Essentials of Investments: Chapter 20 - Taxes, Inflation, and Investment Strategy

Essentials of Investments: Chapter 20 - Taxes, Inflation, and Investment Strategy includes Saving for the Long run, Basic Considerations in Developing a Plan, Finding Your Retirement Annuity, Accounting For Inflation.

Chapter 20 Taxes, Inflation, and Investment Strategy McGraw-Hill/Irwin Copyright © 2010 by The McGraw-Hill Companies, Inc All rights reserved 21.1 Saving for the Long Run 21-2 Basic Considerations in Developing a Plan • The major goal is retirement planning • Time until retirement – When you plan to retire? – When can you collect Social Security? • Life expectancy – How long will you live after you retire? • Rate of return – How much risk are you willing to take? • Allocation of income to savings – How much are you saving for retirement? 21-3 Finding Your Retirement Annuity 21-4 21.2 Accounting For Inflation 21-5 Planning with Inflation • Inflation reduces the real value of the retirement benefit by eroding the purchasing power of the dollars earned – Real consumption = Nominal consumption / Price Deflator (ROR  i) ; 1 i  real return; i  inflation rROR  rROR rROR  (.06  03 )  2.91%  03 ROR  nominal return – Suppose inflation = 3% per year and the nominal rate of return is 6% What is the real rate of return? 21-6 Planning with Inflation • The investor in the example is 30 years old What is the size of the price deflator with 3% inflation at age 35? (1  i)n  1.03  1.16 1.0335  2.81 • By age 65? 21-7 Interest Rates, Inflation, and Real Interest Rates, 1926-2008 21-8 Planning with Inflation • To overcome inflation requires either higher savings or higher rates of return on investment or both • Because taxes are paid out of nominal returns, inflation reduces the after tax rate of return even further 21-9 A Real Retirement Plan 21-10 Spreadsheet 21.8 Roth IRA with Progressive Tax Code 21-25 Table 21.2 Traditional vs Roth IRA Tax Shelters Under a Progressive Tax Code 21-26 Defined Benefit Plans • Defined Benefit Plans – Employer promises to pay a defined or known benefit to employees when they retire • Typically a percentage of salary based on years of service • The employer must fund the pension obligation • Pension Benefit Guaranty Corporation (PBGC) guarantees pension benefits in the event of corporate bankruptcy, but often get an inferior pension plan if administered by the PBGC 21-27 Defined Contribution Plans • Defined Contribution Plans • 401k and 403b Plans are examples – Employee and employer contribute set amounts to an investment plan The employee’s retirement benefit depends on the investment performance – Employees are typically given a choice of mutual funds managed by a fund family such as Vanguard or Fidelity – Because of the employer contributions you want to take advantage of these plans 21-28 Table 21.3 Investing Roth IRA Contributions into Stock and Bonds 21-29 Table 21.4 Investing Traditional IRA or 401k Contributions in Stocks and Bonds 21-30 21.6 Social Security 21-31 Social Security (SS) • Federal pension plan established to provide minimum retirement benefits to all workers – It is unfunded although it is in surplus on a current year basis, projected to go in the red around 2016, – You pay 6.2% of your income to SS, plus 1.45% toward Medicare; your employer matches your contribution, – SS is a means of redistributing income In dollar terms taxes are regressive and low income workers receive a relatively larger share of preretirement income upon retirement 21-32 SS, What You Earn • You pay in every working year but only top 35 years of earnings & contributions count for determining benefits • Lifetime real annuity paid in full if you retire at age 67, you receive a reduced amount if you retire earlier (62) or your receive a larger benefit if you retire later (70) 21-33 SS, What You Earn Four steps to calculate your benefits: The series of your taxed annual earnings is compiled Indexing Factor Series – All past earnings are converted to today’s dollars using the Average Wage Index (AWI) Average Indexed Monthly Earnings (AIME) – The 35 highest annual indexed contributions are summed and then divided by (35 x 12) = 420 This number is the AIME 21-34 SS, What You Earn Four steps to calculate your benefits: 4.Primary Insurance Amount (PIA) – The annuity value received each year, – The income replacement rate is the percentage of the working income received in retirement, – Income replacement rate is substantially higher for low income individuals, – Benefits may be taxed if household income > $32,000 21-35 SS Annuities if You Were to Retire in 2009 at Age 66 21-36 Additional Considerations • 21.7 Children’s Education and Large Purchases • 21.8 Home Ownership: The Rent-verusBuy Decision • 21.9 Uncertain Longevity and Other Contingencies • 21.10 Matrimony, Bequest, and Intergenerational Transfers 21-37 Additional Considerations in Planning • Financing a child’s education – Same procedure as funding retirement • Rent or buy decision – You gain no equity in renting, – Equity is a safeguard for tough times, – Don’t try to buy too much house, – Houses are illiquid investments whose value does not always increase 21-38 Additional Considerations in Planning • Uncertain longevity – Life annuity versus fixed term annuity – Payment received on a life annuity is reduced due to adverse selection • Marriage, bequests and intergenerational transfers – Marriage increases motivation for saving for old age – Dependents increase need to save – Desire for bequests increase need to save – 75% of intergenerational transfers are involuntary (due to earlier than planned demise or under spending in retirement) 21-39 ... 65? 2 1-7 Interest Rates, Inflation, and Real Interest Rates, 1926 -2 00 8 2 1-8 Planning with Inflation • To overcome inflation requires either higher savings or higher rates of return on investment. .. change 2 1-1 8 Savings with a Flat Tax and an IRA Style Tax Shelter 2 1-1 9 Savings With a Progressive Tax Rate 21 -2 0 IRA with a Progressive Tax Code 2 1-2 1 21.5 A Menu of Tax Shelters 2 1-2 2 Tax Sheltered... benefits of shelters – Postponing payment of tax, – Additional earnings on the investment of postponed tax payments • Effectiveness of the shelter – Depends on investment performance and how tax