Saving and Investment Decisions Life Cycle of Savings

Life Cycle of Savings and Consumption § An example: You are 35 years old,

Approach 1: Targeting Replacement Rate of Preretirement Income Aim for a replacement rate of

Approach 1: Targeting Replacement Rate of Preretirement Income You need $22, 500 per year

Approach 1: Targeting Replacement Rate of Preretirement Income § § You save $5, 645.

Approach 2: Maintaining the Same Level of Consumption Spending § You need a constant

Human Capital and Permanent Income § § Human Capital: the present value of one’s

Social Security § § § A mandatory retirement income system One pays a tax

Voluntary Retirement Plans Individual retirement accounts (IRAs) Ø Contributions are deductible from current income

Slides: 10

Download presentation

Saving and Investment Decisions

Life Cycle of Savings and Consumption § An example: You are 35 years old, expect to retire in 30 years when 65, and live for another 15 years till 80. You make $30, 000 per year until age 65. Interest rate is 3% per year. How much to spend for consumption? How much to save for retirement? 2

Approach 1: Targeting Replacement Rate of Preretirement Income Aim for a replacement rate of 75% of pre retirement income § 75% * $30, 000 = $22, 500 per year § 1. Compute the amount needed in the account at the retirement age 2. Compute the annual amount of saving needed to reach that future value 3

Approach 1: Targeting Replacement Rate of Preretirement Income You need $22, 500 per year for 15 years. This is an annuity! PV 30 = $22, 500 * PVAF(3%, 15) = $268, 603. 54 FV 30 = X * FVAF(3%, 30) = $268, 603. 54 X = $5, 645. 85 4

Approach 1: Targeting Replacement Rate of Preretirement Income § § You save $5, 645. 85 per year This means your annual consumption in the next 30 years is $30, 000 - $5, 645. 85 = $24, 354. 15 You annual consumption from age 65 -80 is $22, 500 How do you keep your consumption level the same across all years? 5

Approach 2: Maintaining the Same Level of Consumption Spending § You need a constant cash flow stream in the next 30 + 15 = 45 years PV 30 = C * PVAF(3%, 15) FV 30 = ($30, 000 – C) * FVAF(3%, 30) 268, 603= ($30, 000 – C) * FVAF(3%, 30) PV 30 = FV 30 C = $24, 354. 15 6

Human Capital and Permanent Income § § Human Capital: the present value of one’s future labor income Permanent Income: the constant level of consumption spending that has a PV equal to one’s human capital Human capital = $30, 000 * PVAF(3%, 30) § = $588, 013 Permanent income = $24, 354. 15 7

Human Capital and Permanent Income 8

Social Security § § § A mandatory retirement income system One pays a tax during working years and gets a lifetime annuity in old age Social security payments reduce the amount available for saving or consumption What if social security pays the same rate of return as private saving? What if it pays higher return? Lower return? 9

Voluntary Retirement Plans Individual retirement accounts (IRAs) Ø Contributions are deductible from current income for tax purposes Ø Interests on the contributions are not taxed till the money is withdrawn Ø Tax deferred: any amounts withdrawn from the plan are taxed then § 10