Planning for the Future Essential Question: How does planning for retirement affect a person’s financial plan? Chapter 15

Copyright ©2014 Pearson Education, Inc. All rights reserved.15-2 Learning Objectives Understand the concept of time value of money, including factors that influence it and ways to calculate it Explain the role of diversification in managing an investment portfolio Describe how time value concepts affect retirement planning and estate planning

Copyright ©2014 Pearson Education, Inc. All rights reserved.15-3 Time Value of Money Time value of money –Refers to the fact that money received today is worth more than money received next year or the year after We can put money to work for us in various investments By putting your money to work for you, you can begin saving for any number of goals Postpone certain purchases now and save the money instead

Copyright ©2014 Pearson Education, Inc. All rights reserved.15-4 Future Value versus Present Value Future value –The projected value of a sum of money at some point in the future Compounding –Earning interest on the principal and the interest earned in the past Calculating future value is the most important time value concept when focusing on wealth accumulation You can use this time value of money tool to calculate how much you can save by the time you reach age 40 or 60 Take a look at Figure 15.1 to see how compounding works

Copyright ©2014 Pearson Education, Inc. All rights reserved.15-5 Figure 15.1: Annual Return and Retirement

Copyright ©2014 Pearson Education, Inc. All rights reserved.15-6 Future Value versus Present Value Present value –The value of a sum of money at the present time Present value techniques are the opposite of future value Instead of trying to take some amount today (present value) and seeing what it will grow to in the future (future value), you are taking some future value and brining it back to the present

Copyright ©2014 Pearson Education, Inc. All rights reserved.15-7 Figure 15.2: Present and Future Value

Copyright ©2014 Pearson Education, Inc. All rights reserved.15-8 Math for Personal Finance Assume that Jenise invested $1,000 in the stock market and earned an average of annual return of 12% How much would she have after 50 years?

Copyright ©2014 Pearson Education, Inc. All rights reserved.15-9 Math for Personal Finance Solution: The formula solution is future value = present value x (1 + interest rate) n, where n = number of years. Jenise will have $1,000(1.12) 50 = $289,022.19

Copyright ©2014 Pearson Education, Inc. All rights reserved Math for Personal Finance Shane’s uncle promised to give him $10,000 when he graduates college in one year. What equivalent amount could Shane receive today assuming he could put the money in a CD earning 4% ?

Copyright ©2014 Pearson Education, Inc. All rights reserved Math for Personal Finance Solution: This questions is asking for the present value of $10,000. So, $10,000/(1.04) 1 = $9, In other words, Shane could put $9, in a CD earning 4 percent and have $10,000 at the end of next year.

Copyright ©2014 Pearson Education, Inc. All rights reserved Compound Interest versus Simple Interest Simple interest –Earns interest only on the original amount or principal For example, if we had an initial deposit of $2,000 earning 10% interest, we would earn $200 in interest the first year We would earn only $200 the second year also because we would not earn interest on interest Compounding will always create wealth faster for any given interest rate

Copyright ©2014 Pearson Education, Inc. All rights reserved Math for Personal Finance Jodi has invested $5,000 at 6 percent simple interest rate. How much interest will Jodi earn in three years?

Copyright ©2014 Pearson Education, Inc. All rights reserved Math for Personal Finance Solution: Simple interest earn interest only on the original amount invested. Therefore, Jodi will earn $5,000 x.06 = $300 per year x 3 years = $900 in total interest

Copyright ©2014 Pearson Education, Inc. All rights reserved The Concept of Annuity An annuity is any situation where you have equal cash flows occurring at equal intervals for a fixed period of time A car payment is an annuity We can also solve for the future value or present value of an annuity Go back to Figure 15.1 to see how saving an annuity of $5,000 a year with 10% annual return can generate a lot of money

Copyright ©2014 Pearson Education, Inc. All rights reserved Using Financial Calculators Both present value and future value calculations can be done on a financial calculator Online versions of these calculators are available (see figure 15.3) Follow the instructions and you can figure the future value for an initial investment given a certain interest rate and period of time

Copyright ©2014 Pearson Education, Inc. All rights reserved Figure 15.3: Financial Calculators

Copyright ©2014 Pearson Education, Inc. All rights reserved Math for Personal Finance Using future value techniques for a lump sum amount, calculate the value of a three- year annuity of $1,000 invested at 5 percent. Assume you invest the first $1000 today, the second $1000 in one year, and the last amount in two years.

Copyright ©2014 Pearson Education, Inc. All rights reserved Math for Personal Finance Solution: The annuity formula in a financial calculator will generate the same solution as this, but understanding the process is important. In this problem, you will simply calculate the value of each $1000 amount and add them up. The value of the annuity equals: $1000 x (1.05) 3 = $1, $1,000 x (1.05) 2 = $1, $1,000 x (1.05) 1 = $1, $3,310.12

Copyright ©2014 Pearson Education, Inc. All rights reserved Rule of 72 Rule of 72 allows us to see how long it would take to double our money for a given interest rate We can use the rule of 72 in figuring out future values For example, if you assume a 12% return, you can divide 72 by 12 to find out it would take roughly 6 years to double your money

Copyright ©2014 Pearson Education, Inc. All rights reserved Rule of 72 You can also use the rule of 72 to see what kind of return someone is promising you If someone says they can double your money in 8 years, you know that the person is expecting an annual return of about 9%

Copyright ©2014 Pearson Education, Inc. All rights reserved What does the time value of money mean?

Copyright ©2014 Pearson Education, Inc. All rights reserved It means that money received today has a different value than money received at some other point in time

Copyright ©2014 Pearson Education, Inc. All rights reserved Managing Your Investments A portfolio is your investments Financial professionals can help you manage your investments You will be in charge of what strategy they follow You should always monitor your investments You should keep your portfolio diversified

Copyright ©2014 Pearson Education, Inc. All rights reserved Diversification –Investing in a lot of different types of assets or asset classes Asset class –Each of these types of investments Asset allocation –The process of spreading your investments among asset classes Do not rely on any single type of investment to achieve your financial goals The kinds of investments can have a lot of uncertainty regarding their future performance It is wise to diversify

Copyright ©2014 Pearson Education, Inc. All rights reserved Diversification A diversified portfolio of assets will reduce your risk Different asset classes perform better during different economic periods Make sure you are properly diversified Don’t get caught with all your money in stocks in a declining stock market

Copyright ©2014 Pearson Education, Inc. All rights reserved Risk and Return Tradeoff When you make an investment, you are making a tradeoff between risk and return If you want low risk, you must be willing to accept lower returns Higher-risk investments give a reasonable hope of higher returns to attract investors Just remember, no return is guaranteed

Copyright ©2014 Pearson Education, Inc. All rights reserved Too Good to Be True? Whenever talking about investing money, there are people out there trying to separate you from your cash People might promise you a 20 percent return without any risk Those types of promises are not reasonable, so be very cautious

Copyright ©2014 Pearson Education, Inc. All rights reserved Too Good to be True? There really are no get rich quick schemes Don’t let anyone rush you into a financial commitment or trick you into thinking you can beat the system It always pays to think about your investment and do some investigating of your own

Copyright ©2014 Pearson Education, Inc. All rights reserved Why is diversification an important part of managing your portfolios?

Copyright ©2014 Pearson Education, Inc. All rights reserved Different asset classes perform differently at different times and under different circumstances. Having a variety of investments in a variety of classes helps protect the investor from excessive risk

Copyright ©2014 Pearson Education, Inc. All rights reserved Retirement Planning and Time Value Concepts There is no better time to start the process of retirement planning than now You can accumulate wealth much more easily if you have time to put your money to work for you You can now see how much difference it makes if you wait until you are 30 years old to begin saving for retirement, rather than 20 years old

Copyright ©2014 Pearson Education, Inc. All rights reserved Retirement Planning and Time Value Concepts Establish some financial goals and then take the steps to accomplish them Use a financial calculator to figure what you’d need to save to reach your financial goals Think about your long-term goals Financial security is not a bad thing and can be achieved with some careful planning followed by action

Copyright ©2014 Pearson Education, Inc. All rights reserved Why is it better to begin planning for retirement at age 20 than at age 30?

Copyright ©2014 Pearson Education, Inc. All rights reserved If you start earlier in life, you can take advantage of the power of time to achieve greater results

Copyright ©2014 Pearson Education, Inc. All rights reserved Estate Planning Estate planning –The process of determining how your wealth will be allocated on or before your death Estate planning may be even further into the future, but it is something you should be aware of In other words, what happens to your assets when you die? Who do you want to leave them to?

Copyright ©2014 Pearson Education, Inc. All rights reserved Your Will A will –A legal request for how your estate (everything you have accumulated during your life) should be distributed upon your death Beneficiaries –The person or persons that will receive your estate; heirs One of the most critical tasks in estate planning is the creation of a will In your will you can specify who will receive your estate—your beneficiaries A will ensures that your wishes are followed in the future and it can relieve a burden from your loved ones

Copyright ©2014 Pearson Education, Inc. All rights reserved Figure 15.4: A Sample Will

Copyright ©2014 Pearson Education, Inc. All rights reserved Estate Taxes Your estate may be subject to taxes before it can be distributed to your heirs Review the current law on estate taxes Take the steps necessary to minimize the tax liability for your heirs

Copyright ©2014 Pearson Education, Inc. All rights reserved Trusts –Place assets in the custody of a third party known as a trustee Estate planning involves establishing a trust to transfer assets in a manner that avoids taxes All trust are legal mechanisms that help reduce tax liability as assets are transferred from one person to another The trustee manages those assets for the designated beneficiaries

Copyright ©2014 Pearson Education, Inc. All rights reserved Why is it worthwhile to engage in estate planning today?

Copyright ©2014 Pearson Education, Inc. All rights reserved It can ensure that your wishes are followed in the future and it can relieve a burden from your loved ones

Copyright ©2014 Pearson Education, Inc. All rights reserved Summary Understanding the time value of money concept can help you see how important it is to for the future Planning for the future is easier if you know how much money you need to save and invest Future value and present value calculations can help you plan for these things

Copyright ©2014 Pearson Education, Inc. All rights reserved Summary This financial math can help you evaluate different investment options and manage your portfolio Risk/return tradeoffs exists and you must assume more risk to get a higher return Proper diversification can help you reduce risk in your investment portfolio

Copyright ©2014 Pearson Education, Inc. All rights reserved Summary Sound investing will allow you to accumulate wealth for retirement and pass some of this wealth to your heirs Estate planning and the creation of a will can help you reduce the tax liability when you pass wealth to subsequent generations

Copyright ©2014 Pearson Education, Inc. All rights reserved Key Terms and Concepts Asset allocation Asset class Beneficiary Compounding Diversification Estate planning Future value Intestate Portfolio Present value Rule of 72 Simple interest Time value of money Trust Will

Copyright ©2014 Pearson Education, Inc. All rights reserved Websites Resources.lawinfo.com