(no subject)
Question 1
a. If Barbara retires at 62
The compound interest in 7 years when Barbara retires at 62 is (1+6%)^7= 1.504
The amount of money in the savings account is ($37,000+ $60,000)* 1.504 = $ 145,888
The amount of money she will have available at retirement is $ 145,888+$ 112,500 = $ 258,388
If Barbara retires at 65
The compound interest in 10 years when Barbara retires at 65 is (1+6%)^10= 1.791
The amount of money in the saving account is ($37,000+ $60,000)*1.791 = $ 173,727
The amount of money she will have available at retirement is $173,727+$127,500 = $ 301,227
b. If Barbara retires at 62, the annual retirement income form annuity will be $258,388/12.659= $20,411
If Barbara retires at 65, the annual retirement income from annuity will be $301,227/11.118= $27,094
c. The total annual retirement income if Barbara retires at 62 is $20,411+$16,308 = $36,719<45,000
The total annual retirement income if Barbara retires at 65 is $27,094+$20,256 = $47,350>45,000
d. Based on the above calculation, Barbara will not be able to achieve her long-run financial goal if she retires at 62 since the annual retirement income that she can receive from annuity and pension retiring at 62 equals $36,719 which is less than her goal 45,000. However she will be able to achieve her goal if she retires at 65, because her retirement income $47,350 is greater than her financial goal which is $45,000.
e. Given Barbara’s current financial condition (low savings, large proportion of her current available funds derived from the remaining life insurance policy, presumably a low income job as a receptionist in the remaining years of employment), it is more likely to assume that her risk tolerance is low, which implies that she is at the income requirement stage of her life, consequently, she is highly risk-averse in investments. Therefore, a savings account and an annuity, which are totally risk free best, reflect her risk tolerance level.
An important factor to be mentioned here is that all the above calculations have not included any tax consequences and implications associated with the taxable events. For instance, when Barbara sells her house at retirement, she might be entitled to Capital Gain Tax if she purchased the house after 1985 September 20th. Moreover, employer pension and interest earned on savings account are subject to tax as ordinary income.
However, as low risk investments generate low return, it is unlikely for Barbara to fulfill her goal of retirement according to her plan if she retires at 62. To achieve high return of investment - if she decides to retire at 62- a few other investment vehicles can be employed such as investments in shares, managed funds, and property etc.
Shares
Shares generate high returns which associate with relatively high risks. It is considered as having a greater probability of generating returns that beat inflation, i.e. maintaining purchasing power, which indirectly reduces inflation risk. However, it can be influenced by the general economic condition of the country along with market volatility risk, currency risk if invests in share market overseas, and lack of diversification risk.
In this case, given Barbara’s low risk tolerance, it is suggested that she should select shares with low price variation. Along with that, she should invest in several shares across sectors and across countries to achieve good diversification to ensure relatively low risk.
Managed Funds
By becoming a unit holder in the fund through the purchase of units in the fully diversified managed funds, investors will be entitled to the benefits of a pooled investment structure as follows,
- decreased costs associated with investing,
- decreased risk with investment spread across different asset classes
- management of investments by professionals
- increased returns to investors
Meanwhile, investors will be exposed to the charges of the fund management as well as capital gains tax which are passed onto unit holders.
Property
It will be unrealistic for Barbara to invest in a property with the current funds she has right now to enter a mortgage and also, it is hard for her to repay the loan with her current financial situation.
However, balancing the return and risks, it is probably not worthwhile to invest in managed funds and shares as it involves too many risks.
Recommendations
Considering the fact that Barbara is in the close position to her retirement goal and her high risk-aversion level, it is advised that Barbara should therefore construct a portfolio of investment, to ensure risks to be reduced at minimum level, in vehicles like term deposits, Coupon bonds offered by banks, and Cash management trusts to manage the trade-off between risks and returns. Because these asset classes are less than perfectly positively correlated. As such, the risk is reduced with a relatively high return.
By doing so, Barbara can put a certain proportion, say 40% of the current available funds into a fixed term deposit for the next 7 years to earn a high return as interest on term deposit increases with time to maturity compared to interest earned on a savings account. Another 20% of the current available funds into fixed-interest securities i.e. coupon bonds with less risk, and invest the other 40% into Cash Management Trust to hold a diversified portfolio of cash investments to earn more returns.
Another alternative is that if she wants to retire at 62 while achieving her financial goal, assuming she is extremely risk averse, she can start saving up from now on when she is under employment. It is shown in the calculations below,
$45,000 (financial goal) - $ 36,719 (retirement income according to her plan) = $8,281 (extra to be saved up to achieve financial goal)
A=$8,281/[((1.06^7)-1)/0.06]=$986.56
Therefore, she can start saving extra $986.56 from now on every month to achieve her goal in 7 years.
Nevertheless, although she achieves her goal if she retires at 65, still more returns can be generated and get her a better life while invested in relatively low risk and returns investments, such as term deposit.
Part 2
Ё Tom has retired, however, he receives company pension of $6300 a month, adding up to $75,600 a year. Lets assume that pension is considered to be personal income for tax purposes, therefore he falls into the highest bracket of 47% tax rate. Then after progressive rates, he will end up paying $21,256 in tax to the government. Thus, the biggest concern in the analysis is how to minimise tax paid and maximise return.
Ё Tom should realise that investing into cash management funds is risky, however, as an investor he would get a higher return for tolerating the risk. Therefore, Tom should consider investing into a medium risk managed fund (i.e. AXA's Balanced Diversified Fund, providing medium return at medium risk). The advantages of a managed fund are that it has got direct access to equity markets - economies of scale. This decreases the cost to the investor and provides a very-well diversified market portfolio. Besides, because the investment is managed by quantitative specialists and professionals with years of experience in investing, they can reinforce the good performance of managed fund. Lastly, because Tom is going to enjoy "good life". It's unlikely that he is willing to contribute time and energy to manage his investment, then investing in managed fund will relief himself from numerous investment activities.
Ё Also, Tom has cash at bank and in cash management accounts, earning steady return at 5.5% (according to ABS.gov.au). He has residential and investment properties. The rental of the investment property pays of his mortgage. This wasn't a smart thing to do, as Tom can claim deductions on mortgage payments of the negatively geared investment and save money from the property rental. In favorable times investment property generates return and in bad times investment property brings no return. So, only in good times he tends to get income he can actually save up (taxable income)
Ё Based on those assumptions above, we recommend that first Tom has to decide how much proportion of his current assets to invest in management funds. If his after-tax pension is enough to cover his living and tourism expenses, he'll invest $550,000 into cash management funds (see estimations in the end to support the decision made at this point).
Ё Generally, through managed fund, Tom is going to enjoy the benefit of accessing diversified investment with lower risk and higher return. However, Tom should still check the performance of each managed fund and choose the best performing funds. The reason for doing that is to maximimise the diversification. However, an entrance fee is involved (up to 4%), so Tom would have to choose only a couple managed funds. By choosing two, he will only have $506,880 to invest.
Ё As an example of Tom's investment return from managed fund, we assume Tom brought $350,000 2-year UBS Inflation Linked Bond Fund. Based on the table in textbook page 185, we can get the annual return from this fund is 8.17%, management expense ratio is 0.35%. And, because there is no application fee and exit fee, before tax return from this fund is $350,000,000*(1+8.17%-0.35%)=$377,370 and 7.82%. Furthermore, if it is assumed that the transaction happened after 21 september 1999, 50% capital gain will be taxed under his personal tax regime which is 47%. So Tom will be taxed by ($377,370-$350,000)/2*47%=$6432 and therefore his after tax return is $377,370-$6432=$370,938 and 6%.
Ё Finally, because Tom is already very old, it is believed that he prefers short period investment schemes. Depending on Tom's needs he'll be getting returns fortnightly, monthly, quarterly or annually. Let's assume Tom will be getting the returns monthly at 11% p.a., (assume it to be average market interest rate) to add up to his pension total of approximately $55757+$75,600=$131,357 ($10,946 a month) before tax + rental income (assume it to be $2000 a month) = $131357 before tax +$24,000=$58,741 in tax payable to the government.
So, Tom will end up having $155,357-$58,741=$96,616 after tax, which is $8,051 per month after tax. That money can cover his travelling and entertainment expenses easy in good year (good returns on the portfolio +rental property return).
At present, Tom should not hurry to sell his own home or the rental property to release money for investment after he finishes paying off the mortgage. This is because Tom has to pay a large amount of capital gain tax when he sells the properties. In the worst case scenario, when the managed fund performed at loss, Tom can declare it to be an incurred capital loss. At this time, Tom can sell his own home to enjoy this tax benefit (falling into a relatively lower tax bracket). Extra money relieved can be spent on Tom's entertainment.
a. If Barbara retires at 62
The compound interest in 7 years when Barbara retires at 62 is (1+6%)^7= 1.504
The amount of money in the savings account is ($37,000+ $60,000)* 1.504 = $ 145,888
The amount of money she will have available at retirement is $ 145,888+$ 112,500 = $ 258,388
If Barbara retires at 65
The compound interest in 10 years when Barbara retires at 65 is (1+6%)^10= 1.791
The amount of money in the saving account is ($37,000+ $60,000)*1.791 = $ 173,727
The amount of money she will have available at retirement is $173,727+$127,500 = $ 301,227
b. If Barbara retires at 62, the annual retirement income form annuity will be $258,388/12.659= $20,411
If Barbara retires at 65, the annual retirement income from annuity will be $301,227/11.118= $27,094
c. The total annual retirement income if Barbara retires at 62 is $20,411+$16,308 = $36,719<45,000
The total annual retirement income if Barbara retires at 65 is $27,094+$20,256 = $47,350>45,000
d. Based on the above calculation, Barbara will not be able to achieve her long-run financial goal if she retires at 62 since the annual retirement income that she can receive from annuity and pension retiring at 62 equals $36,719 which is less than her goal 45,000. However she will be able to achieve her goal if she retires at 65, because her retirement income $47,350 is greater than her financial goal which is $45,000.
e. Given Barbara’s current financial condition (low savings, large proportion of her current available funds derived from the remaining life insurance policy, presumably a low income job as a receptionist in the remaining years of employment), it is more likely to assume that her risk tolerance is low, which implies that she is at the income requirement stage of her life, consequently, she is highly risk-averse in investments. Therefore, a savings account and an annuity, which are totally risk free best, reflect her risk tolerance level.
An important factor to be mentioned here is that all the above calculations have not included any tax consequences and implications associated with the taxable events. For instance, when Barbara sells her house at retirement, she might be entitled to Capital Gain Tax if she purchased the house after 1985 September 20th. Moreover, employer pension and interest earned on savings account are subject to tax as ordinary income.
However, as low risk investments generate low return, it is unlikely for Barbara to fulfill her goal of retirement according to her plan if she retires at 62. To achieve high return of investment - if she decides to retire at 62- a few other investment vehicles can be employed such as investments in shares, managed funds, and property etc.
Shares
Shares generate high returns which associate with relatively high risks. It is considered as having a greater probability of generating returns that beat inflation, i.e. maintaining purchasing power, which indirectly reduces inflation risk. However, it can be influenced by the general economic condition of the country along with market volatility risk, currency risk if invests in share market overseas, and lack of diversification risk.
In this case, given Barbara’s low risk tolerance, it is suggested that she should select shares with low price variation. Along with that, she should invest in several shares across sectors and across countries to achieve good diversification to ensure relatively low risk.
Managed Funds
By becoming a unit holder in the fund through the purchase of units in the fully diversified managed funds, investors will be entitled to the benefits of a pooled investment structure as follows,
- decreased costs associated with investing,
- decreased risk with investment spread across different asset classes
- management of investments by professionals
- increased returns to investors
Meanwhile, investors will be exposed to the charges of the fund management as well as capital gains tax which are passed onto unit holders.
Property
It will be unrealistic for Barbara to invest in a property with the current funds she has right now to enter a mortgage and also, it is hard for her to repay the loan with her current financial situation.
However, balancing the return and risks, it is probably not worthwhile to invest in managed funds and shares as it involves too many risks.
Recommendations
Considering the fact that Barbara is in the close position to her retirement goal and her high risk-aversion level, it is advised that Barbara should therefore construct a portfolio of investment, to ensure risks to be reduced at minimum level, in vehicles like term deposits, Coupon bonds offered by banks, and Cash management trusts to manage the trade-off between risks and returns. Because these asset classes are less than perfectly positively correlated. As such, the risk is reduced with a relatively high return.
By doing so, Barbara can put a certain proportion, say 40% of the current available funds into a fixed term deposit for the next 7 years to earn a high return as interest on term deposit increases with time to maturity compared to interest earned on a savings account. Another 20% of the current available funds into fixed-interest securities i.e. coupon bonds with less risk, and invest the other 40% into Cash Management Trust to hold a diversified portfolio of cash investments to earn more returns.
Another alternative is that if she wants to retire at 62 while achieving her financial goal, assuming she is extremely risk averse, she can start saving up from now on when she is under employment. It is shown in the calculations below,
$45,000 (financial goal) - $ 36,719 (retirement income according to her plan) = $8,281 (extra to be saved up to achieve financial goal)
A=$8,281/[((1.06^7)-1)/0.06]=$986.56
Therefore, she can start saving extra $986.56 from now on every month to achieve her goal in 7 years.
Nevertheless, although she achieves her goal if she retires at 65, still more returns can be generated and get her a better life while invested in relatively low risk and returns investments, such as term deposit.
Part 2
Ё Tom has retired, however, he receives company pension of $6300 a month, adding up to $75,600 a year. Lets assume that pension is considered to be personal income for tax purposes, therefore he falls into the highest bracket of 47% tax rate. Then after progressive rates, he will end up paying $21,256 in tax to the government. Thus, the biggest concern in the analysis is how to minimise tax paid and maximise return.
Ё Tom should realise that investing into cash management funds is risky, however, as an investor he would get a higher return for tolerating the risk. Therefore, Tom should consider investing into a medium risk managed fund (i.e. AXA's Balanced Diversified Fund, providing medium return at medium risk). The advantages of a managed fund are that it has got direct access to equity markets - economies of scale. This decreases the cost to the investor and provides a very-well diversified market portfolio. Besides, because the investment is managed by quantitative specialists and professionals with years of experience in investing, they can reinforce the good performance of managed fund. Lastly, because Tom is going to enjoy "good life". It's unlikely that he is willing to contribute time and energy to manage his investment, then investing in managed fund will relief himself from numerous investment activities.
Ё Also, Tom has cash at bank and in cash management accounts, earning steady return at 5.5% (according to ABS.gov.au). He has residential and investment properties. The rental of the investment property pays of his mortgage. This wasn't a smart thing to do, as Tom can claim deductions on mortgage payments of the negatively geared investment and save money from the property rental. In favorable times investment property generates return and in bad times investment property brings no return. So, only in good times he tends to get income he can actually save up (taxable income)
Ё Based on those assumptions above, we recommend that first Tom has to decide how much proportion of his current assets to invest in management funds. If his after-tax pension is enough to cover his living and tourism expenses, he'll invest $550,000 into cash management funds (see estimations in the end to support the decision made at this point).
Ё Generally, through managed fund, Tom is going to enjoy the benefit of accessing diversified investment with lower risk and higher return. However, Tom should still check the performance of each managed fund and choose the best performing funds. The reason for doing that is to maximimise the diversification. However, an entrance fee is involved (up to 4%), so Tom would have to choose only a couple managed funds. By choosing two, he will only have $506,880 to invest.
Ё As an example of Tom's investment return from managed fund, we assume Tom brought $350,000 2-year UBS Inflation Linked Bond Fund. Based on the table in textbook page 185, we can get the annual return from this fund is 8.17%, management expense ratio is 0.35%. And, because there is no application fee and exit fee, before tax return from this fund is $350,000,000*(1+8.17%-0.35%)=$377,370 and 7.82%. Furthermore, if it is assumed that the transaction happened after 21 september 1999, 50% capital gain will be taxed under his personal tax regime which is 47%. So Tom will be taxed by ($377,370-$350,000)/2*47%=$6432 and therefore his after tax return is $377,370-$6432=$370,938 and 6%.
Ё Finally, because Tom is already very old, it is believed that he prefers short period investment schemes. Depending on Tom's needs he'll be getting returns fortnightly, monthly, quarterly or annually. Let's assume Tom will be getting the returns monthly at 11% p.a., (assume it to be average market interest rate) to add up to his pension total of approximately $55757+$75,600=$131,357 ($10,946 a month) before tax + rental income (assume it to be $2000 a month) = $131357 before tax +$24,000=$58,741 in tax payable to the government.
So, Tom will end up having $155,357-$58,741=$96,616 after tax, which is $8,051 per month after tax. That money can cover his travelling and entertainment expenses easy in good year (good returns on the portfolio +rental property return).
At present, Tom should not hurry to sell his own home or the rental property to release money for investment after he finishes paying off the mortgage. This is because Tom has to pay a large amount of capital gain tax when he sells the properties. In the worst case scenario, when the managed fund performed at loss, Tom can declare it to be an incurred capital loss. At this time, Tom can sell his own home to enjoy this tax benefit (falling into a relatively lower tax bracket). Extra money relieved can be spent on Tom's entertainment.