Taxes, Inflation, and Investment Strategy Chapter 21 Taxes, Inflation, and Investment Strategy Describes the financial instruments traded in primary and secondary markets. Discusses Market indexes. Discusses options and futures. McGraw-Hill/Irwin Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved. 1

21.1 Saving for the Long Run

Basic Considerations in Developing a Plan The major goal is retirement planning. Time until retirement When do you plan to retire? When can you collect Social Security? Life expectancy How long will you live after you retire? Rate of return How much risk are you willing to take? Allocation of income to savings How much are you saving for retirement?

Finding Your Retirement Annuity Inputs: Retirement years, income growth rate (which is way too high for many people); income at age 30, your rate of savings (% of income) and the rate or return on investment (ror). The spreadsheet converts your payments into your retirement fund into a level 25 year annuity at age 65. According to the spreadsheet there will be $2.5 million in the retirement fund at age 65, yielding an annuity of $192,444 per year for 25 years. This works out to the same real consumption as at age 51 (can’t see this because it is not in the picture of the spreadsheet). This example does not account for inflation and taxes!

21.2 Accounting For Inflation

Planning with Inflation Inflation reduces the real value of the retirement benefit by eroding the purchasing power of the dollars earned. Real consumption = Nominal consumption / Price Deflator Suppose inflation = 3% per year and the nominal rate of return is 6%. What is the real rate of return?

Planning with Inflation 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?

Interest Rates, Inflation, and Real Interest Rates, 1926-2008 Notice that historically inflation has been much higher than in recent time periods. From the 1990s on the Federal Reserve has managed the money supply to limit inflation. Nevertheless much higher rates than the 3% used in the example are possible and probably even likely after the recovery from the recent economic downturn begins.

Planning with Inflation To overcome inflation requires either higher savings or higher rates of return on investment or both Because taxes are paid out of nominal returns, inflation reduces the after tax rate of return even further.

A Real Retirement Plan Inputs are same as before (Retirement years, income growth rate (which is way too high for many people); income at age 30, your rate of savings (% of income) and the rate or return on investment (ror)) with inflation of 3% added on. rConsumption is real consumption. Thus the $192,244 nominal annuity buys only $49,668 in real purchasing power (same purchasing power as age 30). This will give you the same spending power as you had at age 34. Notice the $2.5 million value of your retirement fund is worth only $873,631 in today’s (age 30) purchasing power.

Another Problem with Inflation Inflation continues after retirement. If you have a level annuity during retirement you will have a declining standard of living: Purchasing power of the $192,244 at age 65 is: Purchasing power of the $192,244 at age 90 is: The two deflators are 2.8138 and 5.8916 respectively.

The Solution? Investment Average Real Return Stocks 9% Should an investor take on more risk to offset inflation? What are the effects of increasing the riskiness of your retirement portfolio? Real returns based on historical averages As you approach retirement what should you do with the risk level of your portfolio? Is this easy to do? The best solution is simply to save more and start early. Investment Average Real Return Stocks 9% Government bonds 2.6% Treasury bills 0.7% Data are through 2006, so may be slightly different from the text. Increasing the risk increases the expected return, but also the probability of not having enough to live on when you retire. As you get older, increasing the risk to make up for years in which you did not save is really rolling the dice. A basic rule of thumb suggested by Burton Malkeil is that the percentage of money in stocks should equal 100 – your age. Nor is it is not easy to reduce the risk level as you retire. It is particularly difficult if you have some bad years of earnings. Do you want to sell at the market bottom to realign your portfolio? There are some mutual funds, target date funds, that do this for you automatically but they have recently come under criticism for large fees and poor performance. You can’t overstress the need to start early. Suppose an investor begins investing $1,000 per year at age 30 and earns 10%. He stops investing $1,000 at retirement. The future value of his retirement fund at age 65 is $271,024. Suppose another investor invested $1,000 per year or 10 years starting at age 20 and then stopped adding any additional funds. This portfolio will have a future value at age 65 (with 10% interest all the way to 65) of $447,880! The point is to start early and invest as much as you can while you have a long time horizon.

21.3 Accounting For Taxes

Planning with Taxes Taxes further reduces the retirement benefits available To overcome the impact of taxes requires larger allocations to savings or higher returns on investments As mentioned, inflation combined with taxes further reduces the benefits available Flat versus graduated tax rates

Saving With a Simple Tax Code Notice how pernicious the effects of inflation and taxes together really are. In this case your real retirement annuity is $37,882 with very modest inflation of 3%, saving a lot of your income, 15% and a tax rate of 25%. Note that the tax rate should (roughly) be the sum of federal, state and local income taxes. At this point you have to recognize that you will probably have to take some risk in your portfolio to generate a large enough expected return. SEC studies have shown that most people under invest in equities but they are probably their best bet (among liquid assets) at earning sufficiently high rates of return to generate a reasonable retirement income.

The Effect of Double Taxation Investors pay income taxes and pay taxes on some of their savings. We can use the numbers in Spreadsheet 21.4 to illustrate the effect on the overall tax rate: Income (1) Lifetime labor income $7,445,673 Total exemptions during working years $949,139 (2) Lifetime Taxable labor income 6,496,534 Taxes During labor years 1,884,163 During retirement 203,199 (3) Lifetime taxes 2,087,362 Lifetime average tax rate = (3) / (1) 28% Lifetime tax rate on taxable income = (3)/ (2) 32% The average tax rate is elevated above the marginal tax rate of 25% as a result.

21.4 The Economics of Tax Shelters

Tax Shelters Means of postponing taxes as long as possible Potential benefits of shelters Postponing payment of tax, Additional earnings on the investment of postponed tax payments Effectiveness of the shelter Depends on investment performance and how tax rates change. You can’t get rid of taxes, you can only postpone them.

Savings with a Flat Tax and an IRA Style Tax Shelter This spreadsheet redoes sheet 21.4 with the tax shelter. It still uses a flat tax rate. All funds in the retirement account are subject to taxation. Total lifetime taxes increases from $2.1 million to $2.5 million. This increase occurs because one earns more on their investments without the tax drain so the investor pay more taxes ($3.7 million versus $1.9 million before). The real annuity is increased from $37,882 to $76,052. There is a large value to the shelter. Taxes on income during the working years reduce the future value of the investments dramatically.

Savings With a Progressive Tax Rate We have seen that taxes on income during the working years reduce the future value of the investments dramatically. A progressive tax code magnifies this effect because retirement tax rates are usually lower than working year tax rates (because income is reduced during retirement.) The overall effect on consumption in both earning and retirement years is fairly small. The higher tax rates you pay after your income rises during your work years is roughly offset by the lower tax rate paid during retirement.

IRA with a Progressive Tax Code The real annuity is increased considerably in this case, it is now up to $83,380, this is better than with a flat tax rate for the reasons noted on the prior slide.

21.5 A Menu of Tax Shelters

Tax Sheltered Accounts Individual Retirement Accounts (IRAs) Created by the Tax Reform Act of 1986, currently allow investors to contribute up to $5,000 per year to a retirement account. Individuals age 50 and older may contribute another $1,000 per year, 10% tax penalty for withdrawal of funds prior to age 59 ½, Must begin withdrawals by age 70 ½. Any withdrawals before age 59 ½ are subject to the ordinary income tax rate and a 10% tax penalty. There are various hardship exclusions to the tax penalty however, including one for first time homebuyers. Actually withdrawing the money for this reason would be a bad idea however because you would lose the compound value of the money withdrawn (unless the house grows in value at the same rate or more).

Types of IRAs Traditional IRAs Roth IRAs Contributions to traditional IRAs are tax deductible, the earnings are tax deferred until withdrawn. Roth IRAs Contributions to Roth IRAs are not tax deductible but earnings on the account are not taxed when withdrawn.

Spreadsheet 21.8 Roth IRA with Progressive Tax Code The effectiveness of the Roth IRA as a tax shelter is independent of tax rates during retirement. The tradeoff with a Roth IRA is deciding whether it is worth it to forego the deductibility of contributions that are possible with a traditional IRA to gain the tax free withdrawals upon retirement that the Roth IRA provides. The differences between the two types of IRAs are summarized in the next slide.

Table 21.2 Traditional vs. Roth IRA Tax Shelters Under a Progressive Tax Code Note that although the Roth IRA results in less taxes paid over the lifetime and a lower average tax rate, the traditional IRA offers a substantially higher retirement annuity. The higher tax rates on the traditional IRA occur because you have higher investment income, which also results in the larger annuity. The Roth IRA can dominate if earnings are initially low and grow rapidly near retirement. This is because in this case in the early years at the low tax rate the value of the tax deduction of the traditional IRA is reduced. Quicken.com and a host of other websites allow a comparison for each individual to see which type is better. This usually has to be decided on a case by case basis.

Defined Benefit Plans Defined Benefit Plans Employer promises to pay a defined or known benefit to employees when they retire. Typically a percentage of salary based on years of service. The employer must fund the pension obligation. Pension Benefit Guaranty Corporation (PBGC) guarantees pension benefits in the event of corporate bankruptcy, but often get an inferior pension plan if administered by the PBGC.

Defined Contribution Plans 401k and 403b Plans are examples Employee and employer contribute set amounts to an investment plan. The employee’s retirement benefit depends on the investment performance. Employees are typically given a choice of mutual funds managed by a fund family such as Vanguard or Fidelity. Because of the employer contributions you want to take advantage of these plans. DC plans are becoming the standard, although substantial DB assets remain. Some firms offer both. Note that the employees have no corporate bankruptcy risk in a DC plan. If the sponsoring corporation went bankrupt no creditor could seize the plan’s assets. The 401k and 403b terms come from the relevant sections of the tax code. 401k plans are used in the for profit sector and 403b plans are for non-profits, but they are very similar to one another in function and regulations.

Table 21.3 Investing Roth IRA Contributions into Stock and Bonds Some investors make the mistake of putting stocks in their IRA and buy bonds outside their IRA. The interest income on bonds is taxed each year and is taxed at the ordinary income rate. Much of the gain on stocks is taxed at the lower capital gains tax rate.

Table 21.4 Investing Traditional IRA or 401k Contributions in Stocks and Bonds

21.6 Social Security

Social Security (SS) Federal pension plan established to provide minimum retirement benefits to all workers. It is unfunded although it is in surplus on a current year basis, projected to go in the red around 2016, You pay 6.2% of your income to SS, plus 1.45% toward Medicare; your employer matches your contribution, SS is a means of redistributing income. In dollar terms taxes are regressive and low income workers receive a relatively larger share of preretirement income upon retirement. Technically it is the Old Age and Survivors Disability Fund Actually you would pay the 7.65% taxes on the first $106,800 of your income in 2009. On your paycheck this will be in the FICA section. Note that between the employee and the employer 12.4% is being paid in to fund SS. SS will require reform if the U.S. demographics don’t change. As the population ages there will be fewer workers to support the growing number of retirees. Expect a combination of changes, certainly older retirement ages, probably coupled with increases in taxes. Actually if we deal with the problem now we only need to increase contributions to about 15% from the 12.4%. If we wait though the required tax rates will be much higher.

SS, What You Earn You pay in every working year but only top 35 years of earnings & contributions count for determining benefits. Lifetime real annuity paid in full if you retire at age 67, you receive a reduced amount if you retire earlier (62) or your receive a larger benefit if you retire later (70) The retirement ages will be going up to help reduce the fiscal problems of the plan.

SS, What You Earn Four steps to calculate your benefits: The series of your taxed annual earnings is compiled Indexing Factor Series All past earnings are converted to today’s dollars using the Average Wage Index (AWI) Average Indexed Monthly Earnings (AIME) The 35 highest annual indexed contributions are summed and then divided by (35 x 12) = 420. This number is the AIME If you work less than 35 years your AIME may be low because you still divide by 420.

SS, What You Earn Four steps to calculate your benefits: Primary Insurance Amount (PIA) The annuity value received each year, The income replacement rate is the percentage of the working income received in retirement, Income replacement rate is substantially higher for low income individuals, Benefits may be taxed if household income > $32,000. Taxed at 50% if household income > $44,000. This is ridiculous.

SS Annuities if You Were to Retire in 2009 at Age 66 Most middle income and higher individuals could do better by investing this money on their own. This is a wealth redistribution plan.

Additional Considerations 21.7 Children’s Education and Large Purchases 21.8 Home Ownership: The Rent-verus-Buy Decision 21.9 Uncertain Longevity and Other Contingencies 21.10 Matrimony, Bequest, and Intergenerational Transfers

Additional Considerations in Planning Financing a child’s education Same procedure as funding retirement Rent or buy decision You gain no equity in renting, Equity is a safeguard for tough times, Don’t try to buy too much house, Houses are illiquid investments whose value does not always increase.

Additional Considerations in Planning Uncertain longevity Life annuity versus fixed term annuity Payment received on a life annuity is reduced due to adverse selection. Marriage, bequests and intergenerational transfers Marriage increases motivation for saving for old age Dependents increase need to save Desire for bequests increase need to save 75% of intergenerational transfers are involuntary (due to earlier than planned demise or under spending in retirement). Kotlikoff and Summers (1981) find that 75% of the wealth left behind is there because the retirees did not spend their savings before they died. These are ‘involuntary intergenerational transfers.’