=$5,144.45
The Advantage of The Advantage of Tax-deferred SavingTax-deferred Saving
18
FinanceFinance School of Management School of Management
Should You Invest in a Professional Degree?Should You Invest in a Professional Degree? Joe Grad has just graduated from college and is deciding whether to
go on for his master’s degree. If he takes job immediately, he can earn $30,000 per year in real
terms. If he goes on for two more years of graduate study, he can increase
his earnings to $35,000 per year. The cost of tuition is $15,000 per year in real terms, and the real
interest rate is 3% per year. Joe is now 20 years old and expects to retire at age 65.
n i PV FV PMT Result
2 3% ? 0 45,000 $86,106
n i PV FV PMT Result
43 3% ? 0 5,000 $119,910
2 3% ? 119,910 0 $113,026
19
FinanceFinance School of Management School of Management
Should You Buy or Rent?Should You Buy or Rent? You are currently renting a house for $10,000 per year and
can buy a house for $200,000. Property taxes are deductible for income tax purposes, and
your tax rate is 30%. The maintenance and property taxes are estimated to be:
Should you buy or continue to rent?
Maintenance $1,200
Property taxes $2,400
Total $3,600
20
FinanceFinance School of Management School of Management
If you buy the house, you have to pay $200,000 now. Because the after-tax outflow for property taxes is
0.7×$2,400=$1,680, the cash outflow each year will be:
The NPV of two alternatives will be:
Cash Outflow in year $1,200 $1,680 $2,880t
2 880 Cost of Owning 200 000
0 710 000
Cost of Renting0 7
$ ,PV $ ,
. i$ ,
PV. i
21
FinanceFinance School of Management School of Management
Assume no inflation so that the real and nominal before-tax discount rate is 3%. Thus,
Rent costs at which would you be indifferent between buying and renting:
$337,143(Owning) $476,190(Renting)
$476,190 $337,143 $139,047NPV
$2 880$200 000
0 021 0 021$7,080
X ,,
. .X
Recommended