Term Paper on "Financial Planning TVM Applications"

Term Paper 15 pages (4167 words) Sources: 1+

[EXCERPT] . . . .

Value of Money: a Retirement Planning Case Study

Financial Planning (TVM Applications)

On September 15, 2006 Mr. And Mrs. Smith came to me for advice in planning for their retirement. Both of them are currently 35 years old. They have two children, ages 3 and newborn. They plan to retire at age 65 and expect a retirement horizon of 25 years. Their goals are two fold. The first is to pay help pay for college for both of their children. The second is to be able to live comfortably their retirement years and to be able to leave some inheritance to their children.

The Smiths own their own home and have excellent medical coverage, which means that there is little to interfere with their plans. They have a combined income of $60,000 and are both paid at the end of each month. In accordance with current government estimates it can be expected that they will receive an annual average increase of 4% annually until they retire. Each of them Deposit 12% of each paycheck into a 401(K) which is expected to receive an annual rate of return of 9%, compounded daily. In addition, their employers match their contribution with an additional 3% of their annual salary. Over a 25-year period, this will result in a combined total of $35,298 at the end of 25 years.

The Smiths have additional income in bonuses that they receive at the end of the year. Their bonuses equate 20% of their salary. The Smiths wish to deposit $10,000 of their bonus money into a 529 plan to help pay for their children' college expenses. Any amount remaining from this bonus check they wish to deposit into a Roth IRA that is expected to generate an 8% annual rate of return, compounded daily.

Current expenses for college are approximately $30,000 per year, per student. These are expected to increase at a rate of approximately 6% a year. The average program takes five years to complete. The Smiths expect their children to be able to pay for 20% of their college expenses on their own. The Smiths plan to use the 529 plan to help pay for the rest and will dip into the Roth IRA if needed. They will not use any of their 401K for this purpose.

It is assumed that both children will enter college at age 18 and that they will complete their degree in the allotted five-year time period. The first child is 3 now, which means that the Smiths have 15 years to save before they have to start paying for child number one. Three years after the first child begins college, the second one will begin. There are two years where the Smiths will have two children in college at the same time.

Calculate at the current rate, this means that the total college expenses for Child 1 will total $229,429 which breaks down into $45,885 per year for the full five-year duration. For child 2 the amount needed for college are slightly higher due to expected increases over the time between college entrances for the two children. For child 2 it is expected to take $329,174.27 for the entire five years. This breaks down into $65,834 per year. The Smiths expect their children to save 20% of their college expenses.

This means that the children will have to save $45,885 and $65,834 respectively.

For the first child the Smiths will still have to come up with $183,543.40. For the second child they will want to come up with $263,339.42 for the second child. The makes the amount needed by the Smiths to $446,882. The amount of contributions to the 529 plus the interest earned on them will total $323,356. This means that they will have to dip into the Roth IRA, which will only have $64,671 at the time to cover the remaining amount. Under this plan they will not be able to pay for college.

It appears that the savings plan for the childrens' college will be able to pay for the needed expenses at that time if both children are able to save the remaining 20% needed. If the children are able to save nothing, then the Smiths will have to come up with an additional $111,719. They would still be able to pay for their children's college and would still have $160,203 for their own retirement. Even under the worst case scenario it appears that the Smiths will be able to pay for their children's college and still have money left over. This is assuming that college expenses will rise at the predicted rate.

Retirement Living

The Smiths not only wanted to put their children through college, but wanted to have enough for their own needs in when they retired as well. After the children have gone to college, the Smiths will use their 401(k) and the remainder of the Roth IRA to fund their retirement. It is expected that the Smiths will need 90% of their retirement at the time just prior to their retirement. The Smiths have indicated that they realistically expect to retire in 30 years at age 65, rather than at 50. This gives them an additional five years to save.

If the inflationary rates and expected increases in pay go as planned, then the Smiths will be making a combined income of $194, 603 per year. This means that they will need $175,142 each year to live at their current lifestyle. It is expected that social security benefits will cover 20% of these expenses and that pensions will cover another 10%. The Smiths will still have to cover $122,600 from their own investments.

When they retire the Smiths plan to roll over all of their savings from the 401(k) and the Roth IRA to an account that will generate an expected return of 6% annually. Assuming that the Smith children will be able to save their allotted 20% for school and that they will have $271,922 left over for retirement, when combined with the $40,838 generated from their retirement accounts, they will have $312,760 to invest. If they earn 6% annually, that will generate $18,765 per year, not nearly enough for them to survive the first few months by these estimates.

Discussion and Recommendations

There are many factors that will affect the results of this exercise. The Smiths did something right in that they chose to start saving earlier rather than later in their working years. Earlier would always be better, but at least they started saving before the age of 40. They have two young children and this may place a damper on being able to save extra early on. Not enough information is available in the case to determine if the Smiths are able to save any additional monies other than their bonuses and the 401 (k) contributions. It is assumed that because other contributions are not mentioned that this means the Smiths do not have significant descressionary income to devote to additional savings.

The savings that the Smiths generated will be able to provide their children a good college education, but they will not be able to survive when they retire. This leaves several options. The first is to hope that the children become professionals that are able and willing to provide for their mom and dad in their golden years. However, barring this, let us see if the children paying for their own college would be enough. If the Smiths do not have to contribute to their childrens' college, then they would have $471,406 in addition to the $40,838 in their retirement. If they are able to invest this $512,244 at 6% then they will have an annual income of $30,734 annually to live on after retirement. This is still not enough for even the first year.

They still do not have enough to survive on the investments alone. If they then started using the principle amount to pay for their monthly expenses, then they would run out of money at approximately age 70. However, there is one major factor that was left out of this analysis. It is assumed that the Smiths will need approximately 90% of their annual salaries. However, one major event will occur before they retire that will significantly impact the amount of money needed after retirement.

They probably have a 30-year mortgage on their house. This means at some time they will have the house paid off and will have additional income to invest in retirement. Even if they only bought the house in recent years, then they will still have it paid off right before they retired and would not need as much in retirement income as they would if they rented or did not have the house paid off. The only expenses that they would have are utilities, groceries and other such recurring expenses.

The amount of the Smiths' mortgage has a significant impact on the outcome of this analysis. If they are living within their means… READ MORE

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