Taxes, Inflation, and Investment Strategy Bodie, Kane and Marcus Essentials of Investments 9 th Global Edition 21

21.1 S AVING FOR THE L ONG R UN Basic Considerations in Developing Plan Time until retirement Life expectancy Rate of return Allocation of income to savings Retirement annuity Stream of level cash flows available for consumption during retirement

S PREADSHEET 21.1 S AVINGS P LAN

21.2 A CCOUNTING FOR I NFLATION Inflation erodes real value of purchasing power Real consumption = Nominal consumption/ Price Deflator What is the real rate of return if inflation = 6% and nominal ROR is 6% annually?

21.2 A CCOUNTING FOR I NFLATION The investor in the example is 30 years old. What is the size of the price deflator with 3% inflation at age 35? By age 65?

A CCOUNTING FOR I NFLATION Overcoming inflation requires either higher savings or higher ROR on investment or both Because taxes are paid out of nominal returns, inflation further reduces after-tax ROR

S PREADSHEET 21.2 R EAL R ETIREMENT P LAN

S PREADSHEET 21.3 B ACKLOADING R EAL S AVINGS P LAN

21.2 A CCOUNTING FOR I NFLATION Another Problem with Inflation Inflation continues after retirement Level annuity equals declining standard of living Purchasing power of the $192,244 at age 65: Purchasing power of the $192,244 at age 90:

21.3 A CCOUNTING FOR T AXES Flat Tax Taxes all income above exemption at fixed rate Taxes further reduce retirement benefits available Overcoming taxes’ impact requires larger allocations to savings or higher returns on investments

S PREADSHEET 21.4 S AVING WITH S IMPLE T AX C ODE

21.4 E CONOMICS OF T AX S HELTERS Potential Benefits Postponing payment of tax Additional earnings on investment of postponed payments Effectiveness of Shelter Depends on investment performance, how tax rates change

S PREADSHEET 21.5 S AVING WITH F LAT T AX AND IRA

S PREADSHEET 21.6 S AVING WITH P ROGRESSIVE T AX

S PREADSHEET 21.7 B ENCHMARK T AX S HELTER WITH P ROGRESSIVE T AX C ODE

21.5 M ENU OF T AX S HELTERS Tax-Sheltered Accounts Individual Retirement Accounts (IRAs) Currently allow investors to contribute up to $5,000/year to retirement account Individuals 50/older may contribute another $1,000/year 10% tax penalty for withdrawal of funds prior to age 59½ Must begin withdrawals by age 70½

21.5 M ENU OF T AX S HELTERS Types of IRAs Traditional Contributions may be tax deductible; earnings tax deferred until withdrawn Roth Contributions not tax deductible; earnings on account not taxed when withdrawn

S PREADSHEET 21.8 R OTH IRA WITH P ROGRESSIVE T AX

T ABLE 21.2 T RADITIONAL VERSUS R OTH IRA UNDER P ROGRESSIVE T AX C ODE

21.5 M ENU OF T AX S HELTERS Defined Benefit Plans Employer promises to pay defined benefit to employees when they retire Typically percentage of salary based on years of service Employer must fund pension obligation Pension Benefit Guaranty Corporation (PBGC) guarantees pension benefits in event of corporate bankruptcy

21.5 M ENU OF T AX S HELTERS Defined Contribution Plans 401k and 403b Plans are examples Employee and employer contribute set amounts to investment plan; employee’s retirement benefit depends on investment performance Employees typically given choice of mutual funds managed by fund family Because of employer contributions these are attractive to employees

S PREADSHEET 21.9 S AVING WITH N O - D IVIDEND S TOCKS UNDER P ROGRESSIVE T AX

T ABLE 21.3 I NVESTING R OTH P LAN C ONTRIBUTIONS IN S TOCKS AND B ONDS *Since the retirement annuity is similar in both plans, taxes on this annuity are ignored.

T ABLE 21.4 I NVESTING IN T RADITIONAL P LANS *Since the retirement annuity is similar in both plans, taxes on this annuity are ignored.

21.6 S OCIAL S ECURITY Federal pension plan established to provide minimum retirement benefits to all workers Unfunded, although in surplus on current-year basis; projected to go into red around 2016 You pay 6.2% of income to SS, plus 1.45% toward Medicare; employer matches contribution SS is means of redistributing income; in dollar terms, taxes are regressive

21.6 S OCIAL S ECURITY What You Earn You pay in every working year but only top 35 years of earnings and contributions count for determining benefits Lifetime real annuity paid in full if you retire at age 67; reduced amount if you retire earlier (62) or larger benefit if you retire later (70)

21.6 S OCIAL S ECURITY What You Earn Four steps to calculate benefits The series of your taxed annual earnings is compiled Indexing factor series All past earnings converted to today’s dollars using average wage index (AWI) Average Indexed Monthly Earnings (AIME) 35 highest annual indexed contributions summed and then divided by (35 x 12) = 420

21.6 S OCIAL S ECURITY What You Earn Four steps to calculate benefits Primary insurance amount (PIA) Annuity value received each year Income replacement rate is percentage of working income received in retirement; substantially higher for low-income individuals Benefits may be taxed if household income > $32,000

T ABLE 21.5 C ALCULATION OF R ETIREMENT A NNUITY OF R EPRESENTATIVE R ETIREES IF 2012, A GE 66 a Income is above the maximum taxable, and income replacement cannot be calculated. b 2008 PIA parameters (bend points) are used is the year of eligibility, that is, the year in which the retiree attains age 62. c COLA adjustment for years 2008–2011: 5.8%, 0.0%, 0.0%, 3.6%. d Internal rate of return.

21.7–10 A DDITIONAL C ONSIDERATIONS Financing Child’s Education Same procedure as funding retirement Rent-or-Buy Decision No equity created by renting Equity is safeguard for tough times Don’t try to buy too much house Houses are illiquid investments whose value does not always increase

21.7–10 A DDITIONAL C ONSIDERATIONS Uncertain Longevity Life annuity versus fixed-term annuity Payment received on life annuity reduced due to adverse selection

A DDITIONAL C ONSIDERATIONS Marriage, bequests and intergenerational transfers Marriage increases motivation for saving for old age Dependents increase need to save Desire for bequests increases need to save 75% of intergenerational transfers are involuntary (due to earlier than planned demise or under- spending in retirement)