It had been a good day for Bob Boomer. He had celebrated his fiftieth birthday with a few beers with some of his programmer friends at the Los Altos Bar and Grill, dropped in at Fry's in Palo Alto to check out some new software, then gone back to his apartment in Cupertino to read over material related to the benefits for which he had just become eligible.
Bob had been hired a year earlier as a software engineer by the William David Company (WD), a major player in the computer industry. His skills in C++ had made him attractive to WD, and he was delighted to be in a firm with both a solid position in the industry and a reputation for openness and concern for its employees. The word in Silicon Valley was that no good employee would ever be laid off by WD.
Bobs gross salary before any deductions was $100,000 per year. He expected that his salary would increase at roughly the rate of inflation until he chose to retire.
Bob's financial situation was adequate but not what it might have been. Two divorces had taken their toll, financially and otherwise. Prior to a year ago he had devoted all his time and much of his money to a start-up that had turned out badly. As a result, he had no savings other than approximately $10,000 in the bank and a Certificate of Deposit worth $10,000 that would come due at the end of the month.
Bob's major tangible assets were his new Jeep Grand Cherokee, for which he had paid $36,000 in cash a month earlier and his year-old 28 foot Bayliner cabin cruiser, for which he had paid $55,000.
His expenses were typical for a programmer in Silicon Valley. His rented a rather luxurious one-bedroom apartment for $2,000 per month. He liked to eat out, but preferred Armadillo Willy's ribs to Madalena's haute cuisine. He had resolved to never marry again. For recreation he liked to play Doom on the internet and talk with his friends about java applets at Starbuck's. He seldom attended operas or concerts. Now that he was eligible for vacations he planned to spend some time in Cabo San Lucas, a resort in Mexico only three hours away by plane. In addition to the usual recurring payments, he paid $150 per month for his boat slip at Peninsula Marina.
The William David Plans
WD provided two retirement plans: the Basic Retirement Plan (BRP) and the Supplemental Retirement Plan (SRP). The former was a traditional defined-benefit plan in which the amount ultimately received by the participant was not a function of investment returns, while the latter was a defined contribution plan in which the amount received by the participant depended on investment performance.
The Basic Retirement Plan
The cost of the Basic Retirement Plan was borne entirely by WD. The plan guaranteed a minimum retirement benefit in the form of monthly income at age 65 according to the following formula:
(1.5% times Average Monthly Salary in Final Year) less $40 times Years of Credited Service
For example, if an employees final year average pay rate at age 65 were $10,000 per month, the first term would be:
(0.015* $10,000) - $40 = $110
If she had 25 years of credited service, the total benefit would then be:
$110 * 25 = $2,750 per month.
or $33,000 per year.
An employee who retired at or after age 65 could elect to receive a lifetime annuity based on this formula. One who retired at an earlier age could elect to receive payments immediately or wait until reaching any age up to 65. The amount paid would be a percentage of the benefit determined by the formula, with the percentage greater, the later the age at which payments began:
Age when annuity payments begin Percent of BRP benefit 65 or over 100 percent 64 93.33 percent 63 86.67 percent 62 80.00 percent 61 73.33 percent 60 66.67 percent 59 63.33 percent 58 60.00 percent 57 56.67 percent 56 53.33 percent 55 50.00 percent
Instead of taking the BRP benefit in the form of an annuity, a participant could elect to receive a single lump sum calculated using a factor determined at the time by the Pension Benefit Guaranty Corporation. The relevant factor would depend on the age of the participant and current levels of interest rates. Some typical examples were:
Age 4% 5% 6% 7% 8% 55 174 157 143 131 121 60 154 141 130 120 111 65 134 123 115 107 100
Thus, if the applicable interest rate were 6% and the monthly benefit were $3,000, a 65-year old participant could elect to receive a lump sum payment of 115*$3,000, or $345,000.
Whether taken as annuity payments or as a lump sum, all money received from defined benefit plans such as the Basic Retirement Plan were subject to standard income tax rates (although lump sums could be rolled over to other types of investment accounts from which only the amounts withdrawn would be subject to income taxes).
The Supplemental Retirement Plan
The SRP qualified for advantageous tax treatment under section 401(k) of the U.S. Internal Revenue Code. Amounts contributed by an employee to the plan would be deducted from the employees taxable income. Moreover, no taxes would be paid on income or capital gains left in the account. However, any amounts withdrawn would be treated as ordinary income and taxed accordingly. Under the regulations in effect at the time, amounts withdrawn prior to age 59 ½ other than for reasons of hardship would be subject to an additional tax of 10%.
WD allowed participants in the SRP plan to borrow up to 50% of their account balance, but no more than $50,000.
After one year with the company, employees could choose whether or not to participate in the plan The benefits office had informed Bob that he could elect to contribute up to 8% of his gross pay each month and that WD would match his contributions dollar-for-dollar up to an amount equal to 4% of his pay.
At retirement, the total value of the SRP could be taken as a lump-sum payment. Alternatively, some or all of it could be rolled into an Individual Retirement Account (IRA) selected by the participant. In general, amounts received by the individual either as lump sum distributions or as subsequent withdrawals from an IRA account would be taxed at standard income tax rates. The tax laws also mandated specified minimum withdrawals after age 70 ½.
Participants in the SRP were allowed to allocate their contributions among the following nine investment alternatives:
New contributions could be allocated in any desired proportions. Participants were also allowed to change the allocations of funds in the account at any time. There were no fees associated with investment, withdrawal, or re-allocations.
Each of the funds was also available for direct investment by anyone, although "retail investors" were sometimes charged "front-end load" fees ranging from 3% to over 5% which were not required for investment via the SRP. WD stock could also be purchased directly. It had performed very well recently, as had most stocks in the technology sector. Bob had been told that due to a conservative financial structure, WD shares were considered to be no more vulnerable to a market decline than those of the average U.S. corporation.
Bob had looked for information about the funds on the World Wide Web. He found detailed information on the Fidelity funds at Fidelity's mutual fund site. In addition, he found that he could obtain a great deal of information about all the funds with the exception of Fidelity Cash Reserves at the Morningstar site, after registering (for which there was no charge), using the following ticker symbols:
Fund Ticker Fidelity Intermediate Bond FTHRX Fidelity Market Index FSMKX Fidelity Growth and Income FGRIX Fidelity Magellan FMAGX Fidelity Contrafund FCNTX Templeton Foreign PBHGX PBHG Growth TEMFX
A friend had also suggested that he check out the Advisor Software Site to get further information concerning the "style" of each of the funds and the recent performance of each one, relative to that of an unmanaged portfolio with a similar style.
One of the great unknowns was the future viability of the Social Security system. If the current schedule of benefit payments were maintained, Bob would be eligible for a significant annuity. The actual magnitude would depend both on the age at which he elected to begin receiving payments and the rate of inflation. According to one article that he had read, the income per year for someone in his generation if there were no further inflation would be roughly:
Age Income 62 $ 12,000 63 $ 13,000 64 $ 14,000 65 $ 15,000 66 $ 16,500 67 $ 18,000
The actual amount was scheduled to increase with inflation. The article indicated that to determine the amount paid in any future year, the "zero-inflation amount" (above) should be multiplied by the ratio of the estimated Consumer Price Index at the time to its current level.
The article indicated that it would be very difficult for the society to make good on these obligations for Bobs generation, since the ratio of active workers to those receiving social security payments would fall significantly as the "baby boomers" moved into retirement. Despite this concern, little was being said by politicians about this problem. The received wisdom was that social security was "sacred" and thus not subject to debate.
Bob enjoyed his job at WD and expected to work there for the rest of his career. He hoped to retire in his sixties -- preferably in his early sixties. Given advances in communications technology he was certain that fast internet connections would soon be available via satellite almost everywhere. He figured that a comfortable house near the beach in Cabo San Lucas, a state-of-the art computer, internet access and some money for entertainment would be all that he would need to live out the rest of his days with gusto. At current price levels, he estimated that he could accomplish this with $60,000 per year before taxes. Since the economy in Cabo San Lucas was virtually dollar-based, he figured that the actual cost would move more or less one-to-one with inflation in the U.S..
Bob had assumed that he could find material on the World Wide Web that would help him analyze his situation. After a short period with the usual search engines, he turned up five promising sites:
However, these seemed to be somewhat limited in scope. At the suggestion of a friend, he had also identified a worksheet produced by an academic economist:
All the retirement planning software that Bob had discovered had required the user to input projections for the return (and, in one case, the risk) of an investment strategy. This presented a serious problem. He found some historic data one of the pages provided at the T. Rowe Price site. This helped, but covered periods of different lengths and Bob was unclear concerning the most relevant for making projections concerning future returns. Fortunately, one of his neighbors had recently spent a great deal of time (and money) with a financial planner. She said that the planner had made the following estimates for an "average year":
Inflation 3 % Short-term Investments 5 % Stocks 10 %
The planner had pointed out that short-term investments tended to track inflation quite closely, but that the difference between the return on stocks and inflation could vary considerably from year to year. While in an average year the "real return" on stocks was projected to be 7% (10% - 3%), in any given year, the actual real return might be very different. The planner's estimate was that in two years out of three, the real return on stocks would fall in a range from -8% (=7%-15%) to 22% (=7%+15%).
Bob felt that it was time to make two major decisions:(1) how much to contribute to the SRP and (2) how to allocate his contributions among the available funds. It was a beautiful evening. He poured a glass of Kendall Jackson sauvignon blanc, made certain that the batteries on his computer and wireless modem were fully charged, and headed for the spa. He looked forward to enjoying the stars above and the lights of Silicon Valley below while working on his future. He figured that the better the decisions he made, the sooner would he be on the beach in Cabo San Lucas, sipping a cerveza and listening to the mariachis.
This case was written by Prof. William F. Sharpe, STANCO 25
Professor of Finance, Stanford University.
Current version: July 13, 1997
Site URL Advisor Software Site http://www.fundstyle.com Fidelity's mutual fund site http://personal12.fidelity.com/products/funds The Fidelity Retirement Planning Calculator http://personal.fidelity.com/fidbin/retire_image?00 Morningstar site http://www.morningstar.net/Cover/Invest.html The Quicken Retirement Planner http://www.quicken.com/retirement/planner T. Rowe Price site. http://www.troweprice.com/retirement/historical.html The T. Rowe Price Retirement Page http://www.troweprice.com/retirement/index.html The Vanguard Retirement Center http://magestic.vanguard.com/RRC/DA W. F. Sharpe's Retirement Planning Worksheet http://sharpe.stanford.edu/ws_ret.htm