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 Steps 1. Estimate before-tax income needs 2. Estimate annual retirement income from employer pension plans 3. Estimate annual retirement income from Social Security 4. Calculate retirement income shortfall 5. Estimate total retirement wealth needed 6. Establish retirement savings goal 7. 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% % 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 Retirement Savings Goal = PMT = Income Shortfall y = Years in retirement r = average return i = average inflation

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 (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