You are on page 1of 51

Chapter 1: The Preretirement Market

Retirement Market Segment: The retirement market has two segments:

A) Retail Segment: The retail segment includes individuals and families looking for solutions to their retirement

Product Providers: The companies that create and market financial products for retirement.
Advisors: Professionals who help customers evaluate and select retirement strategies and products.
Customers: The individuals that purchase and use retirement products.

B) Institutional Segment: The institutional segment includes the businesses and other groups that buy retirement
products, plans, and services for the benefit of their employees or members.

Plan Providers: The companies that offer group retirement plans.

Consultants/Advisors/Brokers: Parties that are compensated for helping plan sponsors evaluate and
select retirement plans.
Plan Sponsors: The businesses and other groups that buy retirement plans for the benefit of their
employees or members.
Plan Participants: The individuals covered by a group retirement plan.
Pre-Retirement Market: Retirement is typically defined by age and employment status:
Past retirement market - people age 65 or older who had left the work force.
Past pre-retirement market - people under age 65 who, with the exception of disabled individuals and
spouses who didn't work for pay, were actively employed

Goals of Pre Retirement Market: People in the pre-retirement market tend to share a common goal To make sure
they have enough money to cover their financial needs. Achievement of this goal depends on two primary factors:

Their available resources

Their expenses

Life Stage:

Young Adults

Mid Life Adults

Pre Retirees


25 to 45 years before retirement

10 to 25 years before retirement
5 to 10 years before retirement

The resources can include:

Employer-sponsored retirement plans
Personal savings

Young Adults

25 to 45 years before retirement

Primarily depend on wages to cover their financial needs

Lower end of wage scale: Relatively new to work force and work at entry or mid-level
Upper end of wage scale: More established , likely to part of two income households and hence more

Like 25% of peers, young adults expect to start saving by the time they reach age 25
Mid Life Adults

10 to 25 years before retirement

Established careers with high income

Apart from wages, other resources include:


Most mid-life adults are homeowners and, for many, the equity they have in their homes represents a
significant financial resource.
Many mid-life adults also own other residential and non-residential real estate

Employer-sponsored retirement plans: Although contributions are voluntary, most mid-life adults have at least
some funds in employer-sponsored retirement plans or pension accounts.
Personal savings and investments:

Most mid-life adults have money in personal savings accounts.

Some also own life insurance, certificates of deposit (CDs), and investments such as stocks, bonds, and
mutual funds.

Most of them are actively saving or paying for higher education for their kids
Pre Retirees

5 to 10 years before retirement

In the United States, Baby Boomers- those people born between 1946 and 1964- represent the largest
segment of the population.
Many of them have already retired and the nearly 50 million Boomers between the ages of 55 and 70
who are still working are getting ready to retire.
Pre-retirees have been in the workforce for half their lives or more and many have increased their
incomes dramatically.
Like mid-life adults, a large number of pre-retirees have also accumulated considerable liquid assets
and retirement savings.

More than half of them own their own homes.

Mass market: Traditionally US households dived into three income-based categories

Low income households

Middle income households
High income households

$0 to $24,999
$25,000 to 74,999
$75,000 to $100,000

Affluent Market: Created by the shift from income to total liquid household assets

Mass affluent households

High Net Worth households
Ultra High Net Worth households

$100,000 to $1 million
$1 million to $24.9 million
$25 million or more

Summary of the life stages of the pre-retirement market:

Pre-retirement expenses: The costs of raising children can be significant, but child-rearing is only one of the many
expenses that compete for resources during preretirement years. Most people also need to cover

Living expenses
Education expenses
Health care expenses

Living expenses - expenses associated with everyday life:

Transportation (gas, car maintenance)
Insurance (homeowners, automobile, life)
Housing (mortgage, rent, furnishings, repairs)
Utilities (gas, electricity, water, garbage)

Actual amount paid towards living expenses depend upon

Geographic location
Family Size
Standard of Living

Education Expenses:

Providing post-secondary education for children can increase household expenses by $20,000 per year or
more, depending on
The colleges children attend
Whether they live at home or on campus
Whether they receive any financial aid
And that amount increases every year.
In fact, the cost of post-secondary education has increased at a faster rate than most other expenses.

Tax Advantaged College Saving Plans: Families in the U.S. can choose from two types of tax-advantaged
Coverdell Education Savings Account (ESA): A federal education savings plan that allows people to contribute up
to a specified amount per year into an education account on behalf of a named beneficiary who is under age 18 or has
special needs.
529 College Savings Plan: A state-based education savings plan that allows people to deposit funds into an
education account on behalf of a named beneficiary

Employer Sponsored Health Plans: The majority of full-time workers in the United States receive health care
coverage through employer-sponsored group plans. In the past, most employers offered employees a choice of:
Traditional medical expense insurance provided benefits for routine and major medical expenses
A managed health care plan - integrates the financing and delivery of health care services to manage the cost of
Although health care costs are reduced for plan participants, there are some participants' expenses.

Coinsurance / Copayment

Premium Deducted from wages

Deductible A flat dollar amount of eligible expenses that an insured must pay before the insurer begins making any
benefit payments under an insurance policy. In medical expense insurance policies, the deductible usually applies to
the total of eligible medical expenses incurred during a period of time, such as a year
Coinsurance / Copayment A specified, fixed amount that managed health care plan members must pay for
specified medical services at the time the services are received
Health Savings Accounts (HSAs): Today, many employees in the United States are managing their own health care
costs by establishing Health Savings Accounts (HSAs). The amount that employees and employers can contribute to
HSAs is specified by the Internal Revenue Service (IRS).
Example: Most HSAs include a high-deductible health plan (HDHP) that provides benefits for qualified medical
expenses. Owners can choose the deductible amount and coinsurance amount for the HDHP as long as deductible and
total out-of-pocket expense amounts satisfy regulatory requirements.
HSA funds can be used to pay the HDHP deductible and/or eligible expenses not covered by the HDHP. If an
employee's medical expenses exceed the amount in the account, the employee must pay the excess costs out of
pocket until costs reach the established maximum.
Benefits of HSAs: HSAs offer benefits over traditional health care options. For example:

Because of the high deductible, monthly premiums for HDHPs are typically lower than premiums for
traditional medical expense insurance or managed care plans.
Contributions to a qualified HSA can be made with pre-tax dollars. Any unused funds in the account at the
end of the year roll over to the following year.
HSAs are portable, so money remains with the individual if she changes jobs or leaves the work force.
HSA contributions are invested in money market accounts, CDs, and mutual funds. Investment earnings
are not taxable until withdrawn.
Funds withdrawn from the HSA to cover qualified medical expenses are tax free. However, funds used for
non-qualified expenses are generally subject to a 20% penalty tax and income taxes

Debt: Another expense for pre-retirees is debt, which arises when people use credit, or borrowed money, to buy
products and services.
Debt most often comes in the form of outstanding balances on

Home mortgages
Home equity loans
Car loans
Personal education loans
Credit cards

Installment Debt: Financial services companies classify most loans as installment debt because they require regular
payments over a specified period of time.
Revolving Debt: In contrast, financial services companies classify credit card debt as revolving debt because
payments can extend indefinitely.
Card owners can add new charges before paying off existing charges.
Advantages of Using Credit: Buying on credit provides a way for people to

Buy products and services they otherwise couldn't afford

Cover emergencies
Avoid carrying large amounts of cash
Establish a credit history

Disadvantages of Using Credit: Buying on credit may also cause people to:

Pay more for credit purchases than they do for cash purchases due to Interest charges on unpaid balances
Damage their credit history by carrying too much debt

Retirement Savings: Saving for retirement is essential, and the earlier people start saving, the more funds they will
have at retirement.
Contributing small amounts to retirement plans over a long period of time can produce a higher account balance than
contributing large amounts over a short period of time.
There are 3 popular savings options:

Employer sponsored retirement plans

Bank based savings

Employer Sponsored Retirement Plans: Employer sponsored retirement plans can be structured in 2 ways:

Defined benefit plans-Specify the amount of the retirement benefit

Defined contribution plans-Specify the level of contributions to the plan

Defined benefit plan: A retirement plan structured using a defined benefit formula that specifies the amount of the
benefit a plan participant will receive at retirement.
What does the plan promise

The benefit amount a participant receives at retirement

How are contributions


The plan sponsor must provide enough assets to the plan to

provide the promised benefits

Who contributes

Plan sponsors. Plan participants typically don't contribute

How are benefits paid

Most defined benefit plans are structured as pension plans that

provide life time benefits beginning at retirement

Defined contribution plan: A retirement plan structured using a defined contribution formula that specifies the level
of contributions that the plan sponsor promises to make to the plan on behalf of participating employees.
What does the plan promise

The amount the plan sponsor would contribute to the plan on behalf of the plan

How are benefits determined

Benefit amounts are based on the total amount in the participant's account at

Who contributes

Usually, both plan sponsors and plan participants can contribute. Each can deduct
the contributions they make from their taxable income

How are benefits paid

Typically in a lump sum, although some plans offer additional payout options

The plan structure determines

if plan sponsor contributions are mandatory or voluntary

if plan participants make contributions
how benefits are paid

Type of Plan

Sponsor Contributions

Participant Contributions


Traditional Profit
Sharing Plan

Voluntary - based on and payable

Usually not allowed
from Employer's profits

Lump sum or monthly annuity


Stock Bonus Plan

Voluntary - based on Company's



Benefits paid in company stock

401(k), 403(b),
457(b) plans

Voluntary - Sponsor's match

participant contribution up to
specified percentage of
participant's salary

Voluntary - usually a fixed

Lump sum, Installments or monthly
percentage of annual
annuity benefits

Individual Retirement Arrangements (IRAs): An individual retirement arrangement (IRA) allows a person
with taxable compensation to deposit a specified amount in a savings arrangement that receives favorable federal tax
IRAs can be funded by financial products including annuities, mutual funds, and certificates of deposit (CDs).
Two forms of IRAs include:
Traditional IRAs: A type of an IRA into which a person with earned income can make annual tax deductible
contributions. Contributions are generally tax deductible

Earnings grow on a tax-deferred basis

Withdrawals must begin by age 70 1/2 and must meet minimum distribution requirements
Withdrawals are taxable as income
Nonqualified withdrawals (made before she reaches age 59%) are subject to an additional 10% tax penalty

Exceptions: Penalty taxes on withdrawals are waived if the withdrawal is

Made at the owners death or disability

Used to buy or rebuild a first home (up to a $10,000 limit)
Used to pay for qualified education expenses
Used to pay unreimbursed medical expenses exceeding a specified percentage of adjusted gross income
Used for health care Insurance payments If the owner Is unemployed and has received unemployment
compensation for 12 consecutive months
One of a series of substantially equal periodic payments

Roth IRAs: A type of an IRA that permits people within certain income limits to make nondeductible contributions and
to withdraw money on tax free basis. Contributions are made with after-tax money

Earnings accrue on a tax-deferred basis

Withdrawals aren't subject to age and minimum amount requirements
Qualified withdrawals are tax free
Nonqualified withdrawals may be taxable and, if made before he reaches age 59%, are also subject to a
10% tax penalty

For a distribution to be qualified:

1) The account must have been in effect for 5 years and
2) Payment must be made to:

an owner who has reached age 59%, become disabled, or withdrawn funds to buy or rebuild a first home,

a named beneficiary after the owner's death

Bank Based Savings Options: Banks in the United States offer two types of savings options:

Savings Account: An interest-earning deposit account that pays compound interest on deposited funds,
typically from the day of deposit to the day of withdrawal
Certificate of Deposit: A contractual agreement issued by a bank or other depository institution that returns
the owner's principal with interest on a specified date

Bank-based savings options don't offer substantial tax advantages, except when they are used to fund an IRA. The
money paid into bank-based savings options can't be deducted from taxable income at the time of payment. Earnings
are taxable as they are earned.

Securities: Security is a financial asset that represents either:

A) Debt Security: An obligation of indebtedness owed by a business, a government or an agency
B) Equity Security: An ownership interest
Investing in securities is an alternative method of accumulating assets. Although the value of securities varies widely,
they tend to increase in value over the long term.
The basic types of securities are:
Stock: An equity security representing a share of ownership in a corporation
Bonds: A debt instrument under which the entity that sells the bond promises to pay the owner of the bond a stated
rate of interest over a specified period of time and to repay the original amount of borrowed money at end of the
specified period.
Mutual fund: An investment account that pools the funds of multiple customers and uses the funds to purchase
shares in diversified portfolios of securities
Variable Annuity: An annuity contract under which the amount of the accumulation value and periodic income
payments fluctuate in accordance with the performance of one or more specified investment funds
Stocks: An equity security representing a share of ownership in a corporation
Typically bought and sold by consumers through stock exchanges or over-the-counter markets
Generate income through

Capital appreciation, which results when stocks sell for more than their original purchase price,
Dividends payable to shareholders out of company earnings


Historically have provided a better return on investment than fixed-rate products and over the long term usually
result in gains
Involve greater risk than fixed-rate products
Bonds: A debt instrument under which the entity that sells the bond promises to pay the owner of the bond a stated
rate of interest over a specified period of time and to repay the original amount of borrowed money at end of the
specified period.

The issuing company pays a stated rate of interest over a specified period of time
At the end of the period, the issuing company repays the face value of the bond to the owner
Safer than stocks, but tend to provide lower returns

Types of bonds include:

Corporate bonds
Treasury bonds
Agency bonds
Municipal bonds

Mutual fund: An investment account that pools the funds of multiple customers and uses the funds to purchase
shares in diversified portfolios of securities

Offer high liquidity and diversification

Have low minimum investment requirements
Offer professional management services

Variable Annuity: An annuity contract under which the amount of the accumulation value and periodic income
payments fluctuate in accordance with the performance of one or more specified investment funds

Generally less liquid than other investments

Offer owners a wide range of payout options

Can be customized to meet owners needs

Individual Investment Accounts:

Although people can buy securities directly from the issuing companies or government agencies and in open markets,
many people prefer to handle investments through a financial advisor
Brokerage Accounts:

Help with buying and selling securities

Personalized investment advice

Brokerage accounts are investment accounts established through securities broker-dealers that specialize in the
purchase and sale of stocks, bonds, and other financial instruments.

Discount Broker Dealers: Execute customers' orders to buy and sell securities
Full service broker dealers: Complete requested transactions and provide personalized investment
Online Brokerage Accounts: Usually offer fewer services than traditional brokerage accounts

In exchange for these services, customers usually pay either commission on sales, transaction fees, and/or
management fees.
Brokerage accounts usually take one of two primary forms:
Cash Account

Transactions are handled on a cash basis

Transactions are usually completed within three days after an investor places a buy or sell order
Most accounts require investors to make a small initial deposit-usually
$50-to open the account and additional cash payments to cover transaction costs

Margin Account

Transactions can be funded with a combination of investor deposits and money borrowed from the
brokerage firm.
Investor is usually required to make a substantial initial deposit either in cash or securities-usually at least
50% of the value of the buy-sell order
If the value of an investment made with borrowed funds falls below a specified percentage of its current
value (at least 25%), the brokerage firm can issue a margin call, which is notice to the investor that
additional cash or securities must be deposited into the account.

Managed Accounts

Active management of investment portfolio to achieve specific objectives

Personalized advice on selection, diversification, and allocation of assets

Managed accounts are customized investment portfolios established to achieve specific objectives, such as current
income or long-term growth.

Managed accounts usually require a high minimum deposit, such as $100,000, and advisers typically charge
an amount each year to cover advisory services, management activities, and transaction costs.

Chapter 2: The Retirement Market

Retirement Resources: Before they retire, many people receive most of their financial resources from wages.
After they retire, they rely on the three resources.

Employer sponsored retirement plans

Personal Savings and Investments
Government sponsored retirement plans

Social Security: It is a United States federal program that provides specified benefits such as retirement benefits,
survivors insurance and disability benefits to eligible individuals
Social Security Funding Details

Tax rate
Who pays?
Taxable wage base

Year of Birth
1937 or earlier
1943 - 1954
1960 or later

12.4% of earned income.

Employer half, employee half.
The maximum income taxed in a given year

Full (Normal) retirement

65 and 2 months
65 and 4 months
65 and 6 months
65 and 8 months
65 and 10 months
66 and 2 months
66 and 4 months
66 and 6 months
66 and 8 months
66 and 10 months

Taking benefits before retirement age: Anne was born on February 1, 1950, and has made contributions to Social
Security for 40 years. She is trying to decide if she will need to continue working until she reaches age 66 or if she can
retire at age 62.
Analysis: If Anne retires at age 66 (in 2016), she will be eligible for full Social Security retirement benefits. If she
chooses to retire at age 62, which is the earliest age she can file for benefits, her benefit will be reduced by 25%. For
example, if Anne's full benefit is $1,000, then her benefit at age 62 will be $750 ($1,000- $250).
Taking benefits with less than 35 years of earnings: Charlie retired in 2010 at age 65. When he retired, he had
30 years of Social Security earnings totaling $1,650,000. His average earnings over those 30 years equaled $55,000
($1,650,000 / 30).He has no plans to work again before he reaches his full retirement age of 66.
Analysis: Because Charlie has fewer than 35 years of Social Security earnings, the Social Security administration will
include five years with $0 earnings when it calculates his average earnings. As a result, his average earnings will
decrease to approximately $47,143 ($1,650,000 / 35), and his monthly Social Security benefit will be reduced.
Retiring Late: Under current rules, people earn a credit for each year they delay benefits, up to age 70, when
benefits reach a maximum.
What is a credit worth? It depends on when the retiree was born. Credit amounts range from

A minimum of 3% (for people born in 1924) to

A maximum of 8% (for people born in 1943 or later)

These credits apply whether a person stops working at the normal age or continues working until delayed benefit
payments begin. Cost of living adjustments, if any, also apply.
Example: Ronald was born after 1943, his benefit will increase by 8% each year he defers payments until he reaches
age 70. If he delays payment for 1 year, he will receive 108% of his scheduled monthly benefit. If he delays payments
for 4 years, he'll receive 132% of his scheduled benefit.
Other social security benefits: In addition to primary workers' benefits, Social Security also pays retirement
benefits to the spouses and survivors of eligible workers. Benefits are calculated as a percentage of the primary
worker's benefit.
Disabled individuals may also be eligible for benefits.
Taxes on social security: Although many may assume that Social Security benefits are tax free, that's not always
the case. The first step in determining whether Social Security benefits are taxable is to calculate the person's or
couple's combined income
Adjusted Gross Income (This is a persons income from all sources minus amounts for specified expenses)
Any Tax-Exempt Income (E.g. Interest from Municipal Bonds)
Half of Social Security Benefits for the Year
Combined Income
Next, determine whether the social security benefits are taxable from this table

Combined income
Taxable amount
Single, head of household Married, filing jointly
Less than $25,000

Less than $32,000

0% of social security benefits

$25,000 to $34,000

$32,000 to $44,000

Upto 50% of social security benefits

Over $34,000

Over $44,000

Upto 80% of social security benefits

Social Security Penalties: People who start receiving Social Security benefits early and continue to work may be
subject to an earned income penalty if their earnings are too high. The limits are set by the Social Security
The penalty is equal to a $1 reduction in benefits for every $2 that earned income exceeds the established limit.
The earned income penalty applies only to people who are younger than their normal retirement age. People who have
passed retirement age are not subject to penalties. In the year in which a person reaches full retirement age, it's
complicated, but we won't get into that.
Withdrawing funds from employer plans:
Retirees who leave the workforce typically have two options for receiving funds that have accumulated in their
employer-sponsored retirement plans:

Lump-sum Distribution: The retiree receives the full account balance in a single payment
Annuitized Payments: The retiree receives a steady income stream for life

Lump Sum distributions: Most defined contribution plans provide benefits in a lump sum at retirement. At
retirement, the participant can:

Take personal possession of the money: In most cases, this is not the best choice because taxes are
payable immediately on the entire taxable portion of the lump sum.
Keep the money In the DC plan: The retiree still has access to the features and investment options of the
group plan. He won't have to pay taxes until he makes withdrawals, and then he'll only pay taxes on the
taxable amount he withdraws.

Transfer the money to an IRA: If funds are transferred directly from the plan to a traditional IRA and not
paid to the plan participant, the transfer qualifies as a rollover, which is not taxed. Taxes are payable on the
taxable portion of any withdrawals taken from the IRA.

Rollover: A tax-free distribution of cash from one retirement plan that the owner then contributes to another
retirement plan within 60 days.
Annuitized Payments: Pension plans automatically pay retirement benefits as an annuity, and some defined
contribution plans offer an optional in-plan annuity. In addition, the participant can roll over a lump sum into an IRA
and use it to purchase an annuity. Taxes on annualized payments are payable when the payments are received.

Advantages of Annuitized Payments

The retiree receives payments for as long as she lives. She cannot outlive her income.
If a retiree lives longer than expected, it's possible that she will receive more in benefits than was paid into the
The retiree doesnt need to manage a large sum of money.

Disadvantages of Annuitized Payments

Fixed income payments lock retirees into a specific amount each month. Retirees can't choose a higher or lower
payment according to their actual needs in a given month.
If a person dies earlier than expected, it's possible that he will receive less in benefits than was paid into the
When an account balance is annuitized, a retiree no longer has access to the funds. He can't withdraw a lump sum
to pay for one-time or emergency expenses.

Withdrawing from Stock Bonus Plans:

Stock bonus plans present a special situation because benefits are paid in the form of company stock. The table below
summarizes how distributions are taxed.

Original value of stock

Increases in the value of stock

When is it taxed
At distribution, whether or not stock is sold
When stock is sold

Taxed as
Ordinary income
Long term capital gain

Withdrawing from Individual Retirement plans:

RMD: Required Minimum Distribution sometimes called Minimum Required Distribution (MRD): Must take distributions
by April 1 of the year after they reach age 70 and 1/2
How large do the distributions need to be? The minimum amount an owner must withdraw from a traditional IRA
each year-the RMD-is calculated by dividing the account balance at the end of the previous year by the owner's
remaining life expectancy.
How do I know what my life expectancy is? Life expectancies used to calculate RMDs are shown in tables
provided by the IRS
Suppose Rosy decided it would be a good idea to extend the amount of time her IRA would provide income payments,
so she decided to take $7,500 in distributions rather than the $10,000 calculated using the IRS tables.

Because contributions to traditional IRAs are most often made with pre-tax dollars and the taxes on earnings are
deferred, Rosy will have to pay income taxes on the entire $7,500 she received as a distribution.
Because she withdrew less than her minimum required distribution, she would also be subject to a tax penalty

Penalty for failing to take minimum required distribution: If an IRA owner withdraws less than the RMD, she
must pay a penalty tax equal to 50% of the difference between the RMD and the amount taken.
Rosys actual distribution in the earlier example is $2,500 less than the required distribution ($10,000 - $7,500), so she
would be assessed a penalty tax of half that amount, or $1,250.
Traditional IRA
Most contributions made with pre-tax money

Roth IRA
Contributions made with after tax

Earnings accrue on a tax-deferred basis

Earnings accrue on a tax-deferred basis

Pretax contributions and Investment earnings taxable on


Qualified withdrawals are not taxable*

"Taxes are payable on the portion of any non-qualified withdrawal that represents investment earnings. A nonqualified withdrawal is one that is taken before the account is five years old or. with some exceptions. before the
account owner is 59Y, years old.
Personal savings and investments:: Retirees make deposits to savings accounts or COs with after-tax money and
pay taxes on earnings in those accounts in the year they're credited to the account. As a result, retirees don't pay
taxes when they withdraw money from the accounts.
Retirees also buy securities with after-tax money, and they don't pay taxes on increases in the value of the securities
as long as they hold the securities. Retirees pay taxes on any increases in value at the time the securities are sold.
These increases in value, however, are taxed as capital gains and not as ordinary income, as long as the investment is
held for more than one year (any income from dividends or interest is taxed as income in the year it is earned).
Withdrawing from savings and investments:
Buying an annuity: Cashing in savings accounts and investment accounts and using the money to buy an annuity
takes the guesswork out of income planning because payments are designed to extend throughout the owner's
Laddering payouts: By staggering the payout dates of COs or bonds, a retiree can guarantee specified amounts at
specified times.
Taking systematic withdrawals: Under a systematic withdrawal plan (SWP), the retiree receives planned payout
amounts at predetermined intervals for as long as the savings or investments last.
Situations that can increase expense: Expenses can be higher than expected when retirees need to:

Assimilate adult children into the household.

Care for aging parents.

In addition, the percentage of retirees who own their own home is decreasing. So, more people may face large
amounts of debt during retirement.
Health care expenses: Aging people become increasingly susceptible to illness and injury. As a result, health care
expenses for retirees often increase dramatically.
In the United States, health care coverage for retirees typically transfers from employer-sponsored plans to
government-sponsored or personal insurance plans. The government provides health care coverage through two basic
plans, Medicare and Medicaid
Medicare: A U.S. federal government program established by the Old Age, Survivors, Disability and Health Insurance
(OASDHI) Act that provides medical expense benefits to elderly and disabled persons.
Medicaid: A joint state and federal program in the US, that provides basic medical expense and nursing home
coverage to the low-income population and certain aged and disabled persons.
Medicare Options:
Part A: It covers basic inpatient hospital services, limited period of confinement in nursing and extended care facilities
or home care after hospitalization, and hospice care.
Enrollment in Part A is automatic when a person applies for Social Security; otherwise, individuals need to formally
apply when they reach age 65
Part B: It covers physicians' professional services and costs for diagnosing and treating illnesses or injuries.
Part B is optional. People age 65 who are currently covered by an employer-sponsored health care plan usually don't
need Part B. Those who don't have outside coverage must formally enroll for Part B.

Part C: Also called Medicare Advantage, Part C combines Part A and Part B coverage and is available as a private feefor-service plan, managed care plan, or Medicare medical savings plan.
Many Medicare Advantage plans also cover prescription drugs.
Prescription Drug Costs: As the costs of medical care grow year after year, one major cause-though by no means
the only cause-is the rise in the costs of prescription drugs
Medicare Part D provides benefits for prescription drugs, but not for the full costs of the drugs.
Monthly Premium: The monthly premium for Medicare Part D varies by plan and is separate from the premium for
Part B.
Participants with income above a certain limit must pay an additional premium, which is deducted from Social Security
Cost Sharing: Part D plans generally feature an annual deductible and a coinsurance charge for each prescription
Plans offered by managed care organizations usually charge net copay for each prescription purchase instead of
Medicare Part D plans include a temporary gap in coverage-the infamous "donut hole"- that begins after a participant's
prescription costs have reached a specified level for the year. Above this level the participant is responsible for her
own drug costs until she reaches the plan's out-of-pocket maximum, at which point plan coverage resumes.

The good news is that, while in the coverage gap, participants receive price discounts from drug
The other good news for Medicare participants is that, as a result of the Patient Protection and Affordable Care
Act, the federal government provides subsidies to people in the donut hole.

These subsidies reduced drug costs during the coverage gap by half in 2011, and the subsidies will increase gradually
until 2020, when participants will pay the same percentage for prescription drugs in the donut hole as they pay before
entering the donut hole.
Government coverage for Long term care: Medicare provides limited coverage for long-term care
2012 skilled nursing home care costs and Medicare benefits
Median daily cost Medicare benefit
Day 1-20



Day 21-100



Day 101+



Medicaid coverage for long-term care varies by states. States that do offer benefits usually offer coverage through
community-based programs.
Long Term Care (LTC): It is insurance providing benefits for medical and other services needed by individuals who,
because of advanced age or the effects of serious illness or injury, need constant care at home, in an assisted living
facility, or in a skilled nursing facility.
Home Care: Most people's first choice for long-term care is the familiar environment of home. Many people also begin
by receiving care from family or friends. However, because the emotional burden of providing care can be
overwhelming for caregivers, they often tum to in-home assistance from an outside service provider. While reducing
stress, this can be very expensive.
Assisted Living: It is for people who are unable to live by themselves but who don't require constant care. The
services include:

Medication management

Housekeeping and laundry

Meal preparation
Assistance with bathing and toileting
Transportation to doctor appointments

Skilled Nursing Facility:

Skilled nursing care 24 hours per day

Hospital-like setting
A last resort for most people
Average length of stay about 2.5 years

Long Term Care Insurance: Clearly, there is a gap between many people's likely long-term care needs and the
coverage provided by the government. In order to navigate retirement successfully, retirees need either to set aside
part of their retirement funds for long-term care expenses or to purchase commercial long-term care
Characteristics of most LTC policies
Between $75 and $250 per day
Up to 100 days
Six month for pre-existing conditions disclosed in the application
Is cognitively impaired OR
Benefits paid if insured
Is unable to perform without assistance one or more of the six activities of daily living
Activities of daily living (ADLs):
Benefit amount
Waiting Period


Social Security Concerns: Social Security was designed:

To use revenues raised from workers

To fund benefits for retiree
With excess amounts placed into the Social Security Fund

In reality, social security pays more than it collects, and the trust fund is growing smaller.
Social Security Concerns: U.S. Congress has engaged in an ongoing debate over Social Security. Congress probably
won't eliminate the system but is likely to modify it. Legislation has already been implemented to increase the age at
which full Social Security retirement benefits will be payable and to encourage people to work longer. Other changes
are also being considered. Proposals include tax increases, benefit reductions, new benefit structures, changes to the
way COLAs are calculated, and program privatization.
A COLA is a cost of living adjustment- an increase in the amount of Social Security benefits to account for
rising prices.
Proponents argue that the new method for calculating COLAs, which would be based on a combination of general price
increases and spending patterns during periods of inflation, could reduce the strain on SS by $112 billion or more.
Opponents contend that the change would create hardship for seniors because the proposed adjustments would not
keep pace with increases in prescription drug costs.
Concerns about Retirement Plans: Shift to DC Plans - Effects:
From a retirement planning point of view, defined benefit (DB) plans offer certain advantages. When they retire, DB
plan participants know:

The amount of income they will receive each month or year

That their retirement income payments will last for the rest of their lives

Defined contribution (DC) plans introduce more uncertainty into the planning process. Plan participants can calculate
how much money goes into the plan, but they cant calculate how much monthly income they'll receive when they
retire or how long their benefits will last.

DC plans are built on the premise that over the long run, U.S. equities have always increased in value. Over the short
run, values can increase or decrease. While funds are accumulating, periodic low return rates usually aren't a problem.
However, when participants begin withdrawing money at retirement, they are subject to sequence of returns risk
Personal Savings: The U.S. government has taken a number of steps to encourage personal retirement savings by
offering savers significant tax advantages, such as those available to people who establish traditional or Roth IRAs.
Another example is the "Saver's Credit." Individuals who make contributions to IRAs, employer-sponsored retirement
plans, and government-sponsored plans may also be eligible for the Retirement Savings Contributions Credit.
Like other tax credits, the Saver's Credit is deducted from the amount of tax due on the individual's taxable income.
The Saver's Credit is intended to benefit low- and moderate-income workers and so is only available to people who
meet certain age and income requirements.
Retirement Savings Contributions Credit (Saver's credit): In the United States, a tax credit available to low- and
moderate-income workers who contribute to an IRA or one of several types of workplace retirement plans. The Saver's
Credit is available in addition to a plan's other tax advantages, but is often limited in amount and subject to various
However, even with these incentives from the government, the overall savings rate is still fairly low and unstable
People with poor saving patterns during employment are more likely to suffer from inadequate income during
Financial status in Retirement: Researchers predict that nearly 70 percent of Americans will experience changes in
financial status during retirement- either because of decreased resources or increased expenses. For example:

Increases in household size-created by the need to assimilate children, grandchildren, or parents into the
household-can increase expenses and affect how available resources are allocated.
Decreases in household size when children move out can make the need for outside assistance for home
care more likely.
The loss of a spouse to death or divorce, and the loss of income and support from that spouse can make
it difficult for the surviving spouse to maintain the same standard of living.

Increasing Longevity: Longevity can also affect a person's financial status. Today, seniors often live additional20
years or more after retirement. People who retire before age 65 may well spend as many years in retirement as they
spend working. Those extra years are likely to create significant mismatches between available retirement funds and
actual retirement needs. Even those people who have planned for retirement face the very real possibility that they
will outlive their funds. Therefore, a significant number of people are working beyond their "normal" retirement age on
a part-time or full-time basis.
Chapter 3: The Retirement Industry
The Financial Services Industry: The companies that offer retirement savings and income options are part of the
larger financial services industry
People, businesses, and governments buy their products and services to help save, borrow, invest, and otherwise
manage money.
Customers trust financial institutions to act fairly and ethically and to put the customers' interests above company
Financial services industry: The companies that offer products and services designed to help individuals,
businesses, and governments meet certain financial goals, such as protecting against financial losses, accumulating
and investing money or other assets, and managing debt and cash flows



Pension Funds




Savings and
Savings Banks

Credit Unions

Broker Dealers

Mutual Fund

Contractual savings institutions:

Collect money from households, businesses, and governments

Invest it in long-term financial assets
Use accumulated assets to pay the benefits promised in a contract

In the United States, the two primary types of contractual savings institutions are

Insurance companies- Offer insurance, protection for their customers against financial loss caused by
specified events
Pension funds -Pool contributions made to pension plans to provide plan participants with lifetime income
benefits beginning at retirement

Insurance companies: Two broad categories of Insurance Companies Include:

Life and Health Insurance Companies: Offer protection against personal risk
Property / Casualty Insurance Company: Offer protection against property damage risk and/or liability risk

Personal risk: It is the risk of economic loss that results from death, poor health, injuries, or outliving one's economic
Liability risk: It is the risk of loss from a person being held responsible for harming others or their property.
Pension Funds: Pension funds pool the assets contributed to employer sponsored pension plans. Pension plans can
be established:

By private plan sponsors, such as employers on behalf of their employees

By public sponsors, such as government agencies on behalf of citizens or public-sector employees

The largest public pension plan in the United States is Social Security.
Pension Benefit Guaranty Corporation (PBGC): A U.S. federal agency that guarantees the payment of part or all
of the retirement benefits for participants in defined benefit retirement plans when those plans become financially
unable to pay benefits.

In the United States, pension plan participants are protected against loss of benefits by the Pension Benefit
Guaranty Corporation (PBGC).
In 2011, the maximum amount payable by PGBC to a 65 year-old participant in a financially impaired pension plan
was $4,500 per month, or $54,000 per year.
Plan sponsors are required to pay a premium every year to participate in this insurance program.

Depository Institutions: It is a financial institution that specializes in accepting deposits and making loans.
The primary activities of depository institutions include:

Accepting deposits
Making loans
Offering checking accounts, savings accounts, and debit and credit cards
Sometimes offering investment services, financial counseling services, and trust services

Types of Depository Institutions: The primary depository institutions in the United States include:
Commercial banks: It is a depository institution that accepts deposits from people, businesses and government
agencies and uses these deposits to make consumer and business loans.

Make personal and commercial loans

Accept savings account deposits from individuals and businesses
Serve as distributors of mutual funds and insurance products

Savings and Loan associations (S & Ls): It is a depository institution that pools the savings of people and makes
residential mortgage loans.

Make residential mortgage loans to consumers

Accept savings account deposits
Offer checking services

Credit Unions: It is a nonprofit depository institution that does business only with its depositors called memberswho traditionally shared a common bond, such as an employer or their industry

Make consumer loans to members

Accept deposits from members
Function as non-profit cooperative organizations owned members

Savings banks (allowed only in certain states)

Accept savings account deposits from individuals

Make mortgage loans to individuals

How do depository institutions operate?

Customers deposit funds with depository institutions. In exchange, the institution pays its depositors interest.
The institution uses deposited funds to make investments or to make loans to other households, businesses, or
government agencies, which pay interest to the institution for use of the funds.
Interest: It is a fee that individuals and financial institutions pay (or charge) for the use of borrowed money.
Depository institutions also invest deposited funds in financial markets.
The interest the institution earns on loans and the earnings generated by the investments are the companys revenue.
The difference between the interest the institution pays and the interest it earns is a large part of the institution's
Federal Deposit Insurance Corporation (FDIC):
The Federal Deposit Insurance Corporation (FDIC) insures deposits in member commercial banks for amounts up to a
specified limit per depositor, per bank, based on account title.
In 2013, the coverage limit was $250,000 per depositor per bank.
The National Credit Union Share Insurance Fund (NCUSIF) provides similar protection for credit union deposits.

National Credit Union Share Insurance Fund (NCUSIF)

It is the insurance arm of the National Credit Union Administration that insures credit union accounts for up to
Our last key type of financial institution is investment institutions, which buy and sell securities.
Securities represent either:

An ownership interest in a business (stock)

A debt owed by a business, government, or agency (bond)

Investment institutions, which can market securities to both institutional and individual investors, fall into two
Broker-Dealers Investment Institution: It is a financial institution that engages primarily in investing and trading
Mutual Fund Company: It is a Type of investment institution that manages one or more mutual funds and sells
shares in those funds to individual or organizational customers. Also called an investment company.
Broker-Dealers: Broker-dealers act as brokers when they serve as intermediaries between buyers and sellers of
securities, supervise the sales process, and provide information and advice to customers.
Broker-dealers act as dealers when they maintain an inventory of securities and market those securities to customers.

Mutual fund companies: Mutual fund companies pool funds collected from investors to buy securities. The company
then assembles the purchased securities into diversified investment portfolios called mutual funds. Individual investors
own shares in the funds based on the amount of their investments.
Example: Most mutual fund companies offer customers a choice of funds, each with its own risk profile and
investment objectives. Investors can buy or sell fund shares at any time- either directly from the fund company or
through a broker-dealer-and can switch from one fund to another.
How do mutual fund companies generate revenue? Mutual fund companies generate revenue by collecting fees
from investors or assessing sales charges for performing transactions.
Two types of sales charges include:

Front-end sales charge: a charge investors pay when they purchase mutual fund shares
Back-end sales charge: a charge investors pay when they sell mutual fund shares

Most companies also assess maintenance charges or expense charges designed to cover their operating expenses.
Features: A product is a bundle of physical, technical, and functional features.
For example, an individual retirement arrangement (IRA) can be described in generic terms as a bundle of asset
accumulation features, tax benefits, and payout options

Purpose: For a customer, a product is a solution to a problem and a way to satisfy needs.
For example, a retirement plan can be a means of providing financial security or protection against financial risk, a way
to manage savings and taxes, evidence of the owner's concern for loved ones, or a legacy left by the owner to future
Value: The value of a product depends on how well it solves problems or satisfies customers' needs.
Product Classification: Most products fall into one of two categories: goods and services

Customers can see, touch, and sometimes smell, hear, and taste goods.
Customers can only experience a service as it is performed or used.
Although some products fit neatly into one category or the other, most have both tangible and intangible

Goods and Services: We can divide goods and services into product classes, package or brand them, and sell them
to individuals or to businesses.

Product Class: Cars are often divided into classes such as luxury cars, economy cars, family cars, or sports
cars according to their use and the image they foster. Joe and Mia's minivan would most likely be classified as
a "family car" rather than a luxury car" or a sports car
Branding: The minivan is branded because it carries the manufacturer's name.
Individual/Business Because they bought the car for their personal use, it is an individual rather than a
business purchase.

Unique characteristics of financial products: Like other products, financial products can be

Distinguished as goods or services

Divided into categories
Sold to individuals or businesses

However, financial products have two unique characteristics that set them apart from other products: their function
and their structure
Product Function: The primary function of all goods and services is to satisfy customer needs

Most tangible goods satisfy needs directly

Most nonfinancial services satisfy needs directly

Most financial services directly satisfy some psychological needs, but satisfy most other needs indirectly.
Product Structure: Structurally, most financial products are augmented products that consist of two parts:

A core product that meets needs

A bundle of value-adding supplementary Services

Supplementary Services:
Facilitating service: Helps customers use product

Information Services: Brad Worley calls Prime Financial Services {PFS) for information about the different
investment options available through his 401{k).PFS provides Brad with detailed information on each option.
Order Taking Services: Brad contacts PFS to make changes in his allocations and to request automatic
investment rebalancing.

Enhancing Service: It adds extra value to product

Billing Services: PFS sends Brad a statement showing his transactions, fees, and account balances.
Payment Services: Brad takes a loan from his account. PFS provides Brad with options for repaying

Types of Depository Institutions: Products offered in todays financial services marketplace can be divided into four
core categories based on the needs they address. Here are the product categories and what they help customers to do
Cash Management:

Pay bills
Make purchases
Store money short-term
Transfer funds from one account to another

Asset Protection: Manage risks and protect against financial losses

Asset Accumulation: Build wealth over time
Asset Distribution: Manage the distribution of accumulated wealth
Cash Management Products: Cash management products are designed primarily to satisfy short-term financial
needs and obligations.

Protection against loss: Since they live in the United States, Carol and Bill's bank-issued products are
protected against loss, subject to certain limitations, by the Federal Deposit Insurance Corporation (FDIC).
Easy Access to Funds (liquidity): Products such as checks and debit cards give Carol and Bill almost
immediate access to their money.
Convenience: Using checks or debit cards allows Bill and Carol to buy products and services quickly and
easily, without having to carry large amounts of cash.
Transaction cost:
Bill and Carol don't pay fees for their checking and savings accounts. They do pay charges for withdrawals
from their money-market account and for mutual fund purchases and sales, but these charges are fairly small.
Wide Acceptance:
Most businesses and individuals accept checks, debit cards, or credit cards as a form of payment for goods and

Asset Accumulation Products: Asset accumulation products are designed to increase the amount or value of assets
over time. Options in this category can help owners save for retirement, fund a child's education, or transfer assets to
future generations.
The particular product a customer purchases generally depends on the products ability to offer an acceptable level of:

Earning potential

Earning Potential: For the value of an asset to increase over time, the asset must generate returns, or earnings.
Most asset accumulation options generate returns in the form of:

Capital Appreciation

Risk: All asset accumulation options carry a certain amount of risk as a result of their exposure to unpredictable
fluctuations in interest rates, market performance, or inflation rates.
Because of the relationship between risk and return, options with higher risks typically produce higher potential
returns and options with lower risks offer lower potential returns
Liquidity: Eventually, customers will need to convert accumulated assets into cash to meet their financial obligations.
The more liquid the asset, the faster and more easily it can be converted to cash.

Shares of stock and mutual funds are highly liquid because they can be sold at any time, without penalty
(although such sales can result in sales charges in some cases).
Under certain circumstances, certificates of deposit (COs), bonds, 401(k) accounts, or IRAs are also
reasonably liquid.

Real estate, business interests, and annuities still in the surrender period, on the other hand, have very low

Cost: Cost asset accumulation options involve sales charges. Owners also commonly pay on-going maintenance fees
or expense charges to cover the issuing company's or distributor's operating expenses.
Insurance: Most asset protection products are forms of insurance, such as:

Automobile insurance
Disability income insurance
Homeowners insurance
Life Insurance
Health Insurance

Asset Distribution Products: A financial product that enables owners to manage the distribution of assets to
ensure that resources are available when needed. Most retirees have a significant need for a reliable stream of income
that will cover everyday living expenses as well as expenses associated with disability or critical illness. Retirees also
need a way to manage lump-sum payments, such as those received from certain retirement plans, inheritances, prizes
or awards, and legal settlements. Asset distribution products can help retirees meet these needs.
Asset distribution products usually include one of two distribution mechanisms:

Managed payouts
Systematic withdrawals

Managed Payouts: Managed payouts provide specified payment amounts on a specified schedule.

For example, annuity owners can receive equal distributions throughout their lifetime, or they can receive
account funds in payments of a fixed amount or for a fixed period of time.
Most mutual funds also offer owners managed payouts that can be structured to distribute account funds
by a specified date or to continue indefinitely. In addition, payouts can be linked to market interest rates or
to historical returns.

Systematic Withdrawals: Systematic withdrawals provide a payout at predetermined intervals, such as monthly,
quarterly, semiannually, or annually. They are available under most IRAs and mutual funds. The amount of withdrawals
can be fixed or variable. Systematic withdrawals allow retirees to:
Access funds when needed
Keep remaining funds in the account to generate earnings
Example: Salona and Ray Manekar invested $100,000 in a mutual fund. They've set up a systematic withdrawal
system that will give them $8,000 per year. When a payment is due, the mutual fund liquidates enough shares from
the Manekars' account to provide the scheduled amount. The remaining shares in the account continue to generate
earnings that will go toward future payments.
Laddering: Investors can create a "ladder" of income payments by investing in vehicles with different maturity dates,
such as certificates of deposit (COs) or bonds. Ladders provide a low-risk way to:

Create a steady stream of income in the form of interest

Increase liquidity because at least some COs mature each year
Increase returns by reinvesting mature COs in longer term CDs with higher interest rates
Extend investment period by annually reinvesting and buying back into the ladder

Institutional Market: The retirement market has two segments: the retail segment and the institutional segment.

The retail segment includes individuals and families looking for solutions to their retirement needs.
The institutional segment includes the businesses and other groups that buy retirement products, plans,
and services for the benefit of their employees or members

The Institutional Market: The institutional market consists of three primary groups:
Plan Providers:

Plan providers design, develop, and market retirement plans for businesses and organizations for the
benefit of employees or members.
Plan providers include insurance companies, banks, mutual fund companies, and broker dealers.

Plan Sponsors:

Plan sponsors purchase retirement plans for the benefit of their employees or members. Plan sponsors
operate in two separate sectors.
Public sector sponsors include federal, state, and local government agencies such as school systems,
police and fire departments, and the military.
Private sector sponsors include all for-profit businesses that are not owned or operated by federal, state, or
local governments.

Plan participants:

Plan participants are employees or group members who elect to participate in retirement plans offered by plan

Additional participants:
Additional participants in the institutional market include people and companies that provide specialized services to
plan sponsors:
Asset managers: Asset managers professionally manage plan retirement plan assets. They are involved primarily in
large plans (those with more than $50 million in assets and more than 500 participants) and are prevalent in trusteedirected or defined benefit plans that don't offer participant-directed investment accounts.
Consultants/ Advisers / Brokers:

Consultants help large-plan sponsors and fiduciaries review and select plan investments and select
advisors and other service providers. They typically work on a fee-for-service basis.
Registered Investment Advisors (RIAs) and brokers typically focus on smaller plans and are usually
compensated on a fee-for-service and/or commission basis.

Plan administrators:

Plan administrators perform regulatory and compliance functions for qualified plans. They usually also
handle communications with plan participants.
Small-plan sponsors typically use third-party administrators (TPAs) and outside record keepers to perform
compliance and record-keeping activities.
Large plans usually appoint an official Plan Administrator who serves as a plan fiduciary. The official Plan
Administrator contracts with TPAs and record-keepers to perform compliance and record-keeping work, and
oversees the activities of other service providers.

Record keepers: Record keepers take receipt of plan contributions and pay out distributions to participants. They
also track each individual participant's account balance, investment allocations and returns, distributions, and
contributions- including the nature of each contribution (for example: employer contribution; tax-deductible employee
contribution; after-tax employee contribution). In addition, they provide account statements to participants.
Institutional Services Offered:

Some plan providers offer services directly to plan sponsors. For example, insurance companies and
mutual fund companies often serve as asset managers. Provider companies also offer bundled or
unbundled compliance and record keeping services.
In a bundled services arrangement, the provider company offers both compliance and record keeping
In an unbundled services arrangement, the provider company offers record keeping services only and
partners with local TPAs to perform compliance work.
*Bundled Services: A combination of record-keeping and administrative services offered by provider
companies to retirement plan sponsors.
*Unbundled Services: Record-keeping services only, offered to retirement plan sponsors by provider
companies. Providers then contract with local third-party administrators (TPAs) to provide administrative


As you've learned, the financial services industry is made up of many different types of financial
institutions. Each institution offers products that pre retirees and retirees can use to manage, accumulate,
protect, and distribute their assets.
You've also learned about the characteristics that distinguish financial products from other goods and
services and the additional services companies can provide to increase customer satisfaction and build
customer loyalty.
Chapter no: 4 Personal Risks

Employment Risk: Risk is the possibility that things won't turn out as expected.
Reasons for Voluntary Unemployment:

To change jobs: Many people change jobs every few years to increase earnings, to advance their careers, or
to pursue a different line of work. They may be unemployed between jobs.
To start a business: Some people dream of owning their own company and being their own boss. Until a new
business becomes profitable, however, their earnings will be interrupted.
To pursue other goals: People often leave the workforce to obtain additional education, to focus on their
families, to care for children, or simply because they want to stop working.

Involuntary Unemployment:
Severance Pay

Two weeks of salary is common.

Employers are sometimes willing to negotiate higher amounts, especially for long-serving employees.
Severance pay is in addition to any other money the employer owes the employee

Unemployment compensation:
Generally payable for a maximum of 26 weeks
Recipient must:

Have worked for a minimum number of weeks

Have earned a specified amount in wages and benefits
Be actively seeking employment

Benefit amounts:

Vary by state
Are based on income prior to unemployment
Are taxable as income

Not available to workers who:

Leave the work force voluntarily

Are dismissed for just cause

Unemployment expenses: Potential Expenses during Unemployment:

Job search expenses

Taxes on retirement fund withdrawals
Penalties for early distributions from retirement funds

Medical expense risk:

Medical expenses for people with insurance:

Copays and drug copays (managed care)
Any excluded expenses, such as most
experimental treatments

Medical expenses for people without insurance

The full cost of care

Consolidated Omnibus Budget Reconciliation Act (COBRA): An employee who loses health care coverage as a
result of a qualifying event can continue group coverage following termination.

Coverage continuation for employee: up to 18 months

Coverage continuation for dependents: up to 36 months

An employee must pay the full cost of coverage, including any part of the premium that was previously paid by the
Affordable Care Act: also known as Patient Protection and Affordable Care Act, aka PPACA, Affordable Care
Act, and ACA,

Became in force beginning in 2014

Applies to people not eligible to obtain group coverage and not eligible to receive coverage through
government programs such as Medicaid

Patient Protection and Affordable Care Act

Individuals and families whose income falls between 100% and 400% of the federal poverty line
(FPL) receive tax credits based on their medical insurance premium.
Tax credits are calculated using a sliding scale from 2% to 9.8%, depending on income.
The law also limits participants' out-of-pocket costs to a specified amount, based on income.
The PPACA imposes a penalty on qualified people who fail to maintain minimum essential coverage (unless
excluded from coverage requirements).
The law also allows enrollment by people who are eligible for employer-sponsored coverage if the cost of that
coverage is greater than 9.8% of income or if the employer pays less than 60% of the premium.

Income Interruption Risk:

Workers' compensation programs

State-based program
Provides wage replacement benefits AND medical expense benefits
Covers losses from work-related accidents or illnesses. Benefits are not payable if a person's disability is not
The federal government has similar programs covering federal employees

Supplemental Security Income (SSI)

Pays periodic benefits to people with limited incomes who are disabled, blind, or age 65 or older.
People do not have to pay a specified amount of Social Security tax in order to receive benefits.

Social Security Disability Income (SSDI)

SSDI pays benefits to people who are unable to work because of a physical or mental illness or injury that has
lasted, or is expected to last, for at least one year, or that is expected to lead to the person's death.
Workers under age 65 must pay a specified amount of Social Security tax for a prescribed number of years in
order to receive benefits.

Private Disability Income (DI) Insurance: Disability income (DI) insurance is available in two forms
Individual Disability Income (DI) Insurance: It is usually purchased and paid for by the insured
Benefits are usually:

A flat amount based on the insured's income when the policy is purchased
Payable after a specified waiting period
Payable only if the insured meets the definition of "disability" included in the policy
Payable for a maximum period of time
Not reduced by other income benefits

Group Disability Income (DI) Insurance

Provided by an employer, who pays all or part of premium

Benefits are usually: Calculated as a specified percentage of a covered employee's pre-disability earnings
Usually payable only after a specified waiting period
Payable only if a disabled employee meets the definition of "disability" included in the policy
Payable only for a specified period of time
Reduced by income replacement benefits a covered employee receives from other sources (such as SSI or

Financial Risk: Let's look at some of the financial risks people face during their working years.

One such risk is identity theft. Cleaning up the mess after an identity theft can be arduous, expensive, and
stressful. Identity theft victims often have to deal with
Creditors who extended credit to the identity thief and now seek repayment from the person whose identity
was stolen
Damage to their credit rating, which may make it difficult to obtain not only credit, but also potentially
insurance, housing, and employment
Reductions in retirement savings caused when income is diverted to cover losses in other areas

Practices that can help prevent Identity theft:

Shredding or destroying documents that include personal information such t:IS account numbers and Social
Security numbers
Using a locking mailbox or a post office box to receive mail
Restricting access to information maintained in the folders or computer records
Mailing personal documents from a post office rather than a home mailbox
Refusing to provide personal information to unsecure online sites or in responses to emails from unknown

Credit Card Debit Risk: Some options for easing the strain of credit card debt include:

Negotiating a lower interest rate or obtaining credit counseling services from the credit card company
Obtaining a debt-consolidation loan
Initiating bankruptcy proceedings
Re-establishing credit after a bankruptcy proceeding is difficult, so the decision to file should be made only as
a last resort and only after consulting an advisor

Death of a Spouse: The death of a spouse usually results in at least some change in the remaining spouse's financial
status. The amount of change and whether the change is positive or negative depends on

How much the deceased spouse contributed to the family income

How many people the couple support
The amount of life insurance coverage on the spouse who dies

If the surviving spouse's income and life insurance proceeds aren't enough to cover expenses for the surviving family
members, the loss can result not only in a reduction in retirement savings, but in the need to find a more modest
residence, a better-paying job, or even a second job.
Example: Before Susan Henry was widowed, her husband's salary was about twice as much as hers. When her
husband died leaving her with three small children, she received a modest amount of group life insurance. She had
to cut back on all her living expenses and stop her retirement plan contributions.
Example: Abdul and Aaliyah Muhammad's salaries were similar. When Aaliyah passed away, Abdul received a
sizeable life insurance benefit. Since his children had grown and were supporting themselves, he was able to
maintain his living standards AND invest most of the life insurance benefit for retirement

Divorce: During a divorce, property is often divided between the two parties as settlement of alimony, child support,
or property rights. One important item of property that may be divided is either spouse's retirement or pension
In the United States, division of retirement benefits is usually accomplished through a qualified domestic relations
order (QDRO).

Example: When Thomas Ann got divorced from his wife, the court assigned half of Thomas's retirement savings to his

Caring for Adult children or Siblings: We generally hope that our sons, daughters, sisters, and brothers will
support themselves and live independently as adults, but this is not always the case.

Circumstances such as unemployment or divorce can cause adults to seek help from parents or siblings.
Adults with special needs may need support throughout their lives. After the parents die, the responsibility
can fall to siblings.

In the United States, physically or mentally disabled persons who meet specified requirements are eligible to receive
health care and long-term nursing care benefits through government programs such as Medicare and Medicaid. Their
parents can also provide additional funds to support such people, without causing them to lose their government
benefits, by establishing a supplemental needs trust.
Caring for Aged Parents: Because of increasing longevity, it's likely that a significant number of adults will be faced
with the responsibility of supporting or caring for their parents. The expense of caring for parents is yet another risk to
a retirement plan.
Planning ahead and making sure that a parent's preferences for care are clearly communicated to family members can
reduce financial surprises, reduce conflicts among caregivers, and provide more care options.
Example: Planning ahead for the Care of an Aging Parent: Geraldine Parker is aging and her three children,
Pamela, David, and Jemima, expect that she will eventually need to receive professional care and support. They're
concerned, though, that Geraldine's assets won't cover the cost of professional care either at home or in a licensed
institution. They've done some research and have identified three possible options:

Having their mother move in with one child while the other children provide financial support
Taking turns caring for their mother in their own homes
Purchasing long-term care (LTC) insurance tor their mother and jointly paying the premiums

Analysis: None of the children feels that having Geraldine move in with them on a permanent basis is feasible. They
also feel that having her change locations is likely to create significant stress for their mother. Sharing the cost of longterm care insurance, however, will be feasible for all of the children. And the combination of Geraldine's financial
assets and her LTC benefits should be adequate to provide her with the care she wants and needs
Measuring Inflation: To measure inflation, economists generally use price indexes including, in the United States and
Canada, the consumer price index (CPI).
Most of the products and services included in the market basket that makes up the CPI are items that are part of the
general cost of living. However, the market basket also includes important financial and retirement values such as tax
rates, Social Security benefits, some pension benefits, and retirement plan contributions.
Retirees and Inflation: Although inflation can create problems for anyone, it's usually a greater risk for retirees.
During working years, wages typically increase annually to account for inflation. During retirement, wages are replaced
by Social Security benefits and withdrawals from personal retirement funds. These sources offer few, if any,

Social Security benefits have a built-in mechanism-the cost of living adjustment (COLA)-that provides a
cushion against inflation. However, legislators may change COLA calculations to make them less generous.
Most defined benefit retirement plans also provide guaranteed amounts at retirement, but those amounts
are generally fixed. Retirees can't increase their benefit payments to adjust for inflation.
Defined contribution retirement plans and personal savings and investments don't offer any
guarantees. Retirees can adjust withdrawal amounts each year to account for inflation, but those increases
ultimately reduce the total number of withdrawals they can make

Other Expense Risks in Retirement:

Health Care Cost Increases: As people progress through retirement, their need for health care often increases.
Unfortunately, when they move from the workforce into retirement, their health care coverage often decreases.
Long-Term Care: The need for long-term care can increase health care costs even more. Long-term care insurance
provides benefits that help reduce the costs of age-related care, but the cost of the insurance adds to retirees'
expenses. Some retirees simply cannot afford the cost of LTC insurance.
Longevity: People, before and during retirement, often don't think much about the potential impact of longevity risk
because it's not as immediate a concern as health care or expense risks.
They also generally underestimate how long they will actually live. One reason for poor estimates is that life
expectancy estimates, based on mortality rates, are averages, so approximately half the people in a given age group
will live longer than expected.
Public Policy Risk: Retirees and retirement savers face the risk that changes to government programs, laws,
regulations, or taxes, will either increase their expenses or decrease their retirement benefits.
Sometimes, such changes work in retirees' favor. An example is the PPACA's closing of the "donut hole" in Medicare
Part D.
However, given the concern over the long-term viability of Medicare and Social Security, most changes to those
programs are designed to save the government money, which generally means that they will be less generous to
Future Medicare Premium and Deductible Increases: Legislators have also proposed gradually raising the
eligibility age for Medicare benefits until it reaches 67 by 2027, bringing it in line with Social Security. This change
would reduce the strain on Medicare funds, but it would have negative consequences for retirees and non-retirees.

65- and 66-year-olds would need to seek private insurance coverage.

Removing younger, healthier people from the Medicare risk pool would drive up premiums for those remaining
in Medicare.
Adding 65- and 66-year olds to private risk pools could raise insurance premiums for the younger members of
those pools.

Public Policy Risk Social Security: Social Security has already been changed to increase the age at which full
retirement benefits are payable. This change has helped reduce the current strain on program funds, but it hasn't
solved the problem. As a result, additional remedies have been proposed.
Social Security Tax Increases: Currently, the Social Security payroll tax in the United States Is 12.4% on the taxable
wage base, half payable by the employee and the other half payable by the employer.
Suggestions have been made to increase contributions by 2% to 3% annually
Social Security Benefit Reductions: One change that's already been proposed is to change the way Social Security
cost of living adjustments are calculated. Proponents argue that changes to COLA calculations could result in a $112
billion reduction of COLA benefits over the next 10 years. Opponents point out those changes to COLA calculations
would have a disproportionate effect on seniors, whose spending patterns are often different than those of younger
Social Security Privatization: Privatization would place more responsibility for securing retirement income on
individuals by allowing individuals to deposit a percentage of current Social Security taxes into personal retirement
At retirement, people would receive monthly payments from both Social Security and their personal accounts to bring
their total benefit to an established guaranteed minimum amount.
Shortfall Risk:
Risk of Increased Expenses
Risk of Increased Longevity
Risk of Decreased Benefits
Shortfall Risk (Risk of not having enough income during retirement to cover expenses)

Evolving problems with Social Security and with private retirement plans threaten to make shortfall risk even worse for
many retirees.
Problems with Social Security:

Social Security in the United States is already paying more in benefits each year than it receives in
employer and employee contributions.

Analysts predict that, if current trends continue, the Social Security trust fund will become insolvent by

After that, the system will be able to pay out only 75% of promised benefits
Problems with private retirement plans: The majority of workers in the United States have access to employersponsored retirement plans, but less than half of workers contribute to those plans.

Contribution levels from plan sponsors and plan participants are low.

Some plan sponsors have responded to poor economic conditions over the past several years by
eliminating their matching contributions, causing many plan participants to also reduce or stop their

In 2010, the average pre-retiree in the US planning to retire within the next five years had only 43% of
recommended savings in an employer-sponsored retirement plan.

Persistent low market interest rates during recent years reduce returns on retirement savings and
reduce the amount of annuity payments available for a given sum.

Low market interest rates during the early years of withdrawals may also mean that accumulated
funds won't last as long as expected because of sequence of returns risk.
Techniques for managing personal risks: People cannot eliminate the personal and financial risks they face, but
they can use some common risk management techniques to reduce the effects of these risks.


Avoid: One way to manage risk is to avoid it.

Risk: Getting struck by lightning How to avoid it: Stay inside during thunderstorms
Although avoidance might be a viable approach to some risks, it's impossible to avoid all risk. When it comes to saving
for retirement, it's not even desirable to avoid all risks; to earn a return on an investment; a person must accept some
Control: Another approach is controlling risk: that is, taking steps to prevent or reduce losses
Jane Crowell just finished talking to her friend, Alison, who told Jane about the nightmare she had experienced after
having her identity stolen.
Alison persuaded Jane to take a number of steps to control her identity theft risk, including registering with a credit
monitoring service, ordering new checks from the bank that do not show her Social Security number, and shredding all
documents that show her account or Social Security number as well as all the credit card offers she receives in the
Accept: Accepting risk involves assuming all financial responsibility for the risk. People accept risks every day-usually
when the losses associated with the risk are insignificant, like losing an umbrella or breaking a dish or a lamp. Some
people also consciously choose to accept more significant risks
Frank Manzoni has one more year before he reaches retirement age. He's been setting aside $100 each month for an
emergency fund for years and now has about three months' worth of salary in the fund
Last week, his employer announced that, if results don't improve, the company will need to lay off workers within one
to two years. Some of Frank's co-workers decide to retire early or switch jobs, but Frank chooses to keep working at his
current job as long as he can and accept the risk of getting laid off
He decides he can afford to take this risk because he can file for unemployment compensation and use the money in
his emergency fund if necessary to cover his lost income

Transferring Risk: A person or business can transfer financial responsibility for specific risks to another party by
buying insurance
Sarah and Paul Carmichael recently learned that, in nearly 75% of 65-year-old couples, one will outlive the other by 5
years or more. In 50% of couples, one will outlive the other by at least 10 years. They know that, when one of them
dies, the surviving spouse will have fewer expenses than they had together, but they are worried that the survivor's
income will fall by even more than expenses
Sarah and Paul can manage the financial risk each of them faces if the other one dies by transferring this risk to
another party. One option would be to buy life insurance policies that would pay death bene fits to the surviving
spouse. Another option would be to purchase a joint and survivor annuity that would provide income to both of them
until one of them dies and then to the survivor until that person dies

Chapter 5 Investment Risk and Returns

Risk and Return: A good start is to understand the relationship between financial risk and return.

Risk is the possibility that things won't turn out as expected

Return is the compensation people receive when they invest or lend money
With more risk comes the possibility of a larger return. It also works in the other direction-less risk usually carries a
smaller potential return. This relationship is known as the risk-return tradeoff.
Financial Risk for Retirement Products: Retirement investments are subject to several types of financial risk,

Some risks

Market risk
Income risk
Reinvestment risk
Default risk
affect ALL investments, but others only affect a specific type of investment

Market Risk: Some types of risk are present in the marketplace.

Market risk is the possibility that fluctuations in an entire market may result in losses or reduced investment returns.
Certain factors tend to cause the prices of most investments of a certain type to rise or fall. For example, bad
economic news generally causes the average price of stocks to fall.
Interest Rate Risk: One specific type of market risk is interest rate risk. Interest rate risk affects many types of
investments, including stocks and real estate, but it has the greatest effect on those that pay a fixed rate of interest,
such as bonds.
Inflation risk, the risk that prices will increase and purchasing power- the amount of goods and services a person can
buy for every dollar he earns- will decrease. In other words, his money won't buy as much as it used to!

Except in rare instances, there is always inflation. The question is, how does the rate of inflation compare to your rate
of investment return?
You may be happy with your investment returns, but, if your returns are only slightly higher than inflation, then your
returns will only slightly increase your purchasing power.
It is even possible for inflation to exceed investment returns.
Another hazard of falling interest rates is reinvestment risk.
The two main types of reinvestment risk:

Maturity risk is the risk that market interest rates on products that mature at a stated time will be lower
at maturity than they were when the products were purchased. For investors, this means they'll have to
reinvest the money they receive on the investment at a lower rate than was formerly available.

Call risk occurs when issuers of certain longer-term securities "call" or redeem their offers before they
Companies face the possibility of unexpectedly low profits, or even a loss. This business risk can also affect
investors. For example, low profits or losses may prevent a company from paying dividends to its investors and/or
cause its stock to lose value.
Business Risk: A variety of factors can cause business risk:

Low per-unit prices

High operating costs

Poor sales volume


Overall market performance

Government regulations

Corruption and fraud

Poor management
Default Risk: Entities that make loans face default risk.
Banks and other businesses that make loans to individuals or other businesses face the risk that borrowers will fail to
make required payments on loans
Individual investors face default risk when they buy bonds. A bond is a loan to the company or government agency
that issues the bond. Even though most bonds are secure, an issuer that doesn't pay principal and interest when due is
in default on the bond.
Risk Measurement: Risk measurement usually involves studying how actual returns vary from expected returns.
Because a particular investment, an asset class, or an investment portfolio can produce gains or losses, risk variance
can be positive or negative.
The main measure of risk is standard deviation, which is a measure of the distance between each individual return
in a series of returns and the mean, or average, return for the series.
General rule: The greater the standard deviation, the greater the potential variation of actual returns from expected
returns and the greater the investment risk.
* Standard deviation calculations assume that values in a data set follow a normal distribution pattern. Even though
investment returns don't always follow a normal pattern, standard deviation calculations can still provide a fairly
accurate estimate of investment risk.
If you're calculating standard deviation, mathematicians assume that values in a data set follow a normal distribution
pattern-which means the values are equally distributed on either side of the mean of the data set.
Here's an example of what a normal curve looks like. Regardless of dimensions, all normal distributions have certain
characteristics. The mean is at "0.

What shape do you see in the graph? You should see bells. When calculated results are plotted on a graph, they
form a bell-shaped curve. The peak of the bell is at the mean value, which is the center value. It's marked at "0."
Numbers to the left are all negative because they're less than the mean, and numbers to the right are all positive
because they're greater than the mean.
The portions of the curve that extend beyond three standard deviations from the mean on either side are called
"tails." The values in the tails are near zero because in a true normal curve, the probability of a value being in one
of the tails is extremely low.
Investment Risk / Return Calculations:
Martin Jones, age 54, is deciding whether to add large-cap common stocks or U.S. government bonds to his
investment portfolio. He has published information on the performance of both investments over the last 10 years

STOCK: Average annual return = 10% with Standard deviation of 18%

BONDS: Average annual return = 6% with Standard deviation of 11%

STOCK analysis:
Martin knows from his research that there's a 95% probability that the return on his stock will be between (+/- 2)
standard deviations of the mean. So, if the mean gain is 10% and the standard deviation is 18%, then the return
on his stock will be between a
46% Gain: [10% + (2 x 18%)]

And a

26% Loss: [10% - (2 x 18%)]

BOND analysis
Martin also knows that there's a 95% probability that the return on the bonds will be between +I- 2 standard
deviations of the mean. If the mean gain is 6% and the standard deviation is 11%, then the return on his bond will
between a 28% gain to a 16% loss.
28% Gain: [6% + (2 x 11%)]

And a

26% Loss: [6% + (2 x 11%)]

Final Analysis: The stock has a greater expected return (46% gain vs. 28% gain) but is riskier than the bonds
because it has a greater expected loss (26% loss vs 16% loss).
Cautions when measuring risk: There are a few caveats for using standard deviation to measure investment
Data used in calculations should cover a long time period and include a variety of economic conditions,
such as war and peace or prosperity and recession.

The standard deviation measures annual deviations in prices. "Bear" and "bull" markets often last longer
than a year, making losses and gains during those periods steeper than for a single year.

Relying on standard deviations and mean investment returns may not always be the best way to measure
investment risk because such measurements assume the future will resemble the past pertaining to
market conditions and that is not always the case.
Investment Risk Management: Usually, people can use the same techniques to manage investment risks that
they use to manage personal risks. Mentioned below are risk management techniques that can be used for
investment risk management

Avoid Risk: A person can avoid certain types of risk by investing in very conservative financial products

For example, fixed annuities, COs, and money market accounts offer a fixed rate of return and generally guarantee
that the investment will not lose value
Control Risk: A person can control investment losses by diversifying investment holdings among a variety of
assets or asset classes with different risk profiles
Diversification involves balancing assets, asset classes, or industries and spreading risk among many risk
characteristics to reduce the effect of any one risk.
Transfer Risk: In some cases, investors can transfer risk to an insurer.
For example, with many variable deferred annuities, the investor can pay an additional fee in order to guarantee
that the "benefit base" used to calculate certain types of annuity benefits will not be charged with any investment
Accept Risk: A person accepts risk when she recognizes the possibility of loss but decides to accept financial
responsibility for the loss.
For example, Agnes Moreno invested in a callable bond that she knows may be called before it matures. If the
bond is "called," Agnes must reinvest her money, possibly at a lower rate.
Agnes isn't ignoring the risk. She's also not avoiding, controlling, or transferring it to someone else. She knows
there's a risk but is willing to accept financial responsibility for any loss
Most investment products generate one of three types of return:

Interest is a fee that banks and other financial institutions pay to use borrowed money.
Dividends are shares of a company's profits owed to the company's stock owners.
Capital appreciation is an increase in the market value of invested assets.

To calculate the amount of return, or earnings, an investment will generate during a particular period, a person can
apply a specified rate of return to the invested amount (the principal).
Earnings = Rate of return x Principal
Or, if you know the amount of your earnings and of the principal, you can calculate the rate of return as follows:
Rate of return = Earnings / Principal
Interest Rates: Financial institutions express interest as an interest rate, which is interest stated as a percent of
the principal-the sum of money originally borrowed or loaned
The formula for finding the amount of interest earned on a sum of money is
Interest Earned = Principal x Interest Rate
In calculations, the interest rate is stated in decimal form. For example, 2% appears as 0.02, so the interest earned
on $1,000 principal is
Interest earned: $1,000 x 0.02 = $20

Simple interest is interest calculated only on the principal amount.

Alexis Green loaned $1,000 to her friend, Patricia, and charged her 2% simple interest on the loan. Because the
interest rate is applied to the same amount of principal each period of time, she'll earn the same amount of
interest ($20) each period.
Period 1

Period 2

Period 3

Beginning principal




Interest Rate

X 0.02

X 0.02

X 0.02

Interest Earned




Compound interest-where interest is earned on not only the principal, but also the previous interest earned.
Period 1

Period 2

Period 3

Beginning principal




Interest Rate

Interest Earned







Nominal vs Effective Interest: Most investments provide quotes for nominal interest rates, which don't
account for the effects of compound interest. On the other hand, effective interest rates do include the effect of
Effects of Compounding: Compounding makes a noticeable difference when a person invests regular payments over
Jenny Reid, age 25, started saving for retirement by contributing $100 each month to her employer-sponsored
retirement plan. She made that same $100 contribution each month until she reached age 65.Jenny's account earned
an 8% average annual compound return.
Jenny contributed a total of $48,000. ($100 x 12 x 40) =$48,000.
Because her account paid interest on principal and earnings, the amount of her interest earned increased each year.
How much money did Jenny have when she retired at age 65?
Amount of Interest:
+ Amount of Principal:


At age 65, Jenny has $322,108 in her account.

Compounding more frequently: Another factor that can affect the amount of interest an investor earns is the
frequency of compounding.
Interest can be compounded once a year, but it is often compounded more frequently, such as semi annually or
quarterly. For example, if a bank compounds interest semi-annually, it calculates interest and adds it to the account
balance twice a year.
But, what interest rate does the bank use in this case? Periodic Interest Rate = Nominal annual interest rate /
Number of compounding periods
Hank Hampstead just opened a new money market savings account with an initial deposit of $1,000.
If interest on Hank's account had been compounded annually, Hank would have earned $20.00 in interest at the end of
Year 1, calculated as:
($1,000 X 0.02)


However, the account offers semiannual compounding, so, instead of earning 2 percent interest at the end of the year,
he'll earn 1% interest in the middle of the year and another 1% at the end of the year.

First compounding period (first six months): $1,000 X 0.01:

New account balance= $1,000 + $10 = $1,010
Second compounding period (second six months): $1,010 X 0.01:$10.10
New account balance= $1,010 + $10.10 = $1,020.10
End of year earnings generated: $10.00 + $10.10 = $20.10
Effective rate of return: 2.01% = ($20.10 + $1,000).

Rule of 72: Investors often want to know how long it will take an investment to double in value, because that
indicates the investment's effectiveness. The Rule of 72 can give investors a reasonable estimate of how long it will
take an investment to double in value
Years to double = 72 / Interest rate
As an example, at an interest rate of 5 percent, the principal will double in more than 14 years:
Years to double = 72 / 5 = 14.4 years
Let's use the Rule of 72 to see how many years it'll take for an investment to double at an interest rate of 10 percent.
Predicting Risk and Return: It's difficult to predict exact risk and return levels, but you can identify characteristics
that affect an investment's risk and return potential-that is, investment time, how and when earnings are paid, and
Let's see some examples of lower risks with lower expected return and then some higher risks with higher expected
Lower risks with lower expected returns:

Owning a short-term asset

Buying bonds issued by a company with a good credit rating
Owning an investment with good liquidity or marketability-one that is easy to sell at a fair value
Obtaining a mortgage loan with a fixed interest rate
Owning an investment that pays returns in the investors domestic currency

Higher risks with higher expected returns:

Owning a long-term asset

Buying bonds issued by a company with a poor credit rating
Owning an investment with poor liquidity or poor marketability which is difficult to sell at a fair value
Obtaining a mortgage loan with a variable interest rate
Owning an investment that pays returns in a currency that is foreign to the investor

Risk Tolerance: How much risk a person is willing to accept is described as risk tolerance. For most people, risk
tolerance depends on factors such as.

Investment time: Young people often accept relatively high levels of risk because they know they have a
long time to meet their financial goals. They'll accept short-term losses and fluctuating values in exchange for
long term earnings. People nearing retirement are more conservative and less willing to tolerate risk.
Family status: Single people tend to be more risk tolerant than married people because their decisions don't
affect anyone else. Having children can also reduce a person's willingness to accept risk.
Financial Situation: People who have accumulated considerable wealth are usually more willing to withstand
losses than people who have limited resources or who, like many retirees, have fixed incomes. The number
and types of assets a person has also affects how much risk a person is willing to accept.
Personality: Some people enjoy the unexpected- they're willing to try new things, explore unknown places,
and make changes in their lives. Other people are more comfortable maintaining their current standard of
living or income level
Age: Young people often are willing to accept relatively high levels of risk because they have a long time to
achieve their financial goals. Older people, especially those nearing retirement, tend to be more conservative
with their financial goals.
Return requirements: The amount of risk a person is willing to tolerate in an investment also depends on
the return the investment offers. To make an investment worthwhile, most investors require at least a
minimum return on their investment. Otherwise, they'd be better off just holding on to their money.

This minimum return, known as the required rate of return, is equal to the risk-free rate of return, which is the rate
available on a risk-free investment, plus a risk premium that represents the compensation investors demand for taking
the risk associated with a specific investment.
Required rate of return =
compensates investors

Rate available on a risk free investment + A risk premium, an amount that

taking on a specific investment risk

Required rate of return =

Risk free rate of return + Risk premium

Risk free investments: But, what are some examples of risk-free investments?
In most cases, they include short-term, highly rated government securities, for example, the U.S. Treasury bill,
which the U.S. Treasury issues as part of its ongoing process to fund the national debt.
Do you know what distinction risk-free investments have? They're considered the safest of all
Let's look at the risk premium, the investor's incentive for accepting risk. If there was no risk, investors would be better
off using their money to buy risk-free investments. The risk premium for any given investment depends on factors
such as the investment's default risk and interest rate risk.
Jordan Donleavy is considering investing in Acme Corporation stock.
Here's the information Jordan has on Acme Corporation.

Today's sales price: $20 per share

News reports show U.S. Treasury bills at a 2% return.
Jordan's analysis reveals she'll need a 9% return to make the investment worthwhile.
To determine her required rate of return for this stock, Jordan assumes a base return of 2%-the risk-free rate of
Then, she adds an additional 7% (her risk premium) to account for the risk of the stock investment.

Ch 6. The Time Value of Money

Time Value of Money: The time value of money tells us that the value of a sum of money changes over time
Why? Primarily because of the effects of interest a fee paid for the use of money
The time value of money applies to any money that generates earnings, whether its an investment account, a savings
account, or a retirement plan.
Present Value and Future Value: According to the time value of money, a sum of money has a present value (PV)
and a future value (FV).





Future Value (Present Value +


In simple terms, the present value of an investment is the principal-the original amount invested before its affected by
Present value = Principal
The future value is the invested principal plus the accumulated earnings or interest generated by the investment over
Future value = Principal + Accumulated earnings
Future Value: As we noted, the future value (FV) of any sum of money can be expressed as
FV =Invested Principal + Accumulated Earnings
Since the invested principal is the present value (PV), we can replace it in our formula, giving us
Invested Principal = PV
FV = PV + Accumulated Earnings
The accumulated earnings are basically the interest earned. For one year, the interest earned would equal the
principal (PV) multiplied by the interest rate (i), so our formula becomes
Accumulated Earnings = Interest Earned = PV * i
FV PV + (PV*i)
FV = PV + (PV * i)
We can simplify the equation by factoring out the common multiplier PV on the right leaving us with
FV = PV * (1 + i)
So the FV of a sum invested for one year is equal to the PV multiplied by 1 plus the interest rate.
To translate interest rates from percentages to decimal form, divide the percentage by 100.
For example, 2% interest = 2 / 100 = 0.02

So, what is the future value of $1000 invested for 1 year at 2% interest?
FV = PV * (1+i)
FV = $1000 * (1 + 0.02)
FV = $1000 * 1.02 = $1020
Future Value Interest Factor (FVIF) Table: Calculating the future value for one year wasnt too hard. But
calculating future values for more than one period can be complicated. Fortunately, mathematicians have created
tables that show future values for $1 invested at numerous interest rates for numerous compounding periods.
In these tables, the interest component is represented by a future value interest factor (FVIF)
If you look closely at the FVIF table, youll notice several trends:




For any given period of time and any given interest rate, the FVIF is always greater than 1
For any given period of time, FVIF value increases as the rate of interest increases
For any given rate of interest, the FVIF values increase as the investment period increases










How to use FVIFs: The FVIF is equal to the value of $1 at a given rate of interest for a stated number of periods.
To find the future value of a sum greater than $1, you multiply the sum by the FVIF.
For example, lets say Joe invests $1000 compounded at 5 percent for 6 periods. How do we find the future value of
this investment? First we find the row for 6 periods. Then we move across that row until we find the column for 5









The FVIF in that box is 1.3401. So, the future value of $1000 compounded at 5 percent for 6 periods is:
$1000*1.3401 = $1340.10
Future Values for Multiple Compounding Periods: Calculations get even more complicated when interest is
compounded more often than once a year. Fortunately, the same FVIF tables you used to calculate future values for
multiple years can be used to calculate future values for multiple compounding periods. For example, what if we want
to determine the future value of $1000 at 4% interest compounded quarterly for five years?

We will still multiply the present value by the FVIF, but we need to do a few extra steps to find the interest rate and the
number of periods to use.
Step 1: To find the number of compounding periods, multiply the number of years a sum is invested by the number of
compounding periods in each year.
Because the money will be invested for 5 years with quarterly compounding (4 periods per year), we multiply 5 years
times 4 compounding periods to get 20 total compounding periods.

2: To find the interest rate to use, divide the stated interest rate by the number of compounding periods each
year. ding

The stated interest rate is 4% and it is compounded quarterly. We divide 4% by 4 to get 1% interest.




4% interest

Step 3: Using the number of periods (20) from Step 1 and the interest rate (1%) from Step 2, find the appropriate FVIF
on the table.
We look on the FVIF table and find the FVIF for $1000 at 1% interest for 20 periods to be 1.2324.
Step 4: Multiply the present value by the FVIF to get the future value of the sum.
We multiply $1000 by 1.2324 and get $1000 * 1.2324 = $1232.40
Present Value: Joe can find out how much he needs to invest today to reach his goal of $1 million by finding the
present value of $100,000. This process is known as discounting.
The equation for finding present value is
PV = FV / (1+i)
Finding the present value of a single sum at a given rate, compounded annually for one year, is relatively simple.
Example: Todd Warren hopes to retire in one year with $1000,000 in his 401(k) plan. If the return on his investment is
5%, how much will he need to have in his account today to have $1000,000 when he retires?
PV = FV / (1+i)
PV = $1000,000 / (1+0.05)
PV = $1000,000 / 1.05
PV = $952,352.35
The Effect of Time and Rate on Present Value Just like the future value, the present value depends on the interest
rate earned and the amount of time the money is invested.
The effect of the interest rate and investment period on present value is the opposite of their effect on future value.
A higher interest rate or a longer investment period creates a lower present value.
Present Value Interest Factors (PVIFs): As with future values, mathematicians have created tables we can use to
calculate present values. The tables show present value interest factors (PVIF) for different interest rates and different
time periods.
To find the present value of a given future value, we multiply it by the PVIF for the appropriate number of periods and


















PVIF Example: Lacey Gonzalez wants to invest money today so that shell be able to donate $25,000 to the
university where she teaches when she retires in 5 years. If she earns 4% on her investment, how much will she need
to invest to reach her goal of $25,000?
To determine the present value, we multiply the amount she wants to have (the future value) by the PVIF for 5 periods
and 4% interest.
PV = 0.822 * $25,000 = $20,550
If interest is compounded more than once a year, we make adjustments similar to those for future value calculations.









Present Value Facts: If you compare PVIF numbers with FVIF numbers, youll see that there are some important

For any given time period and any given interest rate, PVIFs are always less than one
For any given time period, as interest rate increase, PVIFs decrease
For any given interest rate, as time increases, PVIF value decrease

Impact of the Time Value of Money: Understanding future values and present values shows us how important it is
to begin saving early.
Damian and Carol opened retirement accounts at the same time
They both

Contributed $2000 to their accounts each year until they retired at the age of 65
Earned 5% interest, compounded annually, on the balance of their accounts

However, they began contributing to their accounts at different ages:

Carol began contributing to her account at age 35

Damian began contributing to his account at 25

Rules for Understanding the Time Value of Money

Principal Sum: Because a principal sum invested at interest grows over time, the principals

Present Value < its future value

Future Value > its present value

Interest Rate: Because an interest rate is a rate of growth, for money earning a stated rate of interest for a specified
period, an increase in the interest rate will result in

A decrease in the present value of a future sum

An increase in the future value of a present sum

Conversely, a decrease in the interest rate will result in

An increase in the present value of a future sum

A decrease in the future value of a present sum

Number of Periods: Because compound interest is paid periodically, for money earning a stated rate of interest for a
specified period, an increase in the number of the specified periods will result in

A decrease in the present value of a future sum

An increase in the future value of a present sum

Conversely, a decrease in the number of specified periods will result in

An increase in the present value of a future sum

A decrease in the future value of a present sum

Future Value of an Annuity: Being able to calculate the present or future value of a single amount is handy. But
many loans and investments involve more than one payment.
When Mia and Joe met with Chris, Joe found out that if he stopped putting $2000 per year into his 401(k), hed come
up short of his $1 million goal.
But what would happen if he continued making regular contributions each year? How much would he have in 20 years
In this case, Joe is trying to find the future value of an annuity which is series of equal payments.
Annuities: When using an annuity to describe future values and present values, Its important to remember three
facts about annuities:

An annuity is not the same as an annuity contract, which is a specific type of financial product that can be
structured to provide monthly income benefits. As a result, the formulas used to calculate the values of an
annuity are valid without any reference to an actual annuity contract.
An annuity can refer to any series of payments that are equal in amount and paid at regular intervals. An
annuity does not refer to a series of unequal payments or payments made at irregular intervals.
An annuity can refer to payments received or payments made.


Example of payments received: The periodic income benefit payments Social Security pays to a recipient
Example of payments made: The contributions made to a 401(k)

Ordinary Annuity vs. Annuity Due: The timing of each annuity payment determines whether the annuity is an
ordinary annuity or an annuity due.

Ordinary annuity payment made or received at the end of each annuity period
Annuity Due payment made or received at the beginning of each annuity period


Payment occurs
Period 1

Period 2

Period 3

Period 4

Ordinary Annuity

A series of paychecks an employee receives at the end of each month

A series of interest payments on a bond

Annuity Due

A series of rent payments made at the beginning of each month

A series of premiums for a life insurance policy paid at the beginning of each year

Future Value of an Ordinary Annuity: We will find the future value of an annuity by adding together the future
value of each periodic payment in the series. Because payments for an ordinary annuity are made at the end of a
period they dont earn interest until the following period.

Calculating the Future Value of an Ordinary Annuity: To calculate the value of an ordinary annuity, you could
treat each payment as a single sum, find the future value of each payment, then add all of the future values together.
Luckily, you can also consult future value interest factor for an annuity (FVIFA) tables

This table shows future value interest factors for an ordinary annuity of $1 compounded at different interest
rates and periods.

To find the future value of an ordinary annuity, you multiply the amount of each periodic payment by the FVIFA
for the specified period and interest rate.

If you deposit $100 at the end of each of 3 periods, and your account earns 5% interest compounded annually,
what will be the future value of your deposits?









The FVIFA for $1 for 3 periods at 5% interest is 3.153. This means that the future value of your ordinary annuity is
$100 * 3.153 = $315.30
Future Value of an Annuity Due: Payments for an annuity due, which are made at the beginning of a period, earn
interest for the whole period. Assume that you had made your deposits on the first day of the year instead of on the
last day. In this situation, your account would earn interest on December 31 of Year 1, Year 2, and Year 3. In addition,
you would earn interest on all three of your deposits.

This difference in the timing of payments means that the future value of an annuity due is equal to the future value of
a corresponding ordinary annuity of one additional period minus the amount of one payment.
So instead of 3 periods, to calculate the future value of your annuity due, we will use 4 periods. The FVIFA for 4 periods
at 5% interest is 4.310. We multiply the FVIFA by the payment amount and then subtract one payment.
$100 * 4.310 = $431.00 - $100 = $331.00
Present Value of an Annuity: The present value of annuity is the amount a person needs to invest now in order to
provide a specified, regularly spaced series of equal payments at some point in the future. In general terms, the
present value of an annuity is equal to the sum of the present values of each of the separate periodic payments. Like
the future value of an annuity, however, the actual present value of an annuity depends on whether the annuity is an
ordinary annuity or an annuity due.
Present Value of an Ordinary Annuity: The timeline for the present value of an ordinary annuity looks similar to
the timeline for the future value, with payments made and interest earned at the end of each period. However, the
valuation date for the present value is at the beginning of the first period one period before the first payment is
made. As a result, an ordinary annuity that provides three annual payments spans three years.
Ordinary Annuity

Present Value of an Ordinary Annuity Example: To find the present value of an ordinary annuity, you multiply the
periodic payment amount by the present value interest factor for an annuity (PVIFA) for the specified period and
interest rate.
How much do you need to invest today at 5% interest to provide you with payments of $1000 at the end of each year
for the next three days?
The PVIFA for 3 payments at 5% interest is equal to 2.723, so the amount you will need to invest today is equal to
$1000 * 2.723 = $2,723.00

Present Value of an Annuity Due: In an annuity due, the valuation date and the first payment date are both at the
beginning of the first period. An annuity due that provides three payments would make the final payment at the end of
Year 2 rather than Year 3, and there would be no interest credited for Year 3.
The present value for an annuity due, therefore, is equal to the present value of a corresponding ordinary annuity with
one fewer period plus the amount of one periodic payment.

Present Value of an Annuity Due Example: So how much do you need to invest today at 5% to provide you with
three payments of $1000 at the beginning of each year?
To find the present value of an annuity due, we need to use the PVIFA for one fewer period and add the amount of one
periodic payment. So the amount we need to invest today is
PV of annuity due = $1000 * 1.859 (PVIFA for 2 periods) + $1000 = $1859 + $1000 = $2859

Chapter 7 Portfolio Management

Factors Affecting the Portfolio: A key to achieving retirement goals is choosing which investments to own at any
given time.
The make-up of a persons investment portfolio should reflect that persons characteristics and situation. For example,
one factor affecting an investment portfolio is the owners investment time horizon.
Which investor do you think can afford to take more risk with his investments: a man who is 35 years old and planning
to retire at age 67 or a man who is 65 years old and planning to retire at age 67?
Risk Tolerance and the Portfolio: Another factor affecting a persons portfolio is the owners risk tolerance. An
investor with a high risk tolerance is likely to accept greater investment risk in her investment portfolio than an
investor with a low risk tolerance, that is someone who is risk-averse.
Factors that can influence a persons risk tolerance include the persons

Family Status
Financial situation

Financial Situation and the Portfolio

Financial characteristics can help determine how much a person can set aside for investments, what assets she
selects, and how well she can manage the ups and downs associated with market investments.
For example, someone whose current income or cash flow is unpredictable may need to set aside a larger portion of
her investment portfolio in liquid assets, such as cash equivalents, to cover emergencies
A wealthier person with more investable funds may include non-liquid assets such as real estate , artwork, or
collectibles in her portfolio to provide long-term security.
Creating an Investment Portfolio

An investors situation and characteristics determine which investment goals and strategies he will select. When it
comes to building an investment portfolio, this is the first step and the step that guides the rest of the process. Here
are the six basic steps of building an investment portfolio:



Defining investment goals and strategies

Selecting asset classes to be included in the portfolio
Selecting individual investments
Choosing investment vehicles
Allocating assets among the investments
Setting controls to keep the portfolio on track

Step 1: Defining goals and Strategies: Income vs. Growth

Defining investment goals is an important first step in building a portfolio. Unless an investor knows what he wants to
accomplish, he wont know how to accomplish it or whether hes been successful.
Investments can earn a return in two ways: by producing income in the form of dividends or interest, and by increasing
the value of the investment-known as a capital growth.
An investment strategy can focus on income, capital appreciation, or a combination of the two.
Current Income Strategy Stresses current income over growth of principal (but does not completely ignore growth
Attractive to Investors who rely on investment income to cover their financial needs

Aggressive Income portfolio Likely to focus on common stocks and lower-rated bonds
Conservative income portfolio likely to concentrate on government bonds, high-quality corporate bonds, with
limited investments in preferred stocks and high-yield stocks

Current income and Capital Growth Strategy - Balances the goal of generating current income with the goal of
achieving capital growth.
Attractive to Investors who are willing to trade maximum income or maximum growth for a reasonable level of
income and a moderate level of growth
Capital Growth strategy stresses long-term capital growth over current income.
Attractive to investors who dont need current income to meet their financial needs and are willing to accept greater
potential risks in return for greater potential gains.
Capital growth portfolio Focus on high-risk growth stocks, with limited investments in fixed-income bonds and
money market funds.
Aggressive vs. Defensive Investing: The investor also needs to choose whether to use an aggressive or a
defensive strategy.

Aggressive Investor Primary goal is maximizing returns; is willing to accept relatively high risks to achieve
this goal.
Defensive Investor primary goal is minimizing risk; is willing to accept lower returns to achieve this goal.

Aggressive Strategies
Making frequent purchase and sales of securities
in an attempt to buy at a low price and sell at a
high price (called timing the market)
Attempting to identify individual securities with
the potential to earn higher-than-average returns
Attempting to amplify investment returns using
Attempting to amplify investment returns by
purchasing securities on margin, which involves
paying part of the cost of buying securities and

Defensive Strategies
Buying securities and holding them, counting on
the tendency of securities to earn money in the
long run
Focusing on securities that are linked to a
published index, such as Standard & Poors (S&P)
500 composite stock index
Using stock index options to buy and sell shares
of stocks in regular amounts at regular intervals

borrowing the rest

Step 2: Selecting Asset Classes

Asset Classes: After determining his objectives and strategies, an investor needs to decide which asset classes he
will use to achieve his objectives. The primary asset classes include:

Cash and cash equivalents, including money market instruments

Alternative investments, such as intangible assets (commodities, hedge funds, venture capital, and financial
derivatives) or tangible assets (precious metals, art, antiques, jewelry and stamps)

Allocating Among Asset Classes: Investment portfolios usually include at least three types of asset classes, each
with a different risk return profile. Asset classes should also be non-correlated. That way, when market conditions
fluctuate, investors can balance losses from one asset class with gains from other asset classes.
Example: Jennifer Dixons portfolio includes stocks, bonds and cash equivalents.
Analysis: In general, bond values and equity values tend to respond differently to changes in market interest rates.
Stocks tend to increase in value when market interest rise and lose value when market rates decline. Bonds, on the
other hand, tend to lose value when interest rates increase and gain value when interest rates decline.
Cash equivalents dont increase significantly in value when interest rates are favorable, but they also dont lose much
value when rates are unfavorable. Because Jennifers assets respond differently to market conditions, her losses from
some assets can be offset by gains from other assets.

Step 3: Selecting Individual Investments

Factors in Selecting Investments: After determining which asset classes to include in the portfolio, the investor
needs to decide which specific investments he will own within each asset class. For example, If the investor decides
the portfolio should be 40 percent stocks, the next decision is which stocks?
When selecting investments, investors generally consider many factors, ranging from broad global issues to very
specific product characteristics.
The Global Economy
National Economies
Industry or
or Government
Government Situation
Company Charateristics
Asset Characteristics

Economic Conditions and Investment Values: Changes in economic conditions global, regional, or national
have a considerable effect on investment values. Speaking generally, heres what tends to happen when economic
conditions are good and business thrive.

Interest R

Bad economic conditions tend to have the opposite effects.

Forecasting Economic Conditions: It is difficult-sometimes impossible-to accurately predict when economic
changes will occur or how long they will last. Nevertheless, many investors watch for trends and attempt to use them
to increase portfolio returns.
Another factor that investors must consider is that central banks usually try to lower interest rates when the economy
is contracting and raise interest rates when the economy is expanding. The goal is to try to improve bad economic
situations and to partially restrain the economy when it is expanding rapidly. An overheated economy can create
problems, such as too much inflation.
For example, the U.S. Federal Reserve kept interest rates low for a number of years to try to pull the country out of the
recession that followed the 2008 market crash. The prolonged environment of low interest rates had differing effects
on different types of businesses and the securities they issued.

Industry, Company, and Investment Characteristics

Industry Strength Sample industry factors to consider are:


demand for an industrys products and services substantial and growing?

the industry growing, stable, or declining relative to other industries?
the industry subject to new developments in technology?
the industry subject to political changes?

Company Characteristics Sample Company Characteristics to Consider:

What is the quality of the companys upper management? How often does mgt change?
What is the competitive position of the company and its products in the industry?
How have the companys growth and earnings been over a reasonably long period of time?
What is the companys level of product diversification?

Investment Characteristics Characteristics of the Specific Investment are:

Different securities issued by the same company can have different characteristics. Is a stock issue comprised
of preferred or common stock? Is a bon a long-or short-term bond? Is it secured by collateral?
Investors often evaluate individual asset performance by analyzing past performance, although past
performance is no guarantee of future performance.
Investors can evaluate future trends by studying the performance of the market itself. For example, the Dow
Jones Industrial Average, which tracks market averages, is often used to predict trends in stock prices.
However, past performance does not guarantee future results.

Step 4: Selecting Investment Vehicles

Direct Investment: Individuals can make direct or indirect investments. They invest directly by owing stocks, bonds,
real estate, and other investments in their own names. Stock, bonds, real estate etc. owned directly by
individual investor
The primary reason some people choose to invest directly is so that they have control when to buy, sell, or hold
individual stocks, bonds, and other investments.
Indirect Investment: Individuals invest indirectly when they purchase an interest in a portfolio of assets. Professional
portfolio managers decide when to buy, sell, and hold the underlying investments that are part of the portfolio.
Investors invest indirectly when they:

Buy shares of mutual funds , real estate investment trusts (REITs), or exchange traded funds (ETFs)
Invest part of their income in funds within their group retirement plans
Purchase variable insurance products and variable annuities

Mutual Funds and REITs: Two common indirect investment options are mutual funds and real estate investment
trusts (REITs):

Investor purchases shares in the mutual fund/REIT

Mutual fund company maintains a portfolio of stocks, bonds, and/or other securities
REIT Trust maintains a portfolio of real estate or real estate mortgages

Deferred Annuities: Deferred annuities can provide protection against outliving ones assets plus a savings
component. Earnings on the premiums accrue on a tax-deferred basis so that taxes are not due until money is
withdrawn from the contract.

Investor purchases annuity contract

Fixed Deferred Annuity The insurer invests the premiums and credits the contract with a guaranteed
interest rate
Variable Deferred Annuity The contract owner chooses how to invest the premiums by selecting from a
menu of available funds. Returns depend on the performance of the specified funds.

Assets within Retirement Plans: The investments available within a group-sponsored or individual retirement plan
depend on the type of plan. Click below for more details:
Employer Stock Plans As the name implies, contributions to employer stock plans are invested in the employers
Defined Contribution Plans In most defined Contribution plans other than employer stock plans, contributions are
invested in a variety of stocks, bonds, and mutual funds.
Investment options can be selected and managed by the plan sponsor or by participating employees, depending on
the plan structure.

Individual Retirement Arrangements IRAs generally cannot be funded with Insurance Policies and Non-financial
They generally can be funded by

Mutual Funds

Step 5: Asset Allocation Allocating assets among the investments

Asset Allocation Models:
Many financial advisors and institutions have developed models to help investors with asset allocation, which involves
deciding the percentage of each selected asset class to include in the portfolio. The continuum below shows some
common asset allocation model types and indicates the characteristics of the type of investor who might favor each
The names used for asset allocation models are fairly standard, but the allocations described by those names can vary
depending on whose model it is. Even so, the pie charts below represent a set of models that are representative of
many in the industry. Drag the model names to the correct pie charts to match each model name with the appropriate
In summary, the more growth-oriented the model, the more it is likely to feature stocks. The more income-oriented the
model, the more it is likely to feature bonds, cash, and cash equivalents.
21st Century Asset Allocation: Asset allocation can vary from very simple to very sophisticated.
For example, an old rule of thumb was to invest a percentage equal to the investor's age in bonds and cash
equivalents and invest the remainder in stocks. So, a 40-year-old would invest 40 percent in bonds and 60 percent in
stocks and a 60-year-old would invest 60 percent in bonds and 40 percent in stocks.
Today's longer life expectancies and longer times spent in retirement have created a need for more sophisticated asset
allocation models. In addition to the investor's age, these newer models consider the investors current income, assets
and savings, tax bracket, and risk tolerance. They also factor in the general economic outlook.
Also, today's tools can produce asset allocations that are more personalized than the general-purpose models we have

Example: LeAnn Warren and Damian Brent are using an asset allocation calculator to determine how they should
structure their investment portfolios.
LeAnn, age 25, has a steady income and has accumulated $12,000 in current assets. She has no savings, but also no
income requirements. She's in a 25% tax bracket and considers herself to have a moderate to high risk tolerance.
Damian, age 60, has $100,000 in current assets and $36,000 in savings. His income requirements are relatively low.
He's also in a 25% tax bracket and considers himself fairly risk-averse.
Step 6: Keeping the Portfolio on Track
After investors have chosen investments that meet their portfolio objectives, they need to periodically evaluate how
well the investments are meeting the objectives.
Investors should keep in mind that a failure to meet portfolio objectives might derive from the asset allocation
strategy, rather than from the individual assets chosen within a desired asset allocation.
In other words, it may simply be impossible to achieve a desired portfolio return with 40% stocks and 60% bonds; it
may be necessary to increase the number of stocks.
However, before changing the portfolio's asset allocation, the investor should be aware that doing so will affect the
portfolio's level of risk.

Diversification: Investing in multiple asset classes is a good start for trying to avoid asset concentration risk.
However, more complete diversification generally also requires seeking a variety of individual assets within each asset
Example: Suppose that instead of investing in a single corporate stock, Shelly had split her stock investment among
large and small companies in a variety of industries.
Analysis: If large company stocks or stocks in a particular industry perform poorly over the next few years, Shelly
could lose money on those parts of her investment. But if other stocks remain stable or increase in value, those results
will reduce the impact of her losses.
Diversification Inherent in Pooled investments: Note that when an investor invests indirectly by purchasing
shares in an investment fund or trust, those investments are diversified by their very nature because the fund invests
in a very large number of individual assets. Among the investment vehicles that provide this type of "automatic"
diversification are mutual funds, REITs, exchange-traded funds (ETFs), and insurance separate accounts within variable
annuities or variable universal life insurance policies.
Diversifiable Risks: Diversification is only effective for diversifiable risks. Some risks, known as systemic risks, affect
all assets in an economy and can't be diversified.
Systemic risks: Pervasive economic conditions can have a global effect on market values. Significant events, such as
currency devaluations, political unrest, or financial crises such as the one in 2007-2008, can affect market values on a
national or even global level.
Rebalancing: Another important strategy for managing portfolio risk and return is rebalancing.
Perry Jenner created an investment portfolio with an initial $50,000 investment. He invested 50 percent of that amount
in stocks and 50 percent in bonds.
Rebalancing had two advantages for Mr. Jenner.

Advantage 1: First, rebalancing returned his portfolio to the desired asset allocation and the desired risk
Advantage 2: Second he was able to "buy low" and "sell high." In the rebalancing, he sold bonds at a profit
compared to their price at the beginning of the period, and he bought stocks at a relatively low price.

Over the next three months, stocks gain value and bonds lose value.
This time, when Mr. Jenner rebalances, he sells stock for a profit because prices have increased.
He also buys bonds low, with the potential to sell them for a profit in the future.

Conclusion: Rebalancing helps Mr. Jenner maintain his desired risk profile, and buying low and selling high can make
a considerable difference to his investment returns over many years.

Automatic Rebalancing: Rebalance automatically: Because keeping investment allocations balanced requires
constant account monitoring, investment vehicles including defined contribution plans and variable annuities-often
offer automatic rebalancing services.
Dollar-Cost Averaging: Another important strategy for the prudent, long-term investor is dollar-cost averaging. Let's
look at an example.
Mark Jenkins purchased shares of a certain stock on the first day of the month for five months. Here's what he paid per
share each month.
What would you say was Mark's average cost per share? Did you say $20?
Here's how we calculated that number: ([$30 + $25 + $20 + $15 + $10) / 5)
And that number would be correct if he bought the same number of shares every month.
But what if he used dollar-cost averaging?
Let's see
Using dollar-cost averaging, Mark arranges to have $100 transferred from his checking account to his investment
account each month and to have that money used to buy shares of stock (actually, some months the amount is
slightly more or less than $100 because he can't buy partial shares of stock).
Purchase Date
March 1
May 1
June 1
July 1

Share Price


Payment Amount

Shares Purchased


Now, what would you say was Mark's average cost per share?
Purchase Date

Share Price

Payment Amount

March 1
April 1
May 1
June 1
July 1
Average cost per share with dollar-cost averaging
The total amount he paid for shares was $495 (total of column
(total of column 4).
Average cost per share= $495 + 29 = $17.07

Shares Purchased

3) and the total number of shares he bought was 29

Analysis: Previously, we suggested that the average share price during this period was $20. But, with dollar-cost
averaging, the average price of Mark's shares was $17.07. From a "buy low/sell high" point of view, dollar cost
averaging has certainly provided Mark with an advantage.
Purchase Date
March 1
May 1
June 1
July 1


Share Price

Payment Amount

Shares Purchased


Wouldn't Mark have been better off to buy no shares until July? The short answer is "yes." With $500, he could have
bought many more shares (50 vs. 29) at a lower average price ($10 vs. $17.07).
However, many financial advisors would not suggest this approach. Let's see why.
Market Timing: If Mark had predicted that the stock's price would decrease steadily from March to July, he probably
could have improved his investment return considerably. But, could he have predicted this? What if he had been
wrong? In the alternative scenario, waiting until July to buy would have been the worst possible choice. Market timing
offers huge potential rewards but-and this should be no surprise to you by now it involves a huge amount of risk.
That's why so many experts advise against trying to time the market and suggest more systematic strategies instead.
Numerous studies have shown that mistakes made trying to time the market lose money for most investors. According
to one such study, the average investor earned 5.02 percent average return per year for the twenty years ending in

2013. This was 4.20 percent less than the 9.22 percent earned on average by the benchmark S&P 500 in the same
time period.
Dollar-Cost Averaging in DC Plans: Dollar-cost averaging is a valuable strategy that can help investors set up a
regular, disciplined method for purchasing investments for long-term goals, such as retirement. Note that dollar-cost
averaging is a feature of most defined contribution plans: each employee receives a paycheck at regular intervals, and
a pre determined amount is deducted from each paycheck and used to purchase investment fund shares.