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Life –Cycle Financial Planning

Chapter 5. Life –Cycle Financial Planning. Chapter Outline. A Life- Cycle Model of Saving Taking Account of Social Security Deferring Taxes Through Voluntary Retirement Plans Should you Invest in a Professional Degree Should you buy or rent. I- A life-Cycle Model of Saving.

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Life –Cycle Financial Planning

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  1. Chapter 5 Life –Cycle Financial Planning

  2. Chapter Outline • A Life- Cycle Model of Saving • Taking Account of Social Security • Deferring Taxes Through Voluntary Retirement Plans • Should you Invest in a Professional Degree • Should you buy or rent

  3. I- A life-Cycle Model of Saving • Example 1: • You are currently 35 years old, expect to retire in 30 years at age 65, and then to live for 15 more years until age 80. Your current labor income is$ 30 000 per year, and you have not yet accumulated any assets. Assumptions: • Ignore taxes • Your real income is adjusted for inflation so income remains at $ 30 000 per year until 65 & the real interest rate is 3% • You expect to die at 80 years of age and leave nothing • 100% Private • How much should you save now to reach an optimal consumption during retirement?

  4. A life-Cycle Model of Saving • A: Target replacement Rate of Preretiremnet income • 1- How much do I need every year from for 65-80 for consumption? • If 75%, the target retirement income = .75($30000)=$22 500 a year • 2- How much money (savings) needed at age 65 to reach this target? • Calculate PV factor= (1/(1.03)15)= 0,64186 • Annuity PV factor=(1- 0,64186)/0.03= 11,9378 • Annuity PV = $22500 (11,9378)=268 604,247 • 3- How much should I Save Each Year from 35-60 to reach 268 601,247? Consumption: 24354 Saving

  5. A life-Cycle Model of Saving • B- Maintain The same level of consumption • Two steps : • 1- Calculate PV for income, 30 years( Human capital) • 2- Calculate Constant Consumption (45y) that has PV = Human capital (permanent Income) Consumption

  6. A life-Cycle Model of Saving • Salary, consumption, and Saving over life Cycle

  7. A life-Cycle Model of Saving(The last column) Dissaving starts age 66 (calculated for each year up to retirement) :

  8. A life-Cycle Model of Saving • Different assumptions: • How if you started with saving of $10 000 at age 35? • Human capital $588013+$10 000= $598 013 • Solve for C = $598013/24,518= 24390,7 (+408) • How about if want to leave a bequest of $10 000 to your children after you die at age 80? • Human capital $588013 – PV($10 000/(1.03)45) • =$588013 - 2644,802 = $585368,198 • Solve for C = $ 585368,198 /24,518= 23875,038(-108)

  9. A life-Cycle Model of Saving • Example 2 (changing Income) • You are 30 years of age. You expect to earn $25 000 a year for the next coming 5 years and $300 000 a year thereafter until you retire at age 65. Your life expectancy is 85 years and you would like to maintain same level of consumption. If the real interest rate is 3% and you can borrow or lend at this rate, how much should you save now and in the future?

  10. A life-Cycle Model of Saving • Two steps : • 1- Calculate PV for income, 30 years (Human capital) • Discounting the second term :$5880026/(1.03)5 =5072486 • Total = 114446.7+ 5 072 486=5 186 747 • 2- Calculate the permanent Income + Then

  11. A life-Cycle Model of Saving:

  12. Example 2: Computation of Human capital + +

  13. Example 2: Computation of Accumulated Debt and Saving (Column 6)

  14. Example 2: Computation of Accumulated Debt and Saving; Continue + From age 45 to 65

  15. II- Taking Account of Social Security ( Socialförsäkring) • Mandatory retirement (social security). You pay a tax under working years and get Life-Time annuity when you retire. Is it good or bad? • Example 1 again: you are 35 years old and your salary will be $30 000 per year for the next 30 years. Interest rate =3%, human capital is $588013, optimal C= $23982, S= $6018. Pure private • Suppose that social security require that you pay $2000 (as taxes) for 30 years. If the social security pays you same rate of return as private saving , what is the yearly amount you would expect to get from the social security from age 66-80? Are you better of to be part in the social security? • Now you should get: • A- From Social security (tjänstepension ) • The future value • You get per year(66-80): • B- From your private saving( declined by 2000 per year for 30 years) :

  16. Taking Account of Social Security • You get per year (66-80) : • Total annuity payments (7970 + 16013)=$23983 per year . Same amount as if you did it without social security • But, if the social security pays higher interest rate than 3%, then it is better with social security system.

  17. III Voluntary Retirement Plans & Deferring taxes • Is it beneficial? Pensionssparande! • Example. Suppose you face a tax-rate of 20% both before and after retirement. You are 35 years old and the interest rate is 8% a year and you earned $1000. You like to choose between paying this amount in retirement plan or in saving account. • If you put 1000 in retirement plan: • FV before taxes: 1000(1.08)30=10062 • After tax at age 65: 10062 (0,8)= 8050 Better • If you put it in saving account. • You pay immediately 20% and save 800. Interest rate will be taxed ever year. • The after-tax interest earned is : (1-0.2) (8%)=6.4% • The FV :800(1.064)30= 5144

  18. IV- Should you invest in a professional degree? • You are 20 Years old and graduated from college today and considering whether to go on for 2 more years to study the master degree or to start working immediately. Is it worth it to study the master? No uncertainty! • If you take a job now you will get $30 000 a year in real term until 65. • If you have the master you will get $35 000 a year in real terms until 65. The tuition fees $15000 a year in real terms. If the real interest rate is 3%, should you study the master ? • Costs of studying the master (30 000 + 15000) a year, n=2 • Benefits of studying the master : 5000 a year for 43 years

  19. V- Should you buy or rent? • You are currently renting a house for $10 000 per year and have the option to buy it for $200 000. Property taxes are deductible for income tax and your tax rate is 30%. If you buy the house, you will face maintenance of $1200 and property taxes $ 2400 a year. No inflation and the nominal interest rate equal to real =3%. • Should you buy the house? • What is the break-even rent at which you will be indifferent between buying the house or rent it? • The outflow of property taxes is 0.7($2400)=$1680. • No date for Selling the house; perpetuity • Compute: Buy the House • Break even: : • If the rent < $7080, then renting is better. After- tax interest

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