Retirement Planning: Asset Returns & Risk

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Questions and Answers

Explain how an individual's savings rate during their working life affects the amount of funding needed for their retirement plan.

A higher work life savings rate reduces the amount of retirement plan funding required because more savings accumulated during the working years means less reliance on investment returns during retirement.

Describe the 'Try new things' stage of retirement and provide an example of an activity someone might pursue during this phase.

This stage involves exploring new hobbies, interests, or skills that the retiree didn't have time for during their working life. An example would be learning a new language or taking up painting.

Explain the purpose of a Monte Carlo Analysis in retirement planning and what success rate is generally desired.

A Monte Carlo Analysis predicts the likelihood of a financial plan's success by running numerous simulations with varying assumptions. A success rate greater than 90% is generally desired to indicate a robust plan.

List three potential sources of income during retirement and briefly describe the tax implications of each.

Social Security (taxable), Company-sponsored retirement plans (tax deferred), and Personal savings (taxable). Signup and view all the answers

Explain the difference between the top-down and bottom-up approaches to retirement planning.

The top-down approach estimates retirement needs based on a wage replacement ratio. The bottom-up approach involves creating a detailed budget of specific retirement expenses. Signup and view all the answers

Identify three common expenses that an individual might eliminate or significantly reduce once they retire.

Mortgage payment, payroll taxes, savings expense. Signup and view all the answers

What is the primary goal of calculating a wage replacement ratio in retirement planning, and what percentage range is typically targeted?

To determine the percentage of pre-retirement income needed to maintain a similar lifestyle during retirement. Typically, a range of 60-80% is targeted. Signup and view all the answers

Describe the potential emotional impact of the 'Lose your identity' stage of retirement, and suggest a strategy for mitigating this effect.

This stage involves a loss of purpose and self-worth due to no longer being defined by one's job. Mitigating strategies include volunteering or pursuing a long-desired passion or hobby. Signup and view all the answers

Explain how the Rule of 72 can be applied in retirement planning, and provide a specific example.

The Rule of 72 estimates the time it takes for an investment to double at a fixed annual rate of return. Divide 72 by the annual rate of return to get the approximate number of years to double your money. For example, at a 9% return, it will take approximately 8 years for the investment to double. This can help plan savings goals. Signup and view all the answers

Differentiate between the average annual rate of return and the average annual real rate of return. Why is the real rate of return more important for retirement planning?

The average annual rate of return is the nominal return on an investment, while the average annual real rate of return adjusts for inflation. Real rate of return is more important because it reflects the actual purchasing power of investment gains, which is essential for maintaining living standards in retirement. Signup and view all the answers

Describe what Value at Risk (VAR) measures and explain how it can be used to assess the risk associated with different asset classes in a retirement portfolio.

Value at Risk (VAR) estimates the potential loss in value of an asset or portfolio over a specific period, for a given confidence level (typically 95%). It helps to understand the worst-case scenario for investments, informing decisions about risk tolerance and asset allocation in a retirement portfolio to mitigate potential losses. Signup and view all the answers

Currently, what percentage of workers have less than $25,000 in total savings and investments (excluding defined benefit (DB) plans and home equity)? What implications does this have for retirement planning?

34% of workers have less than $25,000 in savings and investments. This highlights a significant lack of retirement preparedness for a substantial portion of the workforce, indicating a future need for increased savings rates, delayed retirement ages, or reliance on social security. Signup and view all the answers

Explain how standard deviation provides insight into the risk of an asset, and how this information can be used in the construction of a retirement portfolio.

Standard deviation measures the volatility of an asset's returns; a higher standard deviation indicates greater risk. In portfolio construction, it helps to balance risk and return by diversifying across assets with different standard deviations to achieve a desired level of portfolio volatility. Signup and view all the answers

Describe the three key components of being 'financially prepared' for retirement.

Being financially prepared for retirement involves: (1) having sufficient accumulated assets; (2) having an appropriate investment plan; and (3) having a sound distribution plan (e.g., the 4% rule). Signup and view all the answers

Explain the 'top-down approach' to financial planning for retirement needs.

The top-down approach starts with broad economic and market forecasts to determine overall asset allocation, then selects specific investments. This approach may not be suitable for all investors. Signup and view all the answers

If the average annual rate of return for large cap stocks is 10%, what is the 95% confidence interval?

The 95% confidence interval is -30% - 50%. This demonstrates a wide range of potential outcomes. Signup and view all the answers

Cedric earns $130,000 per year and expects raises to match inflation. After estimating his retirement income requirements at $82,000 per year in today's dollars, he calculates a future value of $141,301.94 after 18 years. Assuming a cost of living adjustment, what present value (how much does he need at retirement) does Cedric need to fund a 25-year retirement?

$2,557,008.29 Signup and view all the answers

Rochelle, age 30, aims to retire early. She earns $120,000 annually and can live on $35,000 after taxes. Assuming a 6% investment return and 4% inflation, how much money will Rochelle need saved at retirement to fund her retirement, if she plans to retire in 10 years and live until age 98?

$1,836,210.54 Signup and view all the answers

Continuing with Rochelle's scenario, she currently has $39,500 saved. Given her income, expenses, and savings, can she retire in 10 years? What annual amount does she need to save?

$51,400 Signup and view all the answers

Lynda, 35, earns $150,000 annually and wants to retire at 57. After 40% in taxes, she spends $52,000 annually. With $230,000 saved, how much must she save yearly, assuming an 8% investment return and 4% inflation? Describe the overall process for this calculation.

The question requires a multi-step process: determining the wage replacement needed, inflating it to the retirement year, calculating the present value of the annuity required during retirement, and then finding the annual savings needed to reach that goal. Signup and view all the answers

Explain how inflation impacts retirement planning. Provide a specific example of how it affects the calculation of retirement needs.

Inflation increases the cost of living over time, meaning more money will be needed in the future to maintain the same standard of living. For example, if someone needs $50,000 per year today, they will need significantly more in 20 years due to inflation. Signup and view all the answers

How does an individual's risk tolerance influence their retirement investment strategy, and what are the potential trade-offs?

A higher risk tolerance may lead to investing in assets with higher potential returns, like stocks, but also greater volatility. Lower risk tolerance may result in safer, lower-return investments, potentially impacting the ability to reach retirement goals. Signup and view all the answers

Describe the concept of 'wage replacement ratio' and why it is important in retirement planning.

The wage replacement ratio is the percentage of pre-retirement income needed to maintain the same standard of living in retirement, typically around 70-90%. It helps determine how much income a retiree will need. Signup and view all the answers

What are some strategies to mitigate the risk of outliving one's retirement savings?

Strategies include delaying retirement, increasing savings, reducing expenses, working part-time in retirement, and considering annuities or other guaranteed income sources. Signup and view all the answers

Explain why a 403(b) plan, while sharing similarities with qualified plans, is not considered a qualified plan under the IRC.

A 403(b) plan is similar to qualified plans but does not have to follow ERISA rules. Signup and view all the answers

What criteria defines a 'key employee' in the context of retirement plans, and why is identifying them important?

A key employee is defined as someone who is either a greater than 5% owner, a greater than 1% owner making over $150,000 per year, or an officer making over $215,000 per year. Identifying them is important because it affects top-heavy plan rules. Signup and view all the answers

From an administrative perspective, why might a plan sponsor choose to delay the participation of younger employees or those in their initial years of employment in a qualified plan?

Delaying participation can reduce administrative costs and plan contributions for employees with higher turnover rates. Signup and view all the answers

Besides satisfying other coverage test criteria, what specific coverage requirement must a defined benefit plan meet daily throughout the plan year?

A defined benefit plan must also cover the lesser of 50 employees or 40% of all eligible employees each day of the plan year. Signup and view all the answers

If a company's defined contribution (DC) retirement plan is considered top-heavy, what specific contribution must be made to the accounts of non-key employees?

The company must contribute 3% of each non-key, non-excludable employee's salary to their retirement account. Signup and view all the answers

Explain why the statement that a defined benefit plan must cover everyone who is 21 years old and has completed one year of service is false regarding qualified plan coverage requirements.

It's false because this statement describes the standard eligibility rule, not the coverage rules. Signup and view all the answers

In a top-heavy defined benefit (DB) plan, how does the vesting schedule and minimum benefit requirements change, compared to a non-top-heavy DB plan?

The vesting schedule must meet DC plan standards (2-6 year graded or 3-year cliff vesting), and a minimum benefit equal to 2% * years of service (max 10) * average annual salary must be provided. Signup and view all the answers

What are the two limitations on the maximum annual benefit that can be received at retirement from a defined benefit (DB) plan?

The maximum annual benefit is the lesser of $265,000 or the average of the employee's three consecutive highest earning years. Signup and view all the answers

List four essential elements that define a qualified tax-advantaged retirement plan.

Plan documentation, employee vesting, broad employee participation, and effective employee communications. Signup and view all the answers

Provide two reasons for employers to postpone employee eligibility in a retirement plan.

Delaying eligibility can reduce costs and simplify administration, especially with high employee turnover. Signup and view all the answers

An employee is 52 years old in 2023. What are the two limitations to the amount that can be contributed to a defined contribution (DC) plan, including both employer and employee contributions?

The contribution is limited to the lesser of 100% of the employee's annual compensation or $73,500 ($66,000 + $7,500 catch-up contribution). Signup and view all the answers

What are the advantages of having a more restrictive vesting schedule for a qualified retirement plan?

Reducing costs related to employee turnover and improving employee retention. Signup and view all the answers

Briefly describe the primary goal of the SECURE 2.0 Act of 2022.

The primary goal of the SECURE 2.0 Act is to encourage and help people save money for retirement. Signup and view all the answers

An employer sponsors a qualified profit-sharing plan. Out of 200 non-excludable employees, 150 are non-highly compensated (NHC) and 50 are highly compensated (HC). The plan covers 110 of the NHC employees and 15 of the HC employees. Does this plan meet the coverage requirements based on the ratio percentage test? Explain your answer.

Yes, the plan meets the coverage requirements. The percentage of NHC covered is 73.33% (110/150), while the percentage of HC covered is 30% (15/50). Since 73.33%/30% is greater than 70%, the plan passes the ratio percentage test. Signup and view all the answers

Name two advantages of choosing a restrictive vesting schedule for a qualified plan.

Reduced costs attributable to employee turnover and enhanced employee retention. Signup and view all the answers

Explain why a 403(b) plan is not considered a qualified plan.

A 403(b) plan is a tax-advantaged plan, but not necessarily qualified under ERISA like 401(k) plans are, leading to differences in regulations and requirements. Signup and view all the answers

Flashcards

Wage Replacement Ratio

The percentage of income replaced by retirement savings.

Bottom-Up Approach

A detailed estimate of retirement needs through budgeting.