Discussion Question – In the reflection exercise, please read the article attached and share with your colleagues your analysis of its content and, to the extent you can, the impact the paper had on your understanding of the concept of proactive and strategic retirement planning.

### Accumulating Capital for Retirement

Our lecture this week focused on retirement needs analysis – determination of the income amount needed to sustain a chosen retirement lifestyle. Sources for this income were then determined. These sources were shown to be Social Security benefits, pensions income, and your own retirement savings and investments. Some potential retirees also may opt to include income from part-time employment, which is not discussed here.

Of the three sources of retirement income, you have very little control over the first two, Social Security and pension income, in many respects. You have some options about taking or not taking early retirement, and you may be agreeable to working beyond the typical retirement age of 65, therefore postponing current benefits for larger benefits later. And some potential retirees generally have distribution option choices.

The one source of retirement income over which you have the most practical control, then, is retirement savings and investments; this is a matter on which you and your investment portfolio manager can establish a long mutually beneficial relationship.

This article considers approaches to the accumulation of retirement savings and investments. A number of general strategies are reviewed, and then tax-deferred IRAs, rollover IRAs, 403(b)s, and 401(k)s are discussed.

### General Strategies to Accumulate Retirement Income Sources

1^{st} Strategic option: Begin investing early. In accumulating a pool of capital to support retirement income, the first principle is to begin as early as possible, even if the amounts are small. This practice creates an opportunity for an accumulating investment fund to receive the benefits of compounding. For example, as discussed in class, if from age 25 to 65 you invest $300 a month (at a 9% return), then at age 65 you will have a nest egg of $1.4 million. The initial investment and rate of return is the same, so the difference is due to investing early, thereby allowing for significant compounding of the investment. And, of course, time is something that can never be recovered.

Impediments to following this advice are many, including the need to accumulate capital for a home purchase, for a child’s college education, and so forth. While these other needs are important, they should not stop you from accumulating retirement capital. Because of the power of compounding, there are particular advantages for people in their 20s of starting to invest for retirement. It is easy for them to dismiss retirement planning because retirement is so far away. However, because they have so much time, a small investment at their age can grow to a sizeable amount by the time the reach retirement age. Also, at their age, they can accept the risks of common stock investing so, over time, they can benefit from higher returns offered by stocks. The amount accumulated will be even greater if their contributions are matched to some degree by their employer in an employer-sponsored plan. Taking advantage of any matching contribution by an employer should be a priority. In addition, a retirement plan allows the investment to grow tax-deferred which will increase the amount accumulated at retirement.

2^{nd} Strategic option: Invest regularly. Beginning a program of capital accumulation is, by definition, just a first step. Accumulation typically requires a good return on initial investment and additional injections of capital over time. Accumulating large pools of capital is accomplished through a great number of small contributions. Therefore, taking advantage of IRAs and salary reduction plans, such as 401(k) or the 403(b), or simply dollar cost averaging a good mutual fund makes so much sense.

The mathematics of compounding underscores the need to begin early and stay with it. IRAs, 403(b) plans, and 401(k) plans all functions with regular investing as their hallmark. The longer you delay the start of an accumulation program, the greater the amounts you must come up with as retirement draws near. As time passes, the job of funding a retirement program becomes progressively more difficult. The figure below indicates the amount that must be invested at the end of each year at 8% (compounded annually) to accumulate a retirement nest egg of $1 million, given six different time horizons. The first alternatives, $8,827 for 30 years at 8% yield, seems the most manageable.

3^{rd} Strategic option: Reduce taxes and other expenses on accumulating assets. Reducing taxes and expense drag on your return and wealth is a proven method for accumulating retirement capital more quickly. Taxes tend to push back your investment returns 3 steps for every 10 you take forward. Worse, every dollar of investment return taken away by taxes is a dollar that fails to be reinvested gainfully by you, putting a damper on the power of compounding.

Example: Nyla, age 21, is in a combined state and federal tax bracket of 30%. Since Nyla’s investment rate is 10% annually (all currently taxable), she is actually earning only 7% after taxes. Losing 3% each year may not seem a lot, but over long periods of time, this small amount reduces the total value of her portfolio remarkably. The graph below illustrates the long-term effect of this taxation level on Nyla’s $1,000 lump-sum investment over 20 years. The orange line represents a 10% compound annual rate of return; the blue line represents a 7% return.

After 20 years, Nyla’s portfolio will have grown by an additional $2,858 if she reinvests her total return instead of paying out 30% of it in taxes.

This example demonstrates the benefit of compounding made possible in tax-deferred accounts: IRAs, 403(b)s, and 401(k)s. In all of these accounts, funds accumulate free of taxation, although distributions are subject to income taxation.

In this case, Nyla, a Bowie State University student, made a single, lump-sum contribution of $1,000 to her 401(k). This represent income on which she was able to defer current taxes. Most retirement savers make regular, periodic contributions month after month. Because Nyla is only in her 20s, she should consider investing in a growth stock mutual fund via her 401(k) plan.

4^{th} Strategic option: Allocate assets appropriately. How the assets of a portfolio are allocated among different asset classes is the prime determinant of the portfolio’s return over time. Therefore, the preretirement accumulation period and the retirement period itself call for conscientious asset allocation decisions. Although simplistic, two rules of thumb are as follow:

- Seek greater returns when volatility will be most acceptable to you, that is, when your need to draw on that capital is far in the future.
- Seek greater safety when the time for drawing on that capital is near.

Another practical consideration when allocating assets is deciding what are the best investments to place in a retirement account and which are the best to hold outside a retirement account. Before addressing this question, keep in mind that any investment must be suitable and appropriate for you, be a correct “fit” for the portfolio, and have investment merit of its own (that is, it should add value to the portfolio through higher return, or lower risk, and/or more diversification; and not duplicate what is in the portfolio already.

Although the answer to the above question depends on the individual’s circumstances, there are some guidelines to follow. In general, the most tax-inefficient investments should be sheltered in a tax-deferred or Roth retirement account, while the most tax-efficient investment should be held outside such an account. Tax-inefficient investments are those that, in particular, generate dividends and capital gains taxed at ordinary income tax rates. Specifically, this would include dividends that are not “qualified” and short-term capital gains. A prime example of an investment that pays nonqualified dividends is a real estate investment trust (REIT) or a REIT mutual fund.

### Investing in Mutual Funds

**CalculatingNet Asset Value.**

Given the following information, calculate the net asset value for the

**Boston Equity mutual fund.**

Total assets |
$966 million |

Total liabilities |
6 million |

Total number of shares |
38 million |

**Calculating Sales Fees.**

Nyla invested $1,000 in a mutual fund. The fund charges a 5 percent commission when shares are purchased. Calculate the amount of commission Nyla must pay.

**Determining Management Fees.**

Nyla invested a total of $1,000 in an another mutual fund. The management fee for this particular fund is 0.25 percent of the total asset value. Calculate the management fee Nyla must pay this year.

**Calculating 12b-1 Fees.**

Nyla’s parents owns shares in a Small Cap fund that has a current value of $10,000. The fund charges an annual 12b-1 fee of 0.50 percent. What is the amount of the 12b-1 fee Nyla parents must pay?

**Finding Total Return.**

Assume that one year ago, Nyla bought 10 shares of a mutual fund for $25 per share, she received an income dividend of $0.10 cents per share and a capital gain distribution of $0.50 cents per share during the past 12 months. Also assume the market value of the fund is now $30 a share. Calculate the total return for this investment if Nyla were to sell it now

**Finding Percentage of Total Return.**

Given the information in problem 5, calculate the percent of total return for Nyla’s $250 investment.

**Using Dollar Cost Averaging.**

Over a four-year period at Bowie State University, Nyla purchased shares in a mutual fund. Using the following information, answer the questions below.

Year |
Investment Amount |
Price per share |

2020 |
$3,000 |
$40 per share |

2021 |
$3,000 |
$45 per share |

2022 |
$3,000 |
$42 per share |

2023 |
$3,000 |
$50 per share |

- Atthe end offour years, what is the total amount invested?
- Atthe end of four years, what is the total number of mutual fund shares purchased?
- Atthe end offour years, what is the average cost for each mutual fund share?

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