Question

Your client, Steven, age 43, has come to you for assistance with retirement planning. He provides you with the following facts.

He earns $80,000 annually.

His wage replacement ratio has been determined to be 80%.

He expects inflation will average 3% for his entire life expectancy.

He expects to work until 68, and live until 90.

He currently has $60,000 saved, and he is averaging a 9% rate of return and expects to continue to earn the same return over time.

He has been saving $3,000 annually in his 401(k) plan.

Additionally, Social Security Administration has notified him that his annual retirement benefit, in today’s dollars will be $26,000.

4. Provide Steven with 3 alternatives for meeting his retirement goal. In doing so, use calculations to show the impact of each alternative.

Before hiring you as his financial planner, Steven was going to another planner. He mentions that the other planner calculated this retirement needs another way, so he asks you to calculate his retirement needs using other methods.

5. Using the capital preservation method, calculate how much capital Steven needs in order to retire at 68.

6. Using the purchasing power preservation method, calculate how much capital Steven needs in order to retire at 68.

Answer 1

4. It is realistic to use a wage replacement ratio of 80%. If steven uses an 80% wage replacement ratio he will need to plan to have $64000 income in one year of retirement. (80, 000 × 0.8). Based on the notice from the Social security administration, he will have an annual benefit of $26000. In addition, he will have $777, 231 saved in his 401k ($60, 000; 9% rate of return over 25 years; adding 3000 annually for 25 more years) to divide over 22 years or $35, 329. With his social security and 401k, steven retirement income based on his current saving plan is $61, 329.

Using annuity method- annual retirement need is $64000 less social security benefit of $26000 = annual need of $38000 at3% inflation per year, Steven will need $79, 563.56 ( first year of retirement) × 25 yrs = $1989, 089 total amount needed to retire at the age of 68.

5. Using capital preservation method.

80% of his current income = 80, 000 × 0.8 = 64, 000

The future values of $64000 and the social security payment of $26, 000 need to be found. The number of years until retirement 68-43 is 25.

The rate is the inflation rate of 0.3%

The future value of money formula is FV = PV (1+r)^n

a. 80% of current income:

FV = 64000 (1+0.03)^25 = 134001.786

b. Social security:

FV = 26000 (1+0.03)^25 = 54, 438.226

c. Subtract the future value of the social security from the 80% of his income

126309.537 - 51313.249 = 79563.561

He will need to make $79, 563.56 a year on his investments starting when he's 68.

Now wehave to findthe present value of number of cash flows over his retirement years 90 - 68 = 22. He expects a return on investment of 8%, but he also expects an inflation rate of 3%. His net rate will be 5%.

PV = C {1-(1+r)-n}/r

PV = 79563.56 {1-(1+.05)^(-22)}/0.05

PV = 1047295.345

Steven needs $1, 047, 295.35 in capital at the age of 68 to retire. Following the capital preservation model the money should be invested conservatively in low risk vehicles such as bonds and high yield saving accounts.

6. Similary using purchasing power preservation method, steven needs $1, 317, 564.25 in capital at the age of 68 to retire.