MT483 Unit 10 Investment Policy Proposal Example

Counting the Pension as the Bond Side: An MT483 Unit 10 Investment Policy Proposal for a 34-Year-Old Machinist

[Student Name]

Purdue University Global

MT483: Investments

Unit 10 Investment Policy Proposal

[Instructor Name]

[Date]

Kevin Brooks, his accounts, his pension and the plan's funds are composite; the bracketed pension and Social Security figures stand for his own statements; the sources cited are real.

1. Purpose and Scope

This proposal is addressed to Kevin Brooks, a composite 34-year-old union machinist, and sets out a written policy for his two retirement accounts: a 401(k) worth $85,000 and a Roth IRA worth $12,000. Each later decision cites the section that justifies it, so that the policy can be followed without the reasoning being rebuilt each year. The proposal is coursework for a described investor; it is not advice to any real reader.

2. Objective

Kevin's objective is retirement income from age 62 equal to about $5,200 a month in today's dollars. Three sources will supply it. His union pension, a defined benefit plan, will pay a bracketed [$2,300] a month from 62 according to his latest plan statement. Social Security, which he can claim later, will add a bracketed [estimate from his Social Security statement]. His two accounts must supply the rest. The objective is stated in monthly income because that is how Kevin will experience retirement, and a balance target alone would not show whether his income needs are met.

3. Constraints

Five constraints shape the policy, and each is tied to a later decision.

Horizon. Kevin has 28 years until 62, and the accounts may need to last 30 years after that. A long horizon allows a high stock allocation (Section 5).

Liquidity. He holds a funded emergency reserve of three months' spending outside these accounts, so neither account needs to hold cash for emergencies (Section 5).

Taxes. The 401(k) is taxed on withdrawal, while the Roth IRA's qualified withdrawals are tax-free. Assets expected to grow most belong in the Roth (Section 5).

Legal and plan rules. The 401(k) offers a fixed menu of funds, and contributions are subject to annual limits. The policy chooses only from the menu (Section 6).

Unique circumstances. The pension is the circumstance that matters most, because it changes how much of Kevin's wealth is already in a bond-like asset (Section 4).

4. The Pension as a Bond

A defined benefit pension pays a fixed monthly amount for life, which makes it behave much like a bond Kevin owns: it does not rise or fall with the stock market. Bodie (1990) described pensions as a form of retirement income insurance, and in that light they are part of the safe side of an investor's balance sheet even though they never appear on an account statement.

Valuing the pension requires three stated assumptions. Payments of $2,300 a month begin at 62 and continue to age 90, 336 payments. The discount rate is 5 percent a year, close to the yield on high-quality corporate bonds of similar length. And the benefit is treated as fixed, since Kevin's plan does not adjust it for inflation. At 62, the payments are worth about $415,482. Discounted 28 years to today at the same rate, they are worth about $105,987.

Counting the pension, Kevin already holds more than half of his wealth in a bond-like asset.

Kevin's total retirement wealth is therefore about $202,987: $97,000 in the accounts and $105,987 in the pension. The pension is about 52 percent of it. Holding 90 percent stocks in the accounts, $87,300, puts about 43 percent of his total wealth in stocks, a moderate position rather than an aggressive one.

The pension carries its own risks, and the proposal does not treat it as riskless. A multiemployer plan can be underfunded, benefits can be frozen for future service, and a fixed benefit loses purchasing power to inflation: at 2.5 percent a year, $2,300 in 28 years buys what about $1,150 buys today. These risks are reasons to review the allocation if the plan's funding status changes (Section 9).

5. Allocation

The accounts will hold three funds with targets and rebalancing ranges.

US stock index fund: 60 percent target, range 55 to 65 percent, expense ratio 0.02 percent.

International stock index fund: 30 percent target, range 25 to 35 percent, expense ratio 0.06 percent.

Intermediate bond index fund: 10 percent target, range 5 to 15 percent, expense ratio 0.05 percent.

The weighted expense ratio is 0.035 percent. The bond fund is placed in the 401(k), where its interest is sheltered until withdrawal, and the Roth IRA holds stock funds only, since tax-free growth is worth most on the assets with the highest expected return. The 10 percent bond fund stays despite the pension so that, after a bad year for stocks, Kevin has something to sell to buy more of them at lower prices. Bodie et al. (1992) argued that workers whose earnings are flexible and stable can carry more stock risk early in life, and Kevin's steady union wage and pension point the same way.

6. Costs, in Dollars at Retirement

Three ways of holding this allocation were compared, each with the same assumed gross return of 6.5 percent a year and the same yearly saving of $17,200: Kevin's $6,800 401(k) contribution, his employer's $3,400 match and $7,000 to the Roth IRA. Only cost differs.

The three-fund mix at 0.035 percent reaches about $1,831,713 after 28 years. The plan's target-date fund, which holds a similar mix and charges 0.12 percent, reaches about $1,801,804, about $29,909 less. An advisory managed account offered through the plan, charging 0.52 percent all in, reaches about $1,668,099, about $163,614 less.

The target-date fund's extra cost buys automatic rebalancing and a glide path toward bonds, which some investors value enough to pay for. The managed account's cost is harder to defend for Kevin: its main service, choosing an allocation, is the service this policy provides. Sharpe (1991) showed that, before costs, investors as a group earn the market return, so every dollar of fees comes out of the group's return; the dollar figures show what that rule means for one investor over 28 years.

7. Rebalancing

The accounts will be rebalanced once a year, on the first business day after January 15, if any fund is outside its range. A fund that moves more than 5 points from its target between those dates triggers an immediate rebalance. New contributions go first to whichever fund is furthest below target, which reduces the need to sell.

8. Glide Path

From age 50, the bond target rises by 2 points a year until it reaches 30 percent at 60, with US and international stocks reduced in proportion. The pension's growing share of total wealth near retirement is a reason to keep the shift gradual.

9. Review Triggers

The policy is reviewed every three years and immediately if any of three events occurs: a job change that ends pension accruals or alters the 401(k) menu; an amendment to the pension plan or a decline in its funded status reported in its annual funding notice; or marriage, which changes the household's income needs and assets. Each event changes an input in Sections 3 through 5, so the review starts there.

References

Bodie, Z. (1990). Pensions as retirement income insurance. Journal of Economic Literature, 28(1), 28-49.

Bodie, Z., Merton, R. C., & Samuelson, W. F. (1992). Labor supply flexibility and portfolio choice in a life cycle model. Journal of Economic Dynamics and Control, 16(3-4), 427-449. https://doi.org/10.1016/0165-1889(92)90044-F

Sharpe, W. F. (1991). The arithmetic of active management. Financial Analysts Journal, 47(1), 7-9. https://doi.org/10.2469/faj.v47.n1.7