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 basu@clunet.edu

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