Question

Provide Sue with financial advice on which option has the potential to yield the highest monetary value. Support your rational with calculations using time value of money and comment on the risk return relationship for each option, assume interest rate on savings is 4% and is compounded semi-annually.

Sue James is a 55-year old accountant who works at Ernst and Young (EY) who is about to retire. She has the following decision to make:

Option A – Select a lump sum gratuity payment of $120,000 with a reduced pension of $1,750 per month.

Option B – Select a monthly pension of $3,300 with no lump sum gratuity payment.

In addition, Sue has a loan of $72,000 with loan payments of $1,200 per month for the next five years.

Answer 1

	A		B
1. Pension Received Monthly		1750		3300
2. Pension Received Annually	1750 x12	21000	3300x12	39600
3. Annual Interest received (Compounded Semi-annually)	120000 x (1+4/200)2 -120000	2400	0	0
4. Monthly loan Payment	1200		1200
5. Yearly Loan payment	1200 x 12	14400	1200 x 12	14400
6. Annual Savings	21000-14400	6600	39600-14400	25200
7. Total after 5 years	120000+6600x5	153000	25200x5	126000

After 5 years, Sue's loan will be paid off

Thus by the virtue of option A, Sue will receive a yearly pension of $ 21000 and $ 2400 as interest income making. This would make her $ 23400 annually. Thus her net worth would be $(120000+23400x5) =$237000 in another 5 years (i.e. 10 years total) when she turns 65

For option B, Sue would receive $ 39600 yearly with no interest income. Thus her net worth would be $ (126000+39600x5) =$ 324000 in another 5 years (i.e. 10 years total) when she turns 65

Hence we can be say that Option B is the best plan for Sue James for the fact that it provides her with monetary value which is higher of the two options A & B.

Option B has firm specific risk involved. Such risks may arise due to the fact that EY may face the fate of Lehman Brothers in the distant future owing to recession or other factors and may close the pension fund in the future. In such a case, she will not have anything left to make ends meet. Thus it has the highest risk and reward makes it attractive for Sue.

Option A is a much diversified Portfolio that has varied sources of income. Hence even if EY faces closure in the future,s he still would still have $120000 as a emergency in her savings to start with. Although she will have to find another job by then to make ends meet in both cases. But good thing is that it won't be as desperate in Option B than in Option A,  Hence, Option A is the safer option of the two.