Chapter 1: The Preretirement Market Retirement Market Segment: Segment: The The retirement market has two segments: A) Retail Segment: Segment : The retail segment includes individuals and families looking for solutions to their retirement needs. • • •
Product Providers: Providers : The companies that create and market nancial products for retirement. Advisors: Advisors: Professionals who help customers evaluate and select retirement strategies and products. Customers: Customers: The individuals that purchase and use retirement products.
B) Institutional Segment: Segment: The institutional segment includes the businesses and other groups that buy retirement products, plans, and services for the benet of their employees or members. • •
•
•
Plan Providers: Providers: The companies that oer group retirement plans. ConsultantsAdvisorsBrokers:: Parties that are compensated for helping plan sponsors evaluate and ConsultantsAdvisorsBrokers select retirement plans. Plan Sponsors: Sponsors : The businesses and other groups that buy retirement plans for the benet of their employees or members. Plan Participants: Participants : The individuals covered by a group retirement plan. Pre!Retirement Market: Market: Retirement is typically dened by age and employment status: Past retirement market ! people ! people age ! or older who had left the work force. Past pre!retirement market ! people ! people under age ! who, with the e"ception of disabled individuals and spouses who didn#t work for pay, were actively employed
"oals o# Pre Retirement Market: People Market: People in the pre$retirement market tend to share a common goal % To make sure they have enough money to cover their nancial needs. &chievement of this goal depends on two primary factors: • •
Their available available resources resources Their e"penses e"penses
$i#e Stage: ' ' ' ' '
(outh (oung oung &dults &dults % +id ife ife &dult &dults s % Pre Retir tirees % Retirees
)! to *! years years before before retire retirement ment - to )! years years befor before e retir retireme ement nt ! to - years ears befor efore e retir etire emen ment
The resources resources can include: • • • • •
/ages Property 0mployer$sponsored retirement plans Personal savings 1nvestments
%oung %oung Adults & • • •
'( to ( *ears +e#ore retirement
Primarily depend on wages to cover their nancial needs ower end of wage scale: Relatively new to work force and work at entry or mid$level 2pper end of wage scale: +ore established , likely to part of two income households and hence more a3uent
Like 25% of peers, young adults expect to start saving by the time they reach age 25 Mid $i#e Adults • •
&
1, to '( *ears +e#ore retirement
0stablished careers with high income &part from wages, other resources include:
Propert*: •
•
+ost mid$life adults are homeowners and, for many, the e4uity they have in their homes represents a signicant nancial resource. +any mid$life adults also own other residential and non$residential real estate
-mplo*er!sponsored -mplo*er!sponsored retirement plans: <hough contributions are voluntary, most mid$life adults have at least some funds in employer$sponsored retirement plans or pension accounts. Personal savings and investments: • •
+ost mid$life adults have money in personal savings accounts. 5ome also own life insurance, certicates of deposit 678s9, and investments such as stocks, bonds, and mutual funds.
Most of them are actively saving or paying for higher education for their kids Pre Retire Retirees es •
•
•
•
&
( to 1, *ears *ears +e#ore +e#ore retire retirement ment
1n the 2nited 5tates, aby oomers$ those people born between -;* and -;*$ represent the largest segment of the population. population. +any of them have already retired and the nearly ! million oomers between the ages of !! and < who are still working are getting ready to retire. Pre$retirees have been in the workforce for half their lives or more and many have increased their incomes dramatically. ike mid$life adults, a large number of pre$retirees have also accumulated considerable li4uid assets and retirement savings.
More than half of them own their own homes. Mass market: T market: Traditionall raditionally y 25 households households dived into three three income$based categories • • •
ow income households +iddle income households >igh income households
$ $ $
= to =)*,;;; =)!, to <*,;;; =
A.uent Market: 7reated by the shift from income to total li4uid household assets • • •
+ass a3uent households >igh ?et /orth households 2ltra >igh ?et /orth households
$ $ $
=-, to =- million =- million to =)*.; million =)! million or more
Summar* o# the li#e stages o# the pre!retirement market:
Pre!retirement e/penses: e/penses: The costs of raising children can be signicant, but child$rearing is only one of the many e"penses that compete for resources during preretirement years. +ost people also need to cover • • • •
iving e"penses 0ducation e"penses >ealth care e"penses 8ebt
Propert*: •
•
+ost mid$life adults are homeowners and, for many, the e4uity they have in their homes represents a signicant nancial resource. +any mid$life adults also own other residential and non$residential real estate
-mplo*er!sponsored -mplo*er!sponsored retirement plans: <hough contributions are voluntary, most mid$life adults have at least some funds in employer$sponsored retirement plans or pension accounts. Personal savings and investments: • •
+ost mid$life adults have money in personal savings accounts. 5ome also own life insurance, certicates of deposit 678s9, and investments such as stocks, bonds, and mutual funds.
Most of them are actively saving or paying for higher education for their kids Pre Retire Retirees es •
•
•
•
&
( to 1, *ears *ears +e#ore +e#ore retire retirement ment
1n the 2nited 5tates, aby oomers$ those people born between -;* and -;*$ represent the largest segment of the population. population. +any of them have already retired and the nearly ! million oomers between the ages of !! and < who are still working are getting ready to retire. Pre$retirees have been in the workforce for half their lives or more and many have increased their incomes dramatically. ike mid$life adults, a large number of pre$retirees have also accumulated considerable li4uid assets and retirement savings.
More than half of them own their own homes. Mass market: T market: Traditionall raditionally y 25 households households dived into three three income$based categories • • •
ow income households +iddle income households >igh income households
$ $ $
= to =)*,;;; =)!, to <*,;;; =
A.uent Market: 7reated by the shift from income to total li4uid household assets • • •
+ass a3uent households >igh ?et /orth households 2ltra >igh ?et /orth households
$ $ $
=-, to =- million =- million to =)*.; million =)! million or more
Summar* o# the li#e stages o# the pre!retirement market:
Pre!retirement e/penses: e/penses: The costs of raising children can be signicant, but child$rearing is only one of the many e"penses that compete for resources during preretirement years. +ost people also need to cover • • • •
iving e"penses 0ducation e"penses >ealth care e"penses 8ebt
$iving e/penses ! e/penses associated 0ith ever*da* li#e: • • • • • • • •
@ood Transportatio Transportation n 6gas, car maintenance9 maintenance9 7lothing 1nsurance 6homeowners, 6homeowners, automobile, automobile, life9 >ousing 6mortgage, rent, furnishings, repairs9 0ntertainment 2tilities 6gas, electricity, water, garbage9 Travel Travel
&ctual amount paid towards living e"penses depend upon • • •
Aeographic location @amily 5iBe 5tandard of iving
-ducation -/penses: •
• • • • •
Providing post$secondary education for children can increase increase household e"penses by =), per year or more, depending on The colleges children children attend /hether they live at home or on campus /hether they receive any nancial aid &nd that amount increases every year. 1n fact, the cost of post$secondary education has increased at a faster rate than most other e"penses.
Ta/ Advantaged College Saving Plans: @amilies Plans: @amilies in the 2.5. can choose from two types of ta"$advantaged programs: Coverdell -ducation Savings Account -SA): -SA) : & federal education savings plan that allows people to contribute up to a specied amount per year into an education account on behalf of a named beneciary who is under age -C or has special needs. ('2 College Savings Plan: Plan : & state$based education savings plan that allows people to deposit funds into an education account on behalf of a named beneciary
-mplo*er Sponsored 3ealth Plans: The Plans: The maDority of full$time workers in the 2nited 5tates receive health care coverage through employer$sponsored group plans. 1n the past, most employers oered employees a choice of: ' Traditional medical e/pense insurance & provided benets for routine and maDor medical e"penses ' A managed health care plan ! integrates the nancing and delivery of health care services to manage the cost of care. <hough health care costs are reduced for plan participants, there are some participants# e"penses. • • •
Premium 8eductible 7oinsurance E 7opayment
Premium & 8educted from wages
4educti+le & & Fat dollar amount of eligible e"penses that an insured must pay before the insurer begins making any benet payments under an insurance policy. 1n medical e"pense insurance policies, the deductible usually applies to the total of eligible medical e"penses incurred during a period of time, such as a year Coinsurance Copa*ment & & specied, "ed amount that managed health care plan members must pay for specied medical services at the time the services are received 3ealth Savings Accounts 3SAs): 3SAs) : Today, many employees in the 2nited 5tates are managing their own health care costs by establishing >ealth 5avings &ccounts 6>5&s9. The amount that employees and employers can contribute to >5&s is specied by the 1nternal Revenue 5ervice 61R59. -/ample: +ost >5&s include a high$deductible health plan 343P) that provides benets for 4ualied medical e"penses. Gwners can choose the deductible amount and coinsurance amount for the >8>P as long as deductible and total out$of$pocket e"pense amounts satisfy regulatory re4uirements. >5& funds can be used to pay the >8>P deductible andEor eligible e"penses not covered by the >8>P. 1f an employee#s medical e"penses e"ceed the amount in the account, the employee must pay the e"cess costs out of pocket until costs reach the established ma"imum. Bene5ts o# 3SAs: 3SAs: >5&s oer benets over traditional health care options. @or e"ample: •
•
• •
•
ecause of the high deductible, monthly premiums for >8>Ps are typically lower than premiums for traditional medical e"pense insurance or managed care plans. 7ontributions to a 4ualied >5& can be made with pre$ta" dollars. &ny unused funds in the account at the end of the year roll over to the following year. >5&s are portable, so money remains with the individual if she changes Dobs or leaves the work force. >5& contributions are invested in money market accounts, 78s, and mutual funds. 1nvestment earnings are not ta"able until withdrawn. @unds withdrawn from the >5& to cover 4ualied medical e"penses are ta" free. >owever, funds used for non$4ualied e"penses are generally subDect to a )H penalty ta" and income ta"es
4e+t: ¬her 4e+t: ¬her e"pense for pre$retirees is debt, which arises when people use credit, or borrowed money, to buy products and services. 8ebt most often comes in the form of outstanding balances on • • • • •
>ome mortgages >ome e4uity loans 7ar loans Personal education loans 7redit cards
Installment 4e+t: @inancial 4e+t: @inancial services companies classify most loans as installment debt because they re4uire regular payments over a specied period of time. Revolving 4e+t: 1n 4e+t: 1n contrast, nancial services companies classify credit card debt as revolving debt because payments can e"tend indenitely. 7ard owners can add new charges before paying of e"isting charges. Advantages o# 6sing Credit Credit:: uying on credit provides a way for people to • • • •
uy products and services they otherwise couldn#t aord 7over emergencies &void carrying large amounts of cash 0stablish a credit history
4isadvantages o# 6sing Credit: Credit: uying uying on credit may also cause people to: • •
Pay more for credit purchases purchases than they do for cash purchases due to 1nterest charges on unpaid balances 8amage their credit history by carrying too much debt
Retirement Savings: 5aving Savings: 5aving for retirement is essential, and the earlier people start saving, the more funds they will have at retirement. 7ontributing small amounts to retirement plans over a long period of time can produce a higher account balance than contributing large amounts over a short period of time. There are are I popular savings options: options: • • •
0mployer sponsored retirement plans ank based savings 1nvestments
-mplo*er Sponsored Retirement Plans Plans:: 0mployer sponsored retirement plans can be structured in ) ways: • •
4e5ned +ene5t plans$5pecify the amount of the retirement benet 4e5ned contri+ution plans$5pecify the level of contributions to the plan
4e5ned +ene5t plan: plan: & retirement plan structured using a dened benet formula that species the amount of the benet a plan participant will receive at retirement. /hat /hat does does the plan plan promi promise se >ow are contributions determined
The The bene benet t amou amount nt a part partici icipa pant nt rece receive ives s at at reti retire remen mentt The plan sponsor sponsor must provide provide enough enough assets to to the plan to provide the promised benets
/ho contributes
Plan sponsors. Plan participants typically don#t contribute
>ow are benets paid
+ost dened benet plans are structured as pension plans that provide life time benets beginning at retirement
4e5ned contri+ution plan: & plan: & retirement plan structured using a dened contribution formula that species the level of contributions that the plan sponsor promises to make to the plan on behalf of participating employees. /hat does the plan promise
The amount the the plan sponsor sponsor would contribute to the the plan on behalf behalf of the plan plan participant.
>ow are benets determined
enet amounts are based on the total amount in the participant#s account at retirement
/ho contributes
2sually, both plan sponsors and plan participants can contribute. 0ach can deduct the contributions they make from their ta"able income
>ow >ow are are ben bene ets ts pai paid d
Typic ypical ally ly in in a lum lump p su sum, alt altho houg ugh h som some e pla plans ns oer oer addi additi tion onal al payo payout ut opt optio ions ns
The plan structure structure determines determines • • •
if plan sponsor contributions are mandatory or voluntary if plan participants make contributions how benets are paid
Type Type of Plan
5ponsor 7ontributio 7ontributions ns
Participant Participant 7ontributions 7ontributions
enets
Traditiona Traditionall Prot 5haring Plan
Joluntary $ based on and payable 2sually not allowed from 0mployer#s prots
ump sum or monthly annuity benets
5tock onus Plan
Joluntary $ based on 7ompany#s prots
?one
enets paid in company stock
*-6k9, *I6b9, *!<6b9 plans
Joluntary $ 5ponsor#s match participant contribution up to specied percentage of participant#s salary
Joluntary $ usually a "ed ump sum, 1nstallments or monthly percentage of annual annuity benets salary
Individual Retirement Arrangements IRAs): &n individual retirement arrangement IRA) allows a person with ta"able compensation to deposit a specied amount in a savings arrangement that receives favorable federal ta" treatment. 1R&s can be funded by nancial products including annuities, mutual funds, and certicates of deposit 678s9. Two forms of 1R&s include: Traditional IRAs: & type of an 1R& into which a person with earned income can make annual ta" % deductible contributions. 7ontributions are generally ta" deductible • • • •
0arnings grow on a ta"$deferred basis /ithdrawals must begin by age 70 1/2 and must meet minimum distribution re4uirements /ithdrawals are ta"able as income ?on4ualied withdrawals 6made before she reaches age !;H9 are subDect to an additional -H ta" penalty
-/ceptions: Penalty ta"es on withdrawals are waived if the withdrawal is • • • • •
•
+ade at the ownerKs death or disability 2sed to buy or rebuild a rst home 6up to a =-, limit9 2sed to pay for 4ualied education e"penses 2sed to pay unreimbursed medical e"penses e"ceeding a specied percentage of adDusted gross income 2sed for health care 1nsurance payments 1f the owner 1s unemployed and has received unemployment compensation for -) consecutive months Gne of a series of substantially e4ual periodic payments
Roth IRAs: & type of an 1R& that permits people within certain income limits to make nondeductible contributions and to withdraw money on ta" free basis. 7ontributions are made with ater-tax money • • • •
0arnings accrue on a ta"$deferred basis /ithdrawals aren#t subDect to age and minimum amount re4uirements Lualied withdrawals are tax ree ?on4ualied withdrawals may be ta"able and, if made before he reaches age !;H, are also subDect to a -H ta" penalty
7or a distri+ution to +e 8uali5ed: -9 The account must have been in eect for ! years and )9 Payment must be made to: an owner who has reached age !;H, become disabled, or withdrawn funds to buy or rebuild a rst home, or a named beneciary after the owner#s death •
•
Bank Based Savings 9ptions: anks in the 2nited 5tates oer two types of savings options: •
•
Savings Account: &n interest$earning deposit account that pays compound interest on deposited funds, typically from the day of deposit to the day of withdrawal Certi5cate o# 4eposit: & contractual agreement issued by a bank or other depository institution that returns the owner#s principal with interest on a specied date
ank$based savings options don#t oer substantial ta" advantages, e"cept when they are used to fund an 1R&. The money paid into bank$based savings options can#t be deducted from ta"able income at the time of payment. 0arnings are ta"able as they are earned.
Securities: 5ecurity is a nancial asset that represents either: A) 4e+t Securit*: &n obligation of indebtedness owed by a business, a government or an agency B) -8uit* Securit*: &n ownership interest 1nvesting in securities is an alternative method of accumulating assets. <hough the value of securities varies widely, they tend to increase in value over the long term. The +asic t*pes o# securities are: Stock: &n e4uity security representing a share of ownership in a corporation Bonds: & debt instrument under which the entity that sells the bond promises to pay the owner of the bond a stated rate of interest over a specied period of time and to repay the original amount of borrowed money at end of the specied period. Mutual #und: &n investment account that pools the funds of multiple customers and uses the funds to purchase shares in diversied portfolios of securities aria+le Annuit*: &n annuity contract under which the amount of the accumulation value and periodic income payments Fuctuate in accordance with the performance of one or more specied investment funds Stocks: &n e4uity security representing a share of ownership in a corporation ' Typically bought and sold by consumers through stock e"changes or over$the$counter markets ' Aenerate income through 7apital appreciation, which results when stocks sell for more than their original purchase price, 8ividends payable to shareholders out of company earnings
and
' >istorically have provided a better return on investment than "ed$rate products and over the long term usually result in gains ' 1nvolve greater risk than "ed$rate products Bonds: & debt instrument under which the entity that sells the bond promises to pay the owner of the bond a stated rate of interest over a specied period of time and to repay the original amount of borrowed money at end of the specied period. • • •
The issuing company pays a stated rate of interest over a specied period of time &t the end of the period, the issuing company repays the face value of the bond to the owner 5afer than stocks, but tend to provide lower returns
T*pes o# +onds include: • • • •
7orporate bonds Treasury bonds &gency bonds +unicipal bonds
Mutual #und: &n investment account that pools the funds of multiple customers and uses the funds to purchase shares in diversied portfolios of securities • • •
Ger high li4uidity and diversication >ave low minimum investment re4uirements Ger professional management services
aria+le Annuit*: &n annuity contract under which the amount of the accumulation value and periodic income payments Fuctuate in accordance with the performance of one or more specied investment funds • •
Aenerally less li4uid than other investments Ger owners a wide range of payout options
•
7an be customiBed to meet ownersM needs
Individual Investment Accounts: <hough people can buy securities directly from the issuing companies or government agencies and in open markets, many people prefer to handle investments through a nancial advisor Brokerage Accounts: • •
>elp with buying and selling securities PersonaliBed investment advice
Brokerage accounts are investment accounts established through securities broker$dealers that specialiBe in the purchase and sale of stocks, bonds, and other nancial instruments. • •
•
4iscount Broker 4ealers: 0"ecute customers# orders to buy and sell securities 7ull service +roker dealers: 7omplete re4uested transactions and provide personaliBed investment advice 9nline Brokerage Accounts: 2sually oer fewer services than traditional brokerage accounts
1n e"change for these services, customers usually pay either commission on sales, transaction fees, andEor management fees. rokerage accounts usually take one of two primary forms: Cash Account • • • •
Transactions are handled on a cash basis Transactions are usually completed within three days after an investor places a buy or sell order +ost accounts re4uire investors to make a small initial deposit$usually =!$to open the account and additional cash payments to cover transaction costs
Margin Account •
•
•
Transactions can be funded with a combination of investor deposits and money borrowed from the brokerage rm. 1nvestor is usually re4uired to make a substantial initial deposit either in cash or securities$usually at least !H of the value of the buy$sell order 1f the value of an investment made with borrowed funds falls below a specied percentage of its current value 6at least )!H9, the brokerage rm can issue a margin call, which is notice to the investor that additional cash or securities must be deposited into the account.
Managed Accounts •
&ctive management of investment portfolio to achieve specic obDectives
•
PersonaliBed advice on selection, diversication, and allocation of assets
Managed accounts are customiBed investment portfolios established to achieve specic obDectives, such as current income or long$term growth. •
+anaged accounts usually re4uire a high minimum deposit, such as =-,, and advisers typically charge an amount each year to cover advisory services, management activities, and transaction costs.
Chapter ': The Retirement Market Retirement Resources: efore they retire, many people receive most of their nancial resources from wages. &fter they retire, they rely on the three resources. • • •
0mployer sponsored retirement plans Personal 5avings and 1nvestments Aovernment sponsored retirement plans
Social Securit*: 1t is a 2nited 5tates federal program that provides specied benets such as retirement benets, survivorKs insurance and disability benets to eligible individuals Social Securit* 7unding 4etails • • •
Ta" rate /ho paysN Ta"able wage base
%ear o# Birth -;I< or earlier -;IC -;I; -;* -;*-;*) -;*I $ -;!* -;!! -;! -;!< -;!C -;!; -; or later
-).*H of earned income. 0mployer half, employee half. The ma"imum income ta"ed in a given year
7ull ;ormal) retirement age ! ! and ) months ! and * months ! and months ! and C months ! and - months and ) months and * months and months and C months and - months <
Taking +ene5ts +e#ore retirement age : &nne was born on @ebruary -, -;!, and has made contributions to 5ocial 5ecurity for * years. 5he is trying to decide if she will need to continue working until she reaches age or if she can retire at age ). Anal*sis: 1f &nne retires at age 6in )-9, she will be eligible for full 5ocial 5ecurity retirement benets. 1f she chooses to retire at age ), which is the earliest age she can le for benets, her benet will be reduced by )!H. @or e"ample, if &nne#s full benet is =-,, then her benet at age ) will be =is average earnings over those I years e4ualed =!!, 6=-,!, E I9.>e has no plans to work again before he reaches his full retirement age of . Anal*sis: ecause 7harlie has fewer than I! years of 5ocial 5ecurity earnings, the 5ocial 5ecurity administration will include ve years with = earnings when it calculates his average earnings. &s a result, his average earnings will decrease to appro"imately =*<,-*I 6=-,!, E I!9, and his monthly 5ocial 5ecurity benet will be reduced. Retiring $ate: 2nder current rules, people earn a credit for each year they delay benets, up to age <, when benets reach a ma"imum. =hat is a credit 0orth> 1t depends on when the retiree was born. 7redit amounts range from • •
minimum of 3% 6for people born in -;)*9 to maximum of !% 6for people born in -;*I or later9
These credits apply whether a person stops working at the normal age or continues working until delayed benet payments begin. 7ost of living adDustments, if any, also apply. -/ample: Ronald was born after -;*I, his benet will increase by CH each year he defers payments until he reaches age <. 1f he delays payment for - year, he will receive -CH of his scheduled monthly benet. 1f he delays payments for * years, he#ll receive -I)H of his scheduled benet. 9ther social securit* +ene5ts: 1n addition to primary workers# benets, 5ocial 5ecurity also pays retirement benets to the spouses and survivors of eligible workers. enets are calculated as a percentage of the primary worker#s benet. 8isabled individuals may also be eligible for benets. Ta/es on social securit*: <hough many may assume that 5ocial 5ecurity benets are ta" free, that#s not always the case. The rst step in determining whether 5ocial 5ecurity benets are ta"able is to calculate the person#s or couple#s combined income Ad?usted "ross Income This is a person@s income #rom all sources minus amounts #or speci5ed e/penses) An* Ta/!-/empt Income -g Interest #rom Municipal Bonds) O 3al# o# Social Securit* Bene5ts #or the %ear O Com+ined Income ?e"t, determine whether the social security benets are ta"able from this table
7ombined income Ta"able amount 5ingle, head of household +arried, ling Dointly ess than =)!,
ess than =I),
H of social security benets
=)!, to =I*,
=I), to =**,
2pto !H of social security benets
Gver =I*,
Gver =**,
2pto CH of social security benets
Social Securit* Penalties: People who start receiving 5ocial 5ecurity benets early and continue to work may be subDect to an earned income penalty if their earnings are too high. The limits are set by the 5ocial 5ecurity &dministration. The penalty is e4ual to a =- reduction in benets for every =) that earned income e"ceeds the established limit. The earned income penalty applies only to people who are younger than their normal retirement age. People who have passed retirement age are not subDect to penalties. 1n the year in which a person reaches full retirement age, it#s complicated, but we won#t get into that. =ithdra0ing #unds #rom emplo*er plans: Retirees who leave the workforce typically have two options for receiving funds that have accumulated in their employer$sponsored retirement plans: • •
$ump!sum 4istri+ution: The retiree receives the full account balance in a single payment Annuitied Pa*ments: The retiree receives a steady income stream for life
$ump Sum distri+utions: +ost dened contribution plans provide benets in a lump sum at retirement. &t retirement, the participant can: •
•
Take personal possession o# the mone* : 1n most cases, this is not the best choice because ta"es are payable immediately on the entire ta"able portion of the lump sum. eep the mone* In the 4C plan: The retiree still has access to the features and investment options of the group plan. >e won#t have to pay ta"es until he makes withdrawals, and then he#ll only pay ta"es on the ta"able amount he withdraws.
•
Trans#er the mone* to an IRA: 1f funds are transferred directly from the plan to a traditional 1R& and not paid to the plan participant, the transfer 4ualies as a rolloverD which is not ta"ed. Ta"es are payable on the ta"able portion of any withdrawals taken from the 1R&.
Rollover: & ta"$free distribution of cash from one retirement plan that the owner then contributes to another retirement plan within days. Annuitied Pa*ments: Pension plans automatically pay retirement benets as an annuity, and some dened contribution plans oer an optional in$plan annuity. 1n addition, the participant can roll over a lump sum into an 1R& and use it to purchase an annuity. Ta"es on annualiBed payments are payable when the payments are received.
Advantages o# Annuitied Pa*ments ' ' '
The retiree receives payments for as long as she lives. 5he cannot outlive her income. 1f a retiree lives longer than e"pected, it#s possible that she will receive more in benets than was paid into the account. The retiree doesnKt need to manage a large sum of money.
4isadvantages o# Annuitied Pa*ments ' ' '
@i"ed income payments lock retirees into a specic amount each month. Retirees can#t choose a higher or lower payment according to their actual needs in a given month. 1f a person dies earlier than e"pected, it#s possible that he will receive less in benets than was paid into the account. /hen an account balance is annuitiBed, a retiree no longer has access to the funds. >e can#t withdraw a lump sum to pay for one$time or emergency e"penses.
=ithdra0ing #rom Stock Bonus Plans: 5tock bonus plans present a special situation because benets are paid in the form of company stock. The table below summariBes how distributions are ta"ed.
Griginal value of stock 1ncreases in the value of stock
/hen is it ta"ed &t distribution, whether or not stock is sold /hen stock is sold
Ta"ed as Grdinary income ong term capital gain
=ithdra0ing #rom Individual Retirement plans: RM4: Re4uired +inimum 8istribution sometimes called +inimum Re4uired 8istribution 6+R89: +ust take distributions by &pril - of the year after they reach age 70 and 1/2 3o0 large do the distri+utions need to +e> The minimum amount an owner must withdraw from a traditional 1R& each year$the R+8$is calculated by dividing the account balance at the end of the previous year by the owner#s remaining life e"pectancy. 3o0 do I kno0 0hat m* li#e e/pectanc* is> ife e"pectancies used to calculate R+8s are shown in tables provided by the 1R5 5uppose Rosy decided it would be a good idea to e"tend the amount of time her 1R& would provide income payments, so she decided to take =<,! in distributions rather than the =-, calculated using the 1R5 tables. ' '
ecause contributions to traditional 1R&s are most often made with pre$ta" dollars and the ta"es on earnings are deferred, Rosy will have to pay income ta"es on the entire =<,! she received as a distribution. ecause she withdrew less than her minimum re4uired distribution, she would also be subDect to a ta" penalty
Penalt* #or #ailing to take minimum re8uired distri+ution: 1f an 1R& owner withdraws less than the R+8, she must pay a penalty ta" e4ual to !H of the dierence between the R+8 and the amount taken. RosyKs actual distribution in the earlier e"ample is =),! less than the re4uired distribution 6=-, $ =<,!9, so she would be assessed a penalty ta" of half that amount, or =-,)!. Traditional 1R& +ost contributions made with pre$ta" money
Roth 1R& 7ontributions made with after ta" money
0arnings accrue on a ta"$deferred basis
0arnings accrue on a ta"$deferred basis
Preta" contributions and 1nvestment earnings ta"able on withdrawal
Lualied withdrawals are not ta"ableQ
"Taxes are payable on te portion o any non-!ualied #itdra#al tat represents invest$ent earnings & non!ualied #itdra#al is one tat is ta'en beore te account is ve years old or #it so$e exceptions beore te account o#ner is ()*+ years old, Personal savings and investments:: Retirees make deposits to savings accounts or 7Gs with after$ta" money and pay ta"es on earnings in those accounts in the year they#re credited to the account. &s a result, retirees don#t pay ta"es when they withdraw money from the accounts. Retirees also buy securities with after$ta" money, and they don#t pay ta"es on increases in the value of the securities as long as they hold the securities. Retirees pay ta"es on any increases in value at the time the securities are sold. These increases in value, however, are ta"ed as capital gains and not as ordinary income, as long as the investment is held for more than one year 6any income from dividends or interest is ta"ed as income in the year it is earned9. =ithdra0ing #rom savings and investments: Bu*ing an annuit*: 7ashing in savings accounts and investment accounts and using the money to buy an annuity takes the guesswork out of income planning because payments are designed to e"tend throughout the owner#s lifetime. $addering pa*outs: y staggering the payout dates of 7Gs or bonds, a retiree can guarantee specied amounts at specied times. Taking s*stematic 0ithdra0als: 2nder a systematic withdrawal plan 65/P9, the retiree receives planned payout amounts at predetermined intervals for as long as the savings or investments last. Situations that can increase e/pense: 0"penses can be higher than e"pected when retirees need to: ' '
&ssimilate adult children into the household. 7are for aging parents.
1n addition, the percentage of retirees who own their own home is decreasing. 5o, more people may face large amounts of debt during retirement. 3ealth care e/penses: &ging people become increasingly susceptible to illness and inDury. &s a result, health care e"penses for retirees often increase dramatically. 1n the 2nited 5tates, health care coverage for retirees typically transfers from employer$sponsored plans to government$sponsored or personal insurance plans. The government provides health care coverage through two basic plans, +edicare and +edicaid Medicare: & 2.5. federal government program established by the Gld &ge, 5urvivors, 8isability and >ealth 1nsurance 6G&58>19 &ct that provides medical e"pense benets to elderly and disabled persons. Medicaid: & Doint state and federal program in the 25, that provides basic medical e"pense and nursing home coverage to the low$income population and certain aged and disabled persons. Medicare 9ptions: Part A: 1t covers basic inpatient hospital services, limited period of connement in nursing and e"tended care facilities or home care after hospitaliBation, and hospice care. 0nrollment in Part & is automatic when a person applies for 5ocial 5ecurity otherwise, individuals need to formally apply when they reach age ! Part B: 1t covers physicians# professional services and costs for diagnosing and treating illnesses or inDuries. Part is optional. People age ! who are currently covered by an employer$sponsored health care plan usually don#t need Part . Those who don#t have outside coverage must formally enroll for Part .
Part C: &lso called +edicare &dvantage, Part 7 combines Part & and Part coverage and is available as a private fee$ for$service plan, managed care plan, or +edicare medical savings plan. +any +edicare &dvantage plans also cover prescription drugs. Prescription 4rug Costs: &s the costs of medical care grow year after year, one maDor cause$though by no means the only cause$is the rise in the costs of prescription drugs +edicare Part 8 provides benets for prescription drugs, but not for the full costs of the drugs. Monthl* Premium: The monthly premium for +edicare Part 8 varies by plan and is separate from the premium for Part . Participants with income above a certain limit must pay an additional premium, which is deducted from 5ocial 5ecurity benets. Cost Sharing: Part 8 plans generally feature an annual deductible and a coinsurance charge for each prescription purchase. Plans oered by managed care organiBations usually charge net copay for each prescription purchase instead of coinsurance. +edicare Part 8 plans include a temporary gap in coverage$the infamous Sdonut holeS$ that begins after a participant#s prescription costs have reached a specied level for the year. &bove this level the participant is responsible for her own drug costs until she reaches the plan#s out$of$pocket ma"imum, at which point plan coverage resumes. •
•
The good news is that, while in the coverage gap, participants receive price discounts from drug manufacturers. The other good news for +edicare participants is that, as a result of the Patient Protection and &ordable 7are &ct, the federal government provides subsidies to people in the donut hole.
These subsidies reduced drug costs during the coverage gap by half in )--, and the subsidies will increase gradually until )), when participants will pay the same percentage for prescription drugs in the donut hole as they pay before entering the donut hole. "overnment coverage #or $ong term care: +edicare provides limited coverage for long$term care )-) skilled nursing home care costs and +edicare benets +edian daily cost +edicare benet 8ay -$)
=)
=
8ay )-$-
=)
=-*C
8ay --O
=)
=
+edicaid coverage for long$term care varies by states. 5tates that do oer benets usually oer coverage through community$based programs. $ong Term Care $TC): 1t is insurance providing benets for medical and other services needed by individuals who, because of advanced age or the eects of serious illness or inDury, need constant care at home, in an assisted living facility, or in a skilled nursing facility. 3ome Care: +ost people#s rst choice for long$term care is the familiar environment of home. +any people also begin by receiving care from family or friends. >owever, because the emotional burden of providing care can be overwhelming for caregivers, they often tum to in$home assistance from an outside service provider. /hile reducing stress, this can be very e"pensive.
Assisted $iving: 1t is for people who are unable to live by themselves but who don#t re4uire constant care. The services include: '
+edication management
' ' ' '
>ousekeeping and laundry +eal preparation &ssistance with bathing and toileting Transportation to doctor appointments
Skilled ;ursing 7acilit*: ' ' ' '
5killed nursing care )* hours per day >ospital$like setting & last resort for most people &verage length of stay about ).! years
$ong Term Care Insurance: 7learly, there is a gap between many people#s likely long$term care needs and the coverage provided by the government. 1n order to navigate retirement successfully, retirees need either to set aside part of their retirement funds for long$term care e"penses or to purchase commercial long$term care Characteristics o# most $TC policies etween =
' ' ' ' ' '
athing 7ontinence 8ressing 0ating Toileting /alking
Social Securit* Concerns: 5ocial 5ecurity was designed: ' ' '
To use revenues raised from workers To fund benets for retiree /ith e"cess amounts placed into the 5ocial 5ecurity @und
1n reality, social security pays more than it collects, and the trust fund is growing smaller. Social Securit* Concerns: 2.5. 7ongress has engaged in an ongoing debate over 5ocial 5ecurity. 7ongress probably won#t eliminate the system but is likely to modify it. egislation has already been implemented to increase the age at which full 5ocial 5ecurity retirement benets will be payable and to encourage people to work longer. Gther changes are also being considered. Proposals include ta" increases, benet reductions, new benet structures, changes to the way C9$As are calculated, and program privatiBation. A C9$A is a cost o# living ad?ustment! an increase in the amount o# Social Securit* +ene5ts to account #or rising prices Proponents argue that the new method for calculating 7G&s, which would be based on a combination of general price increases and spending patterns during periods of inFation, could reduce the strain on 55 by =--) billion or more. Gpponents contend that the change would create hardship for seniors because the proposed adDustments would not keep pace with increases in prescription drug costs. Concerns a+out Retirement Plans: Shi#t to 4C Plans ! -Eects: @rom a retirement planning point of view, dened benet 689 plans oer certain advantages. /hen they retire, 8 plan participants know: ' '
The amount of income they will receive each month or year That their retirement income payments will last for the rest of their lives
8ened contribution 6879 plans introduce more uncertainty into the planning process. Plan participants can calculate how much money goes into the plan, but they canKt calculate how much monthly income they#ll receive when they retire or how long their benets will last.
87 plans are built on the premise that over the long run, 2.5. e4uities have always increased in value. Gver the short run, values can increase or decrease. /hile funds are accumulating, periodic low return rates usually aren#t a problem. >owever, when participants begin withdrawing money at retirement, they are subDect to se4uence of returns risk
Personal Savings: The 2.5. government has taken a number of steps to encourage personal retirement savings by oering savers signicant ta" advantages, such as those available to people who establish traditional or Roth 1R&s. ¬her e"ample is the S5aver#s 7redit.S 1ndividuals who make contributions to 1R&s, employer$sponsored retirement plans, and government$sponsored plans may also be eligible for the Retirement 5avings 7ontributions 7redit. ike other ta" credits, the 5aver#s 7redit is deducted from the amount of ta" due on the individual#s ta"able income. The 5aver#s 7redit is intended to benet low$ and moderate$income workers and so is only available to people who meet certain age and income re4uirements.
Retirement Savings Contri+utions Credit SaverFs credit): 1n the 2nited 5tates, a ta" credit available to low$ and moderate$income workers who contribute to an 1R& or one of several types of workplace retirement plans. The 5aver#s 7redit is available in addition to a plan#s other ta" advantages, but is often limited in amount and subDect to various re4uirements >owever, even with these incentives from the government, the overall savings rate is still fairly low and unstable People with poor saving patterns during employment are more likely to suer from inade4uate income during retirement. 7inancial status in Retirement: Researchers predict that nearly < percent of &mericans will e"perience changes in nancial status during retirement$ either because of decreased resources or increased e"penses. @or e"ample: ' ' '
1ncreases in household siBe$created by the need to assimilate children, grandchildren, or parents into the household$can increase e"penses and aect how available resources are allocated. 8ecreases in household sie when children move out can make the need for outside assistance for home care more likely. The loss o# a spouse to death or divorceD and the loss of income and support from that spouse can make it dicult for the surviving spouse to maintain the same standard of living.
Increasing $ongevit*: ongevity can also aect a person#s nancial status. Today, seniors often live additional) years or more after retirement. People who retire before age ! may well spend as many years in retirement as they spend working. Those e"tra years are likely to create signicant mismatches between available retirement funds and actual retirement needs. 0ven those people who have planned for retirement face the very real possibility that they will outlive their funds. Therefore, a signicant number of people are working beyond their SnormalS retirement age on a part$time or full$time basis. Chapter <: The Retirement Industr* The 7inancial Services Industr*: The companies that oer retirement savings and income options are part of the larger nancial services industry People, businesses, and governments buy their products and services to help save, borrow, invest, and otherwise manage money. 7ustomers trust nancial institutions to act fairly and ethically and to put the customers# interests above company interests 7inancial services industr*: The companies that oer products and services designed to help individuals, businesses, and governments meet certain nancial goals, such as protecting against nancial losses, accumulating and investing money or other assets, and managing debt and cash Fows
Contractual Savings Institutions
1nsurance 7ompanies
Pension @unds
7ommercial :anks
@inancial 5ervices 1ndustry
4epositor* Institutions
5avings and ,oan &ssociations
5avings :anks
7redit 2nions
:roker 8ealers
Investment Institutions +utual @und 7ompanies
Contractual savings institutions: ' •
'
7ollect money from households, businesses, and governments 1nvest it in long$term nancial assets 2se accumulated assets to pay the benets promised in a contract
1n the 2nited 5tates, the two primary types of contractual savings institutions are •
•
Insurance companies! Ger insurance, protection for their customers against nancial loss caused by specied events Pension #unds $Pool contributions made to pension plans to provide plan participants with lifetime income benets beginning at retirement
Insurance companies: Two broad categories of 1nsurance 7ompanies 1nclude: ' '
$i#e and 3ealth Insurance Companies: Ger protection against personal risk Propert* Casualt* Insurance Compan*: Ger protection against property damage risk andEor liability risk
Personal risk: 1t is the risk of economic loss that results from death, poor health, inDuries, or outliving one#s economic resources. $ia+ilit* risk: 1t is the risk of loss from a person being held responsible for harming others or their property. Pension 7unds: Pension funds pool the assets contributed to employer sponsored pension plans. Pension plans can be established: ' '
y private plan sponsors, such as employers on behalf of their employees y public sponsors, such as government agencies on behalf of citiBens or public$sector employees
The largest public pension plan in the 2nited 5tates is 5ocial 5ecurity. Pension Bene5t "uarant* Corporation PB"C): & 2.5. federal agency that guarantees the payment of part or all of the retirement benets for participants in dened benet retirement plans when those plans become nancially unable to pay benets.
' ' '
1n the 2nited 5tates, pension plan participants are protected against loss of benets by the Pension enet Auaranty 7orporation 6PA79. 1n )--, the ma"imum amount payable by PA7 to a ! year$old participant in a nancially impaired pension plan was =*,! per month, or =!*, per year. Plan sponsors are re4uired to pay a premium every year to participate in this insurance program.
4epositor* Institutions: 1t is a nancial institution that specialiBes in accepting deposits and making loans. The primary activities of depository institutions include: ' ' ' '
&ccepting deposits +aking loans Gering checking accounts, savings accounts, and debit and credit cards 5ometimes oering investment services, nancial counseling services, and trust services
T*pes o# 4epositor* Institutions: The primary depository institutions in the 2nited 5tates include: Commercial +anks: 1t is a depository institution that accepts deposits from people, businesses and government agencies and uses these deposits to make consumer and business loans. ' ' '
+ake personal and commercial loans &ccept savings account deposits from individuals and businesses 5erve as distributors of mutual funds and insurance products
Savings and $oan associations S G $s): 1t is a depository institution that pools the savings of people and makes residential mortgage loans. ' ' '
+ake residential mortgage loans to consumers &ccept savings account deposits Ger checking services
Credit 6nions: 1t is a nonprot depository institution that does business only with its depositors % called members$ who traditionally shared a common bond, such as an employer or their industry ' ' '
+ake consumer loans to members &ccept deposits from members @unction as non$prot cooperative organiBations owned members
Savings +anks allo0ed onl* in certain states) ' '
&ccept savings account deposits from individuals +ake mortgage loans to individuals
3o0 do depositor* institutions operate> 7ustomers deposit funds with depository institutions. 1n e"change, the institution pays its depositors interest. The institution uses deposited funds to make investments or to make loans to other households, businesses, or government agencies, which pay interest to the institution for use of the funds. Interest: 1t is a fee that individuals and nancial institutions pay 6or charge9 for the use of borrowed money. 8epository institutions also invest deposited funds in nancial markets. The interest the institution earns on loans and the earnings generated by the investments are the companyKs revenue. The dierence between the interest the institution pays and the interest it earns is a large part of the institution#s protability. 7ederal 4eposit Insurance Corporation 74IC): The @ederal 8eposit 1nsurance 7orporation 6@8179 insures deposits in member commercial banks for amounts up to a specied limit per depositor, per bank, based on account title. 1n )-I, the coverage limit was =)!, per depositor per bank. The ?ational 7redit 2nion 5hare 1nsurance @und 6?7251@9 provides similar protection for credit union deposits.
;ational Credit 6nion Share Insurance 7und ;C6SI7) 1t is the insurance arm of the ?ational 7redit 2nion &dministration that insures credit union accounts for up to =)!,. Gur last key type of nancial institution is investment institutionsD which buy and sell securities. Securities represent either: ' '
&n ownership interest in a business 6stock9 & debt owed by a business, government, or agency 6bond9
1nvestment institutions, which can market securities to both institutional and individual investors, fall into two categories: Broker!4ealers Investment Institution: 1t is a nancial institution that engages primarily in investing and trading securities. Mutual 7und Compan*: 1t is a Type of investment institution that manages one or more mutual funds and sells shares in those funds to individual or organiBational customers. &lso called an invest$ent co$pany Broker!4ealers: roker$dealers act as brokers when they serve as intermediaries between buyers and sellers of securities, supervise the sales process, and provide information and advice to customers. roker$dealers act as dealers when they maintain an inventory of securities and market those securities to customers.
Mutual #und companies: +utual fund companies pool funds collected from investors to buy securities. The company then assembles the purchased securities into diversied investment portfolios called mutual funds. 1ndividual investors own shares in the funds based on the amount of their investments. -/ample: +ost mutual fund companies oer customers a choice of funds, each with its own risk prole and investment obDectives. 1nvestors can buy or sell fund shares at any time$ either directly from the fund company or through a broker$dealer$and can switch from one fund to another. 3o0 do mutual #und companies generate revenue> +utual fund companies generate revenue by collecting fees from investors or assessing sales charges for performing transactions. T0o t*pes o# sales charges include: ' '
7ront!end sales charge: a charge investors pay when they purchase mutual fund shares Back!end sales charge: a charge investors pay when they sell mutual fund shares
+ost companies also assess maintenance charges or e"pense charges designed to cover their operating e"penses. Products 7eatures: & product is a bundle of physical, technical, and functional features. @or e"ample, an individual retirement arrangement 61R&9 can be described in generic terms as a bundle of asset accumulation features, ta" benets, and payout options
Purpose: @or a customer, a product is a solution to a problem and a way to satisfy needs. @or e"ample, a retirement plan can be a means of providing nancial security or protection against nancial risk, a way to manage savings and ta"es, evidence of the owner#s concern for loved ones, or a legacy left by the owner to future generations alue: The value of a product depends on how well it solves problems or satises customers# needs. Product Classi5cation: +ost products fall into one of two categories: goods and services • • •
7ustomers can see, touch, and sometimes smell, hear, and taste goods 7ustomers can only e"perience a service as it is performed or used. <hough some products t neatly into one category or the other, most have both tangible and intangible 4ualities.
"oods and Services: /e can divide goods and services into product classes, package or brand them, and sell them to individuals or to businesses. •
• •
Product Class: 7ars are often divided into classes such as lu"ury cars, economy cars, family cars, or sports cars according to their use and the image they foster. Uoe and +ia#s minivan would most likely be classied as a Sfamily carS rather than a Vlu"ury carS or a Vsports carV Branding: The minivan is branded because it carries the manufacturer#s name. IndividualBusiness ecause they bought the car for their personal use, it is an individual rather than a business purchase.
6ni8ue characteristics o# 5nancial products: ike other products, nancial products can be • • • •
8istinguished as goods or services 8ivided into categories randed 5old to individuals or businesses
>owever, nancial products have two uni4ue characteristics that set them apart from other products: their function and their structure Product 7unction: The primary function of all goods and services is to satisfy customer needs • • •
+ost tangible goods satisfy needs directly +ost nonnancial services satisfy needs directly +ost nancial services directly satisfy some psychological needs, but satisfy most other needs indirectly.
Product Structure: 5tructurally, most nancial products are augmented products that consist of two parts: • •
& core product that meets needs & bundle of value$adding supplementary 5ervices
Supplementar* Services: 7acilitating service: >elps customers use product •
•
In#ormation Services: rad /orley calls Prime @inancial 5ervices WP@59 for information about the dierent investment options available through his *-Wk9.P@5 provides rad with detailed information on each option. 9rder Taking Services: rad contacts P@5 to make changes in his allocations and to re4uest automatic investment rebalancing.
-nhancing Service: 1t adds e"tra value to product • •
Billing Services: P@5 sends rad a statement showing his transactions, fees, and account balances. Pa*ment Services: rad takes a loan from his account. P@5 provides rad with options for repaying
T*pes o# 4epositor* Institutions: Products oered in todayKs nancial services marketplace can be divided into four core categories based on the needs they address. >ere are the product categories and what they help customers to do Cash Management: • • • •
Pay bills +ake purchases 5tore money short$term Transfer funds from one account to another
Asset Protection: +anage risks and protect against nancial losses Asset Accumulation: uild wealth over time Asset 4istri+ution: +anage the distribution of accumulated wealth Cash Management Products: 7ash management products are designed primarily to satisfy short$term nancial needs and obligations. •
•
•
•
•
Protection against loss: 5ince they live in the 2nited 5tates, 7arol and ill#s bank$issued products are protected against loss, subDect to certain limitations, by the @ederal 8eposit 1nsurance 7orporation 6@8179. -as* Access to 7unds li8uidit*): Products such as checks and debit cards give 7arol and ill almost immediate access to their money. Convenience: 2sing checks or debit cards allows ill and 7arol to buy products and services 4uickly and easily, without having to carry large amounts of cash. Transaction cost: ill and 7arol don#t pay fees for their checking and savings accounts. They do pay charges for withdrawals from their money$market account and for mutual fund purchases and sales, but these charges are fairly small. =ide Acceptance: +ost businesses and individuals accept checks, debit cards, or credit cards as a form of payment for goods and services.
Asset Accumulation Products: &sset accumulation products are designed to increase the amount or value of assets over time. Gptions in this category can help owners save for retirement, fund a child#s education, or transfer assets to future generations. The particular product a customer purchases generally depends on the products ability to oer an acceptable level of: • • • •
0arning potential Risk i4uidity 7ost
-arning Potential: @or the value of an asset to increase over time, the asset must generate returnsD or earnings. +ost asset accumulation options generate returns in the form of: • • •
1nterest 8ividends 7apital &ppreciation
Risk: &ll asset accumulation options carry a certain amount of risk as a result of their e"posure to unpredictable Fuctuations in interest rates, market performance, or inFation rates. ecause of the relationship between risk and return, options with higher risks typically produce higher potential returns and options with lower risks oer lower potential returns $i8uidit*: 0ventually, customers will need to convert accumulated assets into cash to meet their nancial obligations. The more li4uid the asset, the faster and more easily it can be converted to cash. •
•
5hares of stock and mutual funds are highly li4uid because they can be sold at any time, without penalty 6although such sales can result in sales charges in some cases9. 2nder certain circumstances, certicates of deposit 67Gs9, bonds, *-6k9 accounts, or 1R&s are also reasonably li4uid.
•
Real estate, business interests, and annuities still in the surrender period, on the other hand, have very low li4uidity.
Cost: 7ost asset accumulation options involve sales charges. Gwners also commonly pay on$going maintenance fees or e"pense charges to cover the issuing company#s or distributor#s operating e"penses. Insurance: +ost asset protection products are forms of insurance, such as: • • • • •
&utomobile insurance 8isability income insurance >omeownerKs insurance ife 1nsurance >ealth 1nsurance
Asset 4istri+ution Products: & nancial product that enables owners to manage the distribution of assets to ensure that resources are available when needed. +ost retirees have a signicant need for a reliable stream of income that will cover everyday living e"penses as well as e"penses associated with disability or critical illness. Retirees also need a way to manage lump$sum payments, such as those received from certain retirement plans, inheritances, priBes or awards, and legal settlements. Asset distri+ution products can help retirees meet these needs. &sset distribution products usually include one of two distribution mechanisms: • •
+anaged payouts 5ystematic withdrawals
Managed Pa*outs: +anaged payouts provide specied payment amounts on a specied schedule. •
•
@or e"ample, annuity owners can receive e4ual distributions throughout their lifetime, or they can receive account funds in payments of a "ed amount or for a "ed period of time. +ost mutual funds also oer owners managed payouts that can be structured to distribute account funds by a specied date or to continue indenitely. 1n addition, payouts can be linked to market interest rates or to historical returns.
S*stematic =ithdra0als: 5ystematic withdrawals provide a payout at predetermined intervals, such as monthly, 4uarterly, semiannually, or annually. They are available under most 1R&s and mutual funds. The amount of withdrawals can be "ed or variable. 5ystematic withdrawals allow retirees to: '&ccess funds when needed 'Xeep remaining funds in the account to generate earnings -/ample: 5alona and Ray +anekar invested =-, in a mutual fund. They#ve set up a systematic withdrawal system that will give them =C, per year. /hen a payment is due, the mutual fund li4uidates enough shares from the +anekars# account to provide the scheduled amount. The remaining shares in the account continue to generate earnings that will go toward future payments. $addering: 1nvestors can create a SladderS of income payments by investing in vehicles with dierent maturity dates, such as certicates of deposit 67Gs9 or bonds. adders provide a low$risk way to: • • • •
7reate a steady stream of income in the form of interest 1ncrease li4uidity because at least some 7Gs mature each year 1ncrease returns by reinvesting mature 7Gs in longer term 78s with higher interest rates 0"tend investment period by annually reinvesting and buying back into the ladder
Institutional Market: The retirement market has two segments: the retail segment and the institutional segment. • •
The retail segment includes individuals and families looking for solutions to their retirement needs. The institutional segment includes the businesses and other groups that buy retirement products, plans, and services for the benet of their employees or members
The Institutional Market: The institutional market consists of three primary groups: Plan Providers:
•
•
Plan providers design, develop, and market retirement plans for businesses and organiBations for the benet of employees or members. Plan providers include insurance companies, banks, mutual fund companies, and broker dealers.
Plan Sponsors: •
•
•
Plan sponsors purchase retirement plans for the benet of their employees or members. Plan sponsors operate in two separate sectors. Public sector sponsors include federal, state, and local government agencies such as school systems, police and re departments, and the military. Private sector sponsors include all for$prot businesses that are not owned or operated by federal, state, or local governments.
Plan participants: •
Plan participants are employees or group members who elect to participate in retirement plans oered by plan sponsors.
Additional participants: &dditional participants in the institutional market include people and companies that provide specialiBed services to plan sponsors: Asset managers: &sset managers professionally manage plan retirement plan assets. They are involved primarily in large plans 6those with more than =! million in assets and more than ! participants9 and are prevalent in trustee$ directed or dened benet plans that don#t oer participant$directed investment accounts. Consultants Advisers Brokers: •
•
7onsultants help large$plan sponsors and duciaries review and select plan investments and select advisors and other service providers. They typically work on a fee$for$service basis. "egistered #nvestment dvisors $"#s and brokers typically focus on smaller plans and are usually compensated on a fee$for$service andEor commission basis.
Plan administrators: •
•
•
Plan administrators perform regulatory and compliance functions for 4ualied plans. They usually also handle communications with plan participants. 5mall$plan sponsors typically use third$party administrators 6TP&s9 and outside record keepers to perform compliance and record$keeping activities. arge plans usually appoint an ocial Plan &dministrator who serves as a plan duciary. The ocial Plan &dministrator contracts with TP&s and record$keepers to perform compliance and record$keeping work, and oversees the activities of other service providers.
Record keepers: Record keepers take receipt of plan contributions and pay out distributions to participants. They also track each individual participant#s account balance, investment allocations and returns, distributions, and contributions$ including the nature of each contribution 6for e"ample: employer contribution ta"$deductible employee contribution after$ta" employee contribution9. 1n addition, they provide account statements to participants. Institutional Services 9Eered: •
•
•
5ome plan providers oer services directly to plan sponsors. @or e"ample, insurance companies and mutual fund companies often serve as asset managers. Provider companies also oer bundled or unbundled compliance and record keeping services. 1n a bundled services arrangement, the provider company oers both compliance and record keeping services. 1n an unbundled services arrangement, the provider company oers record keeping services only and partners with local TP&s to perform compliance work. HBundled Services: & combination of record$keeping and administrative services oered by provider companies to retirement plan sponsors. H6n+undled Services: Record$keeping services only, oered to retirement plan sponsors by provider companies. Providers then contract with local third$party administrators 6TP&s9 to provide administrative services
Conclusion: •
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&s you#ve learned, the nancial services industry is made up of many dierent types of nancial institutions. 0ach institution oers products that pre retirees and retirees can use to manage, accumulate, protect, and distribute their assets. (ou#ve also learned about the characteristics that distinguish nancial products from other goods and services and the additional services companies can provide to increase customer satisfaction and build customer loyalty. Chapter no: Personal Risks
-mplo*ment Risk: Risk is the possibility that things won#t turn out as e"pected. Reasons #or oluntar* 6nemplo*ment: To change ?o+s: +any people change Dobs every few years to increase earnings, to advance their careers, or to pursue a dierent line of work. They may be unemployed between Dobs. To start a +usiness: 5ome people dream of owning their own company and being their own boss. 2ntil a new business becomes protable, however, their earnings will be interrupted. To pursue other goals: People often leave the workforce to obtain additional education, to focus on their families, to care for children, or simply because they want to stop working.
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Involuntar* 6nemplo*ment: 5everance Pay ' ' '
Two weeks of salary is common. 0mployers are sometimes willing to negotiate higher amounts, especially for long$serving employees. 5everance pay is in addition to any other money the employer owes the employee
2nemployment compensation: ' Aenerally payable for a ma"imum of ) weeks Recipient must: ' ' '
>ave worked for a minimum number of weeks >ave earned a specied amount in wages and benets e actively seeking employment
enet amounts: ' ' '
Jary by state &re based on income prior to unemployment &re ta"able as income
?ot available to workers who: ' '
eave the work force voluntarily &re dismissed for Dust cause
6nemplo*ment e/penses: Potential 0"penses during 2nemployment: ' ' '
Uob search e"penses Ta"es on retirement fund withdrawals Penalties for early distributions from retirement funds
Medical e/pense risk: Medical e/penses #or people 0ith insurance: ' ' ' ' '
8eductibles 7oinsurance 7opays and drug copays 6managed care9 &ny e"cluded e"penses, such as most e"perimental treatments
Medical e/penses #or people 0ithout insurance '
The full cost of care
Consolidated 9mni+us Budget Reconciliation Act C9BRA) : &n employee who loses health care coverage as a result of a 4ualifying event can continue group coverage following termination. ' '
7overage continuation for employee: up to -C months 7overage continuation for dependents: up to I months
&n employee must pay the full cost of coverage, including any part of the premium that was previously paid by the employer. AEorda+le Care Act: also known as Patient Protection and AEorda+le Care ActD aka &&', (ordable 'are ct, and ', ' '
ecame in force beginning in )-* &pplies to people not eligible to obtain group coverage and not eligible to receive coverage through government programs such as +edicaid
Patient Protection and AEorda+le Care Act ' ' ' ' '
1ndividuals and families whose income falls between -H and *H of the federal poverty line 6@P9 receive ta" credits based on their medical insurance premium. Ta" credits are calculated using a sliding scale from )H to ;.CH, depending on income. The law also limits participants# out$of$pocket costs to a specied amount, based on income. The PP&7& imposes a penalty on 4ualied people who fail to maintain minimum essential coverage 6unless e"cluded from coverage re4uirements9. The law also allows enrollment by people who are eligible for employer$sponsored coverage if the cost of that coverage is greater than ;.CH of income or if the employer pays less than H of the premium.
Income Interruption Risk: =orkersF compensation programs ' ' ' '
5tate$based program Provides wage replacement benets &?8 medical e"pense benets 7overs losses from work$related accidents or illnesses. enets are not payable if a person#s disability is not work$related The federal government has similar programs covering federal employees
Supplemental Securit* Income SSI) • •
Pays periodic benets to people with limited incomes who are disabled, blind, or age ! or older. People do not have to pay a specied amount of 5ocial 5ecurity ta" in order to receive benets.
Social Securit* 4isa+ilit* Income SS4I) •
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5581 pays benets to people who are unable to work because of a physical or mental illness or inDury that has lasted, or is e"pected to last, for at least one year, or that is e"pected to lead to the person#s death. /orkers under age ! must pay a specied amount of 5ocial 5ecurity ta" for a prescribed number of years in order to receive benets.
Private 4isa+ilit* Income 4I) Insurance: 8isability income 6819 insurance is available in two forms Individual 4isa+ilit* Income 4I) Insurance: 1t is usually purchased and paid for by the insured enets are usually: • • • • •
& Fat amount based on the insured#s income when the policy is purchased Payable after a specied waiting period Payable only if the insured meets the denition of SdisabilityS included in the policy Payable for a ma"imum period of time ?ot reduced by other income benets
"roup 4isa+ilit* Income 4I) Insurance • • • • • •
Provided by an employer, who pays all or part of premium enets are usually: 7alculated as a specied percentage of a covered employee#s pre$disability earnings 2sually payable only after a specied waiting period Payable only if a disabled employee meets the denition of SdisabilityS included in the policy Payable only for a specied period of time Reduced by income replacement benets a covered employee receives from other sources 6such as 551 or 55819
7inancial Risk: et#s look at some of the nancial risks people face during their working years. •
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Gne such risk is identity theft. 7leaning up the mess after an identity theft can be arduous, e"pensive, and stressful. 1dentity theft victims often have to deal with 7reditors who e"tended credit to the identity thief and now seek repayment from the person whose identity was stolen 8amage to their credit rating, which may make it dicult to obtain not only credit, but also potentially insurance, housing, and employment Reductions in retirement savings caused when income is diverted to cover losses in other areas
Practices that can help prevent 1dentity theft: •
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5hredding or destroying documents that include personal information such t:15 account numbers and 5ocial 5ecurity numbers 2sing a locking mailbo" or a post oce bo" to receive mail Restricting access to information maintained in the folders or computer records +ailing personal documents from a post oce rather than a home mailbo" Refusing to provide personal information to unsecure online sites or in responses to emails from unknown sources
Credit Card 4e+it Risk: 5ome options for easing the strain of credit card debt include: • • • •
?egotiating a lower interest rate or obtaining credit counseling services from the credit card company Gbtaining a debt$consolidation loan 1nitiating bankruptcy proceedings Re$establishing credit after a bankruptcy proceeding is dicult, so the decision to le should be made only as a last resort and only after consulting an advisor
4eath o# a Spouse: The death of a spouse usually results in at least some change in the remaining spouse#s nancial status. The amount of change and whether the change is positive or negative depends on • • •
>ow much the deceased spouse contributed to the family income >ow many people the couple support The amount of life insurance coverage on the spouse who dies
1f the surviving spouse#s income and life insurance proceeds aren#t enough to cover e"penses for the surviving family members, the loss can result not only in a reduction in retirement savings, but in the need to nd a more modest residence, a better$paying Dob, or even a second Dob. -/ample: efore 5usan >enry was widowed, her husband#s salary was about twice as much as hers. /hen her husband died leaving her with three small children, she received a modest amount of group life insurance. 5he had to cut back on all her living e"penses and stop her retirement plan contributions. -/ample: &bdul and &aliyah +uhammad#s salaries were similar. /hen &aliyah passed away, &bdul received a siBeable life insurance benet. 5ince his children had grown and were supporting themselves, he was able to maintain his living standards &?8 invest most of the life insurance benet for retirement
4ivorce: 8uring a divorce, property is often divided between the two parties as settlement of alimony, child support, or property rights. Gne important item of property that may be divided is either spouse#s retirement or pension benets. 1n the 2nited 5tates, division of retirement benets is usually accomplished through a 4ualied domestic relations order 6L8RG9.
-/ample: /hen Thomas &nn got divorced from his wife, the court assigned half of Thomas#s retirement savings to his wife.
Caring #or Adult children or Si+lings: /e generally hope that our sons, daughters, sisters, and brothers will support themselves and live independently as adults, but this is not always the case. • •
7ircumstances such as unemployment or divorce can cause adults to seek help from parents or siblings. &dults with special needs may need support throughout their lives. &fter the parents die, the responsibility can fall to siblings.
1n the 2nited 5tates, physically or mentally disabled persons who meet specied re4uirements are eligible to receive health care and long$term nursing care benets through government programs such as +edicare and +edicaid. Their parents can also provide additional funds to support such people, without causing them to lose their government benets, by establishing a supplemental needs trust Caring #or Aged Parents: ecause of increasing longevity, it#s likely that a signicant number of adults will be faced with the responsibility of supporting or caring for their parents. The e"pense of caring for parents is yet another risk to a retirement plan. Planning ahead and making sure that a parent#s preferences for care are clearly communicated to family members can reduce nancial surprises, reduce conFicts among caregivers, and provide more care options. -/ample: Planning ahead #or the Care o# an Aging Parent: Aeraldine Parker is aging and her three children, Pamela, 8avid, and Uemima, e"pect that she will eventually need to receive professional care and support. They#re concerned, though, that Aeraldine#s assets won#t cover the cost of professional care either at home or in a licensed institution. They#ve done some research and have identied three possible options: • • •
>aving their mother move in with one child while the other children provide nancial support Taking turns caring for their mother in their own homes Purchasing long$term care 6T79 insurance tor their mother and Dointly paying the premiums
Anal*sis: ?one of the children feels that having Aeraldine move in with them on a permanent basis is feasible. They also feel that having her change locations is likely to create signicant stress for their mother. 5haring the cost of long$ term care insurance, however, will be feasible for all of the children. &nd the combination of Aeraldine#s nancial assets and her T7 benets should be ade4uate to provide her with the care she wants and needs Measuring Ination: To measure inFation, economists generally use price inde"es including, in the 2nited 5tates and 7anada, the consumer price inde" 67P19. +ost of the products and services included in the market basket that makes up the 7P1 are items that are part of the general cost of living. >owever, the market basket also includes important nancial and retirement values such as ta" rates, 5ocial 5ecurity benets, some pension benets, and retirement plan contributions. Retirees and Ination: <hough inFation can create problems for anyone, it#s usually a greater risk for retirees. 8uring working years, wages typically increase annually to account for inFation. 8uring retirement, wages are replaced by 5ocial 5ecurity benets and withdrawals from personal retirement funds. These sources oer few, if any, guarantees. •
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Social Securit* +ene5ts have a built$in mechanism$the cost of living adDustment 67G&9$that provides a cushion against inFation. >owever, legislators may change 7G& calculations to make them less generous. +ost de5ned +ene5t retirement plans also provide guaranteed amounts at retirement, but those amounts are generally "ed. Retirees can#t increase their benet payments to adDust for inFation. 4e5ned contri+ution retirement plans and personal savings and investments don#t oer any guarantees. Retirees can adDust withdrawal amounts each year to account for inFation, but those increases ultimately reduce the total number of withdrawals they can make
9ther -/pense Risks in Retirement: 3ealth Care Cost Increases: &s people progress through retirement, their need for health care often increases. 2nfortunately, when they move from the workforce into retirement, their health care coverage often decreases. $ong!Term Care: The need for long$term care can increase health care costs even more. ong$term care insurance provides benets that help reduce the costs of age$related care, but the cost of the insurance adds to retirees# e"penses. 5ome retirees simply cannot aford the cost of T7 insurance. $ongevit*: People, before and during retirement, often don#t think much about the potential impact of longevity risk because it#s not as immediate a concern as health care or e"pense risks. They also generally underestimate how long they will actually live. Gne reason for poor estimates is that life e"pectancy estimates, based on mortality rates, are averages, so appro"imately half the people in a given age group will live longer than e"pected. Pu+lic Polic* Risk: Retirees and retirement savers face the risk that changes to government programs, laws, regulations, or ta"es, will either increase their e"penses or decrease their retirement benets. 5ometimes, such changes work in retirees# favor. &n e"ample is the PP&7&#s closing of the Sdonut holeS in +edicare Part 8. >owever, given the concern over the long$term viability of +edicare and 5ocial 5ecurity, most changes to those programs are designed to save the government money, which generally means that they will be less generous to recipients. 7uture Medicare Premium and 4educti+le Increases: egislators have also proposed gradually raising the eligibility age for +edicare benets until it reaches < by ))<, bringing it in line with 5ocial 5ecurity. This change would reduce the strain on +edicare funds, but it would have negative conse4uences for retirees and non$retirees. • •
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!$ and $year$olds would need to seek private insurance coverage. Removing younger, healthier people from the +edicare risk pool would drive up premiums for those remaining in +edicare. &dding !$ and $year olds to private risk pools could raise insurance premiums for the younger members of those pools.
Pu+lic Polic* Risk & Social Securit*: 5ocial 5ecurity has already been changed to increase the age at which full retirement benets are payable. This change has helped reduce the current strain on program funds, but it hasn#t solved the problem. &s a result, additional remedies have been proposed. Social Securit* Ta/ Increases: 7urrently, the 5ocial 5ecurity payroll ta" in the 2nited 5tates 1s -).*H on the ta"able wage base, half payable by the employee and the other half payable by the employer. 5uggestions have been made to increase contributions by )H to IH annually Social Securit* Bene5t Reductions: Gne change that#s already been proposed is to change the way 5ocial 5ecurity cost of living adDustments are calculated. Proponents argue that changes to 7G& calculations could result in a =--) billion reduction of 7G& benets over the ne"t - years. Gpponents point out those changes to 7G& calculations would have a disproportionate eect on seniors, whose spending patterns are often dierent than those of younger people Social Securit* Privatiation: PrivatiBation would place more responsibility for securing retirement income on individuals by allowing individuals to deposit a percentage of current 5ocial 5ecurity ta"es into personal retirement accounts. &t retirement, people would receive monthly payments from both 5ocial 5ecurity and their personal accounts to bring their total benet to an established guaranteed minimum amount. Short#all Risk: Risk of 1ncreased 0"penses O Risk of 1ncreased ongevity O Risk of 8ecreased enets $$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$ 5hortfall Risk 6Risk of not having enough income during retirement to cover e"penses9
0volving problems with 5ocial 5ecurity and with private retirement plans threaten to make shortfall risk even worse for many retirees. Pro+lems 0ith Social Securit*: 5ocial 5ecurity in the 2nited 5tates is already paying more in benets each year than it receives in employer and employee contributions. &nalysts predict that, if current trends continue, the 5ocial 5ecurity trust fund will become insolvent by )II. &fter that, the system will be able to pay out only
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Pro+lems 0ith private retirement plans: The maDority of workers in the 2nited 5tates have access to employer$ sponsored retirement plans, but less than half of workers contribute to those plans. 7ontribution levels from plan sponsors and plan participants are low. 5ome plan sponsors have responded to poor economic conditions over the past several years by eliminating their matching contributions, causing many plan participants to also reduce or stop their contributions. 1n )-, the average pre$retiree in the 25 planning to retire within the ne"t ve years had only *IH of recommended savings in an employer$sponsored retirement plan. Persistent low market interest rates during recent years reduce returns on retirement savings and reduce the amount of annuity payments available for a given sum. ow market interest rates during the early years of withdrawals may also mean that accumulated funds won#t last as long as e"pected because of se4uence of returns risk. • •
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Techni8ues #or managing personal risks: People cannot eliminate the personal and nancial risks they face, but they can use some common risk management techni4ues to reduce the eects of these risks. Avoid Accept Control Trans#er Avoid: Gne way to manage risk is to avoid it. Risk: Aetting struck by lightning 3o0 to avoid it: 5tay inside during thunderstorms <hough avoidance might be a viable approach to some risks, it#s impossible to avoid all risk. /hen it comes to saving for retirement, it#s not even desirable to avoid all risks to earn a return on an investment a person must accept some risk. Control: ¬her approach is controlling risk: that is, taking steps to prevent or reduce losses Uane 7rowell Dust nished talking to her friend, &lison, who told Uane about the nightmare she had e"perienced after having her identity stolen. &lison persuaded Uane to take a number of steps to control her identity theft risk, including registering with a credit monitoring service, ordering new checks from the bank that do not show her 5ocial 5ecurity number, and shredding all documents that show her account or 5ocial 5ecurity number as well as all the credit card oers she receives in the mail. Accept: &ccepting risk involves assuming all nancial responsibility for the risk. People accept risks every day$usually when the losses associated with the risk are insignicant, like losing an umbrella or breaking a dish or a lamp. 5ome people also consciously choose to accept more signicant risks @rank +anBoni has one more year before he reaches retirement age. >e#s been setting aside =- each month for an emergency fund for years and now has about three months# worth of salary in the fund ast week, his employer announced that, if results don#t improve, the company will need to lay o workers within one to two years. 5ome of @rank#s co$workers decide to retire early or switch Dobs, but @rank chooses to keep working at his current Dob as long as he can and accept the risk of getting laid o >e decides he can aord to take this risk because he can le for unemployment compensation and use the money in his emergency fund if necessary to cover his lost income
Trans#erring Risk: & person or business can transfer nancial responsibility for specic risks to another party by buying insurance 5arah and Paul 7armichael recently learned that, in nearly
Chapter ( Investment Risk and Returns Risk and Return: & good start is to understand the relationship between nancial risk and return. Risk is the possibility that things won#t turn out as e"pected Return is the compensation people receive when they invest or lend money /ith more risk comes the possibility of a larger return. 1t also works in the other direction$less risk usually carries a smaller potential return. This relationship is known as the risk$return tradeo. • •
7inancial Risk #or Retirement Products: Retirement investments are subDect to several types of nancial risk, including: +arket risk 1ncome risk Reinvestment risk 8efault risk 5ome risks aect & investments, but others only aect a specic type of investment • • • •
Market Risk: 5ome types of risk are present in the marketplace. +arket risk is the possibility that Fuctuations in an entire market may result in losses or reduced investment returns. 7ertain factors tend to cause the prices of most investments of a certain type to rise or fall. @or e"ample, bad economic news generally causes the average price of stocks to fall. Interest Rate Risk: Gne specic type of market risk is interest rate risk. 1nterest rate risk aects many types of investments, including stocks and real estate, but it has the greatest eect on those that pay a "ed rate of interest, such as bonds. 1nFation risk, the risk that prices will increase and purchasing power$ the amount of goods and services a person can buy for every dollar he earns$ will decrease. 1n other words, his money won#t buy as much as it used toY
0"cept in rare instances, there is always inFation. The 4uestion is, how does the rate of inFation compare to your rate of investment returnN (ou may be happy with your investment returns, but, if your returns are only slightly higher than inFation, then your returns will only slightly increase your purchasing power. 1t is even possible for inFation to e"ceed investment returns. ¬her haBard of falling interest rates is reinvestment risk The two main types of reinvestment risk: Maturit* risk is the risk that market interest rates on products that mature at a stated time will be lower at maturity than they were when the products were purchased. @or investors, this means they#ll have to reinvest the money they receive on the investment at a lower rate than was formerly available. Call risk occurs when issuers of certain longer$term securities ScallS or redeem their oers before they mature. 7ompanies face the possibility of une"pectedly low prots, or even a loss. This +usiness risk can also aect investors. @or e"ample, low prots or losses may prevent a company from paying dividends to its investors andEor cause its stock to lose value. •
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Business Risk: & variety of factors can cause business risk: ow per$unit prices >igh operating costs Poor sales volume 7ompetition Gverall market performance Aovernment regulations 7orruption and fraud Poor management 4e#ault Risk: 0ntities that make loans face de#ault risk • • • • • • • •
anks and other businesses that make loans to individuals or other businesses face the risk that borrowers will fail to make re4uired payments on loans 1ndividual investors face default risk when they buy bonds. & bond is a loan to the company or government agency that issues the bond. 0ven though most bonds are secure, an issuer that doesn#t pay principal and interest when due is in default on the bond. Risk Measurement: Risk measurement usually involves studying how actual returns vary from e"pected returns. ecause a particular investment, an asset class, or an investment portfolio can produce gains or losses, risk variance can be positive or negative. The main measure of risk is standard deviationD which is a measure of the distance between each individual return in a series of returns and the meanD or average, return for the series. "eneral rule: The greater the standard deviation, the greater the potential variation of actual returns from e"pected returns and the greater the investment risk. Q 5tandard deviation calculations assume that values in a data set follow a normal distribution pattern. 0ven though investment returns don#t always follow a normal pattern, standard deviation calculations can still provide a fairly accurate estimate of investment risk. 1f you#re calculating standard deviation, mathematicians assume that values in a data set follow a normal distribution pattern$which means the values are e4ually distributed on either side of the mean of the data set. >ere#s an e"ample of what a normal curve looks like. Regardless of dimensions, all normal distributions have certain characteristics. The mean is at S. V
/hat shape do you see in the graphN (ou should see bells. /hen calculated results are plotted on a graph, they form a bell$shaped curve. The peak of the bell is at the mean value, which is the center value. 1t#s marked at S.S ?umbers to the left are all negative because they#re less than the mean, and numbers to the right are all positive because they#re greater than the mean. The portions of the curve that e"tend beyond three standard deviations from the mean on either side are called Stails.S The values in the tails are near Bero because in a true normal curve, the probability of a value being in one of the tails is e"tremely low. Investment Risk Return Calculations: +artin Uones, age !*, is deciding whether to add large$cap common stocks or 2.5. government bonds to his investment portfolio. >e has published information on the performance of both investments over the last - years • •
5TG7X: &verage annual return -H with 5tandard deviation of -CH G?85: &verage annual return H with 5tandard deviation of --H
5TG7X analysis: +artin knows from his research that there#s a ;!H probability that the return on his stock will be between 6OE$ )9 standard deviations of the mean. 5o, if the mean gain is -H and the standard deviation is -CH, then the return on his stock will be between a *H Aain: Z-H O 6) " -CH9[
&nd a
)H oss: Z-H $ 6) " -CH9[
G?8 analysis +artin also knows that there#s a ;!H probability that the return on the bonds will be between .- ) standard deviations of the mean. 1f the mean gain is H and the standard deviation is --H, then the return on his bond will between a )CH gain to a -H loss. )CH Aain: ZH O 6) " --H9[
&nd a
)H oss: ZH O 6) " --H9[
7inal Anal*sis: The stock has a greater e"pected return 6*H gain vs. )CH gain9 but is riskier than the bonds because it has a greater e"pected loss 6)H loss vs -H loss9. Cautions 0hen measuring risk: There are a few caveats for using standard deviation to measure investment risks: 8ata used in calculations should cover a long time period and include a variety of economic conditions, such as war and peace or prosperity and recession. The standard deviation measures annual deviations in prices. SearS and SbullS markets often last longer than a year, making losses and gains during those periods steeper than for a single year. Relying on standard deviations and mean investment returns may not always be the best way to measure investment risk because such measurements assume the future will resemble the past pertaining to market conditions and that is not always the case. Investment Risk Management: 2sually, people can use the same techni4ues to manage investment risks that they use to manage personal risks. +entioned below are risk management techni4ues that can be used for investment risk management •
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Avoid Risk: & person can avoid certain types of risk by investing in very conservative nancial products
@or e"ample, "ed annuities, 7Gs, and money market accounts oer a "ed rate of return and generally guarantee that the investment will not lose value Control Risk: & person can control investment losses by diversifying investment holdings among a variety of assets or asset classes with dierent risk proles 8iversication involves balancing assets, asset classes, or industries and spreading risk among many risk characteristics to reduce the eect of any one risk. Trans#er Risk: 1n some cases, investors can transfer risk to an insurer. @or e"ample, with many variable deferred annuities, the investor can pay an additional fee in order to guarantee that the Sbenet baseS used to calculate certain types of annuity benets will not be charged with any investment losses Accept Risk: & person accepts risk when she recogniBes the possibility of loss but decides to accept nancial responsibility for the loss. @or e"ample, &gnes +oreno invested in a callable bond that she knows may be called before it matures. 1f the bond is Scalled,S &gnes must reinvest her money, possibly at a lower rate. &gnes isn#t ignoring the risk. 5he#s also not avoiding, controlling, or transferring it to someone else. 5he knows there#s a risk but is willing to accept nancial responsibility for any loss +ost investment products generate one of three types of return: • • •
1nterest is a fee that banks and other nancial institutions pay to use borrowed money. 8ividends are shares of a company#s prots owed to the company#s stock owners. 7apital appreciation is an increase in the market value of invested assets.
To calculate the amount of return, or earnings, an investment will generate during a particular period, a person can apply a specied rate of return to the invested amount 6the principal9. -arnings J Rate o# return / Principal Gr, if you know the amount of your earnings and of the principal, you can calculate the rate of return as follows: Rate o# return J -arnings Principal Interest Rates: @inancial institutions e"press interest as an interest rate, which is interest stated as a percent of the principal$the sum of money originally borrowed or loaned The formula for nding the amount of interest earned on a sum of money is 1nterest 0arned Principal " 1nterest Rate 1n calculations, the interest rate is stated in decimal form. @or e"ample, )H appears as .), so the interest earned on =-, principal is 1nterest earned: =-, " .) =)
Simple interest is interest calculated only on the principal amount. &le"is Areen loaned =-, to her friend, Patricia, and charged her )H simple interest on the loan. ecause the interest rate is applied to the same amount of principal each period of time, she#ll earn the same amount of interest 6=)9 each period. Period -
Period )
Period I
eginning principal
=-,
=-,
=-,
1nterest Rate
\ .)
\ .)
\ .)
1nterest 0arned
=)
=)
=)
Compound interest$where interest is earned on not only the principal, but also the previous interest earned. Period -
Period )
Period I
eginning principal
=-,
=-,)
=-,*.*
1nterest Rate
\
\
\
1nterest 0arned
=)
.)
.)
=).*
.)
=).C-
;ominal vs -Eective Interest: +ost investments provide 4uotes for nominal interest ratesD 0hich donFt account #or the eEects o# compound interest Gn the other hand, eective interest rates do include the eect of compounding. -Eects o# Compounding: 7ompounding makes a noticeable dierence when a person invests regular payments over time. Uenny Reid, age )!, started saving for retirement by contributing =- each month to her employer$sponsored retirement plan. 5he made that same =- contribution each month until she reached age !.Uenny#s account earned an CH average annual compound return. Uenny contributed a total of =*C,. 6=- " -) " *9 =*C,. ecause her account paid interest on principal and earnings, the amount of her interest earned increased each year. >ow much money did Uenny have when she retired at age !N &mount of 1nterest: O &mount of Principal:
=)<*,-C =*C, =I)),-C
&t age !, Uenny has =I)),-C in her account. Compounding more #re8uentl*: ¬her factor that can aect the amount of interest an investor earns is the fre4uency of compounding. 1nterest can be compounded once a year, but it is often compounded more fre4uently, such as semi annually or 4uarterly. @or e"ample, if a bank compounds interest semi$annually, it calculates interest and adds it to the account balance twice a year. ut, what interest rate does the bank use in this caseN &eriodic #nterest "ate ) *ominal annual interest rate + *umber of compounding periods >ank >ampstead Dust opened a new money market savings account with an initial deposit of =-,. 1f interest on >ank#s account had been compounded annually, >ank would have earned =). in interest at the end of (ear -, calculated as: K1D,,, L ,,')
K',,,
>owever, the account oers semiannual compounding, so, instead of earning ) percent interest at the end of the year, he#ll earn -H interest in the middle of the year and another -H at the end of the year. • • • • • •
@irst compounding period 6rst si" months9: =-, \ .-: =-. ?ew account balance =-, O =- =-,- 5econd compounding period 6second si" months9: =-,- \ .-:=-.- ?ew account balance =-,- O =-.- =-,).- 0nd of year earnings generated: =-. O =-.- =).- 0ective rate of return: ).-H 6=).- O =-,9.
Rule o# ': 1nvestors often want to know how long it will take an investment to double in value, because that indicates the investment#s eectiveness. The Rule of <) can give investors a reasonable estimate of how long it will take an investment to double in value ears to double ) -2 + #nterest rate &s an e"ample, at an interest rate of ! percent, the principal will double in more than -* years: (ears to double <) E ! -*.* years et#s use the Rule of <) to see how many years it#ll take for an investment to double at an interest rate of - percent. Predicting Risk and Return: 1t#s dicult to predict e"act risk and return levels, but you can identify characteristics that aect an investment#s risk and return potential$that is, investment time, how and when earnings are paid, and li4uidity. et#s see some e"amples of lower risks with lower e"pected return and then some higher risks with higher e"pected returns. $o0er risks 0ith lo0er e/pected returns: • • • • •
Gwning a short$term asset uying bonds issued by a company with a good credit rating Gwning an investment with good li4uidity or marketability$one that is easy to sell at a fair value Gbtaining a mortgage loan with a "ed interest rate Gwning an investment that pays returns in the investorKs domestic currency
3igher risks 0ith higher e/pected returns: • • • • •
Gwning a long$term asset uying bonds issued by a company with a poor credit rating Gwning an investment with poor li4uidity or poor marketability which is dicult to sell at a fair value Gbtaining a mortgage loan with a variable interest rate Gwning an investment that pays returns in a currency that is foreign to the investor
Risk Tolerance: >ow much risk a person is willing to accept is described as risk tolerance. @or most people, risk tolerance depends on factors such as. •
•
•
•
•
•
Investment time: (oung people often accept relatively high levels of risk because they know they have a long time to meet their nancial goals. They#ll accept short$term losses and Fuctuating values in e"change for long term earnings. People nearing retirement are more conservative and less willing to tolerate risk. 7amil* status: 5ingle people tend to be more risk tolerant than married people because their decisions don#t aect anyone else. >aving children can also reduce a person#s willingness to accept risk. 7inancial Situation: People who have accumulated considerable wealth are usually more willing to withstand losses than people who have limited resources or who, like many retirees, have "ed incomes. The number and types of assets a person has also aects how much risk a person is willing to accept. Personalit*: 5ome people enDoy the une"pected$ they#re willing to try new things, e"plore unknown places, and make changes in their lives. Gther people are more comfortable maintaining their current standard of living or income level Age: (oung people often are willing to accept relatively high levels of risk because they have a long time to achieve their nancial goals. Glder people, especially those nearing retirement, tend to be more conservative with their nancial goals. Return re8uirements: The amount of risk a person is willing to tolerate in an investment also depends on the return the investment oers. To make an investment worthwhile, most investors re4uire at least a minimum return on their investment. Gtherwise, they#d be better of Dust holding on to their money.
This minimum return, known as the re4uired rate of return, is e4ual to the risk$free rate of return, which is the rate available on a risk$free investment, plus a risk premium that represents the compensation investors demand for taking the risk associated with a specic investment. Re8uired rate o# return J compensates investors
Rate available on a risk free investment O & risk premium, an amount that taking on a specic investment risk
Re8uired rate o# return J
Risk free rate of return O Risk premium
Risk #ree investments: ut, what are some e"amples of risk$free investmentsN 1n most cases, they include short$term, highly rated government securities, for e"ample, the 6S Treasur* +illD which the 2.5. Treasury issues as part of its ongoing process to fund the national debt. 4o *ou kno0 0hat distinction risk!#ree investments have> The*Fre considered the sa#est o# all investmentsN et#s look at the risk premium, the investor#s incentive for accepting risk. 1f there was no risk, investors would be better o using their money to buy risk$free investments. The risk premium for any given investment depends on factors such as the investment#s default risk and interest rate risk. Uordan 8onleavy is considering investing in &cme 7orporation stock. 3ereFs the in#ormation Oordan has on Acme Corporation • • • •
•
Today#s sales price: =) per share ?ews reports show 2.5. Treasury bills at a )H return. Uordan#s analysis reveals she#ll need a ;H return to make the investment worthwhile. To determine her re4uired rate of return for this stock, Uordan assumes a base return of )H$the risk$free rate of return. Then, she adds an additional
Ch The Time alue o# Mone* Time alue o# Mone*: The time value of money tells us that the value of a sum of money changes over time /hyN Primarily because of the eects of interest % a fee paid for the use of money The time value of money applies to any money that generates earnings, whether itKs an investment account, a savings account, or a retirement plan. Present alue and 7uture alue: &ccording to the time value of money, a sum of money has a present value 6PJ9 and a future value 6@J9.
Present
Intere
Intere
Intere
7uture alue Present alue Q
1n simple terms, the present value of an investment is the principal$the original amount invested before itKs aected by interest Present value J Principal The future value is the invested principal plus the accumulated earnings or interest generated by the investment over time 7uture value J Principal Q Accumulated earnings 7uture alue: &s we noted, the future value 6@J9 of any sum of money can be e"pressed as 7 JInvested Principal Q Accumulated -arnings 5ince the invested principal is the present value 6PJ9, we can replace it in our formula, giving us Invested Principal J P 7 J P Q Accumulated -arnings The accumulated earnings are basically the interest earned. @or one year, the interest earned would e4ual the principal 6PJ9 multiplied by the interest rate 6i9, so our formula becomes Accumulated -arnings J Interest -arned J P H i 7 & P Q PHi) 7 J P Q P H i) /e can simplify the e4uation by factoring out the common multiplier PJ on the right leaving us with 7 J P H 1 Q i) 5o the @J of a sum invested for one year is e4ual to the PJ multiplied by - plus the interest rate. To translate interest rates from percentages to decimal form, divide the percentage by -. @or e"ample, ' interest J ' 1,, J ,,'
5o, what is the future value of =- invested for - year at )H interestN 7 J P H 1Qi) 7 J K1,,, H 1 Q ,,') 7 J K1,,, H 1,' J K1,', 7uture alue Interest 7actor 7I7) Ta+le: 7alculating the future value for one year wasnKt too hard. ut calculating future values for more than one period can be complicated. @ortunately, mathematicians have created tables that show future values for =- invested at numerous interest rates for numerous compounding periods. 1n these tables, the interest component is represented by a #uture value interest #actor 7I7) Periods 1 ' < ( 1 -.- -.) -.I -.* -.! ' -.)-.** -.; -.C- -.-)! < -.II -.-) -.;)< -.-)*; -.-!< -.* -.C)* -.-)!! -.-;; -.)-!! ( -.!- -.-*-.-!;I -.)-< -.)<I -.-! -.-)) -.-;*-.)!I -.I* -.<)-.-*C< -.));; -.I-!; -.*<1f you look closely at the @J1@ table, youKll notice several trends: • • •
-. -.-)I -.-;- -.))! -.IIC) -.*-C! -.!I
-.< -.--*; -.))! -.I-C -.*) -.!< -.!C
-.C -.-* -.)!;< -.I! -.*;I -.!C; -.<-IC
@or any given period of time and any given interest rate, the @J1@ is always greater than @or any given period of time, @J1@ value increases as the rate of interest increases @or any given rate of interest, the @J1@ values increase as the investment period increases
Periods 1 ' < (
1 -.- -.)-.II -.* -.!- -.-! -.<)-
' -.) -.** -.-) -.C)* -.-*-.-)) -.-*C<
< -.I -.; -.;)< -.-)!! -.-!;I -.-;*-.));;
-.* -.C- -.-)*; -.-;; -.)-< -.)!I -.I-!;
( -.! -.-)! -.-!< -.)-!! -.)<I -.I*-.*<-
-. -.-)I -.-;- -.))! -.IIC) -.*-C! -.!I
-.< -.--*; -.))! -.I-C -.*) -.!< -.!C
-.C -.-* -.)!;< -.I! -.*;I -.!C; -.<-IC
3o0 to use 7I7s: The @J1@ is e4ual to the value of =- at a given rate of interest for a stated number of periods. To nd the future value of a sum greater than =-, you multiply the sum by the @J1@. @or e"ample, letKs say Uoe invests =- compounded at ! percent for periods. >ow do we nd the future value of this investmentN @irst we nd the row for periods. Then we move across that row until we nd the column for ! percent. Periods 1 ' < (
1 -.- -.)-.II -.* -.!- -.-! -.<)-
' -.) -.** -.-) -.C)* -.-*-.-)) -.-*C<
< -.I -.; -.;)< -.-)!! -.-!;I -.-;*-.));;
-.* -.C- -.-)*; -.-;; -.)-< -.)!I -.I-!;
( -.! -.-)! -.-!< -.)-!! -.)<I -.I*-.*<-
-. -.-)I -.-;- -.))! -.IIC) -.*-C! -.!I
-.< -.--*; -.))! -.I-C -.*) -.!< -.!C
-.C -.-* -.)!;< -.I! -.*;I -.!C; -.<-IC
The @J1@ in that bo" is -.I*-. 5o, the future value of =- compounded at ! percent for periods is: K1,,,H1<,1 J K1<,1, @uture alues #or Multiple Compounding Periods: 7alculations get even more complicated when interest is compounded more often than once a year. @ortunately, the same @J1@ tables you used to calculate future values for multiple years can be used to calculate future values for multiple compounding periods. @or e"ample, what if we want to determine the future value of =- at *H interest compounded 4uarterly for ve yearsN
/e will still multiply the present value by the @J1@, but we need to do a few e"tra steps to nd the interest rate and the number of periods to use. Step 1: To nd the number of compounding periods, multiply the number of years a sum is invested by the number of compounding periods in each year. ecause the money will be invested for ! years with 4uarterly compounding 6* periods per year9, we multiply ! years times * compounding periods to get ) total compounding periods.
StepCompoun ': To nd the interest rate to use, divide the stated interest rate by the number of compounding periods each %ear %ear %ear %ear %ear year. din The stated interest rate is *H and it is compounded 4uarterly. /e divide *H by * to get -H interest.
1
1
1
1 interest
Step <: 2sing the number of periods 6)9 from 5tep - and the interest rate 6-H9 from 5tep ), nd the appropriate @J1@ on the table. /e look on the @J1@ table and nd the @J1@ for =- at -H interest for ) periods to be -.)I)*. Step : +ultiply the present value by the @J1@ to get the future value of the sum. /e multiply =- by -.)I)* and get K1,,, H 1'<' J K1'<', Present alue: Uoe can nd out how much he needs to invest today to reach his goal of =- million by nding the present value of =-,. This process is known as discounting The e4uation for nding present value is P J 7 1Qi) @inding the present value of a single sum at a given rate, compounded annually for one year, is relatively simple. -/ample: Todd /arren hopes to retire in one year with =-, in his *-6k9 plan. 1f the return on his investment is !H, how much will he need to have in his account today to have =-, when he retiresN PJ @J E 6-Oi9 PJ =-, E 6-O.!9 PJ =-, E -.! PJ =;!),I!).I! The -Eect o# Time and Rate on Present alue Uust like the future value, the present value depends on the interest rate earned and the amount of time the money is invested. The eect of the interest rate and investment period on present value is the opposite of their eect on future value. & higher interest rate or a longer investment period creates a lower present value. Present alue Interest 7actors PI7s): &s with future values, mathematicians have created tables we can use to calculate present values. The tables show present value interest factors 6PJ1@9 for dierent interest rates and dierent time periods. To nd the present value of a given future value, we multiply it by the PJ1@ for the appropriate number of periods and interest. Periods
1
'
<
(
1 ' < (
.;; .;C .;<.;.;!.;*) .;II
.;C .;.;*) .;)* .; .CCC .C<-
.;<.;*I .;-! .CCC .CI .CI< .C-I
.;) .;)! .CC; .C!! .C)) .<; .<
.;!) .;< .C* .C)I .
.;*I .C; .C* .<;) .<*< .<! .!
.;I! .C
.;) .C!< .<;* .
PI7 -/ample: acey AonBaleB wants to invest money today so that sheKll be able to donate =)!, to the university where she teaches when she retires in ! years. 1f she earns *H on her investment, how much will she need to invest to reach her goal of =)!,N To determine the present value, we multiply the amount she wants to have 6the future value9 by the PJ1@ for ! periods and *H interest. P J ,'' H K'(D,,, J K',D((, 1f interest is compounded more than once a year, we make adDustments similar to those for future value calculations. Periods 1 ' < (
1 .;; .;C .;<.;.;!.;*) .;II
' .;C .;.;*) .;)* .; .CCC .C<-
< .;<.;*I .;-! .CCC .CI .CI< .C-I
.;) .;)! .CC; .C!! .C)) .<; .<
( .;!) .;< .C* .C)I .
.;*I .C; .C* .<;) .<*< .<! .!
.;I! .C
.;) .C!< .<;* .
Present alue 7acts: 1f you compare PJ1@ numbers with @J1@ numbers, youKll see that there are some important dierences. • •
@or any given time period and any given interest rate, PJ1@s are always less than one @or any given time period, as interest rate increase, PJ1@s decrease @or any given interest rate, as time increases, PJ1@ value decrease
Impact o# the Time alue o# Mone*: 2nderstanding future values and present values shows us how important it is to begin saving early. 8amian and 7arol opened retirement accounts at the same time They both • •
7ontributed =) to their accounts each year until they retired at the age of ! 0arned !H interest, compounded annually, on the balance of their accounts
>owever, they began contributing to their accounts at dierent ages: • •
7arol began contributing to her account at age I! 8amian began contributing to his account at )!
Rules #or 6nderstanding the Time alue o# Mone*
Principal Sum: ecause a principal sum invested at interest grows over time, the principalKs • •
Present Jalue ] its future value @uture Jalue ^ its present value
Interest Rate: ecause an interest rate is a rate of growth, for money earning a stated rate of interest for a specied period, an increase in the interest rate will result in • •
& decrease in the present value of a future sum &n increase in the uture value of a present sum
7onversely, a decrease in the interest rate will result in • •
&n increase in the present value of a future sum & decrease in the uture value of a present sum
;um+er o# Periods: ecause compound interest is paid periodically, for money earning a stated rate of interest for a specied period, an increase in the number of the specied periods will result in • •
& decrease in the present value of a future sum &n increase in the future value of a present sum
7onversely, a decrease in the number of specied periods will result in • •
&n increase in the present value of a future sum & decrease in the uture value of a present sum
7uture alue o# an Annuit*: eing able to calculate the present or future value of a single amount is handy. ut many loans and investments involve more than one payment. /hen +ia and Uoe met with 7hris, Uoe found out that if he stopped putting =) per year into his *-6k9, heKd come up short of his =- million goal. ut what would happen if he continued making regular contributions each yearN >ow much would he have in ) years thenN 1n this case, Uoe is trying to nd the future value of an annuity which is series of e4ual payments. Annuities: /hen using an annuity to describe future values and present values, 1tKs important to remember three facts about annuities: •
•
•
&n annuity is not the same as an annuity contract, which is a specic type of nancial product that can be structured to provide monthly income benets. &s a result, the formulas used to calculate the values of an annuity are valid without any reference to an actual annuity contract. &n annuity can refer to any series of payments that are e8ual in amount and paid at regular intervals. &n annuity does not refer to a series of une4ual payments or payments made at irregular intervals. &n annuity can refer to pa*ments received or pa*ments made
-/amples • •
0"ample of payments received: The periodic income benet payments 5ocial 5ecurity pays to a recipient 0"ample of payments made: The contributions made to a *-6k9
9rdinar* Annuit* vs Annuit* 4ue: The timing of each annuity payment determines whether the annuity is an ordinary annuity or an annuity due. • •
9rdinar* annuit* & payment made or received at the end of each annuity period Annuit* 4ue & payment made or received at the +eginning of each annuity period
-/amples
9rdinar* Annuit*:
Annuit* 4ue: 9rdinar* Annuit* • •
& series of paychecks an employee receives at the end of each month & series of interest payments on a bond
Annuit* 4ue • •
& series of rent payments made at the beginning of each month & series of premiums for a life insurance policy paid at the beginning of each year
7uture alue o# an 9rdinar* Annuit*: /e will nd the future value of an annuity by adding together the future value of each periodic payment in the series. ecause payments for an ordinary annuity are made at the end of a period they donKt earn interest until the following period.
Calculating the 7uture alue o# an 9rdinar* Annuit*: To calculate the value of an ordinary annuity, you could treat each payment as a single sum, nd the future value of each payment, then add all of the future values together. uckily, you can also consult future value interest factor for an annuity 6@J1@&9 tables Periods 1 ' < ( 1 -. -. -. -. -. -. -. -. ' ).- ).) ).I ).* ).! ). ).< ).C < I.I I. I.;I.-)) I.-!I I.-C* I.)-! I.)* *. *.-)) *.-C* *.)* *.I- *.I
•
•
Periods 1 ' < (
1 -. ).- I.I *. !.--
' -. ).) I. *.-)) !.)*
< -. ).I I.;*.-C* !.I;
-. ).* I.-)) *.)* !.*-
( -. ).! I.-!I *.I- !.!)
-. ). I.-C* *.I
-. ).< I.)-! *.** !.
-. ).C I.)* *.! !.C<
.-!) .IC .*C .II .C) .;
This dierence in the timing of payments means that the future value of an annuity due is e4ual to the future value of a corresponding ordinary annuity of one additional period minus the amount o# one pa*ment Periods 1 ' < ( 1 -. -. -. -. -. -. -. -. ' ).- ).) ).I ).* ).! ). ).< ).C < I.I I. I.;I.-)) I.-!I I.-C* I.)-! I.)* *. *.-)) *.-C* *.)* *.I- *.Iowever, the valuation date for the present value is at the beginning of the rst period % one period before the rst payment is made. &s a result, an ordinary annuity that provides three annual payments spans three years. 9rdinar* Annuit*
Present alue o# an 9rdinar* Annuit* -/ample: To nd the present value of an ordinary annuity, you multiply the periodic payment amount by the present value interest factor for an annuity 6PJ1@&9 for the specied period and interest rate. >ow much do you need to invest today at !H interest to provide you with payments of =- at the end of each year for the ne"t three daysN The PJ1@& for I payments at !H interest is e4ual to ).<)I, so the amount you will need to invest today is e4ual to K1,,, H ''< J K'D'<,,
Present alue o# an Annuit* 4ue: 1n an annuity due, the valuation date and the rst payment date are both at the beginning of the rst period. &n annuity due that provides three payments would make the nal payment at the end of (ear ) rather than (ear I, and there would be no interest credited for (ear I. The present value for an annuity due, therefore, is e4ual to the present value of a corresponding ordinary annuity with one fewer period plus the amount of one periodic payment.
Present alue o# an Annuit* 4ue -/ample: 5o how much do you need to invest today at !H to provide you with three payments of =- at the beginning of each yearN To nd the present value of an annuity due, we need to use the PJ1@& for one fewer period and add the amount of one periodic payment. 5o the amount we need to invest today is P o# annuit* due J K1,,, H 1(2 PI7A #or ' periods) Q K1,,, J K1(2 Q K 1,,, J K'(2
Chapter Port#olio Management 7actors AEecting the Port#olio: & key to achieving retirement goals is choosing which investments to own at any given time. The make$up of a personKs investment portfolio should reFect that personKs characteristics and situation. @or e"ample, one factor aecting an investment portfolio is the ownerKs investment time horiBon. /hich investor do you think can aord to take more risk with his investments: a man who is I! years old and planning to retire at age < or a man who is ! years old and planning to retire at age
Personality &ge >ealth @amily 5tatus @inancial situation
7inancial Situation and the Port#olio @inancial characteristics can help determine how much a person can set aside for investments, what assets she selects, and how well she can manage the ups and downs associated with market investments. @or e"ample, someone whose current income or cash Fow is unpredictable may need to set aside a larger portion of her investment portfolio in li4uid assets, such as cash e4uivalents, to cover emergencies & wealthier person with more investable funds may include non$li4uid assets such as real estate , artwork, or collectibles in her portfolio to provide long$term security. Creating an Investment Port#olio
&n investorKs situation and characteristics determine which investment goals and strategies he will select. /hen it comes to building an investment portfolio, this is the rst step and the step that guides the rest of the process. >ere are the si" basic steps of building an investment portfolio: • • • • • •
Step Step Step Step Step Step
1: 8ening investment goals and strategies ': 5electing asset classes to be included in the portfolio <: 5electing individual investments : 7hoosing investment vehicles (: &llocating assets among the investments : 5etting controls to keep the portfolio on track
Step 1: 4e5ning goals and Strategies: Income v s "ro0th 8ening investment goals is an important rst step in building a portfolio. 2nless an investor knows what he wants to accomplish, he wonKt know how to accomplish it or whether heKs been successful. 1nvestments can earn a return in two ways: by producing income in the form of dividends or interest, and by increasing the value of the investment$known as a capital growth. &n investment strategy can focus on income, capital appreciation, or a combination of the two. Current Income Strateg* % 5tresses current income over growth of principal 6but does not completely ignore growth opportunities9 Attractive to 1nvestors who rely on investment income to cover their nancial needs • •
Aggressive 1ncome portfolio ikely to focus on common stocks and lower$rated bonds Conservative income portfolio likely to concentrate on government bonds, high$4uality corporate bonds, with limited investments in preferred stocks and high$yield stocks
Current income and Capital "ro0th Strateg* $ alances the goal of generating current income with the goal of achieving capital growth. Attractive to 1nvestors who are willing to trade ma"imum income or ma"imum growth for a reasonable level of income and a moderate level of growth Capital "ro0th strateg* % stresses long$term capital growth over current income. Attractive to investors who donKt need current income to meet their nancial needs and are willing to accept greater potential risks in return for greater potential gains. Capital gro0th port#olio @ocus on high$risk growth stocks, with limited investments in "ed$income bonds and money market funds. Aggressive vs 4e#ensive Investing: The investor also needs to choose whether to use an aggressive or a defensive strategy. •
Aggressive Investor & Primary goal is ma"imiBing returns is willing to accept relatively high risks to achieve this goal. 4e#ensive Investor & primary goal is minimiBing risk is willing to accept lower returns to achieve this goal.
Aggressive Strategies +aking fre4uent purchase and sales of securities in an attempt to buy at a low price and sell at a high price 6called Vtiming_ the market9 &ttempting to identify individual securities with the potential to earn higher$than$average returns &ttempting to amplify investment returns using options &ttempting to amplify investment returns by purchasing securities Von margin_, which involves paying part of the cost of buying securities and
4e#ensive Strategies uying securities and holding them, counting on the tendency of securities to earn money in the long run @ocusing on securities that are linked to a published inde", such as 5tandard ` PoorKs 65`P9 ! composite stock inde" 2sing stock inde" options to buy and sell shares of stocks in regular amounts at regular intervals
borrowing the rest
Step ': Selecting Asset Classes Asset Classes: &fter determining his obDectives and strategies, an investor needs to decide which asset classes he will use to achieve his obDectives. The primary asset classes include: • • • •
7ash and cash e4uivalents, including money market instruments 5tocks onds <ernative investments, such as intangible assets 6commodities, hedge funds, venture capital, and nancial derivatives9 or tangible assets 6precious metals, art, anti4ues, Dewelry and stamps9
Allocating Among Asset Classes: 1nvestment portfolios usually include at least three types of asset classes, each with a dierent risk %return prole. &sset classes should also be non$correlated. That way, when market conditions Fuctuate, investors can balance losses from one asset class with gains from other asset classes. -/ample: Uennifer 8i"onKs portfolio includes stocks, bonds and cash e4uivalents. Anal*sis: 1n general, bond values and e4uity values tend to respond dierently to changes in market interest rates. 5tocks tend to increase in value when market interest rise and lose value when market rates decline. onds, on the other hand, tend to lose value when interest rates increase and gain value when interest rates decline. 7ash e4uivalents donKt increase signicantly in value when interest rates are favorable, but they also donKt lose much value when rates are unfavorable. ecause UenniferKs assets respond dierently to market conditions, her losses from some assets can be oset by gains from other assets.
Step <: Selecting Individual Investments 7actors in Selecting Investments: &fter determining which asset classes to include in the portfolio, the investor needs to decide which specic investments he will own within each asset class. @or e"ample, 1f the investor decides the portfolio should be * percent stocks, the ne"t decision is Vwhich stocks_N /hen selecting investments, investors generally consider many factors, ranging from broad global issues to very specic product characteristics. The Alobal 0conomy ?ational 0conomies 1ndustry or Aovernment 5ituation 7ompany 7harateristics &sset 7haracteristics
-conomic Conditions and Investment alues: 7hanges in economic conditions % global, regional, or national % have a considerable eect on investment values. 5peaking generally, hereKs what tends to happen when economic conditions are good and business thrive.
Interest
ad economic conditions tend to have the opposite eects. 7orecasting -conomic Conditions: 1t is dicult$sometimes impossible$to accurately predict when economic changes will occur or how long they will last. ?evertheless, many investors watch for trends and attempt to use them to increase portfolio returns. ¬her factor that investors must consider is that central banks usually try to lower interest rates when the economy is contracting and raise interest rates when the economy is e"panding. The goal is to try to improve bad economic situations and to partially restrain the economy when it is e"panding rapidly. &n Voverheated_ economy can create problems, such as too much inFation. @or e"ample, the 2.5. @ederal Reserve kept interest rates low for a number of years to try to pull the country out of the recession that followed the )C market crash. The prolonged environment of low interest rates had diering eects on dierent types of businesses and the securities they issued.
Industr*D Compan*D and Investment Characteristics Industr* Strength & Sample industry factors to consider are: • • • •
1s 1s 1s 1s
demand for an industryKs products and services substantial and growingN the industry growing, stable, or declining relative to other industriesN the industry subDect to new developments in technologyN the industry subDect to political changesN
Compan* Characteristics & Sample 7ompany 7haracteristics to 7onsider: • • • •
/hat is the 4uality of the companyKs upper managementN >ow often does mgt changeN /hat is the competitive position of the company and its products in the industryN >ow have the companyKs growth and earnings been over a reasonably long period of timeN /hat is the companyKs level of product diversicationN
Investment Characteristics & Characteristics of the 5pecic 1nvestment are: •
•
•
8ierent securities issued by the same company can have dierent characteristics. 1s a stock issue comprised of preferred or common stockN 1s a bon a long$or short$term bondN 1s it secured by collateralN 1nvestors often evaluate individual asset performance by analyBing past performance, although past performance is no guarantee of future performance. 1nvestors can evaluate future trends by studying the performance of the market itself. @or e"ample, the 8ow Uones 1ndustrial &verage, which tracks market averages, is often used to predict trends in stock prices. >owever, past performance does not guarantee future results.
Step : Selecting In vestment ehicles 4irect Investment: 1ndividuals can make direct or indirect investments. They invest directly by owing stocks, bonds, real estate, and other investments in their own names. StockD +ondsD real estate etc o0ned directl* +* individual investor The primary reason some people choose to invest directly is so that they have control when to buy, sell, or hold individual stocks, bonds, and other investments. Indirect Investment: 1ndividuals invest indirectly when they purchase an interest in a portfolio of assets. Professional portfolio managers decide when to buy, sell, and hold the underlying investments that are part of the portfolio. 1nvestors invest indirectly when they: • • •
uy shares of mutual funds , real estate investment trusts 6R01Ts9, or e"change traded funds 60T@s9 1nvest part of their income in funds within their group retirement plans Purchase variable insurance products and variable annuities
Mutual 7unds and R-ITs: Two common indirect investment options are mutual funds and real estate investment trusts 6R01Ts9: •
1nvestor purchases shares in the mutual fundER01T
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+utual fund company maintains a portfolio of stocks, bonds, andEor other securities R01T % Trust maintains a portfolio of real estate or real estate mortgages
4e#erred Annuities: 8eferred annuities can provide protection against outliving oneKs assets plus a savings component. 0arnings on the premiums accrue on a ta"$deferred basis so that ta"es are not due until money is withdrawn from the contract. • •
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1nvestor purchases annuity contract 7i/ed 4e#erred Annuit* & The insurer invests the premiums and credits the contract with a guaranteed interest rate aria+le 4e#erred Annuit* & The contract owner chooses how to invest the premiums by selecting from a menu of available funds. Returns depend on the performance of the specied funds.
Assets 0ithin Retirement Plans: The investments available within a group$sponsored or individual retirement plan depend on the type of plan. 7lick below for more details: -mplo*er Stock Plans & &s the name implies, contributions to employer stock plans are invested in the employerKs stock. 4e5ned Contri+ution Plans & 1n most dened 7ontribution plans other than employer stock plans, contributions are invested in a variety of stocks, bonds, and mutual funds. 1nvestment options can be selected and managed by the plan sponsor or by participating employees, depending on the plan structure.
Individual Retirement Arrangements & 1R&s generally cannot be funded with 1nsurance Policies and ?on$nancial assets They generally can be funded by • • • •
5tocks onds +utual @unds &nnuities
Step (: Asset Allocation & Allocating assets among the investments Asset Allocation Models: +any nancial advisors and institutions have developed models to help investors with asset allocation, which involves deciding the percentage of each selected asset class to include in the portfolio. The continuum below shows some common asset allocation model types and indicates the characteristics of the type of investor who might favor each model. The names used for asset allocation models are fairly standard, but the allocations described by those names can vary depending on whose model it is. 0ven so, the pie charts below represent a set of models that are representative of many in the industry. 8rag the model names to the correct pie charts to match each model name with the appropriate model. 1n summary, the more growth$oriented the model, the more it is likely to feature stocks. The more income$oriented the model, the more it is likely to feature bonds, cash, and cash e4uivalents. '1st Centur* Asset Allocation: &sset allocation can vary from very simple to very sophisticated. @or e"ample, an old rule of thumb was to invest a percentage e4ual to the investor#s age in bonds and cash e4uivalents and invest the remainder in stocks. 5o, a *$year$old would invest * percent in bonds and percent in stocks and a $year$old would invest percent in bonds and * percent in stocks. Today#s longer life e"pectancies and longer times spent in retirement have created a need for more sophisticated asset allocation models. 1n addition to the investor#s age, these newer models consider the investorKs current income, assets and savings, ta" bracket, and risk tolerance. They also factor in the general economic outlook. &lso, today#s tools can produce asset allocations that are more personaliBed than the general$purpose models we have discussed.
-/ample: e&nn /arren and 8amian rent are using an asset allocation calculator to determine how they should structure their investment portfolios. e&nn, age )!, has a steady income and has accumulated =-), in current assets. 5he has no savings, but also no income re4uirements. 5he#s in a )!H ta" bracket and considers herself to have a moderate to high risk tolerance. 8amian, age , has =-, in current assets and =I, in savings. >is income re4uirements are relatively low. >e#s also in a )!H ta" bracket and considers himself fairly risk$averse. Step : eeping the Port#olio on Track &fter investors have chosen investments that meet their portfolio obDectives, they need to periodically evaluate how well the investments are meeting the obDectives. 1nvestors should keep in mind that a failure to meet portfolio obDectives might derive from the asset allocation strategy, rather than from the individual assets chosen within a desired asset allocation. 1n other words, it may simply be impossible to achieve a desired portfolio return with *H stocks and H bonds it may be necessary to increase the number of stocks. >owever, before changing the portfolio#s asset allocation, the investor should be aware that doing so will aect the portfolio#s level of risk.
4iversi5cation: 1nvesting in multiple asset classes is a good start for trying to avoid asset concentration risk. >owever, more complete diversication generally also re4uires seeking a variety of individual assets within each asset class. -/ample: 5uppose that instead of investing in a single corporate stock, 5helly had split her stock investment among large and small companies in a variety of industries. Anal*sis: 1f large company stocks or stocks in a particular industry perform poorly over the ne"t few years, 5helly could lose money on those parts of her investment. ut if other stocks remain stable or increase in value, those results will reduce the impact of her losses.
4iversi5cation Inherent in Pooled investments: ?ote that when an investor invests indirectly by purchasing shares in an investment fund or trust, those investments are diversied by their very nature because the fund invests in a very large number of individual assets. &mong the investment vehicles that provide this type of SautomaticS diversication are mutual funds, R01Ts, e"change$traded funds 60T@s9, and insurance separate accounts within variable annuities or variable universal life insurance policies. 4iversi5a+le Risks: 8iversication is only eective for diversiable risks. 5ome risks, known as systemic risks, aect all assets in an economy and can#t be diversied. S*stemic risks: Pervasive economic conditions can have a global eect on market values. 5ignicant events, such as currency devaluations, political unrest, or nancial crises such as the one in )<$)C, can aect market values on a national or even global level. Re+alancing: ¬her important strategy for managing portfolio risk and return is rebalancing. Perry Uenner created an investment portfolio with an initial =!, investment. >e invested ! percent of that amount in stocks and ! percent in bonds. Rebalancing had two advantages for +r. Uenner. Advantage 1: @irst, rebalancing returned his portfolio to the desired asset allocation and the desired risk prole. Advantage ': 5econd he was able to Sbuy lowS and Ssell high.S 1n the rebalancing, he sold bonds at a prot compared to their price at the beginning of the period, and he bought stocks at a relatively low price. Gver the ne"t three months, stocks gain value and bonds lose value. This time, when +r. Uenner rebalances, he sells stock for a prot because prices have increased. >e also buys bonds low, with the potential to sell them for a prot in the future.
Conclusion: Rebalancing helps +r. Uenner maintain his desired risk prole, and buying low and selling high can make a considerable dierence to his investment returns over many years.
Automatic Re+alancing: Re+alance automaticall*: ecause keeping investment allocations balanced re4uires constant account monitoring, investment vehicles including dened contribution plans and variable annuities$often oer automatic rebalancing services. 4ollar!Cost Averaging: ¬her important strategy for the prudent, long$term investor is dollar$cost averaging. et#s look at an e"ample. +ark Uenkins purchased shares of a certain stock on the rst day of the month for ve months. >ere#s what he paid per share each month. /hat would you say was +ark#s average cost per shareN 8id you say =)N >ere#s how we calculated that number: 6Z=I O =)! O =) O =-! O =-9 E !9 &nd that number would be correct if he bought the same number of shares every month. ut what if he used dollar$cost averagingN et#s see 2sing dollar$cost averaging, +ark arranges to have =- transferred from his checking account to his investment account each month and to have that money used to buy shares of stock 6actually, some months the amount is slightly more or less than =- because he can#t buy partial shares of stock9. Purchase 4ate +arch &pril+ay Uune Uuly -
Share Price
=I =)! =) =-! =-
Pa*ment Amount =; =- =- =-! =-
Shares Purchased
I * ! < -
?ow, what would you say was +ark#s average cost per shareN Purchase 4ate
Share Price
Pa*ment Amount
+arch =I =; &pril =)! =- +ay =) =- Uune =-! =-! Uuly =- =- &verage cost per share with dollar$cost averaging The total amount he paid for shares was =*;! 6total of column 6total of column *9. &verage cost per share =*;! O ); =-<.<
Shares Purchased
I * ! < - I9 and the total number of shares he bought was );
Anal*sis: Previously, we suggested that the average share price during this period was =). ut, with dollar$cost averaging, the average price of +ark#s shares was =-<.<. @rom a Sbuy lowEsell highS point of view, dollar cost averaging has certainly provided +ark with an advantage. Purchase 4ate +arch &pril+ay Uune Uuly -
=I =)! =) =-! =-
Share Price
Pa*ment Amount =; =- =- =-! =-
Shares Purchased
I * ! < -
/ouldn#t +ark have been better o to buy no shares until UulyN The short answer is Syes.S /ith =!, he could have bought many more shares 6! vs. );9 at a lower average price 6=- vs. =-<.<9. >owever, many nancial advisors would not suggest this approach. et#s see why. Market Timing: 1f +ark had predicted that the stock#s price would decrease steadily from +arch to Uuly, he probably could have improved his investment return considerably. ut, could he have predicted thisN /hat if he had been wrongN 1n the alternative scenario, waiting until Uuly to buy would have been the worst possible choice. +arket timing oers huge potential rewards but$and this should be no surprise to you by now it involves a huge amount of risk. That#s why so many e"perts advise against trying to time the market and suggest more systematic strategies instead. ?umerous studies have shown that mistakes made trying to time the market lose money for most investors. &ccording to one such study, the average investor earned !.) percent average return per year for the twenty years ending in
