Academic journal article Management Accounting Quarterly

Which Would You Choose: Funding Retirement or Paying off Consumer Debt?

Academic journal article Management Accounting Quarterly

Which Would You Choose: Funding Retirement or Paying off Consumer Debt?

Article excerpt

Financial advisors are asked to assist their clients in achieving personal financial goals involving a variety of areas such as investment, insurance, retirement, and debt planning. Two of the most important steps in achieving financial independence involve funding a 401(k) or other retirement plan and repaying consumer debt. (Individuals typically pursue these goals after they establish an adequate emergency fund.)

Ideally, an individual would eliminate his or her outstanding consumer debt immediately while simultaneously contributing the maximum allowed amount into a retirement account. But what happens when people must choose between one of these two objectives because of budgetary constraints? After all, it is not atypical to have insufficient funds to pay offconsumer debt and maximize retirement contributions at the same time. Should one goal be pursued to the exclusion of another, or should both be partially pursued to the extent allowed by available resources and contractual constraints?

An article in the April 2006 issue of Money magazine addressed this question.1 While it provided good advice, it did not attempt to create a general methodology to identify optimal courses of action given a particular individual's situation. It did, however, cause us to come up with our own method. In this article we attempt to provide specific guidance to financial planners and their clients that will help them optimize the allocation of limited financial resources between retirement savings and consumer debt repayment.

Methodology

At its core, the decision rule governing the allocation of an individual's funds between these objectives is relatively simple. To identify the optimal course of action, we make a basic assumption concerning individual behavior: We assume that consumers are motivated to pay offtheir existing debt and that they will not incur any additional debt during the planning period. This assumption allows the identification of an optimal solution without complicating the analysis by requiring additional constraints. Obviously, deviations from this behavioral assumption, which is not atypical, will lead to suboptimal results. Nonetheless, there is still value in identifying the optimal solution, even with the tenuous assumption of rational human behavior, in order to make fully informed decisions and to identify the cost associated with less-than-optimal courses of action and human behaviors.

Given the specified behavioral assumption, the optimal decision rule reduces to a net present value (NPV) or terminal wealth analysis. Under these decision criteria, an individual should choose the alternative resulting in the highest NPV or terminal wealth. The NPV and terminal wealth analysis methodologies will result in the same decision-as long as the discount rate used is held constant across the various alternatives under consideration. Utilizing a terminal wealth methodology, however, simplifies the analysis by avoiding the need to determine the appropriate discount rate to use in identifying the present value of the relevant cash flows over the relevant time horizon. Given this consideration, the simpler criterion of maximizing terminal wealth over the planning period is utilized to identify the optimal strategy.

There are four possible allocation strategies:

1. Individuals can use all of their available funds to repay their debt.

2. They can use all of their available funds in excess of their required minimum payments on their debt to accumulate retirement savings.

3. They can split their available funds to simultaneously pay more than the required minimum payment on their outstanding debt and accumulate retirement savings.

4. They can switch between the three strategies over the planning period.

The terminal wealth analysis takes the form of an optimization problem in which our decision variables are the amount to allocate each month to repay credit card debt and/or invest for retirement. …

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