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MBA572 Financial Planning and Insurance

Assignment 11

Required Readings:

Book 1 (R. Frasca): Chapters 15-16. Book 2 (Gitman): Chapters 14-16.

Knowledge Points:

1. Life insurance and retirement planning.

(a) There are mainly two categories of life insurance: term life insurance that provides only death protection, and cash value life insurance that provides both death protection and cash value buildup. Cash value insurance therefore carries the savings feature and the return is relatively safe and better than some investments. But the Consumers Union has suggested that it is better off buying a term life and invest the difference of premiums.

(b) The sufficient life insurance coverage is determined by the continuing survivors’ expenses, sur- vivors’ income, and the length of time needed for adjustment (annuity factor). The following is an example.

Survivors’ monthly expenses 3,500 Survivors’ monthly income 2,800 Gap per month 700 × 12 Gap per year 8,400 × Annuity factor 10 Life insurance needs 84,000

2. Retirement pension (annuity) distribution.

(a) There are two types of employer-sponsored retirement pension plans: defined benefit plans and defined contribution plans. With the defined benefit plan, the employer guarantees the employee a specified retirement benefit, so the employee knows exactly what he will have at retirement. The investment risk is entirely borne by the employer. Since the last recession, many govern- ments and businesses have switched to the defined contribution plans that only require employers to contribute a specified amount to their employees’ retirement accounts. The investment risk therefore is shifted to the employee.

(b) Expected pension balance at retirement depends on the size of periodical contributions, the length of time till retirement, and the investment strategy (which determines the expected rate of return). For instance, if a person contributes $6,000 a year ($500 a month) to his/her retirement pension and the employer matches the contribution, has 30 years till retirement, and expects 6% annual return, then the expected pension balance at retirement is:

12,000 PMT

30 N

0 PV

6 I/YR

CPT FV

Balance = $948,698.24

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(c) Realistically, unless the total balance of a pension is disbursed to the employee at retirement, the remaining balance will continue to generate investment returns. But because the retiree now lives partly on the pension distribution, the investment normally will be switched to a safer strategy (i.e., switching from investing in stocks to holding high-quality bonds). Since a safer investment is expected to generate a smaller return, in a simplified case, we can obtain the annual distribution from a pension plan by dividing the balance at retirement by the number of years of distribution. In the above case, if the fund is disbursed to the retiree over a 20-year span, the annual disbursement will be $474,349.12

20 = $23, 717.46 without factoring in the after-retirement

investment income.

Case Study 1 (Life Insurance):

John (age 40), Jane (35) and Jimmy (10) are a family of three. One day, John talked to a CFP and wanted to find out how much life insurance is adequate to provide a financial safety net to the family for the next 10 years should a dramatic event happen to John. Here are the needs and considerations:

• The family currently finances its home, with monthly mortgage payment of $1,500 for the next 20 years.

• Regular expenses such as food, fuel and auto-related are about $1,500 a month.

• Jimmy’s education cost is estimated to be $1,000 a month on average for the next 10 years.

• The only survivors’ source of income comes from Jane’s job, which pays $50,000 annual salary or $3,200 per-month take-home pay.

• The annuity factor is given at 10.

Questions:

1. Use Figure 15.2 of Book 1 as a reference. How much term life insurance is adequate to cover the expenses for the survivors?

(a) $50,000

(b) $96,000

(c) $190,000

(d) $150,000

2. If the premium is $5 per $100,000 coverage per month, what is the monthly cost of the term life insurance for John?

(a) $5

(b) $10

(c) $15

(d) $20

Case Study 2 (Retirement Planning):

Patti is a 37-year old sales representative who started her employment at company J last year. She needs a CFP to draft a retirement plan for her. The following list has the details:

• Patti earns pretax income of $100,000 this year. For simplicity, assume that her income does not grow and the tax rate is 25%.

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• Her current annual cost of living is $40,000, which is expected to increase by 4% annually. She plans to retire at the age of 67, and the cost of living after then will be roughly 80% of the pre-retirement cost of living. The applicable tax rate after retirement is 20%.

• In the past year, she paid $6,250 of Social Security Tax, and it is estimated that the Social Security benefits at the time of retirement will be $4,500 per month.

• She has an employer-sponsored 401(K) retirement account, to which she contributes 5% of pretax income and the employer matches 5%. Based on the historical performance, the average return is 10% a year. Assume that the account no longer grows once she starts withdrawing funds at age 67. The accumulated dollars will be distributed evenly to her for 20 years.

Questions:

3. Considering all factors such as inflation and life style. What will be Patti’s cost of living at age 67 when she plans to retire?

(a) $103,788.72

(b) $129,735.90

(c) $155,478.58

(d) $80,637.96

4. What will be the annual retirement income from Social Security Benefits and 401(K)? Will the two sources be enough to cover the cost of living after 67?

(a) From Social Security: $54,000; from 401 (K): 52,143; sufficient to cover.

(b) From Social Security: $54,000; from 401 (K): 82,247; sufficient to cover.

(c) From Social Security: $54,000; from 401 (K): 82,247; insufficient to cover.

(d) From Social Security: $58,000; from 401 (K): 52,143; insufficient to cover.

5. She also considers making a one-time contribution of $5,000 pretax money to either a traditional IRA or a Roth IRA. Which option is more beneficial? Why (show after tax results at age of 67)?

(a) Contributions to a traditional IRA are tax-exempt, so it is better.

(b) Withdrawals from a Roth IRA are tax-exempt, so it is better.

(c) Because the current tax rate is greater than that after retirement, so a traditional IRA is better than a Roth IRA for Patti.

(d) Because the current tax rate is greater than that after retirement, so a Roth IRA is better than a traditional IRA for Patti.

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