1. 1 (of 23) FIN 200: Personal Finance Topic 22–Retirement Lawrence Schrenk, Instructor

2. 2 (of 23`) Learning Objectives 1. Explain the importance of longevity risk. ▪ 2. Discuss the ways of saving for retirement. 3. Calculate the savings needed to ensure a specified retirement lifestyle. ▪

3. Life and Retirement Expectancy Life Expectancy  83 Years (at age 20) Retirement Expectancy  13 Retirement Years (retirement at age 70) ▪ Probability of 20 Year Old Male Living to… ▪  Calculator Calculator 3 (of 23`) 707580848994 83%72%56%41%21%7%

4. Longevity Risk  Risk that you might live longer than expected  Risk that you might out-live your retirement savings Women live longer–more longevity risk Longevity risk will continue to increase  Now 13 years  In 50 years (when you retire) ??? 4 (of 23`)

5. Social Security Most widely used source of retirement income, covering 97% of U.S. workers. Part of retirement income, not sole source. Earnings & Benefit Statement Full benefits at 67, reduced at age 62. See www.ssa.govwww.ssa.gov In 2050 it is estimated there will be two workers per retiree. 5 (of 23`)

6. Why Do Companies Set Up Retirement Plans? Competition Tax Shelters Personal Retirement for the Owners Personal Retirement for the Employees 6 (of 23`)

7. DB versus DC, etc. Defined Benefit Plan (DB)  The amount you receive after retirement is fixed. Defined Contribution Plan (DC)  The amount your employer contributes to your retirement fund is fixed. Alternatives Portability 7 (of 23`)

8. Defined Benefit Plan (DB) Fixed Amount in Retirement Percentage of Ending Salary Firm Bears  Longevity Risk  Investment Risk Underfunding Diversification Concern Incentive/Agency/Control Issues 8 (of 23`)

9. Defined Contribution Plan (DC) Fixed Contribution during Employment Percentage of Salary You Bear  Longevity Risk  Investment Risk Types  Money-Purchase Pension Plans  Stock Bonus Plans  Profit-Sharing Plans 9 (of 23`)

10. Tax Deferred Accounts Employer Qualified Plans:  401(k), Roth 401(k), 403(b), Roth 403(b), or 457 retirement plans for the employee Individual and Small Business Retirement Accounts:  IRA’s (Roth and Traditional), Keoghs, SEP’s and SIMPLE’s for the self- employed 10 (of 23`)

11. Employer: 401(k) Plan Employer makes non-taxable contributions and reduces your salary by the same amount. Employee contributions are tax- deferred. Some employers match a portion of the funds you contribute. 11 (of 23`)

12. Individual: Regular IRA Contribute up to $5,000 May be tax-deductible. Interest accumulates tax free until you start taking it out. You pay taxes on the money as you withdraw 12 (of 23`)

13. Individual: Roth IRA Not tax deductible, but earnings accumulate with distributions tax free after age 59½ Traditional versus Roth  Marginal Tax Rate  Calculator Calculator 13 (of 23`)

14. Annuities Guaranteed Income for Life Fixed or Variable Payments Single Payment or Periodic Payments With deferred annuities, income payments begin at some future date. Contributions, and the interest they earn, are tax-deferred until you begin drawing the money out. High Fees 14 (of 23`)

15. Longevity Insurance Pros  Bigger payouts than alternatives, e.g., deferred annuities.  Payments come for the rest of your life.  Amount of the future payments is generally fixed Cons  There's no death benefit.  You lose the ability to use the money you invest in this product for other investments. 15 (of 23`)

16. Planning for Retirement How long will you live? What income do you need?  Remember inflation! Do you have additional resources?  Social Security, House, Life Insurance, etc. How much do you need to save?  Tax Implications How should you invest this?  Risk Tolerance 16 (of 23`)

17. Retirement Needs Amount needed depends on  Age at Retirement  Health Status and Life Expectancy  Goals (e.g., Travel, Hobbies, Work in Retirement)  Lifestyle Decisions (e.g., Choice of Area/Housing)  Available Resources (e.g., Health Benefits) Resources  Calculator Calculator  BLS Data 17 (of 23`)

18. Retirement Needs Some expenses may go down or stop  401(k) Retirement Fund Contributions  Work, Clothing, and Housing Expenses Other expenses may go up.  Life and health insurance unless your employer continues to pay them.  Medical Expenses  Expenses for Leisure Activities 18 (of 23`)

19. Asset Allocation: Traditional Approach Diversified Portfolio Stock, Bond, Cash Mix Shifting Allocations over Time Factors  Use a diversified set of investments  Consider the number of years to retirement  Consider your level of risk tolerance 19 (of 23`)

20. Asset Allocation: Traditional Approach 20 (of 23`)

21. Asset Allocation: Worry Free Approach Risk Free, Inflation Proof Investments  TIPS  I-Bonds  Inflation Adjusted Annuities 21 (of 23`) Zvi Bodie and Michael J. Clowes. Worry Free Investing: A Safe Approach to Achieving Your Lifetime Financial Goals. Zvi Bodie and Michael J. Clowes. Worry Free Investing: A Safe Approach to Achieving Your Lifetime Financial Goals.

22. Simplified Example You hope to retire in 50 years and need $70,000 in pretax income to retire comfortably for 20 years. Data  Expected Social Security $10,000/year (real)  Inflation 4%  Investment Return 8% before retirement 7% during retirement. 22 (of 23`)

23. 23 Simplified Example (cont’d) Time 50 years 20 years Return 8% Return 7% Inflation 4% Inflation 4% Now Retirement Death

24. 24 Simplified Example (cont’d) Two Stage Calculation Stage One:  How much do I need at retirement? Stage Two:  How much do I need to save until retirement?

25. 25 Simplified Example (cont’d) Calculate shortfall (before tax basis): The shortfall is $70,000 – $10,000 = $60,000 or $5,000 monthly How much do you need at retirement? P/Y = 12 PMT = -$5,000 N = 20 x 12 = 240 I/Y = 7% - 4% = 3% CPT, PV = $901,554.57

26. 26 Simplified Example (cont’d) How much do you need to save monthly? P/Y = 12 N = 50 x 12 = 600 I/Y = 8% - 4% = 4% FV = -$901,554.57 PMT = $472.18

27. Project Note 27 (of 23`)

28. 28 (of 23`) Ethical Dilemma