1. Age Banding in Retirement Planning © 2002 Dr. Somnath Basu

2. Presentation by Dr. Somnath Basu Professor of Finance School of Business California Lutheran University 805-493-3980 basu@clunet.edu

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4. The Retirement Objective  The need to maintain our standard of living during retirement  Time horizon typically backed out of the mortality tables and client- specific information  Risk-return subjectively dependant on clients

5. Traditional View: Weaknesses  Replacement ratio: (e.g. 40-90%)  No formal model to compute this ratio  Conservative – Aggressive  Assumes expenses during retirement increase at the inflation rate  Leisure/Healthcare inflation app 7%

6. Traditional View: Weakness  Investment horizon & allocation  Single basket  Risk management  Choice of securities  Incorporating Long Term Care, etc  Inflexible

7. Alternate View  Retirement is dynamic  No different from any other stage of life  Typical observations  Leisure spending to healthcare spending  Life-cycle dynamics

8. Alternative View  Generality of Model  Retirement at any other age  Different activities, etc  Life cycle changes can occur with any frequency -- 2 yrs, 5 yrs, etc

9. The Age-Banding Model: Case Studies  Case 1 : The Smiths  Individual and spouse  Both around 60 years  Expect to retire in 5 years  Expect to live in retirement for about 30 years  Case 2: Ms. Jones  35 year old individual  Single, mid-career

10. The Age-Banding Model: Case Studies

11. Planning for Retirement Needs

12. Case 1: The Smiths Pre-retirement Expenses Taxes28000 Basic Living36000 Health Care6000 Leisure5000 Total75000 Cost of Living at Age 60 (Today)

13. Cost Projections: Traditional All expenses are expected to grow at the long term rate of inflation Assumed as 3% in this example Traditional View Costs at Age 5 Yr. Growth & Inflation RateMultiply by factor Costs at Age 60 65 Total750003%1.15986925

14. Cost Projections: Alternate Taxes and Basic Living Expenses increase at 3%/Yr. Healthcare and Leisure expenses increase by 7%/Yr. Table2B: Alternate View Costs at Age 5 Yr. Growth & Inflation Rate Multiply by factor Costs at Age 60 Table 165 Taxes280003%1.15932452 Basic Living360003%1.15941724 Healthcare60007.00%1.4038418 Leisure50007.00%1.4037015 Total75000 89674

15. Assumptions  Alternate: Life Cycle Factors  Factors proxy lifestyle changes during retirement  Factor values around 1  Factor adjustments made at discrete intervals  Example of factor values  Alternate: life cycle changes at 65, 75, 85  Traditional : Assume RR factor = 80%  Traditional : Inflation Rate of 3%

16. Example – Factor values at Age 65 CategoryValueNotes Taxes0.50FICA- Average tax rate Client specific Basic Expenses 0.70Mortgage paid off Healthcare1.15Aging Leisure1.5Postponed increases

17. Factor values during retirement Life Cycle factors Age657585 Taxes0.511 Basic Living0.70.80.9 Healthcare1.151.21.25 Leisure1.50.50.25

18. Replacement Ratios Table 3A: Alternative Traditional View Total869250.869540 Table 3B: Adjustments Alternate View Pre- retirementPost- retirement Costs at AgeLifeCycle factorCost at Age 65at Age 6566 Taxes324520.516226 Basic Living417240.729207 Healthcare84181.159681 Leisure70151.510523 Total89609 65636

19. Expense Projections: Traditional

20. Expense Projections: Age Bander

21. Comparison of Projections Cost Comparisons Between Methods 667576858695 716269345696260125597129365168792 6841310080190329136819134877210978 4.70%-7.29%6.57%-8.20%-4.09%-20.00%

22. Alternate Chart: Component Costs

23. Traditional: Retirement Fund Table 5A: Traditional View of Expense Projection and Funding Requirements At Age Retirement Fund (Amt) NeededAt Age Funding Needed (Today) Expenses at Age 6569,540651,379,006601,133,543 Increases annually at3% Safe Investment at6%

24. Alternate: Funding Requirements  Expenses recorded separately for 3 decades  (66-75, 76-85, 86-95)  3 dedicated portfolios.  Differential returns :  6%, 8% and 10% for 5, 15, 25 year portfolio  Retirees are more risk averse than others  A circuit breaker for risk  5 year cushion

25. Funding Needs Table 5B: Funding Needs Alternate View AmountPV ofAmountPV 5 Yrs. Needed At CFsNeeded At Earlier 6560210260449926 7580564470602024 85122206780913199

26. Alternate: Retirement Fund Alternate View Amount Needed at Age Earnings Rate PV Factor At Age Amount Today 604499260.06 1.00060449926 10 Yrs Later706021020.080.46360278890 20 Yrs Later809014390.100.38660133993 Total 862809

27. Asset Allocation 75% Bonds 25% Equity

28. Comparative Analysis Required funds at 60  Traditional1,133,543  Alternate- 862,809  Excess $ 270,734 A saving of nearly 24% today (at age 60)!!

29. Case Study 2: Ms. Jones

30. Case Study 2  Assume (simplifying) that the same retirement expenses are projected  3 portfolios - 30 year – 12% - 40 year – 13.5% - 50 year – 15% Individual has 50 years for managing portfolio

31. Case 2: Comparative contributions Table 7A: Contributions-Traditional View At Age Amount Needed Expected Rate Annual Contrib. 30 Yr. P’folio651,379,0060.12$5,714.13 Table 7B: Contributions-Alternate View 30 Yr. P’folio65596,1750.12$2,470 40 Yr. P’folio75796,7200.135$683 50 Yr. P’folio851.206,7460.15$167 Total $3,321

32. Case 2: Comparative Analysis

33. Risk Analysis Table 8: Risk Analysis Ms. JonesBondsLarge CapsSmall CapsP'fol Risk Traditional View0100020.40% Alternate View0851522.95% The Smiths Traditional View100007.96% Alternate View78.79%21.21%010.07%

34. Risk Analysis: Ms. Jones

35. Risk Analysis: The Smiths  Risk Increase = 2.1%  Reduction in funding needs = 24%  $270,000  Time to manage risk = 25 years

36. Risk Analysis: 60 year old couple  Additional risk considerations  5 year safety cushion  First 10 years risk free – same as traditional  More precise expense estimation mitigates risk  Buy two $50,000 (from savings) of fixed income securities with maturities of 15 and 25 yr.  Most of the risk increase goes away

37. Generality of model  Income netting :  Social security  GACs (risk adjusted), etc.  Point estimates:  Estimate of effects of inflation, returns, etc can be made using range estimates rather than single point estimates  Introduce additional statistical analysis

38. Generality of model  Life cycle decades & expenses  Any time span (1 year, 5 year, etc can be used)  Continuous time modeling  Breakup expenses (e.g. healthcare) into component costs for further fine – tuning  Time Long Term Care policy benefits to various phases of retirement

39. The End Thank You