Bajtelsmit, Personal Finance: Skills for Life © John Wiley & Sons 2006 Chapter 15 Saving for Distant Goals: Retirement & Education Funding

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


…applying the planning process


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)


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


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


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


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


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


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


Three-legged Stool Analogy


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


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)


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


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


Estimated Social Security Benefits


Social Security Benefits Example: Current salary $30,000, age 25

Social Security benefit = $62,772 per year at age 67.


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


What is your Shortfall? Total Before-tax Income Needs Minus: Projected income from employer plan Minus: Projected Social Security benefit Equals: Retirement Income Shortfall


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


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


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*

)(



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?



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


Amount to save each month until retirement 42 years from now: Straightforward TVM problem Use the payment table (Exhibit A-5)

or a calculator


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:


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)


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 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


Retirement Payout Options Annuity for a specific term Life annuity Joint and Survivor annuity Lump sum


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


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


Estimating Future Education Costs


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%?


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


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

Documents

Bajtelsmit, Personal Finance: Skills for Life © John Wiley & Sons 2006 Chapter 15 Saving for Distant Goals: Retirement & Education Funding