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Chapter 5: Life-Cycle Financial Planning

Chapter 5: Life-Cycle Financial Planning. Objective To analyze how much to save for retirement To determine whether to defer taxes or pay then now, and to get a professional degree, and to buy or rent an apartment. Analyze how much to save for retirement.

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Chapter 5: Life-Cycle Financial Planning

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  1. Chapter 5: Life-Cycle Financial Planning Objective To analyze how much to save for retirement To determine whether to defer taxes or pay then now, and to get a professional degree, and to buy or rent an apartment

  2. Analyze how much to save for retirement. Determine whether to defer taxes or pay them now. Determine whether to get a professional degree. Determine whether to buy or rent an apartment. Chapter 5 Contents

  3. Consumption over the Life Cycle • You are currently 35 years old, expect to retire in 30 years at age 65, and then to live for 15 more years until age 80. • You current income is $30,000 per year, and you real labor income adjusted for inflation remains at $30,000 per year until age 65. • The real rate of interest is 3% per year. • How much should you spend for consumption now and how much should you save for retirement ?

  4. Two Approaches • Aim for a target replacement rate of preretirement income. • Aim for maintaining the same level of consumption spending before and after retirement.

  5. Target Replacement Rate of Preretirement Income • Recommendation: You should aim for a replacement rate equal to 75% of your preretirement income. • That is 0.75×$30,000 = $22,500.

  6. Maintaining the Same Level of Consumption • Assume you plan to consume a constant stream of the same amount in each of the next 45 years, denoted by C.

  7. — Permanent income — Human capital

  8. The Intertemporal Budget Constraint • i = real interest rate • R = number of years to retirement • T = number of years of remaining life • W0 = initial wealth • B = bequest

  9. The Effect of Changes in Real Income • Dr.Omar Ben Holim’shas just graduated from medical school at age 30 and has started training to be a surgeon. • His real salary for the next five years will be $25,000 per year. • After completing his residency, Omar expects to earn $300,000 per year in real terms until he retires at age 65. • Assume that the real interest rate is 3%. • If he wants to maintain the same level of consumption for the rest of his life and his life expectancy is 85 years, how much should he allocate his wealth?

  10. Taking Account of Social Security • In many countries governments oblige citizens to participate in a mandatory retirement system called social security. • Pay a tax during their working years and in turn qualify for a lifetime annuity in their old age. • The influence of mandatory saving on voluntary saving.

  11. The Influence of Mandatory Saving on Voluntary Saving • Suppose that social security benefits are equal to what you would have if • you had saved each year an amount equal to the amount you pay in social security taxes, and • earned a real interest rate of 3% per year. • Suppose that you are required to pay $2,000 per year in social security taxes for 30 years.

  12. The real interest rate implied in social security account vs. that earned in your bank account. • Lifetime annuity implies that the longer you live, the higher your actual rate of return.

  13. Deferring Taxes through Voluntary Retirement Plans • In many countries governments encourage voluntary saving for retirement through provisions of the tax code. • Tax-advantage accounts: IRAs (Individual Retirement Accounts). • Contributions are deductible, and • interest on the contributions is not taxed until the money is withdrawn.

  14. The tax-deferredplan You face a tax rate of 20% and interest rate is 8%. You are 30 years before retirement and contribute $1000 to IRAs. Your total before-tax cum. account will be: $1000×1.0830 =$10,063 You will pay taxes: 0.2×$10,063=$2,012 You will be left with $8,050. The ordinary saving plan: You have to pay $ 200 in taxes. The remaining $800 goes into ordinary saving plan, and interest earnings will be taxed, so after-tax int. rate: (1-0.2) ×8%=6.4% The cum. account will be $800×1.06430=$5,144.45 The Advantage of Tax-deferred Saving

  15. Should You Invest in a Professional Degree? • Joe Grad has just graduated from college and is deciding whether to go on for his master’s degree. • If he takes job immediately, he can earn $30,000 per year in real terms. • If he goes on for two more years of graduate study, he can increase his earnings to $35,000 per year. • The cost of tuition is $15,000 per year in real terms, and the real interest rate is 3% per year. • Joe is now 20 years old and expects to retire at age 65.

  16. Should You Buy or Rent? • You are currently renting a house for $10,000 per year and can buy a house for $200,000. • Property taxes are deductible for income tax purposes, and your tax rate is 30%. • The maintenance and property taxes are estimated to be: • Should you buy or continue to rent?

  17. If you buy the house, you have to pay $200,000 now. • Because the after-tax outflow for property taxes is 0.7×$2,400=$1,680, the cash outflow each year will be: • The NPV of two alternatives will be:

  18. Assume no inflation so that the real and nominal before-tax discount rate is 3%. Thus, • Rent costs at which would you be indifferent between buying and renting:

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