RETIREMENT ASSIGNMENT II Spring, 2015
THE EFFECT OF EARLY CAREER MOBILITY on FINANCING YOUR RETIREMENTWITH DEFINED BENEFIT VS. DEFINED CONTRIBUTION PROGRAMS
NOTE: If you plan not to live and work in the US, you may either:
a) Do this assignment as if you were going to work and live in the US, or
b) Write an equivalent paper describing the various retirement plans (sponsored by both the Government of your country, and/or private employers), and how you plan to care for your retirement.
Before beginning this assignment, consult text and be sure you understand:
1. DEFINED BENEFIT (TRADITIONAL PENSION) PLAN: Pays a retiree a specified annual retirement as long as the person lives. The amount of the annual retirement payment will be based on a formula specified by the employer. (These vary from employer to employer, but usually include the number of years worked for the firm, the person’s salary while working, and some %.)
2. DEFINED CONTRIBUTION PLAN (Also known as a 401k program after the section of the IRS Code which gives them tax deferred status): Pays some specified amount each pay period into an account over which the employee will have some investment options. Once vested, the employee literally owns these funds, and they stay with the employee (if the employee takes the initiative to convert the funds into their own Individual Retirement Account which maintains tax deferred advantages) throughout their life. In a defined contribution plan, once the employee leaves a firm, that firm has no obligation to provide further funds to the employee.
3. VESTING: Whether DB or DC, vesting means that the employee literally owns the retirement or pension benefit. If you are not vested, you do not own anything. You can find more information here: http://www.dol.gov/ebsa/publications/wyskapr.html
(When you use this website look only at Defined Benefit, Defined Contribution and Vesting. That is all you need for the assignment. Read more later if you like.)
Minimum vesting rules (Pension Reform Act, 2006) are:
100% @ 3 years and 0% before 3 years
20% in year 2 and 20% each year thereafter until 100% in year 6.
For both DB & DC plans, employers may voluntarily vest earlier than these rules if they so choose.
Life expectancies are increasing and many people now in their 20’s can expect to live into their 90’s and 100’s. This means that many people will need to finance their retirement for a period of 30 years or longer (given a projected retirement age of 70). The decisions you make early in your career will have a very substantial effect on your retirement income. In fact many financial advisors argue that one of the most important things individuals can do to help themselves is to begin planning and investing EARLY (e.g. even before you begin working). In general, the purpose of this assignment is to help you begin this planning process. More specifically the assignment is designed to show you how the type of pension plan an employer offers, and your movement between jobs early in your career have a very large impact on your retirement. This assignment has the potential to be a very significant help to your life.
A. Primary sources of retirement income are as follows:
1. Social Security- it appears that Social Security will at best provide a partial income (perhaps 20% of necessary funds). Some people argue that Social Security might not even be around when you retire. Others argue that it will need to evolve in the future, perhaps becoming more “progressive” (less pay out or higher taxes for those in higher income brackets).
http://calculator.socialsecurity.org/ (calculator for social security)
(In this assignment, we assume a worst case scenario that you will receive no Social Security benefits, even if you are required to pay into Social Security.)
2. Employer Retirement Programs- There is no legal requirement that firms have an Employee retirement program, although most large employers do (voluntarily) have some type of program. These programs do vary considerably however, both in amount of employer contribution, and in basic design.
Two basic types of retirement programs WHICH YOU NEED TO KNOW:
a) Defined Benefit plans provide a fixed monthly or annual income based on some combination of ending salary, age, years of service, etc. These plans literally define what the retired employee will be paid for the remainder of their lives after retirement, even if the employee lives a very long time. These plans do have limitations in that the amount paid out is fixed, and the pay out is usually not adjusted for inflation after retirement. Because these plans are based on ending salary, they tend to be “back end loaded” and heavily favor long-term employees. (See class discussion for additional information.) Finally employees do not own rights to the pension until they are “vested”, which means that an employee leaving the firm before their fifth year of employment may loose all or part of their pension. (Be sure to study alternative vesting provisions described in the text.) Defined benefit plans are the most prevalent type of plan today. The problems you will do in this assignment will attempt to illustrate the impact of vesting and its importance on your future financial portfolio.
b) Defined Contribution plans set aside a specified amount of money in the employee’s name while they work. These funds are kept in a tax-deferred account (IRS code, section 401k), which means that the money invested and any earnings from the investment are taxed only when money is withdrawn during retirement. The employee has the right and responsibility to direct the investment of their own funds within the plan. (Most employer’s plans provide a range of investment options such as stock or bond mutual funds, cash insured savings, etc. from which the employee makes investment choices). These funds are also subject to vesting (although sometimes earlier than defined benefit plans) and employees sometimes may contribute a portion of their earnings to the plan. Any contributions made by the employee are immediately vested, while the employer’s contribution and earnings from these investments are often vested immediately or after a short probationary period. (In this Assignment, we will assume that the Employer makes all contributions, and the employee makes no contributions.) Defined contribution plans have the advantage of 1) higher potential earnings, 2) are not affected by changes in employment (after vesting), and 3) are front end loaded in the sense of having the advantage of long term compounding. These plans have the disadvantage that if poor investment decisions are made, the employee will suffer the consequences, and the employer has no obligation provide additional income. These plans also require the employee to actively choose investment options (within the plan) for their own retirement funds. Defined contribution plans are the fastest growing type of plan today, and in one way or another are very likely to affect everybody in this class.
3. Other employer sponsored programs such as voluntary savings program used by some firms to supplement their regular retirement plans. Any money that the employee contributed to these plans are vested or owned by the employee immediately. Funds contributed by the employer are subject to minimum vesting rules. The plans usually match any employee contribution to their retirement account either dollar for dollar, or some fraction of a dollar, up to a specified amount (e.g. 2.0% of salary). These savings plans are tax deferred (under IRS code section 401k), and require active employee management of the investments. See above websites for more information. Thus, these plans provide the employee with a way to add to their retirement (and in essence get “free money” from their employer.
4. Individual Retirement Accounts are private investments made by the employee, and are not supported by the employer. IRA’s are either tax-deferred (regular IRA/Keogh) or are taxed only when money is put into the fund, not when it is withdrawn (Roth IRA). The amounts one may put in these accounts (and still receive tax advantages) are limited by your income, but the limits have been raised in recent years. There are many websites that illustrate the difference in the plans and highlight, which are most appropriate given your specific financial situations and needs. (Most college graduates will have salaries that permit them to take advantage of IRAs.) In addition to being an additional tax advantaged retirement savings plan, IRA’s play a critical role for individuals in a DC plan when they change employers. Once leaving an employer, the individual employee may take their funds out of the employer’s plan and roll it over into their own IRA. They almost certainly have better investment options if they do so.
5. Other private savings may be used to prepare for retirement, but these are not supported by employers and typically do not have tax advantages.
6. Non-earned income: Win the lottery. Marry rich. Etc. What the heck, somebody is going to win the lottery… but most likely it won’t be you, or me, or anybody we know.
B. A Few General Principles Concerning Retirement Investing.
Before you begin the specific assignment, there are two general investment considerations of which you should be aware.
1. Inflation: Even though this assignment will incorporate inflation rates into the problems, the seriousness of its impact on your retirement is often disregarded. Any investor and/or individual must understand that an account’s value in today’s dollars (even projected future values) will not have the same worth (or purchasing power) in forty + years when you actually begin to withdraw funds from your retirement account(s). Inflation must be considered and accounted for when planning your retirement and considering your standard of living, rates-of-return, salary increases, etc.
2. Diversification. The principle of diversification is that all investors face uncertainty (i.e. can’t tell for sure whether an investment will be worth more or less in the future). We try to plan and analyze the best we can, but future returns on any investment are uncertain. An important strategy to deal with this problem is to have a number of different categories of investments so that while some might do poorly, others will do well, and overall the value of your total investments (your “portfolio”) will provide the returns you need. The primary asset types for retirement planning for most individuals are: cash (savings accounts, T-bills, other types of bank accounts), real estate such as rental property or your home, stocks, bonds, and personal possessions. Keep in mind that these asset classes can produce various rates-of-return (both positive and negative) due to the risk associated with them and the reasons for their ownership. Over the long run, a properly diversified portfolio yields the highest rate of return for a given level of risk. Note that diversification means having investments in different asset classes. One would not be diversified if they had, 1) an employer retirement program invested in stocks, 2) an individual IRA invested in stock, and 3) an employer stock option program. Even if there were different individual stocks in each of the 3 investments, the individual still has all of his/her assets in stocks, and little or nothing in bonds, cash, property, etc.
C. Your Assignment
This assignment first leads you through some basic analyses of what income you will need when you retire (and therefore the size of your retirement portfolio). The assignment then analyzes how the value of your portfolio will vary if you choose an employer offering a defined benefit retirement program versus one with a defined contribution retirement program. The comparison is made assuming that you stay with one employer for a career, and alternatively that you have several employers.
DEFINED BENEFIT & 1 EMPLOYER
(Problem 4) DEFIENED BENEFIT & MULTIPLE EMPLOYERS
(Problem 5 & 6)
DEFINED CONTRIBUTION & 1 ER
(Problem 9) DEFINED CONTRIBUTION & MULTIPLE ERs
Assume that when you invest, you will be able to attain historical long run rates of return on your investments. For convenience, assume that your investments have an average 8% rate of return.
Please be sure to answer the questions in the order that they are asked, and number them as they appear below.
When there is a numeric answer, round to the nearest $100.
A. HOW MUCH MONEY DO I NEED TO HAVE WHEN I RETIRE? (The importance of this section is that it will generate a realistic target for the amount of money you need to accumulate.)
ASSUMPTIONS: For all of this assignment assume:
a) You start working on the day you turn 22.
b) You retire on the day you turn 70. Therefore, your working career in this Assignment is 48 years.
c) You get a raise on the first day of each year you work, beginning in the second year. Therefore, you will receive 47 raises. We will assume that you receive a 5.0% raise each year, because you work hard and perform very well.
d) Your annual starting salary is $54,000.
1. How long do you expect to live after retirement? Here is a good life-span estimator available online: http://gosset.wharton.upenn.edu/~foster/mortality/perl/CalcForm.html What risk do you face in this estimate? I.e. what happens if you cover the cost of your retirement until say, age 90, but you live to be 95?
In your paper, report the average, lower quartile, and upper quartile life expectancy.
Because of major advances in healthcare, it is reasonable to expect that you will live to be 100. Therefore use a life expectancy of 100 in all calculations below.
2. What standard of living (annual income) do you expect to have once you retire? Express this as both a specific annual dollar amount, and as a percentage of ending salary (by “ending salary”, we mean your salary in the last year that you work, age 70.) To answer this question, assume you are 22 years old, and that your starting salary is $54,000, and that you receive a 5.0% raise each year. If you worked for 48 years, then you could calculate your ending salary by: End Salary = ($Start Salary) x (1+ i)t where “i” is annual raise expressed in decimal form, and “t” is the number of raises you receive in your career. (Show how you calculated your ending salary and the number that you calculated. Then answer the question about your desired retirement income.) Many financial planners suggest that retirement income (from all sources) should be from 70% to 100% of the salary one had in the last year before they retire.
3. How large will your portfolio have to be (when you retire) to provide your desired standard of living? This problem asks how much money you must accumulate (PVA) by the time you retire or are done working to live for n years, on a retirement income of (PMT) per year if you earn interest rate i.
(Note: x-n = 1/xn)
For example, imagine somebody about to retire today, who assumes that they are going to live for n=20 years, wants an income (PMT)= $200,000 per year during their retirement and their annuity earns i = 10% interest:
Or, verbally, if this person had a portfolio of $1,702,712 on the day they retired, if they lived for another 20 years, and earned 10%, their annuity would pay $200,000 per year, and there will be nothing left when the person died. (Remember this example is for today: Your number will be much larger because your retirement will take place almost 50 years from now.)
B. HOW WELL WILL DEFINED BENEFIT AND DEFINED CONTRIBUTION PROGRAMS HELP YOU REACH YOUR GOALS?
FOR THE REMAINDER OF THIS PROBLEM, ASSUME THAT YOU START WORK ON THE DAY YOU TURN 22, AND RETIRE ON THE DAY THAT YOU TURN 70. THEREFORE, YOU WORK FOR 48 YEARS.
4. Value of Defined Benefit Plan with Single Employer: Suppose you take your first job with an employer that offers a defined benefit retirement plan and a beginning salary of $54,000/yr. Suppose also that you average 5.0% raises every year and that you stay with the same employer for all 48 years of your career. Note that during your 48-year career, you will receive 47 raises, the last of which happens on your last working day, which is also your 70th birthday. (No matter your current age, consider that you start working at age 22, and retire at 70). Assume a salary of $54,000 in the first year and an inflation rate of 2.0%.
a. What is your ending salary in nominal dollars (not adjusted for inflation)?
b. What is your ending salary in real dollars (adjusted for inflation, i.e. in $2015)?
c. Assuming that the employer’s defined benefit plan pays 1.25% of ending salary per year of employment, what will your annual retirement income be from this retirement plan (do not adjust for inflation):
Retirement Salary = (.0125)(Ending Salary)(Years employed)
d. On a scale of 1 (very little) to 10 (very much) how much would you like or prefer this particular defined benefit plan?
e. In a defined benefit plan, is your employer required to increase your monthly retirement pay based on the rate of inflation? What does this mean to you?
f. What happens to you if your employer goes out of business and has no money to pay for your (and others) retirement?
5. Imagine the same situation as above, but now you work for two employers during your career: You work for Employer A for the first 24 years, and Employer B for the second 24 years. Everything else in the problem is the same. Calculate your retirement salary from Employer A, from Employer B, and the total of the two retirement salaries. (Note that throughout your career, you receive a raise of 5.0% every year, even if you change employers, and you never loose salary when you change employers.
6. Value of early career Defined Benefit plan: Assuming the same situation as problem 4 (starting salary of $54,000; Defined benefit plan which pays 1.25% of your ending salary for each year that you worked for the company) what will your retirement income be if you quit this employer:
a. After 10 years (calculate your salary in the tenth year and then apply the retirement formula of 1.25% of ending salary for every year worked)
1) In nominal $
2) In “real” or inflation adjusted $ (assume inflation of 2.0%)
b. After 20 years.
1) In nominal $
2) In “real” or inflation adjusted $ (assume inflation of 2.0%)
c. Is a defined benefit a good plan if you do not stay with the company for your whole career?
d. If you work at a company for a whole career, you retire on your defined benefit salary, and the firm goes bankrupt, can the firm’s obligation to retirees like yourself be lowered, i.e. can retirees be left with a lowered retirement salary by the bankruptcy judge?
For questions 7-9 it is easiest to use a spreadsheet to formulate your answers.
7. Value of early career Defined Contribution plan in a mobile career
a. As a point of comparison, assume a starting salary of $54,000 and 5.0% annual increases each year for the first 10 years of your career. Assume that you are in a defined benefit plan, that you change employers every 2 years and 11 months (total of 4 employers) and that you were never vested in any of the three plans. How much money do you have in total from these three retirement plans at the end of the first 10 years of your career?
b. Assume a starting salary of $54,000 and 5.0% annual increases each year for the first 10 years of your career. Assume that you are in a defined contribution plan in which your employer contributes 7.0% of your salary each year, that you change employers every 3 years (total of 4 employers) and that you were vested in each of the four plans. How much money do you have in your plan at the end of the 10 years? Pragmatically, you can consider this as one plan for the whole 10 years since you would take the accumulated money with you across firms. Assume an 8% rate-of-return based on an index fund yielding a market average return. (Note that you will have 10 streams of income compounded over 9, 8, 7, …0 years of earnings. This is because we will simplify by assuming that the employer makes only 1 contribution per year and it comes on the last day of the year. In the 10th year, you get the contribution, but there is no interest earned.)
c. Calculate the value of those funds from the first 10 years if you let them stay invested with a return of 8% until you retire at age 70 (for this second part, don’t add any principle or employer contribution after the tenth year, just calculate what the compound earnings will yield if left invested at 8% until age 70.
d. What % of your desired retirement portfolio (question #3) does this represent?
e. What are the advantages of a defined contribution plan?
8. Verbally state what you learned from problem 7.
9. Value of Full Career Defined Contribution Plan: Finally, suppose that you again begin your 48 year career at age 22, beginning salary of $54,000/yr., 5.0% raises every year, and stay with the same employer for your whole career (or are always vested before you move between employers). Assume your employer always contributes 5.0% of your salary each year into your defined contribution plan. Assume that you invest in a mix of stocks and bonds such that you realize an annual average rate of return of 8%. What will the value of your defined contribution retirement fund be at retirement (age 70):
a. In nominal dollars (not adjusted for inflation)?
b. In inflation adjusted (2.0%) dollars?
c. On a scale of 1 (very little) to 10 (very much) how much would you like or prefer this particular defined contribution plan?
10. How can you tell how generous an employer is:
a) In a defined contribution plan?
b) In a defined benefit plan?
11. In the first part of this assignment you estimated the total retirement portfolio you needed for retirement. Why is that an important thing to do? What is likely to happen if you grossly overestimate that amount? What is likely to happen if you grossly underestimate that amount?
12. Usually, a Defined Contribution plan has a number of investment options that the employee may choose to invest in. One of those options will likely be federally insured savings at the then current market rate. That typically would pay less than 0.5% to 3% interest (based on averages over the past 15 years). This is also usually the default choice if you do not tell the plan to invest in stock or bond mutual funds.
a. If you did not choose your investment mutual fund(s) within the plan, but rather just let the plan put you into the default insured savings account, what would be the value of your plan at retirement? (For this problem, you may assume an average rate of return of 2% in the savings plan, and a 2.0% rate of inflation.)
b. Verbally state what you learned from problem 12, a. above.
12. If you change employers during your career, and all of them have defined contribution plans, what can you do with your vested funds once you leave an employer?
a) Leave it in each employer’s defined contribution program.
b) Move it (sequentially) to each of your next employer’s plan.
c) Roll it over into your own Individual Retirement Account.
Which of the three options above is most advantageous, and why?
NOTE. SOME PEOPLE MAY ALREADY HAVE SUBSTANTIAL ASSETS FROM ONE SOURCE OR ANOTHER. DO NOT DISCLOSE THESE ASSETS IN THIS ASSIGNMENT. RATHER, JUST DO THE ASSIGNMENT ASSUMING YOU DO NOT HAVE ANY EXISTING ASSETS. LATER, IF YOU LIKE YOU CAN REDO YOUR CLACULATIONS FOR YOUR OWN UNDERSTANDING. HOWEVER, I DO NOT WANT TO KNOW YOUR PERSONAL FINANCIAL SITUATION.
NOTE. THIS IS AN INDIVIDUAL ASSIGNMENT, TO BE DONE ONLY AS INDIVIDUAL WORK.
Be certain that you answer the questions that are asked, and answer them in the order asked. Show how you set up each problem and attach your spread sheet results.
1. Future Value (FV) = P*(1+i)^t
Where P is the starting amount, i is the interest rate (in decimal), and t is the number time periods. (We will use whole years in all of our problems). Use this formula to calculate how much an investment of $P at an interest rate i for t years. You can also use this formula to calculate your salary starting at $54,000 with raises of 5.0% for “t” years.
2. Present Value (PV) = P/(1+i)^t. Starting at one point in time, if you have an inflation rate of i% (in this assignment inflation is always 2.0%), what is the purchasing power of $P after t years?