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Math and Investment

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Chapter Objectives

Discuss criteria for selecting investments for reallocating consumption

Describe the basic types of investments and their attendant characteristics

Discuss common performance measurements used to compare investments

Introduction

During adult life people make consumption and investment decisions to balance

their need for immediate consumption with the desire to accumulate wealth. Investing,

purchasing appropriate amounts of life, health and annuity coverage and engaging in

financial planning provides certainty to a family's future consumption pattern.

This chapter focuses on two issues underlying this life-long process. First, we

describe the importance of the time value of money and the mathematical techniques

used to solve a variety of time value of money problems. Second, we introduce

investment topics, describe different types of investments, suitability for different

purposes, their associated risk and measurements of performance. The goal is to

provide a background in investment topics and to describe alternatives cash value life

insurance for saving. The chapter presents examples solved algebraically and by a

popular computer spreadsheet program. Computer spreadsheet programs can be used

effectively in solving financial problems and as a tool in making long-term projections

and decisions.1

1Lotus 1-2-3 spreadsheet formulas are used - a product of Lotus Development Corp. Other

spreadsheet programs have similar formulas and work just as well.

-1-

1) How does the time value of money influence financial planning decisions?

The amount of interest paid on investments influences the amount that needs to be

deposited on a periodic basis to meet certain financial goals. Inflation and deflation can

also modify the purchasing power of the dollar especially over long periods of time.

2) What investments can be substituted for cash value life insurance allowing

consumers to allocate lifetime consumption? Cash value life insurance has a unique

function and a shared function. No other contract can promise a death benefit whenever

death occurs (the unique function). Other investments, however, compete with its

shared function, accumulating saving. Alternative investments include stocks, bonds,

U.S. Treasury securities and collectibles. Each investment has specific characteristics

with respect to liquidity, risk and return.

3) How do consumers make intelligent long-term projections of income,

expenses and investment returns? Long-term financial planning is difficult because the

future is unknown. Individuals, however, must make intelligent decisions based upon

incomplete information and they must make projections based upon reasonable

assumptions of future conditions. Personal computers and spreadsheet software

simplifies the process allowing for changes in income and expense patterns and

providing instantaneous recalculation of results based upon the changes made in the

assumptions or formulas.

Financial Mathematics

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especially when long periods are involved. For the purpose of this discussion, the

reader is assumed to be somewhat familiar with present value and future value

concepts. We provide only a brief review of these concepts.2

Future value of $1

When money is invested at a positive interest rate, the sum grows to a larger

amount, the future value, by a specific factor (1 + i)n. This relationship is expressed

algebraically as:

FV = PV x (1 + i)n

Formula 1

where

FV = future value amount

PV = present value amount

i = interest rate

n = the number of periods the money is to be invested at rate i.

For an example, if $1,000 is deposited at an interest rate of 7 percent for one

period (in this example, one year), the future value will be $1,070. If the $1,070 is now

invested for one year at 7 percent, the original $1,000 will grow to $1,144.90. This can

be calculated by using Formula 1:

FV = $1,000 x 1.07 x 1.07 or

FV = $1,000 x 1.072

FV = $1,000 x 1.1449

FV = $1,144.90

Many financial problems can be solved with Formula 1.

Example 1

2For a detailed source see Elbert B. Greynolds, Jr., Julius S. Aronofsky and Robert J. Frame,

Financial Analysis Using Calculators: Time Value of Money (New York: McGraw-Hill, 1980).

- 3 -

How much will a depositor accumulate at the end of four years if $1,500 is

deposited now at 8 percent interest compounded annually?

FV = PV x (1 + i)n

FV = $1,500 x (1.08)4

FV = $1,500 x 1.3604

FV = $2,040.60

Example 2

What yearly rate of return is generated if $1,500 grows to $2,000 in five years

when interest is compounded annually?3

FV = PV x (1 + i)n

$2,000 = $1,500 (1 + i)5

$2,000 / $1,500 = (1 + i)5

1.333 = (1 + i)5

1.3331/5 = (1 + i)

i = 1 - 1.3331/5

i = 0.059

Use the following spreadsheet formula to calculate future value factors. For 8 percent for 4 periods (see

Example 1) use: +(1+.08)^4 = 1.3604

The 5th root of 1.333 or the periodic growth rate for Example 2 is: 1.333^(1/5) = 1.059

Present value of $1

The process of calculating the future value of an amount growing at some stated

rate can be reversed. This concept is called present value. One question answered with

present value is how much must be deposited so the investment will grow to a stated

amount at some future point. Calculating the present value (Formula 2) of an amount is

just the inverse of calculating the future value amount.

- 4 -

PV = FV x [1 / (1 + i)n]

Formula 2

Example 3

How much money must be deposited today so that in 10 years $20,000 will be

accumulated if the interest rate is 12 percent?

PV = FV x [ 1 / (1 + i)n ]

PV = $20,000 x [1 / (1 + .12)10]

PV = $20,000 x 0.322

PV = $6,440.00

Present values and present value factors are used extensively in calculating life

insurance premiums and the reader should be familiar with and be able to solve

problems using formulas 1 and 2.4

Use the following spreadsheet formula to calculate present value factors. For 6 percent for 5 periods use:

+1/((1+.06)^5) = 0.7472

Annuities

Not all cash flows occur as one lump sum. Many investments involve a series of

equal payments . Streams of equal payments are called annuities.5 One must be

careful when analyzing annuities. Single payments or streams of payments can occur at

the end of a period or at the beginning of a period, thus affecting the compounding

process. When a payment is made at the end of a period, as in the present value and

future value calculations discussed above, the annuity is called an ordinary annuity.

3To solve for i, one may simply use future value time value of money tables. (See the book's

appendix for selected factors.) Look for approximately 1.333 in the table for five periods. The result is

found at 6 percent.

4These and other formulas are reproduced in Appendix to this text.

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When the payment occurs at the beginning of the period, the annuity is called an

annuity due. Formulas 3 and 4 provide the formulas for calculating the present value of

an annuity and an annuity due.

PVa = A x

n

S

t=1

[1 / (1 + i)]t

n-1

PVd = A x S

[1 / (1 + i)]t + 1

Annuity Due Formula 4

t=1

(note: replace "S" with mathematical sum sign in above 2 equations.)

An example will help distinguish between the two. If people receive an annuity (A

= $100) consisting of two payments and the discount rate is 10 percent, the respective

present values of the ordinary annuity and the annuity due are computed as follows:

Ordinary annuity:

PVa = ($100 x .909) + ($100 x .826)

PVa = $173.50

Annuity due:

PVd = ($100 x 1.00) + ($100 x .909)

PVd = $190.90

In the ordinary annuity calculation the first payment is discounted one year and

the second payment is discounted two years. In the annuity due calculation, payment is

received at the beginning of the period and the present value of the first payment is

equal to $100. The second payment is only discounted for one year.

5This is a financial definition of an annuity. The term is also used in life insurance to describe a

- 6 -

Tables are constructed to provide present value and future value annuity factors

consisting of sums of the present value and future value factors. By looking at the above

example, the sum of the present value factors in the ordinary annuity case is equal to

1.735 (.909 + .826) and the sum of the annuity due factors equal 1.909 (1.00 + .909).

The factors 1.735 and 1.909 appear in their respective tables for a two-year annuity

under the discount rate of 10 percent. The formulas to calculate the time value of money

factors are found in Appendix ?? to this book.

Table 1 demonstrates how the present value of an annuity and how the present

value of an annuity due may be calculated using a spreadsheet program. The method

demonstrated assumes that your computer software calculates the present value of a

stream of equally spaced, regular or irregular dollar amounts. The @NPV function

performs the task in Lotus 1-2-3 and other programs. Refer to Table 1 which shows the

calculation of the present value of a hypothetical education fund. In the years 1993

and 1994 we assume that $7,000 is needed for expenses. We calculate the present

value of the stream of payments at the beginning of each year.

The formula used for the ordinary annuity for 1992 (cell D8) in Table 1 is equal to

@NPV($D$3,D6...$F$6) and equals the sum of the present value of the numbers found

in D6, E6 and F6. The discount rate is found in cell D3.6 The formula for the annuity

6The "$" sign is used in formulas to fix cell as an absolute reference if the formula is copied.

- 7 -

due (cell D10) is equal to +D6+@NPV($D$3,E6...$F$6). This adds the number found in

cell D6 to the present value of education amounts found in cells E6 and F6.7

Table 1 Illustration of an Annuity and Annuity Due

1

2

3

4

5

6

7

8

9

10

11

A

B

C

D

Present Value of Education Fund

Inv. Rate

Education Expense

PV of Education Fund

Annuity

Annuity Due

1992

0

1993

7,000

1994

7,000

12,396

13,016

6,667

13,016

13,667

7,000

0.05

Example 4

If Mr. Wilkinson wants to retire in 10 years with $100,000 dollars in savings, how

much must be deposited at the end of each year (PMT) so that the $10,000 will be

available? Assume a 7 percent annual interest rate.

FVa = PMT x FVAF at 7% for 10 periods

$100,000 = PMT x 13.816

PMT = $100,000 / 13.816

PMT = $7,237.98

where

FVAF = Future value annuity factor

Mr. Wilkinson will have $100,000 available at the end of 10 years if $7,237.98 is

deposited at the end of each period and if funds deposited earn 7 percent.

Example 5

7The formula in F10 is +F6 since the present value of one payment received immediately is equal

to that number.

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house over 30 years at a 10 percent annual rate? Each loan payment is made at the

end of the year.

PVa = PMT x PVAF at 10% for 30 periods

$50,000 = PMT x 9.4269

PMT = $50,000 / 9.4269

PMT = $5,303.97

where

PVAF = Present value annuity factor

Thus, at 10 percent the bank is indifferent between receiving $50,000 now or

$5,303.97 at the end of each year for the next 30 years.

Example 6

If Mrs. Webster can afford a payment of $200 at the end of each year for 12

years, what is the maximum that can be borrowed if the interest rate is 12 percent?

PVa = PMT x PVAF at 12% for 12 periods

PVa = $200 x 6.194

PVa = $1,238.80

At a 12% loan rate, Mrs. Webster makes 12 - $200 annual payments to repay the

$1,238 loan.

The following spreadsheet formulas calculate the present value and future value of an annuity:

@FV(payments, interest, term) Future Value of an annuity (payments made at the end of the period.

@PV(payments, interest, term) Present Value of an annuity (payments made at the end of the period.

@NPV(interest, range) Net Present Value of a range of amounts (payments are made at the end of

period.

@TERM(payments, interest, future value) Calculates the number of payments made at the end of period

necessary to accumulate the future value at the interest rate.

To adjust for an annuity due use:

@FV(payments, interest, term)*(1+interest)

@PV(payments, interest, term)*(1+interest)

@TERM(payment, interest, future value/(1+interest))

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While constructing your financial plan, you may need to calculate the remaining

balance of a loan. We present a generalized mortgage calculator. Some money

management programs have this function built in, but escrow amounts, private

mortgage insurance and other loan peculiarities often result in only a close

approximation of your actual results. Refer to Table 2 which shows the results of

calculating the remaining balance at the end of each year for a $80,000, 10 year

(payable at the end of each year), 10 percent mortgage loan.

Table 2 Mortgage Calculator

A

B

C

D

1 Mortgage Calculator

2

3

4 Assumptions:

5

Principal

80,000

6

Interest Rate

0.100

7

Years

10

8

Payments per Yr.

1

9

10 Output:

11

Total # Payments

10

12

Rate per period

0.1

13

PV. factor

6.145

14

Periodic Payment 13,020

15

16

17

Balance End

Per. of Period

0

80,000

1

74,980

2

69,459

3

63,385

4

56,704

5

49,355

6

41,270

7

32,378

8

22,596

9

11,836

10

0

The mortgage payment is equal to the principal amount divided by the present value of an annuity factor

@PV(1,interest,term) calculates the present value of a $1 annuity.

80000/@PV(1,0.1,10) = 13020

8Some of this material is adapted with permission from Dorfman, Mark S. and Adelman, Saul W.,

The Dow Jones-Irwin Guide to Life Insurance, Dow Jones-Irwin, Chicago, IL, 1988.

- 10 -

The following formula alternatively can be used to calculate the mortgage payment:

@PMT(principal, interest, term)

The outstanding principal balance at the end of the year is calculated by subtracting the principal

payment from the beginning principal amount:

beginning principal - (payment - (beginning principal x interest rate))

Any savings program represents a reallocation of consumption. Saving for

college or a home means postponing current consumption to allow future consumption

to take place. From the standpoint of financial efficiency, determining the goal for saving

also determines the investment strategy and the savings medium used. If the savings

goal is short term, for example, the investor would not choose to put funds in hard to

liquidate investments or whose liquidation causes adverse tax consequences. When

people save or reallocate consumption to the future, funds are invested to take

advantage of growth opportunities. A variety of investments with different risk, return

and liquidity characteristics compete with cash value life and annuity contracts for

personal savings. Some of these investments including cash value life insurance enjoy

a favorable tax status.

Making investment decisions requires the simultaneous consideration of the

following four characteristics:

liquidity

safety

current yield and growth potential

taxability.

Liquidity

- 11 -

Liquidity means an investment can be turned into cash quickly without suffering a

decline in value attributed solely to changing the investment into cash. This concept is

distinguished from a change in the value solely due to market conditions.

Example 8

A $1,000, 8% coupon, 30 year bond is purchased at 100% of its maturity value or

$1,000. If market interest rates decline to 6%, the market price of the bond will increase.

The bond is considered liquid since an active secondary financial market exists allowing

easy cash sales. A small transaction charge reduces the proceeds. The increase in the

bond's value is due to market conditions. The existence of an active secondary financial

market enhances the bond's liquidity.

The most liquid investments, such as bank deposits, may be turned into cash

quickly without penalty. Investments in publicly traded securities are easily marketable.

When securities are bought or sold, transaction costs usually apply and there is a slight

delay in obtaining the cash after the sale. Certificates of deposit (CDs) can be converted

to cash quickly but "substantial" penalties may apply if the CDs are cashed in before

maturity. Investments in real estate or business ventures are less liquid than publicly

traded securities. Cash sales of real estate or business assets often require a long time,

a considerable concession in price and the payment of substantial transaction costs.

Investments with maximum liquidity typically have lower rates of return than less

liquid investments. Maximum current liquidity is not required for investments made to

finance retirement income, especially when the investments are made during middle

age. As one approaches retirement years, a portion of one's investments should be

systematically switched from illiquid to liquid investments.

- 12 -

Safety

Safety - or its opposite, "riskiness" - relates to the variability of realized and

expected returns. The return on a safe investment held to maturity can be predicted

accurately in advance and the possibility of monetary loss is low. Short-term U.S.

government obligations, Treasury notes, are often spoken of as being risk free because

the return is predictable and the chance of loss is assumed nonexistent. Long-term U.S.

government bonds and notes are subject to loss of value when interest rates rise, but

are assumed to have no risk of default. The greater the riskiness of an investment, the

greater the variation in possible gains or losses. As a general rule, the greater the

investment's safety, the lower its expected return. While safety is important in saving for

retirement, maximum safety is not required. The investor may be willing to sacrifice

some safety to achieve greater yield.

Figure 1 provides a list of common investments arrayed by risk. U.S. Treasury

bills are considered to be virtually risk free, while common stocks (especially of small,

newer companies) are the highest risk investments.

- 13 -

FIGURE 1

Relative Risk of Common Investments

Low Risk:

U.S. Treasury bills

Commercial paper

Long-term government bonds

High Risk:

Long-term corporate bonds

Preferred stock

Common stock

categorized in a variety of ways and arises from several sources. The following

categories describe the more important sources of risk:

market risk

interest rate risk

issue specific risk.

Purchasing power risk. The loss of purchasing power caused by the general rise

in prices is one risk investors must be concerned about, especially over long time

periods. If prices increase, the purchasing power of a fixed amount of principal

declines. Typically, investors seek investments producing rates of return that, at least,

compensate for lost purchasing power. These investments are considered "hedges

against inflation." Investors must realize that these investments do not guarantee a

stable purchasing power level, but provide the opportunity to achieve the results.

Fixed types of securities such as bonds, CDs, savings accounts and life

insurance cash values (in traditional products) are not good hedges against inflation.

Equity investments are better inflation hedges than fixed investments. However, no sure

hedge exists against inflation. In times of low or moderate levels of inflation, a portfolio

- 14 -

of equity investments may increase in value and offset the effects of the reduction in

purchasing power. However, in times of rapid inflation, the value of stock tends to fall

dramatically if the government uses monetary policy to fight general price increases.

Market risk. Market risk refers to the general trend of changes in the value of the

securities market. Market risk may be the result of inflationary expectations, political

announcements, the risk of war, unexpected insolvencies or default, changes in

international monetary exchange rates or comparative advantage shifts in the

expanding global economy. Investors summarize these trends by labeling the market a

"bull" or a "bear" market. If the market, as measured by one of the many indexes, is

falling it is labeled a bear market, if rising, a bull market. Thus, an investor is subject to

market risk due to timing of the purchases or sales.

Example 9

Harry Smith needs to liquidate a sufficient amount of shares in a high quality

mutual fund to replace the roof on his house. Because a bull market has existed for two

years, Harry only needs to liquidate 100 shares to pay for his roof. If a bear market

existed for two years, Harry would have to liquidate 200 shares to produce the required

amount of cash.

Interest rate risk. Changes in the level of interest rates can increase or decrease

investment value. An inverse relationship exists between investment values and

changes in interest rates. If interest rates decline, investment values increase. If interest

rates increase, investment values decline.

Example 10

- 15 -

Sara Butler purchased a high quality $1,000 bond. The bond pays $80 interest

per year (8% coupon). If interest rates increase such that a comparable bond yields

12%, the value of Sara's bond falls. Since the bond pays only $80 annually, the value

(what someone would pay for it) declines to produce a yield of 12 percent.

current yield before = 8% ($80 / $1000)

current yield after = 12% ($80 / $666.66)

Price x 0.12 = $80.00

Price = $80 / 0.12

Price = $666.66

The longer the maturity, the more sensitive is this relationship. The price of a 30

year bond changes more dramatically than that of a 10 year bond since both market

values equal the present value of all future cash flows.

Example 11

Compare the difference in market value of a $1,000, 8% bond purchased at par.

If prevailing rates of return change to 12% from 8%, the following theoretical market

value results.

The present value of $80 for 10 years plus a maturity value for $1,000 at 12%

equals $774. The present value of $80 for 30 years plus a maturity value for $1,000 at

12% equals $678.

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Year Payment

PV

1

80

0.893

2

80

0.797

3

80

0.712

4

80

0.636

5

80

0.567

6

80

0.507

7

80

0.452

8

80

0.404

9

80

0.361

10 1,080

0.322

Sum of PV amounts

Pmt x PV

71.43

63.78

56.94

50.84

45.39

40.53

36.19

32.31

28.85

347.73

773.99

Year

Payment

PV

1

80

0.893

2

80

0.797

3

80

0.712

4

80

0.636

5

80

0.567

6

80

0.507

7

80

0.452

8

80

0.404

9

80

0.361

10

80

0.322

11

80

0.287

12

80

0.257

13

80

0.229

14

80

0.205

15

80

0.183

16

80

0.163

17

80

0.146

18

80

0.130

19

80

0.116

20

80

0.104

21

80

0.093

22

80

0.083

23

80

0.074

24

80

0.066

25

80

0.059

26

80

0.053

27

80

0.047

28

80

0.042

29

80

0.037

30 1,080

0.033

Sum of PV amounts

Pmt x PV

71.43

63.78

56.94

50.84

45.39

40.53

36.19

32.31

28.85

25.76

23.00

20.53

18.33

16.37

14.62

13.05

11.65

10.40

9.29

8.29

7.40

6.61

5.90

5.27

4.71

4.20

3.75

3.35

2.99

36.05

677.79

The above table shows the calculation on a year by year basis. Alternatively,

present value of annuity factors may be used to discount the annual payment. Present

value of $1 factor may be used to discount the $1,000 maturity amount.

Issue specific risk. Issue specific risk, default or financial risk arises from

changes in the issuer's financial condition. These changes may lead to less security for

bond holders, a reduction in the dividend amount to stockholders, not paying or

- 17 -

defaulting on bond interest payments and the inability to retire or refinance outstanding

debt. Issue specific risk may reduce if the profitability of the firm improves. Therefore,

issue specific risk focuses on the timing and magnitude of expected cash flows and its

certainty.

Example 12

Purchasers of Rydex bonds have increased their required rate of return to 15

percent. This increase is the result of Rydex's rise in the proportion of debt to equity

financing. Bond holders view the issue as more risky since the amount of debt has

increased in the capital structure and it is more difficult to make the required interest

payments.

Current yield and growth potential

Current yield and growth potential may be combined and spoken of as the total

return on an investment. Total return is always of concern because if one investment is

chosen, another must be forgone. Holding other factors constant, rational investors

choose investments with the highest total return. However, other factors cannot be held

constant in the real world, nor can investors ever have all the information needed to

make the optimal choice. The theory that rationality is bounded by the costs of acquiring

information applies to investment decision making. In general, the higher an

investment's potential total return, the less its safety. If an investor wants more return it

will be accompanied by more risk.

Tax Aspects of Investments

The possibility of deferring or eliminating federal, state and/or local taxes is a

consideration in many savings decisions and is especially germane to a discussion of

- 18 -

saving for retirement. As Chapter 11 explains, investments may have no tax advantages

and be fully taxable, produce tax free income or produce tax deferred income.9

Taxable Investments. Investments with no tax advantage require owners to pay

tax on current income and pay tax on any capital gains when sold. Taxable investments

are not limited to common or preferred stock but include investments such as rare

coins, art work and antiques.

Example 13

Jake purchases 100 shares of Rydex stock for $32. During the year he receives

a $1.50 per share dividend. Jake must report $150 as dividend income. Next year, Jake

sells the stock for $36 per share. Assuming no transaction costs, the capital gain of

$400 ([$36 - $32] x 100 shares) is taxable in the year sold.

Tax deferred vs. tax free investments. An important distinction exists between tax

deferred and tax free investments. Tax free investments such as state and local bonds

generally are free of federal income taxes. However, any capital gains and losses are

treated as taxable events. Tax-deferred income arises when income that otherwise

would be currently taxed is given special treatment, delaying imposition of the tax.

Ultimately however, the tax must be paid. Important sources of tax-deferred income

include the cash value of life insurance contracts, annuities and U. S. Savings Bonds.10

Depending on the type of plan, the amount contributed to the tax advantaged account is

9A mathematical example of the value of tax deferred income is given in the appendix to Chapter

11. Also see: M. S. Dorfman and S. W. Adelman, "Comparing the TDA to a Non-TDA Investment

Program for Accumulating and Liquidating Wealth," CLU Journal, January 1983, p. 40.

10The cash value increases of life insurance contracts are tax deferred. If the contract matures

as a death claim, the policy face including the cash value is usually paid tax free to the beneficiary.

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deductible for income tax purposes. In such cases, when a taxable event occurs, all

funds received are taxable since no tax was ever paid on the principle or investment

earnings. Examples of tax deductible and tax deferred investments include the

individual retirement account (IRA) under certain circumstances, the Section 401(k) plan

and the Section 403(b) plan.11 The IRA and 403(b) plans have tax penalties if

withdrawals are made before age 59 1/2.12

A Numerical Comparison. Assume an individual earns $4,000 and has three

options for investing the money. The three options include 1) a fully taxable investment,

2) an investment with investment earnings tax deferred and 3) an investment with the

tax on current income and investment earnings deferred. Table 3 shows the results of

using $4,000 of before tax income to make the various investments.

11The IRA and the 403(b) plans are described in Chapter XX.

12See Chapter XX for a discussion of the taxation of IRAs and other tax advantaged

investments.

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TABLE 3

COMPARISON OF INVESTMENT RESULTS

BASED ON TAX METHOD

Current Income

Fully

Tax Deferred

Reduced and

13

14

Taxable

on Earnings

Tax Deferred15

Amount Before Tax $ 4,000

$ 4,000

$ 4,000

Tax Rate

0.30

0.30

0.30

Invested Funds

2,800

2,800

4,000

Rate of Return

0.08

0.08

0.08

Year

Account Balance Account Balance Account Balance

1

$ 2,957

$ 3,024

$ 4,320

2

3,122

3,266

4,666

3

3,297

3,527

5,039

4

3,482

3,809

5,442

5

3,677

4,114

5,877

6

3,883

4,443

6,347

7

4,100

4,799

6,855

8

4,330

5,183

7,404

9

4,572

5,597

7,996

10

4,828

6,045

8,636

11

5,099

6,529

9,327

12

5,384

7,051

10,073

13

5,686

7,615

10,878

14

6,004

8,224

11,749

15

6,340

8,882

12,689

16

6,695

9,593

13,704

17

7,070

10,360

14,800

18

7,466

11,189

15,984

19

7,884

12,084

17,263

20

8,326

13,051

18,644

Taxation

Taxes paid

Taxes payable

Taxes payable

method

on earnings

on total amount

= 0.30 x (13,051= 0.30 x 18,644

2,800)

Penalties may apply

when withdrawn early.

Wealth

After Taxes

$8,326

$ 9,976

$ 13,051

This example assumes all funds are withdrawn at the end of 20 years.

14Investments such as cash value life insurance and Series EE Bonds.

15Investments such as tax-deferred IRA, 401(k) and 403(b) plans.

- 21 -

In the first option, the fully taxable investment, only $2,800 is invested since

taxes must be paid on the $4,000 of income. Taxes at the rate of 30 percent are also

paid on investment income earned each year. With the second option, where only

investment earnings are tax deferred, $2,800 is invested since tax must be paid on the

$4,000 of earnings. In this case, investment earnings are tax deferred - tax is paid on

earnings only when withdrawn. The original $2,800 is not taxable at withdrawal since it

has already been taxed. The third option defers tax on current income and investment

earnings. Taxes are paid on current income (the $4,000) and investment earnings when

withdrawn. Table 3 shows that wealth after taxes is maximized if current taxable income

is reduced by the contribution and earnings are deferred until withdrawn. A fourth option

is also illustrated by Table 3. If a tax-free investment is made with after tax dollars

($2,800), the resulting wealth after 20 years equals $13,051.16

Basic Types of Investments

Investments may be divided into two categories - fixed income investments and

equity investments.

Fixed Income Investments

Fixed income investments pay the investor a fixed rate of interest over the life of

the investment. The principle amount is returned at maturity. Common fixed income

investments include bank passbooks, CDs, corporate bonds, municipal bonds, U.S.

Treasury Securities and traditional cash value life insurance. Most fixed income

investments may be purchased directly or indirectly using a mutual fund. A mutual fund

16Tax free investments usually pay lower rates of return. For the purpose of this comparison, the

- 22 -

pools the assets of many investors and purchases the securities in the financial

markets.

Bank instruments. Saving accounts, some checking accounts, CDs and money

market accounts are fixed investments. Return of principal is guaranteed and relatively

low amounts of interest are paid. These alternatives are highly liquid. And, there is low

risk associated with these types of investments since the principal amount is not subject

to market fluctuation and there is little or no cost for withdrawing the funds except early

withdrawal penalties. These investments are typically guaranteed up to $100,000 by the

Federal Deposit Insurance Corporation (FDIC).

Corporate Bonds. Corporate debt obligates the issuer to pay a stated interest

amount (coupon rate) on the principal until the investment matures. At maturity the

principal or face amount is returned. The quality of corporate bonds vary according to

the credit worthiness of the issuer, the interest rate, the maturity date, sinking fund

provisions and callable features.

Mortgage bonds are secured by real and fixed property owned by the

corporation. Debentures are unsecured debt based on the faith in the issuer's earning

capacity. Upon default, there is less security for the debenture owner than the mortgage

bond holder.

Many bonds contain a callable provision. If a bond is callable, the issuer can

retire the bond before the maturity date. Issuers call outstanding issues to take

advantage of lower interest rates. For example, if Acme Corporation has an outstanding

- 23 -

12% bond and interest rates decline to 8%, it is advantageous to retire the 12% debt

and refinance it at the lower rate. Many callable bonds provide creditors with a measure

of call protection for the first 5 to 10 years of the issue. Investors lower their required

rate of return in exchange for such call protection. Most bonds are retired or called

before they mature. Either the issuer repurchases them in the financial markets or

exercises the bond's call provision.

Often bonds require a sinking fund. Sinking funds require systematic retirement

of a bond issue or the accumulation of a fund for ultimate retirement. Sinking funds

protect bond holders by requiring the firm to set-aside sufficient cash or to repurchase

the bonds in the financial markets.

Deep-discount or zero coupon bonds pay a low or zero interest rate for the use of

the funds. The market price for these bonds can be well below its face amount which

produces the investor's required yield. With a zero coupon bond, instead of the bond

paying a competitive interest rate (coupon percent), the bond holder receives his return

from capital appreciation (approaching the maturity value of the bond) instead of current

income.

Example 14

The market price of a 20 year, $1,000, zero coupon bond equals $61.10 (0.0611

x $1,000) if the investor's required rate of return is 15 percent. [1 / (1.15)20 = 0.0611]

The market price of the same bond with only 10 years until maturity is $247.18

(0.2471 x $1,000). [1 / (1.15)10 = 0.2471]

Municipal Bonds. Cities, towns, states, housing authorities and political

subdivisions can issue municipal bonds. Interest paid on municipal bonds is exempt

- 24 -

from federal income tax. Some issues are also exempt from state and local taxes. When

an investor sells a municipal security, capital gains (or losses) are taxable events.

Municipal bonds are attractive to people in high marginal tax brackets. Depending upon

the person's marginal tax bracket, more wealth may be accumulated by investing in

municipals than in a comparable risk taxable investment. If a person is subject to a low

marginal tax rate, more wealth may be kept by making taxable investments and paying

the applicable tax.

Example 15

Jake has the opportunity to purchase a tax free investment yielding 8 percent or

a taxable investment yielding 10 percent. His marginal tax rate is 30 percent. The after

tax yield of the tax free investment is equal to 8% since no tax is paid. The after tax

yield on the taxable investment equals 7% [0.10 x (1 - 0.30)]. Jake should invest in the

tax free investment since it has a greater after tax yield.

In order to make the taxable investment attractive, it must yield greater than

11.43 percent [0.08 / (1 - 0.30)]. If the taxable investment yields 11.43% the after tax

yields of both investments are equivalent [0.1143 x (1 - 0.30) = 0.08].

U.S. Treasury Securities. The United States Government finances its $3 trillion

debt by selling Treasury bills, notes and bonds. Table 4 presents a schedule of

Treasury Securities based upon the type, maturity, minimum purchase and the

frequency of issue.

- 25 -

Type

Table 4

Treasury Bills, Notes and Bonds

Maturity

Treasury Bills

3, 6 and 12 months

Treasury Notes

2 or 3 years

4 - 10 years

Treasury Bonds

Over 10 years

Minimum Purchase/

Issued

$10,000 (sold in multiples

of $5,000) 3 and 6 month

bills issued weekly

(Monday); 12 month sold

monthly.

$5,000 (sold in multiples of

$5,000) 2-year notes

monthly; 3-year notes

quarterly.

$1,000 (sold in multiples of

$1,000); Sold quarterly.

$1,000 (sold in multiples of

$1,000); Sold quarterly.

Treasury bills, notes and bonds can be purchased directly from the Federal

Reserve through the Treasury Direct System or indirectly through banks and brokerage

houses. Treasury bills are zero coupon instruments sold at a discount. Notes and bonds

have a stated coupon and pay interest semiannually. New notes and bonds cannot be

redeemed before their stated maturity. However, notes and bonds are actively traded in

the secondary markets.17

Purchasing Treasury bills at a discount raises the effective return. If a $10,000, 1

year bill is purchased with an 8% coupon, the purchase price equals $9,200 since the

interest is subtracted from the face amount. The effective return equals 8.69% ($800 /

$9,200) not 8% ($800 / $10,000).

17Secondary markets exist to provide a marketplace to buy and sell securities after they are sold

by the issuer.

- 26 -

Since the Federal Government is the issuer, income is exempt from state and

local taxes and no risk of default exists. There is, however, risk associated with general

economic conditions and reinvestment risk. That is, if the owner sells the security before

maturity, the price received is a function of the prevailing interest rates and the maturity

date. Also, when the security matures or is sold, there is risk associated with the

financial environment at the time of reinvestment.

The Treasury yield curve is reported in publications such as the Wall Street

Journal on a daily basis and shows the relationship of yield to maturity. The publication

also supplies information concerning new issues, sales in the secondary market and the

results of Treasury auctions. Figure 2 shows the yield curve of at the close of business

on Thursday March 14, 1991.

Figure 2 Treasury Yield Curve

Friday, March 15, 1991, 1990 (Wall Street Journal)

U.S. Savings Bonds. Series EE and Series HH U.S. Savings bonds can be

purchased and sold from financial institutions with no transaction costs. Series EE

- 27 -

bonds are issued on a discount basis. Interest accrues over time increasing the bond's

redemption value. The purchase price of the bond is 1/2 the face amount.

Denominations range from $50 to $10,000. An annual purchase limit of $30,000 (face

amount) applies. If there are co-owners, the limit is doubled.

If the Series EE bond is held less than five years, the bond currently pays a rate

of 4.16 percent (held six months). The rate gradually increases based upon the holding

period to the minimum rate at 5 years. When the Series EE bond is held five years or

longer, the interest is set at the higher of 1) 85 percent of the average return

(compounded semi-annually) on 5 year marketable Treasury securities or 2) the

minimum rate (currently 6 percent).

No state or local income taxes apply to interest earned. Federal income tax on

any accrued interest can be deferred until the bonds are cashed or they mature. The

U.S. Treasury sets the maturity date and the minimum interest percent when issued. If

bonds are held past maturity, no interest accrues unless the maturity date is extended.

Series HH bonds pay current income semiannually. Series HH bonds are only

available through the exchange of Series EE bonds and are issued by the Federal

Reserve Banks and the Bureau of Public Debt. Purchasers of Series EE bonds may

defer income tax on earnings by purchasing HH bonds. Then, when the HH bond

matures or is redeemed, income tax on the deferred earnings must be paid. The current

income paid by the HH bond is taxable income.

The denomination and the purchase price are equal for Series HH bonds. They

have a 10 year term to maturity and do not earn market interest rates. Currently, the

- 28 -

percent annually. These payments are subject to Federal income tax when received.

Example 16

Randy Turnup has a $5,000 Series EE bond which is currently worth $5,500. It is

11 years old. No income tax has been paid on accrued earnings. Randy exchanges the

Series EE bond for an HH bond. Each year Randy receives $330 ($15 x 2 x $5,500 /

500) from the semiannual payments and reports $330 in taxable income. When the HH

Bond matures or is cashed in, $3,000 must be reported in taxable income ($5,500 $2,500 purchase price). The $3,000 is the deferred earnings on the EE Bond.

Equity Investments

Equity investments, such as common stock, entitle the investor to the residual

earnings of the company. These investments have no stated maturity date and do not

guarantee a specific rate of return. Equity investments can be purchased directly in the

secondary markets or indirectly through a mutual fund.

Common Stock. When investors buy common stock, they receive a proportionate

share in the ownership of the corporation. That means after all obligations are met, the

owner has a claim on the residual assets or income of the company. Common stock

owners control the organization through their voting power and bear the major portion of

the business risk, but usually benefit the most from the gains.

Common stockholders receive benefits in two ways. First, if the company pays

cash dividends, stockholders receive a portion of the company's earnings. Second, if

the price of the stock increases, the wealth of the owner increases and the security can

be sold in the secondary capital markets. The first income source is referred to a

- 29 -

dividend income and the second as capital gains. If the company performs poorly,

dividends may be reduced or eliminated and the value of the stock may decline

producing capital losses.

Dividends may be paid in cash, may be reinvested (if a reinvestment plan exists)

or be paid by a stock split or dividend. Stock splits or dividends increases the number of

outstanding shares while the value of each outstanding share declines by a

proportionate amount. Stock splits and dividends by themselves do not increase the

wealth of the owner, but they give recognition to past earning retentions. Cash

dividends and capital gains (or losses) are taxable events and are reported annually.

Preferred Stock. Preferred stockholders receive a fixed payment even though the

security represents equity capital. Preferred stock does not have a maturity date like

bonds, but can be convertible and callable. If a 7%, $100 par value preferred stock is

purchased, the corporation promises to pay $7 each year after the debt holders are paid

but before any payment to the common stockholders. If the preferred stock is

convertible, it may be exchanged for common stock. Preferred stockholders typically do

not have voting rights unless the dividends are cumulative and have not been paid. Any

past due cumulative preferred stock dividends must be paid before the common

stockholders receive any dividend distribution.

Refer to Table 5 which reviews the characteristics of several alternate

investments to cash value life insurance. All of the investments have a different set of

attributes relative to liquidity, safety, current yield, potential growth and tax. Since the

investor must make investment choices to meet financial goals, one investment type

- 30 -

may not meet all savings needs efficiently and therefore, savings strategy may rely on

multiple types of investments.

TABLE 5

CHARACTERISTICS OF SELECTED INVESTMENTS

Type

Liquidity

Safety

Current Yield

Growth

Potential

Cash value

amount

scheduled.

Tax

Whole Life

Insurance

Cash value is

highly liquid.

Cash value

amount

scheduled.

Cash value

amount

scheduled.

Universal Life

Insurance

Highly liquid.

Fees may

apply to

withdrawals

Cash value

based on

investment

results.

Based on

investment

results. Added

to cash value.

Based on

investment

results.

Corporate

Bonds

Active

secondary

market.

Commission

paid on

transaction.

Active

secondary

market.

Commission

paid on

transaction or

direct

purchases.

Active

secondary

market.

Commission

paid on

transaction.

Active

secondary

market.

Commission

paid on

transaction.

Ranges from

high grade to

"junk."

Based on

coupon rate.

Value inversely

related to

interest rates.

No default risk.

Based on

coupon rate.

Value inversely

related to

interest rates.

No state and

local tax on

interest.

Capital gains

taxable.

Low to high

risk depending

on issue.

Based on

dividend

payment.

High growth

possible.

Depends on

issue.

Tax on

dividends and

capital gains.

Low to high

risk depending

on issue.

Based on

coupon rate.

Limited due to

fixed

distribution.

Tax on

dividends and

capital gains.

U.S.

Treasuries

Common

Stock

Preferred

Stock

No tax as cash

value

increases.

Possible tax on

surrender.

No tax as cash

value

increases.

Possible tax on

surrender.

Current

income and

capital gains

taxable.

Performance Measurements

People need to monitor and measure accurately the performance of their

investments. Since one goal of the investor is to maximize the rate of return and capital

- 31 -

gains of the investment, it is important to calculate and know their rate of return. The

following section provides a description of various performance measures with

examples. These measures include the price / earnings ratio (P/E), the current yield, the

holding period return and yield and, the yield to maturity. In addition, the difference

between after-tax and before-tax yields and returns are discussed along with basic

portfolio and diversification concepts and the mathematics of dollar cost averaging.

Price earnings ratio (P/E)

The P/E ratio is calculated by dividing the current market price of a share of

common stock by its earnings per share. The P/E ratio measures the willingness of

investors (in market price) to pay for the right to the future earnings of the corporation.

current market price

P/E ratio = ------------------------------------- Formula 5

earnings available for

common shareholders

Example 17

Ardmore stock is selling for $26.00. Over the latest 12 months, Ardmore earned

$2.20 per share. The P/E ratio is equal to 11.81 ($26.00 / $2.20).

A high P/E ratio usually signals investors expect the earnings of the corporation

to grow and they are willing to increase the price in order to participate in the expected

profitability of the firm. Lower P/E ratios may be found where the company pays out

most of its earnings in current dividends, is quite stable in earnings or investors feel it

has little future growth prospects. P/E ratios of a particular stock should be compared to

similar companies and to past information to become more familiar with the markets

assessment of the stock's performance and to spot any trends based on this calculation.

The reciprocal of the P/E ratio is the earnings to price ratio (E/P). The earnings to price

- 32 -

ratio provides the stockholder with the earnings rate of return relative to the market price

of the stock.

Example 18

The earnings to price ratio for Ardmore is 8.46% ($2.20 / $26.00). Based upon

the stock price, $2.20 of earnings is generated on a $26.00 investment. The investor

does not receive the $2.20. The dividend actually paid may be greater or less than the

earnings per share.

Current yield

The current yield measures the annual benefit an investor receives from

investment income. The current yield is equal to the actual dividend or interest received

divided by the current market price. The current yield does not include any rate of return

for expected capital gains although the market price reflects investor's expectations of

future payments as well as market value adjustments.

investment income (annual)

Current Yield = --------------------------------current market price

Formula 6

Example 19

The current distribution of Ardmore's 7% preferred stock (par value equals $100)

is $7.00. The current market price is $82.00. The current yield is 8.53% ($7.00 /

$82.00).

Holding period yields and return

Investments are typically held over long periods of time and investors benefit not

only from the annual distribution of dividends and interest, but their wealth increases or

decreases based upon the security's underlying market value. The holding period yield

- 33 -

(HPY) and the holding period return (HPR) are useful in calculating the geometric rate

of return or the growth rate of the investment.

Total current value

of the investment

Holding period return (HPR) = --------------------------------Original amount of

investment

Formula 7

Formula 8

Example 20

Six years ago Randal Smith purchase 100 shares of Ardmore stock at $18.00.

He has reinvested all dividends through Ardmore's reinvestment plan. He now owns 187

shares at the $26.00 current market price. His original investment was $1,800 (100 x

$18.00). The current value is $4,862 (187 x $26.00). With a holding period of 6 years,

the HPR is 2.70 ($4,862 / $1,800). The HPY is 1.70 (2.70 - 1). Randal's stock is worth

2.7 times the amount paid and will receive 1.7 times his investment in new wealth.

investment of $1,800 grow to $4,862 in 6 years. The annual geometric rate of return is

18.01 percent calculated as follows.

$4,862 = $1,800 (1 + X)6

$4,862 / $1,800 = (1 + X)6

2.70 = (1 + X)6

2.701/6 = (1 + X)

X + 1 = 1.1801

X = 18.01%

The annual rate of return is calculated by using the following formula:

- 34 -

+((4862/1800)^(1/6)) -1 = 0.1801

Yield to maturity

The yield to maturity is used with investments paying an amount annually with

the principal paid to the investor upon maturity. Bonds and other debt securities fall into

this category. Bonds pay a fixed coupon rate annually based upon the par or face

amount of the bond.18 The bond matures at a stated date at which time, the par

amount is returned to the investor. The yield to maturity measures the rate of return of

the bond based upon its purchase price if the bond is held to maturity. If the bond is sold

before maturity, the market price is paid based upon prevailing economic conditions.

The yield to maturity is equal to the internal rate of return (IRR) on the

investment. The IRR may be calculated directly or an estimating formula may be used.

Yield to maturity (estimate) =

annual coupon interest

Formula 9

+ (discount

or

/ number of years to maturity)

- (premium

Example 21

Assume a 8.5% bond (par $1,000) is currently selling for $802 and has 12 years

to maturity. The discount is $198 ($1,000 - $802). The yield to maturity is 11.27 percent

and the current yield is 10.60 percent.

85 + (198 / 12)

----------------------

85 + 16.5

----------------

= 11.27%

- 35 -

(802 + 1000) / 2

901

If the current market price is $1,037, the premium is $37. The yield to maturity is

8.042 percent and the current yield is 8.196 percent.

85 - (37 / 12)

-----------------------(1,037 + 1000) / 2

85 - 3.083

------------1,018.5

= 8.042%

If the market price of the bond is selling at a price equal to par, the coupon rate

equals the yield to maturity. If the market price increases, the yield to maturity

decreases - an inverse relationship. If market interest rates increase, the bond's market

price decreases. The amount of change is a function of time to maturity and the

magnitude of the interest rate change.

Alternatively the internal rate of return may be calculated by using the following

spreadsheet formula:

@IRR(guess, range) where guess is a starting interest rate for the estimating procedure and range is the

range of cells containing the periodic cash flows.

As noted above, investors need to be sensitive to after tax investment results. It

is difficult to compare investments if the tax obligations vary. Therefore, to compare

investments with different tax obligations, an after tax rate should be used. However,

the applicable tax rate and the timing of the adjustment depends upon the investment's

taxability. Investments are either taxable currently, tax free or tax deferred. Capital gains

are usually taxable, but in some cases taxes may be deferred. Some investments made

with before tax dollars are taxable when constructively received.

Example 22

- 36 -

Arnold buys 100 share of stock with after-tax income. Any dividends are taxable

in the year received. When Arnold sells the stock, taxable gains or losses will be

realized.

Arnold also makes contributions to a 403(b) plan. Payroll amounts are invested

on a before tax basis. Any earnings or capital gains in the plan are deferred until

distributions are made.

Both investments may be generating the same before tax rate of return.

However, the after tax consequences are different.

The after tax yield on a fully taxable investment equals its before tax yield

multiplied by 1 minus the tax rate.

Example 23

Arnold invests in a tax free municipal bond. If the bond pays 7.35 percent of its

market price, the after tax yield is 7.35 percent.

An alternative common stock investment is yielding 5.23 percent. Arnold is in the

28 percent marginal tax bracket. His after tax dividend yield is calculated by the

following.

yield x (1 - tax rate) =

5.23% x (1 - 0.28) = 3.76%

Basic Portfolio and Diversification Concepts

Prudent investors do not purchase one type of security or buy only the stock of

one firm. Investors build diversified portfolios of securities. A portfolio is a group of

investments exhibiting different characteristics. Diversification strategies stabilize the

total value of the investments and their distributions and minimize loss potential.

Unfortunately, diversification often limits the growth potential of the portfolio's value.

- 37 -

approaches:

preferred stock, bonds, U.S. Treasuries, real estate and collectibles.

speculative versus "blue chip" common stocks.

cash) and whether the investment is fixed (pays fixed interest rates) or

variable (the value changes based on market conditions).

portfolio may possess all of the above characteristics in an attempt to meet the person's

financial goals. The basic idea behind diversification is to add individual investments to

the portfolio that tend to stabilize value, earnings or payments. These investments are

said to be negatively correlated. Negatively correlated investments move in opposite

directions.

Example 24

Randy Azwald purchased 100 shares each of two common stocks for $32 and

$18 respectively for $5,000 ($3,200 + $1,800). One year later the price of the $32 stock

equals $40 while the $18 stock fell to $10. The total value of the portfolio now is $5,000

($4,000 + $1,000). The value of the portfolio remains the same as these two stocks are

negatively correlated.

- 38 -

life cycle. When young people invest, their strategy should focus on long-term results,

the maintenance and improvement of purchasing power and an emphasis on receiving

capital gains. Older people should focus on the stabilization of investment value and

generating current income while trying to maintain or improve purchasing power.

Dollar cost averaging

One strategy used by people with a long-term investment horizon is called dollar

cost averaging. Dollar cost averaging calls for a periodic investments to be made in a

mutual fund or other security. Given a fixed amount of dollars to invest, the number of

shares a person can purchase is a function of the share price. As the share price

increases or decreases, the number of shares one can purchase decreases or

increases respectively. Over a long enough time and in a cyclical market, the average

share purchase price tends to be lower than the average market price. Table 6

illustrates this process. If $400 is invested each month as the share price of the

common stock increases and decreases, a different number of shares purchased

results. Over this short period of time, the average market value at the end of the 12

month period is higher than the average share purchase price. Even though the investor

derives benefits from dollar cost averaging, the strategy does not protect an investor in

a continually down market or from selecting poor investments. It also does not help the

investor when there is a requirement to sell in a temporarily depressed market at which

time, the market value could be less than the cost.

TABLE 6

EXAMPLE OF DOLLAR COST AVERAGING

Periodic

Purchase

- 39 -

Shares

Total

Period

1

2

3

4

5

6

7

8

9

10

11

12

Investment

400

400

400

400

400

400

400

400

400

400

400

400

-----------$4,800

Price

32.00

32.50

31.00

29.00

25.00

28.25

30.00

33.00

34.00

35.50

38.00

39.00

(5,886.38 / 150.93)

Average Share Cost

(4,800 / 150.93)

Purchased

12.50

12.31

12.90

13.79

16.00

14.16

13.33

12.12

11.76

11.27

10.53

10.26

-----------150.93

Value

400.00

806.25

1,169.04

1,493.62

1,687.60

2,306.99

2,849.90

3,534.89

4,042.01

4,620.33

5,345.71

5,886.38

$39.00

$31.80

The main purpose of life insurance is to produce dollars to solve financial

problems when the insured dies. Term insurance contracts provide pure protection

since there is no accumulation in cash values. Whole life policies are a blend of

protection and savings due to the necessity of funding a death claim when the death

occurs, not if the death occurs.19 Part of the life insurance contract is unique in that it

cannot be duplicated by any other financial product. No other financial product can

guarantee the payment of thousands of dollars whenever a death occurs - even if the

contract has just begun. The life insurance contract also has a shared function - the

accumulation of dollars. Even though the main purpose for the accumulation is to

produce an affordable plan for life-long insurance protection, the cash value may be

- 40 -

used for other purposes and may be withdrawn. This use of the cash value provides

much flexibility but imposes upon life insurance the character of an alternate

investment. When the cash value life insurance is purchased, the life insurance and

saving decision is intimately entwined.

In the material in this chapter, we have described alternative investments that

reasonably substitute for the life insurance product and their characteristics. We now

describe the characteristics of the life insurance products. Measuring the cost of life

insurance, making comparisons and calculations of rates of return are fully developed in

Chapter 6.

Traditional Cash Value Life Insurance

There are advantages and disadvantages of using the traditional cash value life

insurance product for savings. These advantages and disadvantages are summarized

below.

Advantages of saving using life insurance

Forced savings. The constant reminder to pay the premium notice is one

advantage of the cash value life insurance product. Many people do not have the self

discipline to set money aside without external persuasion.

Professional investment and diversification. For those having the discipline to

save, the expertise in developing an investment strategy, building a portfolio, selecting

individual securities and monitoring its performance may be lacking. Life insurance

19The mathematics of life insurance is fully developed in Chapters XX, XX and XX.

- 41 -

offers instant diversification, regardless of the cash value amount and professional

investment management of the funds.

Favorable tax treatment. As of this writing, the periodic increase in cash value is

tax deferred. When the policy is surrendered, the cash value amount in excess of the

policy's cost basis is taxable. If the policy matures because of a death claim, the death

benefits (which include the cash value amount) can be paid to the beneficiary tax free.

The tax aspects of life insurance are fully explored in Chapters 3 and 4.

Low risk. Historically, life insurance products have proven to be safe. Newly

developed life insurance guarantee funds exist to protect policyholders in the event of

bankruptcy providing further security. The regulation of the life insurance industry has

created a secure environment for the policyowner. Life insurance investments and the

company's overall financial stability are reviewed by state regulators to spot abnormal or

dangerous trends. Because of investment restraint and necessity to invest in

conservative securities, low risk - low return investments are made.

Creditor protection. The cash value contained in life insurance is treated

favorably by the states in the event of bankruptcy. Depending upon state law, the cash

value of the life insurance product is protected from the claims of the owner's creditors.

Disadvantages of saving with life insurance.

The disadvantages of saving using traditional cash value life insurance include

the high initial transaction costs, the reduced rate of return compared to alternative

investments and the erosion of purchasing power in an inflationary environment.

Transaction cost. Traditional whole life insurance is heavily front-end loaded. For

the first several years, a large percentage of the premium pays for commission to the

- 42 -

sales agent and the overhead of the insurer. The cash value amount increases slowly

during the first several years while increasing faster in the later years. If the owner

surrenders the policy in its early years, a large "loss" may occur since much of the

premium paid for expenses instead of going into the cash value. Therefore, the decision

to purchase cash value life insurance should assume a long contractual relationship for

reasonable financial results to occur.

Return potential. Alternative investments may generate a higher after-tax rate of

return. Because of regulatory constraints and the need to protect principle amounts,

insurers invest in relatively low risk - low return investments. Insurers retain the risk of

investment loss and cannot afford a reduction in asset values. Insurers must have the

cash available to pay death claims, make policy loans and pay surrender values when

policyowners terminate contracts.

Purchasing power. The purchasing power of the dollars produced by fixed face,

guaranteed cash value life insurance contracts can be substantially eroded by inflation

especially over long periods of time. Traditional cash value life insurance contracts

provide a schedule of guaranteed policy values based on the policy's duration. The face

amount is fixed as part of the contract. Dividend options and the exercise of policy riders

can increase both the death benefit and cash value amounts. At a 7 percent inflation

rate, the number of dollars will approximately double to purchase the same basket of

goods 10 years earlier. This fact underscores the fact that financial plans should be

reviewed at least annually.

Universal Life Insurance

- 43 -

The nontraditional life insurance products including variable life, universal life and

variable - universal life insurance are designed to overcome the perceived

disadvantages associated with traditional cash value life insurance products and

compete favorably for a method of savings.

The nontraditional contracts retain all of the advantages of traditional life

insurance but investment risk is shifted from the insurer to the policyowner. In return for

the opportunity to earn competitive market rates of return and provide an inflation

hedge, ULI contracts allow the policyowner to participate in the risks as well as the

rewards. Variable life, universal life and variable - universal life insurance products are

described in detail in Chapter XX.

REVIEW QUESTIONS

1. Why are time value of money calculations important in financial planning?

2. Life insurance products can be broken into a unique and a shared function. What is

the unique function and shared function of the life insurance product? Explain.

3. Distinguish between the process of calculating the present value of $1 and

calculating the future value of $1.

4. What is the difference between an annuity and an annuity due? Identify a cash flow

following an annuity pattern and one following the annuity due pattern.

5. What four factors should be investigated before any investment is made? Explain

each. Provide examples of situations where an investment need does not match the

investment's characteristics. What problems result from this mismatch?

- 44 -

6. What is meant by purchasing power risk, market risk, interest rate risk and issue

specific risk? Explain each.

7. What is the difference between tax deferred and tax free investments? What

financial factors go into the decision to invest in one versus the other?

8. What is the difference between a fixed income and equity investment? What can an

investor expect to receive from each?

9. Describe a U.S. Treasury bill, note and bond. Why are Treasury bills discounted and

notes and bonds pay semi-annual interest? Do you pay taxes on interest? Capital

gains?

10. Describe the relationship between maturity and yield.

11. How can the tax on U.S. saving bond series EE interest be postponed?

12. Compare traditional life insurance as an investment to bonds and stocks.

13. What is the basic idea behind building portfolios of securities? What is meant by

diversification?

14. Summarize the advantages and disadvantages of using traditional and nontraditional

life insurance policies for saving.

BIBLIOGRAPHY

Branch, Ben, Investments Principles and Practices (2nd Edition), Dearborn

Financial Services Publishing, 1989.

Greynolds, Elbert B. Jr., Aronofsky, Julius S. and Frame, Robert J., Financial

Analysis Using Calculators: Time Value of Money, (New York: McGraw-Hill, 1980).

Widicus, Wilbur W. and Stitzel, Thomas E., Personal Investing (5th Edition), Irwin

Publishing Company, Homewood, IL, 60430, 1989.

- 45 -

- 46 -

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