Age Banding in Retirement Planning © 2002 Dr. Somnath Basu.
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Transcript of Age Banding in Retirement Planning © 2002 Dr. Somnath Basu.
Age Banding in Retirement Planning © 2002 Dr. Somnath Basu
Presentation by
Dr. Somnath Basu Professor of Finance
School of Business California Lutheran University
805-493-3980 [email protected]
The Retirement Objective The need to maintain our standard of living during retirement
Time horizon typically backed out of the mortality tables and client-specific information
Risk-return subjectively dependant on clients
Traditional View: Weaknesses
Replacement ratio: (e.g. 40-90%)
No formal model to compute this ratio Conservative – Aggressive
Assumes expenses during retirement increase at the inflation rate
Leisure/Healthcare inflation app 7%
Traditional View: Weakness
Investment horizon & allocation Single basket
Risk management Choice of securities
Incorporating Long Term Care, etc Inflexible
Alternate View
Retirement is dynamic No different from any other stage of life
Typical observations
Leisure spending to healthcare spending Life-cycle dynamics
Alternative View
Generality of ModelRetirement at any other ageDifferent activities, etc Life cycle changes can occur with any frequency -- 2 yrs, 5 yrs, etc
The Age-Banding Model: Case Studies
Case 1 : The Smiths Individual and spouse
Both around 60 yearsExpect to retire in 5 years
Expect to live in retirement for about 30 years
Case 2: Ms. Jones 35 year old individual Single, mid-career
The Age-Banding Model: Case Studies
Planning for Retirement Needs
Case 1: The Smiths Pre-retirement Expenses
Taxes 28000
Basic Living 36000
Health Care 6000
Leisure 5000
Total 75000
Cost of Living at Age 60 (Today)
Cost Projections: Traditional
All expenses are expected to grow at the long term rate of inflation
• Assumed as 3% in this example
Traditional View
Costs at Age
5 Yr. Growth & Inflation Rate Multiply by factor
Costs at Age
60 65
Total 75000 3% 1.159 86925
Cost Projections: Alternate
•Taxes and Basic Living Expenses increase at 3%/Yr.
•Healthcare and Leisure expenses increase by 7%/Yr.
Table2B: Alternate View
Costs at Age
5 Yr. Growth & Inflation Rate
Multiply by factor
Costs at Age
60 Table 1 65
Taxes 28000 3% 1.159 32452
Basic Living 36000 3% 1.159 41724
Healthcare 6000 7.00% 1.403 8418
Leisure 5000 7.00% 1.403 7015
Total 75000 89674
Assumptions
Alternate: Life Cycle Factors Factors proxy lifestyle changes during retirement Factor values around 1 Factor adjustments made at discrete intervals Example of factor values
Alternate: life cycle changes at 65, 75, 85
Traditional : Assume RR factor = 80% Traditional : Inflation Rate of 3%
Example – Factor values at Age 65Category Value Notes
Taxes 0.50 FICA- Average tax rate
Client specific
Basic Expenses
0.70 Mortgage paid off
Healthcare 1.15 Aging
Leisure 1.5 Postponed increases
Factor values during retirement
Life Cycle factors
Age 65 75 85
Taxes 0.5 1 1
Basic Living 0.7 0.8 0.9
Healthcare 1.15 1.2 1.25
Leisure 1.5 0.5 0.25
Replacement Ratios Table 3A: Alternative Traditional View
Total 86925 0.8 69540
Table 3B: Adjustments Alternate View
Pre- retirement Post- retirement Post- retirement
Costs at Age LifeCycle factor Cost at Age
65 at Age 65 66
Taxes 32452 0.5 16226
Basic Living 41724 0.7 29207
Healthcare 8418 1.15 9681
Leisure 7015 1.5 10523
Total 89609 65636
Expense Projections: Traditional
Age Amount Age Amount Age AmountUnadjusted Costs 65 69540 75 93456 85 125597
Adjusted Costs 66 71626 76 96260 86 129365
67 73775 77 99147 87 133246
68 75988 78 102122 88 137243
69 78268 79 105185 89 141361
70 80616 80 108341 90 145601
71 83034 81 111591 91 149969
72 85525 82 114939 92 154468
73 88091 83 118387 93 159102
74 90734 84 121939 94 163876
75 93456 85 125597 95 168792
Table 4A: Projected Costs for 3 Decades: Traditional View
Expense Projections: Age Bander
Age Amount Age Amount Age AmountUnadjusted Costs 65 65702 75 86409 85 128568
Adjusted Costs 66 68413 76 90329 86 134877
67 71330 77 94461 87 141546
68 74395 78 98815 88 148599
69 77617 79 103406 89 156059
70 81005 80 108249 90 163954
71 84569 81 113360 91 172311
72 88319 82 118753 92 181159
73 92266 83 124449 93 190530
74 96422 84 130464 94 200458
75 100801 85 136819 95 210978
Table 4B: Projected Costs for 3 Decades: Alternate View
Comparison of Projections
Cost Comparisons Between Methods
66 75 76 85 86 95
71626 93456 96260 125597 129365 168792
68413 100801 90329 136819 134877 210978
4.70% -7.29% 6.57% -8.20% -4.09% -20.00%
Alternate Chart: Component Costs
0
0.2
0.4
0.6
0.8
1
%age of Total
66 69 72 75 78 81 84 87 90 93
Age
Life Cycle Cost Changes
Leisure
Healthcare
Basic Living
Taxes
Traditional: Retirement Fund
Table 5A: Traditional View of Expense Projection and Funding Requirements
At
Age
Retirement Fund (Amt) Needed At Age
Funding Needed (Today)
Expenses at Age 65 69,540 65 1,379,006 60 1,133,543
Increases annually at 3%
Safe Investment at 6%
Alternate: Funding Requirements Expenses recorded separately for 3 decades
(66-75, 76-85, 86-95) 3 dedicated portfolios. Differential returns :
6%, 8% and 10% for 5, 15, 25 year portfolio
Retirees are more risk averse than others A circuit breaker for risk
5 year cushion
Funding Needs
Table 5B: Funding Needs Alternate View
Amount PV of Amount PV 5 Yrs.
Needed At CFs Needed At Earlier
65 602102 60 449926
75 805644 70 602024
85 1222067 80 913199
Alternate: Retirement Fund
Alternate View
Amount Needed at Age
Earnings Rate
PV Factor
At Age
AmountToday
Today 60 449926 0.06 1.000 60 449926
10 Yrs Later 70 602102 0.08 0.463 60 278890
20 Yrs Later 80 901439 0.10 0.386 60 133993
Total 862809
Asset Allocation
Asset Allocation Stocks(E)
Bonds(B)
75% Bonds
25% Equity
Comparative Analysis
Required funds at 60Traditional 1,133,543Alternate - 862,809
Excess $ 270,734
A saving of nearly 24% today (at age 60)!!
Case Study 2: Ms. Jones
Case Study 2
Assume (simplifying) that the same retirement expenses are projected
3 portfolios - 30 year – 12% - 40 year – 13.5% - 50 year – 15%
Individual has 50 years for managing portfolio
Case 2: Comparative contributions
Table 7A: Contributions-Traditional View
At Age
AmountNeeded
Expected Rate
Annual Contrib.
30 Yr. P’folio 65 1,379,006 0.12 $5,714.13
Table 7B: Contributions-Alternate View
30 Yr. P’folio 65 596,175 0.12 $2,470
40 Yr. P’folio 75 796,720 0.135 $683
50 Yr. P’folio 85 1.206,746 0.15 $167
Total $3,321
Case 2: Comparative Analysis
Risk Analysis
Table 8: Risk Analysis
Ms. Jones Bonds Large Caps Small Caps P'fol Risk
Traditional View 0 100 0 20.40%
Alternate View 0 85 15 22.95%
The Smiths
Traditional View 100 0 0 7.96%
Alternate View 78.79% 21.21% 0 10.07%
Risk Analysis: Ms. Jones
Risk Analysis: The Smiths
Risk Increase = 2.1%
Reduction in funding needs = 24%
$270,000
Time to manage risk = 25 years
Risk Analysis: 60 year old coupleAdditional risk considerations
5 year safety cushion
First 10 years risk free – same as traditional
More precise expense estimation mitigates risk
Buy two $50,000 (from savings) of fixed income securities with maturities of 15 and 25 yr.
Most of the risk increase goes away
Generality of model
Income netting:
Social security
GACs (risk adjusted), etc.
Point estimates:
Estimate of effects of inflation, returns, etc can be made using range estimates rather than single point estimates
Introduce additional statistical analysis
Generality of model
Life cycle decades & expenses
Any time span (1 year, 5 year, etc can be used)
Continuous time modeling
Breakup expenses (e.g. healthcare) into component costs for further fine – tuning
Time Long Term Care policy benefits to various phases of retirement
The End
Thank You