Planning for Retirement
Chapter 14
How Will This Affect Me?
While almost everyone understands that planning for retirement is important, far too few people
actually implement a comprehensive plan, much less set aside enough savings to fund their
retirement adequately. This chapter discusses the importance of retirement planning and
encourages action by identifying the major pitfalls that you must overcome. In order to make the
process more concrete and accessible, the steps for estimating your retirement income needs and
the income that your investments will support are explained. Eligibility requirements to receive
Social Security benefits and their amounts are detailed, as well as the key aspects of
supplemental employer-sponsored pension plans and the potential benefits of self-directed
retirement programs like traditional and Roth individual retirement accounts (IRAs). In addition,
the usefulness of various annuity products in retirement planning is evaluated. After reading this
chapter, you should understand how to develop and implement a financial plan that will help you
achieve your long-term retirement objectives.
Learning Objectives
14-1 Recognize the importance of retirement planning, and identify the three biggest
pitfalls to good planning.
If your school or community will allow it, I suggest you take a branding iron and brand the
student’s forehead with the words: ”Plan NOW”. Planning for retirement needs to begin when
14-2 Estimate your income needs in retirement and the level of retirement income you’ve
estimated from various sources.
14-3 Explain the eligibility requirements and benefits of the Social Security program.
14-4 Differentiate among the types of basic and supplemental employer sponsored pension
plans.
14-5 Describe the various types of self-directed retirement plans.
Traditional and ROTH IRAs are discussed. The features of these plans should be discussed
14-6 Choose the right type of annuity for your retirement plan.
Financial Facts or Fantasies?
These may be used as “teasers” to get the students on the right page with you. Also, they may be
used as quizzes after you covered the material or as “pre–test questions” to get their attention.
• Social security retirement benefits should be sufficient to provide retired workers and their
spouses with a comfortable standard of living.
Fantasy: Social security is intended to be only a foundation for retirement income. By itself,
these benefits will likely permit retirees only a small fraction of their pre-retirement standard of
living.
• Because participation in a company’s defined benefit pension plan is mandatory, you’re
entitled to immediate vesting of all contributions.
Fantasy: While the employer may offer immediate vesting, that’s usually not the case. By law,
the employee is entitled to full vesting rights within a maximum of five to seven years,
depending on whether the company is using cliff or graded vesting procedures.
Financial Facts or Fantasies?
These may be used as a quiz or as a pre-test to get the students interested.
1. True False The first step in retirement planning is to set your retirement goals.
2. True False In order to receive maximum social security retirement benefits, a
worker must retire before his or her 66th birthday.
3. True False Social security retirement benefits should be sufficient to provide
retired workers and their spouses with a comfortable standard of
living.
4. True False Because participation in a company’s defined benefit pension plan
is mandatory, you’re entitled to immediate vesting of all
contributions.
5. True False Your contributions to an IRA account may or may not be tax
deductible, depending in part on your level of income.
6. True False Since an annuity is only as good as the insurance company that
stands behind it, you should check the company’s financial rating
before buying an annuity.
Answers:
YOU CAN DO IT NOW
The “You Can Do It Now” cases may be assigned to the students as short cases or problems.
They will help make the topic more real or relevant to the students. In most cases, it will only
take about ten minutes to do, that is, until the student starts looking around at the web site. But
they will learn by doing so.
YOU CAN DO IT NOW
Get a Rough Estimate of Your Future Social Security Benefits
YOU CAN DO IT NOW
Calculating the Benefits of a Traditional IRA
YOU CAN DO IT NOW
What Do Annuities Cost?
Financial Impact of Personal Choices
Read and think about the choices being made. Do you agree or not? Ask the students to discuss
the choices being made.
Hannah and Elizabeth’s Different Approaches to a Traditional IRA
Hannah Bennett and Elizabeth Cruz, both 30 years old, are good friends who work together at a
management consulting firm. They both take advantage of their firm’s 401(k) plan. But they
Financial Planning Exercises
1. Retirement planning pitfalls. Explain the three most common pitfalls in retirement
planning.
The three most common pitfalls in retirement planning are:
2. Calculating amount available at retirement.
Molly Lincoln, a 25-year-old personal loan
officer at First National Bank, understands the importance of starting early when it comes
to saving for retirement. She has designated $3,000 per year for her retirement fund and
assumes that she’ll retire at age 65.
a. How much will she have if she invests in CDs and similar money market instruments
that earn 8 percent on average?
b. Molly is urging her friend, Isaac Stein, to start his plan right away because he’s 35.
What would his nest egg amount to if he invested in the same manner as Molly and he, too,
retires at age 65? Comment on your findings.
© 2020 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole
or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a
password-protected website or school-approved learning management system for classroom use.
Fund earn 10%: Isaac will only be able to invest for 30 years. Using the Appendix B, the
annuity factor for 10% for 30 years is 164.494. Thus, investing $3,000 per year will amount to
$493,487 [$3,000 * 164.494= $493,487]. Using a financial calculator, the key strokes are:
3,000 +/- PMT Using the FV Excel function,
30 N =FV(.10,30,3000) = $493,482.07
10 I/YR
FV $493,482.07
The ability to accumulate funds for retirement depends upon both the time available to build the
fund and the return you can earn. Molly has an extra ten years more than Isaac, so she has a
greater likelihood of building a larger retirement fund.
3. Calculating annual investment to meet retirement target.
Use Worksheet 14.1 to help
George and Jude Sullivan determine how much they need to retire early in about 20 years.
Both have promising careers, and both make good money. As a result, they’re willing to
put aside whatever is necessary to achieve a comfortable lifestyle in retirement. Their
current level of household expenditures (excluding savings) is around $75,000 a year, and
they expect to spend even more in retirement; they think they’ll need about 125 percent of
that amount. (Note: 125 percent equals a multiplier factor of 1.25.) They estimate that
their Social Security benefits will amount to $20,000 a year in today’s dollars and that
they’ll receive another $35,000 annually from their company pension plans. George and
Jude feel that future inflation will amount to about 3 percent a year, and they think they’ll
be able to earn about 6 percent on their investments before retirement and about 4 percent
afterward. Use Worksheet 14.1 to find out how big their investment nest egg will have to be
and how much they’ll have to save annually to accumulate the needed amount within the
next 20 years.
Size of inflation–adjusted annual shortfall (I × K)
Funding the Shortfall:
Anticipated return on assets held after retirement
Expected rate of return on investments prior to retirement
Compound interest factor (in Appendix B):
47,666.00$
years to retirement (A) and an expected rate of return
Date
I.
A.
B. $
C.
expenses 125 %
D.
II.
E. $
F. $
G. $
H.
I.
III.
J. 3 %
K. Based on 20 years to
20,000.00
35,000.00
55,000.00$
38,750.00$
Inflation Factor:
Expected average annual rate of inflation over the period to retirement
Inflation factor (in Appendix A):
retirement (A) and an expected average
Social security, annual income
Company/employer pension plans, annual amounts
Other sources, annual amounts
Total annual income (E + F + G)
Additional required income, or annual shortfall (D – H)
PROJECTING RETIREMENT INCOME AND INVESTMENT NEEDS
Name(s)
George and Jude Sullivan
Estimated Income in Retirement:
Estimated Household Expenditures in Retirement:
Approximate number of years to retirement
10/11/2018
Current level of annual household expenditures, excluding savings
20
75,000.00
93,750.00$
Estimated household expenses in retirement as a percent of current
Estimated annual household expenditures in retirement (B × C)
4. Average Social Security benefits and taxes. Use Exhibit 14.2 to estimate the average
Social Security benefits for a retired couple. Assume that one spouse has a part-time job
that pays $24,000 a year, and that this person also receives another $47,000 a year from a
company pension. Based on current policies, would this couple be liable for any tax on their
Social Security income?
5. Retirement Planning. At what age would you like to retire? Describe the type of lifestyle
you envision—where you want to live, whether you want to work part-time, and so on.
Discuss the steps you think you should take to realize this goal.
6. Comparing Retirement Plans. Millie Russell has just graduated from college and is
considering job offers from two companies. Although the salary and insurance benefits are
similar, the retirement programs are not. One firm offers a 401(k) plan that matches
employee contributions with 25 cents for every dollar contributed by the employee, up to a
$10,000 limit. The other firm has a contributory plan that allows employees to contribute
up to 10 percent of their annual salary through payroll deduction and matches it dollar for
dollar; this plan vests fully after five years. Because Millie is unfamiliar with these plans,
explain the features of each so Millie can make an informed decision.
© 2020 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole
or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a
password-protected website or school-approved learning management system for classroom use.
The first plan would add $12,500 per year or after four years it would total $50,000 before
considering investment returns. If Millie stays for five years the plan would amount to $62,500,
before investment returns.
The second plan would amount to $40,000 if Millie leaves after four years. If Millie stays for
five years, at the end of five years her contributions would amount to $50,000 and the company’s
contribution would be another $50,000 for a total of $100,000 before investment returns.
The deciding question becomes what is the chance that Millie will still be with the company after
five years. If she thinks that she will still be with the company, go with the second company, all
other things being equal.
7. Effective after-tax cost of 401(k) contribution. Luis Gomez is an operations manager for a
large manufacturer. He earned $68,500 in 2016 and plans to contribute the maximum
allowed to the firm’s 401(k) plan. Assuming that Brad is in the 24 percent tax bracket,
calculate his taxable income and the amount of his tax savings. How much did it actually
cost Luis on an after-tax basis to make this retirement plan contribution?
8. Deciding between traditional and Roth IRAs. Elijah James is in his early 30s and is
thinking about opening an IRA. He can’t decide whether to open a traditional/deductible
IRA or a Roth IRA, so he turns to you for help.
a. To support your explanation, you decide to run some comparative numbers on the two
types of accounts; for starters, use a 25-year period to show Elijah what contributions of
$5,500 per year will amount to (after 25 years), given that he can earn, say, 10 percent on
his money. Will the type of account he opens have any impact on this amount? Explain.
b. Assuming that Elijah is in the 22 percent tax bracket (and will remain there for the next
25 years), determine the annual and total (over 25 years) tax savings that he’ll enjoy from
the $5,5,000-a-year contributions to his IRA; contrast the (annual and total) tax savings
he’d generate from a traditional IRA with those from a Roth IRA.
c. Now, fast-forward 25 years. Given the size of Elijah’s account in 25 years (as computed
in part a), assume that he takes it all out in one lump sum. If he’s now in the 40 percent tax
bracket, how much will he have, after taxes, with a traditional IRA, as compared with a
Roth IRA? How do the taxes computed here compare with those computed in part b?
Comment on your findings.
d. Based on the numbers you have computed as well as any other factors, what kind of IRA
would you recommend to Elijah? Explain. Would knowing that maximum contributions
are scheduled to increase to $7,000 per year make any difference in your analysis? Explain.
9. Deciding whether to convert a traditional IRA to a ROTH IRA. Explain the circumstances
in which it makes sense to convert a traditional IRA to a ROTH IRA.
It is all about you estimated tax rate in the future. If you think the rate when you will withdraw
10.
Comparing variable annuities and mutual funds. Explain how buying a variable
annuity is much like investing in a mutual fund. Do you, as a buyer, have any control over
the amount of investment risk to which you’re exposed in a variable annuity contract?
Explain.
11. Fixed vs. variable annuities. What are the main differences between fixed and variable
annuities? Which type is more appropriate for someone who is 60 years old and close to
retirement?
