In: Finance

Let’s consider a retirement planning problem.

Suppose you just have had your 55th birthday and you plan to retire in five years. As far as your retirement goal is concerned, all you want is to maintain your living standard at the same level as when you start your retirement. You expect to “stick around” until 90 and you plan to leave nothing to “no one”. Therefore, your “sole” concern is maintaining your living standard during your retirement years.

Your current living expense per month is $20,000 (which include everything that you can possibly lay your fingers on) and you expect it to go up in exactly the same pace as the Composite CPI (of Hong Kong). The average yearly rate of increase of the index for the next five years is 3%. You do, however, expect the index to pick up its (yearly) pace afterwards (indeed, throughout your entire retirement period) by 2 percentage points. That is, the expected yearly inflation rate as measured by the CPI is 5% per year during your retirement years.

To facilitate the planning of your retirement, you listed out the following relevant questions which you would like to think over.

(i) State the approximate AND exact relationships between nominal rate of return, real rate of return and (expected) inflation rate. What is the name of this relationship?

(ii) Using the PVA formula, estimate how much money do you need to have in your investment account at the beginning of your retirement to achieve your “sole” retirement goal IF the expected yearly investment return is

- 7%

- 10%

- 4%

[Note: Marks would only be given for using the PVA formula in the calculations. Although some of you may be tempted to use the present value growing annuity formula (which was NOT covered in the Introduction to financial management course) to answer this question, I would strongly urge you NOT to use that formula. Instead, please draw on the insights derived from Part (i) above to construct the relevant equation and carry out the calculations.]

(iii) Based on your answer to Part (ii) above, what conclusion can you draw with respect to the relationships between (a) nominal cash flow, (b) real (inflation-adjusted) cash flow, (c) nominal interest rate and (d) real interest rate when using the PVA formula to answer Part (ii)?

(i) | Assume Nominal return =Rn | ||||||||||

Real Return=Rr | |||||||||||

Inflation Rate =Ri | |||||||||||

Approximate relationship: | |||||||||||

Rr=Rn-Ri | |||||||||||

Exact relationship: | |||||||||||

(1+Rr)*(1+Ri)=(1+Rn) | |||||||||||

(ii) | |||||||||||

Pmt | Monthly expense required after 5 years | $23,185 | (20000*(1.03^5) | ||||||||

Nper | Number of months of expenses after retirement | 420 | (90-55)*12 | ||||||||

Inflation Rate during retirement=5% | 0.05 | ||||||||||

Rate1 | Inflation adjusted return if nominal return is 7% | 1.90% | (1.07/1.05)-1 | ||||||||

Rate2 | Inflation adjusted return if nominal return is 10% | 4.76% | (1.10/1.05)-1 | ||||||||

Rate3 | Inflation adjusted return if nominal return is 4% | -0.95% | (1.04/1.05)-1 | ||||||||

PV1 | Present Value of expenses at retirement at 7% return | $1,216,798 | (Using PV function of excel with Rate =1.90%, Nper=420,Pmt=-23185) | ||||||||

PV2 | Present Value of expenses at retirement at 10% return | $486,895 | (Using PV function of excel with Rate =4.76%, Nper=420,Pmt=-23185) | ||||||||

PV3 | Present Value of expenses at retirement at 4% return | $133,055,924 | (Using PV function of excel with Rate =-0.95%, Nper=420,Pmt=-23185) | ||||||||

Money needed in investment account at the beginning of retirement: | |||||||||||

Yearly investment return 7% | $1,216,798 | ||||||||||

Yearly investment return 10% | $486,895 | ||||||||||

Yearly investment return 4% | $133,055,924 | ||||||||||

(iii) | As the nominal interest rate reduces, the real interest rate will also reduce | ||||||||||

Consequently , the amount required at beginning for same cash flow will increase | |||||||||||

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