Spending wisely also involves making a judgment call as to which of the funds that are available can prudently be spent. Surely funds saved for emergencies, for funding the education of children and retirement should only be drawn on for spending when there are dire circumstances. Today’s scenario considers the judgment call related to funds which have been saved in a corporate pension plan towards funding retirement.
The scenario is as follows: A 29-year-old man decides to take up an exciting new job. He leaves his previous employer and his accumulated pension fund balance of $20 000 becomes available to him to decide how it will be disposed.
This pension fund balance is the total of his pension contributions as well as the vested company’s contribution over the past 13 years working with that company. It may be taken as a cash payment to him net of applicable income taxes, or be transferred into another pension scheme.
If he transferred this accumulated fund into his new employer’s pension plan, what is your estimate of its value on his retirement when he is 65 years old? Assume a six per cent annual rate of return for the ensuing period.
1. $72 000?
2. $94 000? or
3. $114 800?
The relevant multiplier factor from the annuity future value table for a 35-year period compounded at six per cent is 5.74. Thus the fund accumulated by retirement would be approximately $114 800 ($20 000 x 5.74).
Unfortunately, many employees in this situation may eagerly consider spending the available funds to spruce up their home, car or wardrobe, or take a long awaited overseas vacation. The worst of it is that this $20 000 fund, which would have been accumulated by the employee free of income tax, will then attract income taxes if drawn for spending.
Given that the employee will be moving to a job where he will be likely earning a higher income, the funds available for spending will be at most say, 20 per cent less – $16 000 after taxes.
Thoughts about spending available funds always seem to arise first. We have all been conditioned to make choices that please us in the short term. However, with greater understanding, we learn to balance our short-term and long-term outlooks and make better choices. In this example, the long-term cost of withdrawing the accumulated pension funds is very high. Is it worth the upgrade in home, car or wardrobe or that overseas vacation?
Another way of looking at it is: is the upgrade in home, car or wardrobe or overseas vacation worth the $114 800 that could help fund retirement?
Let us look at what 15-year annuity at an annualised rate of four per cent this $114 800 can fund. The present value annuity factor for 15 years at four per cent compounded is 11.12. There are 12 months in each year. That is an annuity of over $850 per month ($114 800/11.12/12 = $860.03) can be provided when the man becomes 65 years old by transferring the accumulated $20 000 into another pension plan.
Early savings
Again, this example emphasises the power of early savings towards retirement. For this employee to cash in the accumulated pension fund is to release funds that will accumulate the highest level of compound interest as he grows nearer and nearer to retirement. To expend these funds and then save later on to replace their value would be a greater financial burden on his earning level going forward.
This scenario places the raiding of retirement funds in any measure for spending, particularly on consumption, as imprudent. Retirement funds should be treated as sacrosanct except in very dire circumstances.
• Louise Fairsave is a personal financial management adviser, providing practical advice on money and estate matters. Her advice is general in nature; readers should seek advice about their specific circumstances. She can be contacted at louisefairsave@nationnews.com.
This column is sponsored by the Barbados Workers’ Union Co-op Credit Union Ltd.
