Old Alfred Road, who is well-known to drivers on the Maine Turnpike, has reached

Question

Old Alfred Road, who is well-known to drivers on the Maine Turnpike, has reached his seventieth birthday and is ready to retire. Mr. Road has no formal training in finance but has saved his money and invested carefully.

Mr. Road owns his home—the mortgage is paid off—and does not want to move. He is a widower, and he wants to bequeath the house and any remaining assets to his daughter.

He has accumulated savings of $180,000, conservatively invested. The investments are yielding 9% interest. Mr. Road also has $12,000 in a savings account at 5% interest. He wants to keep the savings account intact for unexpected expenses or emergencies.

Mr. Road’s basic living expenses now average about $1,500 per month, and he plans to spend $500 per month on travel and hobbies. To maintain this planned standard of living, he will have to rely on his investment portfolio. The interest from the portfolio is $16,200 per year (9% of $180,000), or $1,350 per month. Assume that the investment portfolio continues to yield a 9% rate of return and that the inflation rate will be 4%.

Mr. Road will also receive $750 per month in Social Security payments for the rest of his life. These payments are indexed for inflation. That is, they will be automatically increased in proportion to changes in the consumer price index.

Mr. Road’s main concern is with inflation. The inflation rate has been below 3% recently, but a 3% rate is unusually low by historical standards. His Social Security payments will increase with inflation, but the interest on his investment portfolio will not.

Question

1. What advice do you have for Mr. Road? Can he safely spend all the interest from his investment portfolio? How much could he withdraw at year-end from that portfolio if he wants to keep its real value intact?

2. Suppose Mr. Road will live for 20 more years and is willing to use up all of his investment portfolio over that period. He also wants his monthly spending to increase along with inflation over that period. In other words, he wants his monthly spending to stay the same in real terms. How much can he afford to spend per month?

Explanation / Answer

Monthly Yearly Basic Living Expenses 1500 18000 Travel and Hobbies 500 6000 Total 2000 24000 Accumulated Savings 180000 Interest 0.09 Interest(Amt) 16200 1350 Monthly Saving accounts 12000 Interest 0.05 Interest(Amt) 600 50 Monthly Social Security payments 750 9000 Yearly Real Rate of Interest after adjusting inflation on accumulated savings 1.09/1.04-1 4.80% Real rate of interest on saving bank 1.05/1.04-1 0.96% 1) Can he safely spend all the interest from his investment portfolio? The real value of accumulated yield = 180000*4.80% 8640 720 Social security 750 Total montly income 1470 Expenditure 2000 He cannot spend all the interest from his investment portfolio as expense is $2000 and the income earn is $1470, his only basic living expenses are also not been fulfilled 2) How much could he withdraw at year-end from that portfolio if he wants to keep its real value intact? Future value in real terms = 180000*0.04 7200 Annual Interest 16200 Actual Interest 9000 The above interest is possible only if the portfolio and interest are not utilised $9000 3) Suppose Mr. Road will live for 20 more years and is willing to use up all of his investment portfolio over that period. He also wants his monthly spending to increase along with inflation over that period. In other words, he wants his monthly spending to stay the same in real terms. How much can he afford to spend per month? Annual real interest 0.048 Monthly 0.004 Monthly cash payment = Accumulated Savings/Annuity factor Annuity factor = 1/0.004 - (1/0.004*1.004^240) Solving above gives 154.093 Monthly cash payments = 180000/154.093 1168.125742 Social security payment = $ 750 Total monthly income in real would be 1168.13+750 $1918.13 So Mr Road can spend $1918.13 is he uses up his portfolio in 20 yrs and not $2000

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