Old Alfred Road MINI CASE Problem

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

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

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

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

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

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

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

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

Assume that the investment portfolio continues to yield a 9 percent rate of return and that the inflation rate will be 4 percent.

Oct
22
2009

Several trains of thought have emerged within our group as we attempted to do right by our “client,” Mr. Road. These ranged from aggressively investing any and all available assets on his behalf to reducing his lifestyle to well below his wishes in order to be conservative. Certainly several options in between were also contemplated.

In the end, two thought processes were considered finalists and these both fit within the assignment parameters of interest rates and inflation rates. The first, labeled “Basic” in the tab area of the spreadsheet, took a simple equation and applied it to both income and expenditures for Mr. Road. It applied a 4% inflation rate to his expenses, compounded yearly, and a similar 4% adjustment to his Social Security earnings; again, compounded annually. The surplus or deficit left behind (after the application of his $600.00 per year interest earnings on his $12000.00 in savings) was applied to his investment portfolio. This affected his income the following year in either a positive (if more interest was earned and available) or negative (if deficits were offset by his portfolio) way. The investment portfolio balance always yielded a 9% return on investment, compounded annually. This interest, along with his slow-growing Social Security became his living expenses “account.” Again, the surplus or deficit in this account was applied to the investment portfolio and this action affected the next year’s available monies.

This method can be defended through the thought process that each set of funds (expenses and incomes) were independently affected by their own interest rates.

These calculations resulted in the following answers to the MiniCase questions:

What advice to you have for Mr. Road: Follow this plan very carefully and with much discipline and you may continue to spend the desired amount monthly for the remainder of your years and leave behind $27503.00 to his daughter.

How much could he withdraw at year-end from that portfolio if he wants to keep its real value intact: In order to keep the real value of the portfolio intact, the most that may be withdrawn is the interest rates paid for the previous year. For the first several years, as demonstrated by the spreadsheet, he may withdraw less than the entire interest paid and allow the balance to continue compounding. However, the 4% inflation rate catches up with him in year five, causing a continuous reduction in the principle of his investment. Again, follow the plan and you will achieve your goals, Mr. Road.

How much can he afford to spend per month if he were willing to spend his portfolio to maintain his spending in line with inflation: As the spreadsheet demonstrates, Mr. Road is able to pace inflation throughout the balance of his years by subsidizing only the amount needed out of his portfolio.

The second method, labeled “Complex” in the tab section of the spreadsheet used a different equation and math process to find its results. I include the author’ s own words in explanation as follows:

For Mr. Road this means that the real interest rate = 1.09 / 1.04 which yields 4.8%. (I used 5.8% because I was using 3% inflation rate)

I reworked my tabs on your spreadsheet to show both 9% interest rate and a 4.8% interest rate. At 9% it looks like Mr. Road will be able to make it the full 20 years (even if he does not touch the extra $600 from the interest earned on his savings). At the real interest rate of 4.8% the picture painted for Mr. Road is a much grimmer one. Including the rollover from the interest earned on his savings account it looks like he will only be able to continue to live his present lifestyle for 16 more years before his savings account is totally depleted.

The tab labeled “monthly spending of 1700” is used to show that Mr. Road could sacrifice $300 monthly on his traveling/hobbies portion of the budget and he will be able to sustain the full 20 years, assuming he rolls the extra $600 annually from his savings.

According to my calculations the answers to the specific questions are:

•&νβσπ;How much can Mr. Road spend each year? In order to survive 20 years Mr. Roads would have to reduce his annual spending from $24000 to $20400 which gives him a monthly spending of ~ $1700 at year one and increase, due to inflation of 4%, to $3581.06.

•&νβσπ;What’s the impact of inflation on his future incomes? Mr. Road will continue to build upon his initial investment of $180000 until year 5, based on a monthly spending of $20400. After year five the sum of the account will dwindle to $3,676.67 by year 20.

•&νβσπ;How much can he withdraw and afford to spend each month given the condition? See the second part of the answer for question 1.

•&νβσπ;What specific recommendation can you give to Mr. Road? In my opinion, Mr. Road will have to reduce his monthly spending from his initial $24000 to $20400. Additionally, he will have to add the 5% interest from his savings account to help subsidize his current living condition. Mr. Road could also seek out an account which yields a higher interest rate that could allow him to finance his desires of traveling / hobbies.

The differences between these two solutions seem to be rooted in the definition of “real” and “nominal.” Truthfully, I believe that the author of the second version may well possess a better grasp of this…for now. There are some great minds in this group, each disposed to learn much this term. I am confident that that will be the case.

Hi. Do you have the spreadsheet for this?

Am afraid, I don’t have it. If I found it I will share