Academic journal article Risk Management and Insurance Review

Teaching Note for a Retirement Planning Exercise

Academic journal article Risk Management and Insurance Review

Teaching Note for a Retirement Planning Exercise

Article excerpt

INTRODUCTION

This teaching note contains a student exercise that provides an overview of the retirement planning process for people entering the workforce. The exercise is equally applicable to a personal finance class, an introduction to risk management and insurance class, or a more advanced class in financial planning. The retirement planning exercise presented here can be used to facilitate discussions concerning a variety of concepts and issues. Specifically, the exercise can provide an insight into the following questions:

* What is retirement planning? What are the goals of retirement planning and how does one go about it?

* What are the current starting salaries for college graduates? What are the expected amount and pattern of raises throughout a working career?

* How many dollars should one save for retirement? How much is enough? When should a person start saving for retirement?

* How do you determine the long-run rate of return on investments? How sensitive are ending portfolio values to small differences in rates of return?

* Is compounding important? What is the difference between the geometric rate of return and the average rate of return? Is the difference important?

* How does a person estimate long-run inflation? How sensitive is future purchasing power to small changes in inflation rates? What happens to purchasing power over a long period of time?

* Why is compounding beneficial and inflation harmful in the retirement planning process?

OVERVIEW OF THE EXERCISE

Students are instructed to use a spreadsheet program to estimate various numbers resulting in a retirement plan over the expected number of employment years before retirement. Students actually do this exercise twice. The first time the students are given a little guidance and are asked to make their own decisions and assumptions. They are also told that no right answer exists, but that there are wrong or unreasonable assumptions. Once students have turned in the plan, a discussion ensues focusing on retirement goals and the range of assumptions. These assumptions include starting salary and the rate of increases over time, how much money to save, taxes, future rates of return and inflation. Faculty at this time should discuss the difference between average rates of return and geometric rates of return and how risk (the variations experienced in rates of return) impacts the result.1

Once students have an appreciation for the set of realistic assumptions to use and their numerical ranges, they are then instructed to redo the plan and correct any problems found in the original solution. The result is a newly constructed spreadsheet using the new assumptions. Through this iterative process, students should discover that people only have real control over four variables: (1) how long one works, (2) how much money one saves, (3) choice of profession and willingness to relocate or change jobs, and (4) future investment in professional training and education. The other variables used in the retirement planning projection such as rates of return and inflation are marketdetermined and generally out of the control of workers. Thus, simulating retirement income needed focuses on the four controllable variables.2

The following set of instructions provides guidance to construct the spreadsheet. It also provides the impetus to focus on the variables required to make intelligent decisions concerning retirement planning projections. This exercise is not intended to help students determine how money will be invested to save for retirement. Investment vehicles such as 401 (k)s and IRAs as well as investment types such as stocks and bonds and asset allocation percentages are discussed in class following the completion of the retirement planning exercise.

THE RETIREMENT PLANNING EXERCISE

The students are asked to construct a spreadsheet, such as the one shown in Table 1, with the following minimal information. …

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