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Financial Planning Exercises
1. Calculating amount available at retirement. Marisa Gale, a 25-year-old personal loan
officer at Second 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 4 percent on average?
Using the Appendix B, the annuity factor for 4% for 40 years is 95.026. Thus, investing $3,000
per year will amount to $285,078 [$3,000 * 95.026 = $285,078]. Using a financial calculator,
b. How much will she have if instead she invests in equities and earns 10 percent on
average?
Using the Appendix B, the annuity factor for 10% for 40 years is 442.593. Thus, investing
$3,000 per year will amount to $1,327,779 [$3,000 * 442.593= $1,327,779]. Using a financial
c. Marisa is urging her friend, Nolan Ransom, 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 Jacqueline and he,
too, retires at age 65? Comment on your findings.
Funds earn 4%: Nolan will only be able to invest for 30 years. Using the Appendix B, the
annuity factor for 4% for 30 years is 56.085. Thus, investing $3,000 per year will amount to
Fund earn 10%: %: Nolan 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
The ability to accumulate funds for retirement depends upon both the time available to build the
2. Calculating annual investment to meet retirement target. Use Worksheet 14.1 to help Bill
and Shirley Hogan, who’d like to retire while they’re still relatively young—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. They 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.
Projecting Retirement Income and Investment Needs Worksheet 14.1
Name(s): Bill and Shirley Hogan Date: May 5, 2017
I, Estimated household Expenditures in Retirement:
II. Estimated income in Retirement
E. Social Security, annual income $20,000
F. Company/Employer pension plans, annual amounts $35,000
G. Other sources, annual amounts
retirement (A) and an expected average
annual rate of inflation (J) of ___3%____ 1.806
L. Size of inflation-adjusted annual shortfall (I * K) $69,982
IV. Funding the Shortfall
M. Anticipated return on assets held after retirement 4%
3. Critical evaluation of Social Security benefits. Many critics of the Social Security
program feel that participants are getting a substandard investment return on their money.
Discuss why you agree or disagree with this viewpoint.
The average monthly benefit for a retired couple in 2015 was $2,176. In you assume that the
average couple will live for 20 years after retirement, the present value of $2,176 * 12 = $26,112
per year for 20 years at 4% is 13.590 * 26,112 = $354,076. [Present value factor from Appendix
D.] If assume that the average couple worked 40 years and earned $50,000 per year paying in
12.4% [employee + employer tax rate] per year, that is taxes paid $6,200 per year over a 40 year
With this analysis, social security is a bad deal. But there are many assumptions in this
computation. For the baby boomers, this analysis might be close to accurate. Over the baby
boomers lives, the stock market has returned about 8% per year. But if those social security
taxes had not been paid into the government treasury, either expenditures would have had to be
4. Retirement planning. Use Worksheet 14.1 to assist Tara Easley with her retirement
planning needs. She plans to retire in 15 years, and her current household expenditures run
about $50,000 per year. Tara estimates that she’ll spend 80 percent of that amount in
retirement. Her Social Security benefit is estimated at $15,000 per year, and she’ll receive
$12,000 per year from her employer’s pension plan (both in today’s dollars). Additional
assumptions include an inflation rate of 4 percent and a rate of return on retirement assets
of 8 percent a year before retirement and 5 percent afterward. Use Worksheet 14.1 to
calculate the required size of Tara’s retirement nest egg and the amount that she must save
annually over the next 15 years to reach that goal.
Projecting Retirement Income and Investment Needs Worksheet 14.1
Name(s): Tara Easley Date: May 5, 2017
I, Estimated household Expenditures in Retirement:
A. Approximate number of years to retirement 15
II. Estimated income in Retirement
E. Social Security, annual income $15,000
III. Inflation Factor
J. Expected average annual rate of inflation over the period to
retirement 4%
K. Inflation factor (in Appendix A): Based on ___20__ years to
retirement (A) and an expected average
annual rate of inflation (J) of ___4%____ 1.801
L. Size of inflation-adjusted annual shortfall (I * K) $23,413
IV. Funding the Shortfall
M. Anticipated return on assets held after retirement 5%
5. Average Social Security benefits and taxes. Use Exhibit 14.3 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?
Average benefits for a retired couple are $2,176 per month or $26,112 per year. With the part-
time job and company benefit, their income would be$71,000 without social security. Current
6. Average Social Security benefits. Use Exhibit 14.3 to determine the annual Social
Security benefit for Bob Lemus, assuming that he is an “average” retiree. Bob is 65 years
old and earns $18,000 a year at a part-time job. (Note that Bob is already at “full
retirement age,” because he was born well before 1960.)
Retired worker average $1,328 per month in benefits or $14,936 per year. His part-time job plus
one half of benefits are combined to determine the provision income which is $18,000 + $7,468
Since Bob is at full retirement age, the “earnings test” that would reduce benefits for earnings
7. 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.
I personally think you should be able to retire at 25 for a 5 year period, and then work until you
8. Comparing Retirement Plans. Ellen Honeycut 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 Ellen is unfamiliar with these plans,
explain the features of each to her so she can make an informed decision.
Under the first plan, the maximum contribution would be $10,000 by Ellen plus $2,500 by
The second plan has the employer matching contributions dollar for dollar, thus if Ellen
contributed $10,000 the employer would contribute $10,000. But there is a five year vesting
9. Effective after-tax cost of 401(k) contribution. Brad Shin is an operations manager for a
large manufacturer. He earned $68,500 in 2012 and plans to contribute the maximum
allowed to the firm’s 401(k) plan. Assuming that Brad is in the 25 percent tax bracket,
calculate his taxable income and the amount of his tax savings. How much did it actually
cost Brad on an after-tax basis to make this retirement plan contribution?
The 401(k) maximum is $18,000 in 2015 [$17,500 in 2014]. So his taxable income is:
Salary $68,500
Less 401(k) (for 2015) 18,000
Less Standard Deduction (for 2015) 6,300
10. Defined benefit vs. defined contribution pension plans. Briefly describe the main
characteristics of defined contribution and defined benefit pension plans, and discuss how
they differ from cash-balance plans. In each of these plans, does the employee or employer
bear the risk of poor investment performance?
Defined contribution plans specify the contribution amount to be contributed to the plan. The
Defined benefit plans have a formula by which the benefits are computed, then contributions are
With a cash-balance plan, the contribution is entirely made by the employer. The employer then
guarantees a return that is small, about 2%. The cash-balance vest immediately therefore if the
employee leaves the company he/she may take the funds in the plan with them. The benefits are
11. Nature of different types of IRAs. Describe the three basic types of IRAs (traditional,
Roth, and nondeductible), including their respective tax features and what it takes to
qualify for each. Which is most appealing to you personally? Explain.
Traditional: Contribution is limited to $5,500 per year, contribution is deductible, and all of the
Roth: Contributions are limited to $5,500, ability to establish a Roth is limited based upon
Non-deductible: Contribution is limited to $5,500 per year, contribution is not deductible, and
Non-deductible is not good. Roth depends upon tax rate now versus tax rate when withdrawn. If
the rate will be higher later, use Roth now; if rate will be same or lower later, do not use Roth.
12. Deciding between traditional and Roth IRAs. Clint Crandall 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 Clint what contributions of
$4,000 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.
The following table is used for both a and b.
Traditional Roth
Amount available to contribute $4,000 $2,880 [tax rate is 28%]
Time money invested 25 years 25 years
b. Assuming that Clint is in the 28 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 $4,000-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.
If the tax rate at the time of contribution and at the time of distribution is the same, it makes no
c. Now, fast-forward 25 years. Given the size of Clint’s account in 25 years (as computed in
part a), assume that he takes it all out in one lump sum. If he’s still in the 30 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.
If the tax rate goes from 28% at the time of contribution to 30% at the time of distribution, the
d. Based on the numbers you have computed as well as any other factors, what kind of IRA
would you recommend to Clint? Explain. Would knowing that maximum contributions are
scheduled to increase to $7,000 per year make any difference in your analysis? Explain.
Since I believe that the tax rates later will not be higher for Clint, I still think that at Traditional
IRA is better than a ROTH. There is some chance that Clint will die and therefore his heirs will
receive the IRA funds and they may have a lower tax rate. Clint may decide to contribute the
IRA to a charity and never have to pay the taxes. The maximum contribution amount will be the
13. 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.
With a mutual fund, the investor gives money to the mutual fund that uses that money to buy and
With a variable annuity, the investor gives money to an insurance company which uses that
money to purchase stocks and other securities. The annual income is not subject to tax until
The investor in a variable annuity may be able to select the mutual funds the amounts are
14. Tax shelter aspects of annuities. Briefly explain why annuities are a type of tax-sheltered
investment. Do you have to give up anything to obtain this tax-favored treatment? (Hint:
Age 59½.)
The earnings from an investment in an annuity are not taxable until received. In this way, they are like a
tax-sheltered investment. The contract will specify when the annuity will be paid out. Most annuities are
designed to pay at retirement at age 65. If there is a pre-mature distribution before the investor is 59 ½,
15. Considerations in annuity purchase. Why is it important to check an insurance
company’s financial ratings when buying an annuity? Why should you look at past
performance when considering the purchase of a variable annuity?
It is extremely important to select a highly rated insurance company with an excellent financial
position when purchasing an annuity for several reasons. Fixed annuity assets are commingled
with the assets of the insurance company and hence are subject to the claims of the company’s
creditors. You certainly don’t want your investment assets used to pay the company’s bills.
Typically, the assets of variable annuities are in separate accounts and not commingled with
company assets and therefore not subject to the claims of the company’s creditors. However,
during the accumulation phase of your variable annuity, the size to which your investment grows
16. 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?
Fixed-rate annuities grow at a minimum fixed rate set by the insurance company, which is
Variable annuities are much like an investment in mutual funds, because the variable annuities
offer a collection of securities, usually mutual funds managed by the insurance company. You
For someone age 60 and close to retirement, a fixed annuity would probably be the better choice.
Even though the variable annuity offers greater growth potential, it could also suffer a loss,
