The overriding consideration in individual investor goal-setting is one’s stage in the life cycle. Most young people start their adult lives with only one asset—their earning power.
In this early stage of the life cycle an individual may not have much interest in investing in stocks and bonds. The needs for liquidity and preserving safety of principal dictate a conservative policy of putting savings in a bank or a money market fund. If and when a person gets married, the purchase of life and disability insurance will be required to protect the value of human capital.
When a married couple’s labor income grows to the point at which insurance and hous- ing needs are met, the couple may start to save for any children’s college education and their own retirement, especially if the government provides tax incentives for retirement savings. Retirement savings typically constitute a family’s first pool of investable funds.
This is money that can be invested in stocks, bonds, and real estate (other than the primary home).
Human Capital and Insurance
The first significant investment decision for most individuals concerns education, building up their human capital. The major asset most people have during their early working years is the earning power that draws on their human capital. In these circumstances, the risk of illness or injury is far greater than the risk associated with financial wealth.
The most direct way of hedging human capital risk is to purchase insurance. With the combination of your labor income and a disability insurance policy viewed as a portfolio,
the rate of return on this portfolio is less risky than the labor income by itself. Life insur- ance is a hedge against the complete loss of income as a result of death of any of the family’s income earners.
Investment in Residence
The first major economic asset many people acquire is their own house. Deciding to buy rather than rent a residence qualifies as an investment decision.
An important consideration in assessing the risk and return aspects of this investment is the value of a house as a hedge against two kinds of risk. The first kind is the risk of increases in rental rates. If you own a house, any increase in rental rates will increase the return on your investment.
The second kind of risk is that the particular house or apartment where you live may not always be available to you. By buying, you guarantee its availability.
Saving for Retirement and the Assumption of Risk
People save and invest money to provide for future consumption and leave an estate. The primary aim of lifetime savings is to allow maintenance of the customary standard of liv- ing after retirement. As Figure 28.2 suggests, your retirement consumption depends on your life expectancy at that time. Life expectancy, when one makes it to retirement at age 65, approximates 85 years, so the average retiree needs to prepare a 20-year nest egg and sufficient savings to cover unexpected health care costs. Investment income may also increase the welfare of one’s heirs, favorite charity, or both.
Questionnaires suggest that attitudes shift away from risk tolerance and toward risk aversion as investors near retirement age. With age, individuals lose the potential to recover from a disastrous investment performance. When they are young, investors can respond to a loss by working harder and saving more of their income. But as retire- ment approaches, investors realize there will be less time to recover. Hence the shift to safe assets.
Retirement Planning Models
In recent years, investment companies and finan- cial advisory firms have created a variety of “user- friendly” interactive tools and models for retirement planning. Although they vary in detail, the essential structure behind most of them can be explained using The American Saving Education Council’s “Ballpark Estimate” worksheet (See Figure 28.3 ). The work- sheet assumes you’ll need 70% of current income, that you’ll live to age 87, and you’ll realize a constant real rate of return of 3% after inflation. For example, let’s say Jane is a 35-year-old working woman with two children, earning $30,000 per year. Seventy percent of Jane’s current annual income ($30,000) is $21,000. Jane would then subtract the income she expects to receive from Social Security ($12,000 in her case) from $21,000, equaling $9,000. This is how much Jane needs to make up for each retirement year.
Jane expects to retire at age 65, so (using panel 3 of Figure 28.2 Long life expectancy is a
double-edged sword
Source: www.glasbergen.com . Copyright 2000 by Randy Glasbergen. Reprinted by permission of Randy Glasbergen.
Figure 28.3 Sample of American Saving Education Council worksheet
Source: EBRI (Employee Benefit Research Institute)/American Saving Education Council.
1. How much annual income will you want in retirement? (Figure 70% of your
current annual income just to maintain your current standard of living. Really.) $ 21,000 2. Subtract the income you expect to receive annually from:
• Social Security
If you make under $25,000, enter $8,000; between $25,000 ⫺ $40,000,
enter $12,000; over $40,000, enter $14,500 − $ 12,000
• Traditional Employer Pension—a plan that pays a set dollar amount for life, where the dollar amount depends on salary and years of service
(in today’s dollars) − $
• Part-time income − $
• Other − $
This is how much you need to make up for each retirement year = $ 9,000 Now you want a ballpark estimate of how much money you’ll need in the bank the day you retire. So the accountants went to work and devised this simple formula. For the record, they figure you’ll realize a constant real rate of return of 3% after inflation, you’ll live to age 87, and you’ll begin to receive income from Social Security at age 65.
3. To determine the amount you’ll need to save, multiply the amount you
need to make up by the factor below. $147.600
Age you expect to retire: 55 Your factor is: 21.0
60 18.9
65 16.4
70 13.6
4. If you expect to retire before age 65, multiply your Social Security
benefit from line 2 by the factor below. + $
Age you expect to retire: 55 Your factor is: 8.8
60 4.7
5. Multiply your savings to date by the factor below (include money
accumulated in a 401(k), IRA, or similar retirement plan): −$ 4,800 If you want to retire in: 10 years Your factor is: 1.3
15 years 1.6
20 years 1.8
25 years 2.1
30 years 2.4
35 years 2.8
40 years 3.3
Total additional savings needed at retirement: = $142,800 6. To determine the ANNUAL amount you’ll need to save, multiply the TOTAL
amount by the factor below. $ 2,856
If you want to retire in : 10 yrs. Your factor is: .085
15 yrs. .052
20 yrs. .036
25 yrs. .027
30 yrs. .020
35 yrs. .016
40 yrs. .013
BALLPARK ESTIMATE®
This worksheet simplifies several retirement planning issues such as projected Social Security benefits and earnings assumptions on savings. It also reflects today’s dollars; therefore you will need to re-calculate your retirement needs annually and as your salary and circumstances change. You may want to consider doing further analysis, either yourself using a more detailed worksheet or computer software or with the assistance of a financial professional.
the worksheet) she multiplies $9,000 3 16.4 equaling $147,600. Jane has already saved
$2,000 in her 401(k) plan. She plans to retire in 30 years so (from panel 4) she multiplies
$2,000 3 2.4 equaling $4,800. She subtracts that from her total, making her projected total savings needed at retirement $142,800. Jane then multiplies $142,800 3 .020 5 $2,856 (panel 6). This is the amount Jane will need to save annually for her retirement.
CONCEPT CHECK
1
a. Think about the financial circumstances of your closest relative in your parents’
generation (preferably your parents’ household if you are fortunate enough to have them around). Write down the objectives and constraints for their investment decisions.
b. Now consider the financial situation of your closest relative who is in his or her 30s.
Write down the objectives and constraints that would fit his or her investment decision.
c. How much of the difference between the two statements is due to the age of the investors?
Manage Your Own Portfolio or Rely on Others?
Lots of people have assets such as Social Security benefits, pension and group insurance plans, and savings components of life insurance policies. Yet they exercise limited control, if any, on the investment decisions of these plans. The funds that secure pension and life insurance plans are managed by institutional investors.
Outside the “forced savings” plans, however, individuals can manage their own invest- ment portfolios. As the population grows richer, more and more people face this decision.
Managing your own portfolio appears to be the lowest-cost solution. Conceptually, there is little difference between managing one’s own investments and professional finan- cial planning/investment management.
Against the fees and charges that financial planners and professional investment manag- ers impose, you will want to offset the value of your time and energy expended on diligent portfolio management. People with a suitable background may even look at investment as recreation. Most of all, you must recognize the potential difference in investment results.
Besides the need to deliver better-performing investments, professional managers face two added difficulties. First, getting clients to communicate their objectives and constraints requires considerable skill. This is not a one-time task because objectives and constraints are forever changing. Second, the professional needs to articulate the financial plan and keep the client abreast of outcomes. Professional management of large portfolios is com- plicated further by the need to set up an efficient organization where decisions can be decentralized and information properly disseminated.
The task of life cycle financial planning is a formidable one for most people. It is not surprising that a whole industry has sprung up to provide personal financial advice.
Tax Sheltering
In this section we explain three important tax sheltering options that can radically affect opti- mal asset allocation for individual investors. The first is the tax-deferral option, which arises from the fact that you do not have to pay tax on a capital gain until you choose to realize the gain. The second is tax-deferred retirement plans such as individual retirement accounts, and the third is tax-deferred annuities offered by life insurance companies. Not treated here at all is the possibility of investing in the tax-exempt instruments discussed in Chapter 2.
The Tax-Deferral Option A fundamental feature of the U.S. Internal Revenue Code is that tax on a capital gain on an asset is payable only when the asset is sold; this is its tax-deferral option. The investor therefore can control the timing of the tax payment. This
To see this, compare IBM stock with an IBM bond. Suppose both offer an expected total return of 12%. The stock has a dividend yield of 4% and expected price appreciation of 8%, whereas the bond pays an interest rate of 12%. The bond investor must pay tax on the bond’s interest in the year it is earned, whereas the stockholder pays tax only on the dividend and defers paying capital gains tax until the stock is sold.
Suppose one invests $1,000 for 5 years. Although in reality interest is taxed as ordi- nary income while capital gains and dividends are taxed at a rate of only 15% for most investors,2 to isolate the benefit of tax deferral, we will assume that all investment income is taxed at 15%. The bond will earn an after-tax return of 12% 3 (1 2 .15) 5 10.2%. The after-tax accumulation at the end of 5 years is
$1,00031.10255$1,625.20
For the stock, the dividend yield after taxes is 4% 3 (1 2 .15) 5 3.4%. Because no taxes are paid on the 8% annual capital gain until year 5, the before-tax accumulation will be
$1,0003(11.0341.08)551,000(1.114)55$1,715.64 In year 5, when the stock is sold, the (now-taxable) capital gain is
$1,715.642$1,000(1.034)551,715.6421,181.965$533.68
Taxes due are $80.05, leaving $1,635.59, which is $10.39 more than the bond investment yields. Deferral of the capital gains tax allows the investment to compound at a faster rate until the tax is actually paid. Note that the more of one’s total return that is in the form of price appreciation, the greater the value of the tax-deferral option.
Tax-Deferred Retirement Plans Recent years have seen increased use of tax- deferred retirement plans in which investors can choose how to allocate assets. Such plans include traditional IRAs, Keogh plans, and employer-sponsored “tax-qualified”
defined contribution plans such as 401 (k) plans. A feature they have in common is that contributions and earnings are not subject to federal income tax until the individual with- draws them as benefits.
Typically, an individual may have some investment in the form of such qualified retire- ment accounts and some in the form of ordinary taxable accounts. The basic investment principle that applies is to hold whatever bonds you want to hold in the retirement account while holding equities in the ordinary account. You maximize the tax advantage of the retirement account by holding it in the security that is the least tax advantaged.
To see this point, consider an investor who has $200,000 of wealth, $100,000 of it in a tax-qualified retirement account. She currently invests half of her wealth in bonds and half in stocks, so she allocates half of her retirement account and half of her nonretirement funds to each. She could reduce her tax bill with no change in before-tax returns simply by shifting her bonds into the retirement account and holding all her stocks outside the retire- ment account.
2These tax rates are likely to change in 2011, with the rate on capital gains rising to 20%, and dividends taxed as ordinary income.
CONCEPT CHECK
2
Suppose our investor earns a 10% per year rate of interest on bonds and 15% per year on stocks, all in the form of price appreciation. In 5 years she will withdraw all her funds and spend them. By how much will she increase her final accumulation if she shifts all bonds into the retirement account and holds all stocks outside the retirement account? She is in a 28%
tax bracket for ordinary income, and her capital gains income is taxed at 15%.
Deferred Annuities Deferred annuities are essentially tax-sheltered accounts offered by life insurance companies. They combine deferral of taxes with the option of withdrawing one’s funds in the form of a life annuity. Variable annuity contracts offer the additional advantage of mutual fund investing. One major difference between an IRA and a variable annuity contract is that whereas the amount one can contribute to an IRA is tax- deductible and extremely limited as to maximum amount, the amount one can contribute to a deferred annuity is unlimited, but not tax-deductible.
The defining characteristic of a life annuity is that its payments continue as long as the recipient is alive, although virtually all deferred annuity contracts have several withdrawal options, including a lump sum of cash paid out at any time. You need not worry about running out of money before you die. Like Social Security, therefore, life annuities offer longevity insurance and thus would seem to be an ideal asset for someone in the retirement years. Indeed, theory suggests that where there are no bequest motives, it would be optimal for people to invest heavily in actuarially fair life annuities. 3
There are two types of life annuities, fixed annuities and variable annuities. A fixed annuity pays a fixed nominal sum of money per period (usually each month), whereas a variable annuity pays a periodic amount linked to the investment performance of some underlying portfolio.
In pricing annuities, insurance companies use mortality tables that show the probabili- ties that individuals of various ages will die within a year. These tables enable the insurer to compute with reasonable accuracy how many of a large number of people in a given age group will die in each future year. If it sells life annuities to a large group, the insurance company can estimate fairly accurately the amount of money it will have to pay in each future year to meet its obligations.
Variable annuities are structured so that the investment risk of the underlying asset port- folio is passed through to the recipient, much as shareholders bear the risk of a mutual fund.
There are two stages in a variable annuity contract: an accumulation phase and a payout phase. During the accumulation phase, the investor contributes money periodically to one or more open-end mutual funds and accumulates shares. The second, or payout, stage usually starts at retirement, when the investor typically has several options, including the following:
1. Taking the market value of the shares in a lump sum payment.
2. Receiving a fixed annuity until death.
3. Receiving a variable amount of money each period that depends on the investment performance of the portfolio.
Variable and Universal Life Insurance Variable life insurance is another tax- deferred investment vehicle offered by the life insurance industry. A variable life insurance policy combines life insurance with the tax-deferred annuities described earlier.
To invest in this product, you pay either a single premium or a series of premiums.
In each case there is a stated death benefit, and the policyholder can allocate the money invested to several portfolios, which generally include a money market fund, a bond fund, and at least one common stock fund. The allocation can be changed at any time.
Variable life insurance policies offer a death benefit that is the greater of the stated face value or the market value of the investment base. In other words, the death benefit may rise with favorable investment performance, but it will not go below the guaranteed face value.
Furthermore, the surviving beneficiary is not subject to income tax on the death benefit.
3 For an elaboration of this point see Laurence J. Kotlikoff and Avia Spivak, “The Family as an Incomplete Annuities Market,” Journal of Political Economy 89 (April 1981).
The policyholder can choose from a number of income options to convert the policy into a stream of income, either on surrender of the contract or as a partial withdrawal. In all cases income taxes are payable on the part of any distribution representing investment gains.
The insured can gain access to the investment without having to pay income tax by bor- rowing against the cash surrender value. Policy loans of up to 90% of the cash value are available at any time at a contractually specified interest rate.
A universal life insurance policy is similar to a variable life policy except that, instead of having a choice of portfolios to invest in, the policyholder earns a rate of interest that is set by the insurance company and changed periodically as market conditions change. The disadvantage of universal life insurance is that the company controls the rate of return to the policyholder, and, although companies may change the rate in response to competitive pressures, changes are not automatic. Different companies offer different rates, so it often pays to shop around for the best.