Exploring the Personal Financial Management Practices of ...
Personal Financial Management
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Transcript of Personal Financial Management
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Personal Financial Management
Semester 2 2008 – 2009Gareth Myles [email protected] Collier [email protected]
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Pension Planning
The lectures so far have mostly focused upon managing wealth during employment
Many people now retire in their mid 50s
A working life of 30 years must then support a retired life of 20-30 years My current reading
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Pension Planning
To maintain affluence during a long retirement requires careful planningEach year of work might need to support a
year of retirement In the absence of interest this provides a
simple calculationAnd decisive action early in life
Money saved early in life accumulates interest
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Early Investment
The benefit of early invested is easily illustrated
£5000 invested when 25 is worth 5000 (1.05)40 = £35200 at retirement
£5000 invested when 35 is worth 5000 (1.05)30 = £21610 at retirement
£5000 invested when 45 is worth 5000 (1.05)20 = £13266 at retirement
£5000 invested when 55 is worth 5000 (1.05)10 = £8144 at retirement
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Early Investment
If these are the only pension contributions Observe that 73%
of the pension fund comes from the first two investments
Early contributions are the most valuable
0
5000
10000
15000
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25000
30000
35000
40000
20 30 40 50 60 70
Age when invested
Valu
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The Basic State Pension
In most developed countries those who have worked and made contributions to the state (National Insurance in the UK) are entitled to a state pension
No-one should rely upon this to support them (comfortably) in retirement
The UK basic state pension reached a high of 20% of average earnings in 1980
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The Basic State Pension
Since then it has been indexed to prices not earnings
As real earnings rise its value relative to earnings falls
Pension as a Percentage of Earnings The state pension will not even provide a
subsistence level of income
1980 2000 2050
20 14 7
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Pensions Crisis
Countries around the world are suffering from a pensions crisis
UK Many company schemes are closing Others are in deficit Public sectors workers may have to work longer
US Pension system expected to go into permanent
deficit around 2018
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Population Issues
Life expectancy is increasing
The birth rate is falling A smaller proportion of
workers has to support a increasing proportion of retired
This makes it impossible to sustain current arrangements
1960 1990 2050
France 18.8 20.8 39.1
Japan 9.5 17.1 44.5
UK 17.9 24.0 38.7
US 15.4 19.1 36.8
Dependency Ratio (over 65 to working)OECD
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State Pension Systems
There are two basic forms of state pension system
Fully-funded: the state taxes workers, invests the funds and pays pensions from the investment Pay-as-you-go: taxes on those in work pay the pensions of the current retired
The UK system is pay-as you-go As are most systems
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Pay-As-You-Go
There is a direct link between dependency ratio/tax payment/pension
The budget constraint istW = pR
t = tax, W = no. working, p = pension, R = no. retired
Let D = R/W (the dependency ratio) thent = pD
It is expected to be p that falls as D rises Reliance will be placed on private pensions
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Fully-Funded
A tax t is paid when working This is invested by the pension fund And returned with interest when retirement is
reached The budget constraint of the pension fund is
p = (1 + r)t This is a form of forced saving
Private saving is replaced by state saving Only has an effect if private saving is too low
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Pension Requirements
Pension planning begins with determining requirements
The central issue is the proposed standard of living in retirement Will this be simple in a country retreat? Or active and expensive?
Assume it is decided that £20,000 per year is needed Simplify by ignoring taxation
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Also assume Retirement is at 60 The expected lifespan remaining is 15 years The interest rate is 5%
Then the sum required at retirement is
217970£
05.01
05.0120000
14
15
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1
t
t
S
Pension Requirements
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(Calculation)
Assume savings of S in retirement fund and expenditure of E for two years
At the end of year 1
(S – E)(1+r) If this can finance a second year at E
(S – E)(1+r) = E So S(1 + r)= E + (1 + r)E Giving
1
10
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r
rrES
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Pension Requirements
The general version of this formula is
Where S is the sum required E the expenditure r the interest rate T the expected lifespan
11
1
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1
T
T
t
t
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rES
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For E = £30,000, r = 4% and T = 20 it follows
S = £424,020 Note that these numbers
Leave nothing for bequests Do not guard against a longer lifespan Provide no insurance against inflation or falling
interest rates
Pension Requirements
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Savings Rates
What rate of saving obtains such sums? Assume £400,000 is required Saving for 15 years at a 7% return (from 45 to
60) needs a yearly contribution of
14876£
07.1
40000015
1
t
tC
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Savings Rates
Saving for 25 years at 7% (from 35 to 60) needs a contribution of £5,910
There is a major advantage to early pension planning
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Forms of Pension
There are three categories of pension 1. State Pension
Probably of very limited future value 2. Occupational pensions
Provided to those in employment 3. Private pensions
For those in employment with small firms or who have opted-out
Also uses in addition to occupational For the self-employed
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Occupational Pensions
There are two categories of occupational pension Final salary schemes (defined benefits)
Pension received is a fraction of salary at retirement Money purchase schemes (defined contributions)
Pension is determined by value of accumulated fund The advantage of both these schemes is that
employers contribute and employees contributions are tax-deductible
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Final salary schemes are the most attractiveNow found mostly in the public sectorMany are closed to new employees in
private sectorRisk falls upon the employer (because they
must meet the promises of the scheme)
Occupational Pensions
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Final Salary Scheme Pension is equal to
Where n = number of years of serviceD = 60 or 80
With D = 80, someone working for 40 years obtains ½ final salary
Plus a lump-sum of 2 to 3 times final salary (which is not taxed)
Pension is usually indexed for inflation USS
salary final pension D
n
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Take the USS scheme What is the equivalent private pension fund? Assume salary of £70,000 The lump-sum on retirement is £140,000 Then need an income of £35,000 for 20 years If at 3% this gives a fund of £536,330 Together the total is £676,330
Final Salary Scheme
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Money Purchase Scheme
Contributions to the pension scheme are invested in a fund
On retirement, the fund is used to purchase an annuity An investment paying a fixed sum until death
The value of this form of scheme is uncertain Relies on the return on the fund Depends on annuity rates
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Annuities
An annuity is the purchase of a stream of income flows
The basic annuity will promise to pay a constant income until the purchaser dies
The income for any given price depends on the expected lifespan of the purchaser market conditions at the time of purchase Annuity Rates
Annuities may involve the immediate loss of substantial capital
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Private Pensions
Allow the choice of investment fund Can be transported between employers Have additional flexibility in the final
annuitisation Have to annuitise at least 75% of the fund
But do receive favourable tax treatment on contributions up to a limit on the interest earned by fund
Final value is uncertain
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Final Observations
Much of the UK population does not have adequate pension provision
This will become a major political issue in future years
There is no costless way for society to resolve the problems
Personal provision is required