Engineering Economic Paper

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Engineering Economic Analysis

Appendix 9A

Investing for Retirement and Other Future Needs

Copyright Oxford University Press 2017

Donald G. Newnan

San Jose State University

Ted G. Eschenbach

University of Alaska Anchorage

Jerome P. Lavelle

North Carolina State University

Neal A. Lewis

University of New Haven

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1

Appendix Outline

Defined Contribution & Defined Benefit Plans

What Returns are Reasonable to Expect & What Risks Go with Them

Copyright Oxford University Press 2017

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2

Defined Benefit & Defined Contribution

Defined benefit

Overseen by the employer for employees

Employer responsible for managing the fund

Usually both employer & employee contribute

Predictable benefit

Defined contribution

Employee designates amount to be directed into fund

Employee responsible for management

Benefit not predictable; only the contribution

Copyright Oxford University Press 2017

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3 Types of Investments

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Common stock = share of firm

Treasury bonds = longer term government debt

Treasury bills = short term government debt

Common Stocks Treasury Bonds Treasury Bills Inflation Rate
Geometric mean 11.0% 6.2% 4.5% 3.7%
Standard deviation 17.5% 10.8% 2.8% 2.9%
Maximum 1950-2012 52.6% 40.4% 11.6% 13.3%
Minimum 1950-2012 -35.5% -12.2% 0.0% -0.5%

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Mean & Risk

Stocks have higher risk than bonds

Stocks have much higher risk than T-bills

Geometric mean is the correct average

Compounds like time value of money

Copyright Oxford University Press 2017

Where ri = return in year i

(9A-2)

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Example

Gaining 50% one year and losing 50% the other year in either order

Arithmetic average=0%

Indicate you are back where you started

Geometric average=-13.4%=

Indicate you have lost 25%, only 75% (=1.5*0.5) of what you started with

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Maximize Return; Minimize Risk

Copyright Oxford University Press 2017

No choice is dominant; Stocks higher return, T-bills lower risk.

The best mix of investment depends on the trade-off between risk

and return.

Diversified portfolio of stocks is expected to perform better than few

stocks.

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0.17519999999999999 0.10840000000000002 2.8400000000000012E-2 0.11000000000000006 6.2100000000000079E-2 4.5300000000000069E-2

Risk = Standard Deviation of Return

Expected Return

Example 9A-1

Current salary $63,000; invests 15% yearly for 35 years. How much saved if all invested in T-bills, or bonds, or stocks?

Copyright Oxford University Press 2017

Stocks have returned 7.3% over inflation; bonds 2.5% over inflation; T-bills 0.8% over inflation.

So, the interest rate = market rates - inflation

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Copyright Oxford University Press 2017

Example 9A-2

Current salary $63,000; works 35 years. Goal of $1M at retirement. What % of salary must be saved?

Stocks have the greatest return, but stocks also have the greatest risk.

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Copyright Oxford University Press 2017

Example 9A-3

Salary was $63,000; needs 80% of that in retirement. How many years will savings last? (Same investment and return before and after retirement)

Note that annual amount spent before retirement is $63,000 𝗑 (1-% saved).

There is no answer for stocks; the number is too large.

=(63000-6774)*0.8

Annual return of 7.3% is $73000, which is more than the expected spending and pre-retirement salary!

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Copyright Oxford University Press 2017

Example 9A-3

Current salary $63,000, increases 2% faster than inflation; 15% of salary yearly for 35 working years. How much saved if invested all in T-bills, or bonds, or stocks?

Table needed for

annual increase

in salary.

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