Case study
Part 1:
You’re at a family party when your cousin, Sarah, approaches you admitting she knows “nothing about money.” She is starting a new job at UConn and has a choice between a 401k and a pension. She really wants to make the smart choice and asks for your advice. In order to vest in the pension plan, Sarah must work at her job for 10 years and contribute 2% of her salary to the pension fund. If she does works at least 10 years, she will receive a percentage of the last year before she retires salary. Assume the amount she receives each year in retirement is 40% of her final salary and is guaranteed to be paid out each year until death. If she does not stay the full 10 years, she will be refunded the amount she has contributed, plus 1% interest. Alternatively, she can contribute 5% of her salary into a 401 (k) plan, and UConn will match it with 5% of her salary (i.e., she puts in $1, UConn also puts in $1). There is no vesting period in order to receive this matching, and she can walk away with the full amount if she ever decides to leave. There are three different investment options – a safe investment that cannot go down in value and generates a 3% return annually, a passive market index that moves up and down with the S&P500, and an actively managed mutual fund that holds a mix of stocks and bonds. She is currently 25 and plans to work for about 40 years.
What information would you need from Sarah in order to give her sound advice?
Sarah doesn’t know what any of this stuff means-write a memo to her as if she is a client of a financial planner (should be about 3 pages).
Outline the pros and cons of each type of investment and what she should consider before making a decision.
Remember this is someone who does not have an MBA. You need to walk her through the correct thought process and use easy numerical examples.
When using technical terminology, explain what it means and provide relevant analogies. Include graphics to show how amounts accumulate over time.
Part 2:
Many years passed after Sarah took your advice. At 65, she is getting ready to retire. She has $1m in a 401 (k) plan, a house worth $300k, and a cash savings account worth another $500k. She has decided that she has gone far too long without a will. She again asks your advice as to what she should bequeath to her husband and two children. The problem is that one child is in the Peace Corp. and makes very little money, whereas the other child is a wealthy attorney. She does not know their marginal tax rates, but she has heard the attorney say she’s paying too much in taxes.
Discuss the taxability of the different types of assets.
Are some tax-preferred assets upon bequeath, and are there non-tax benefits to the cash?
Come up with a plan that helps “equalize” the after-tax receipts for her two children and husband (hint: the lawyer probably shouldn’t be given the 401k). This question does not need to be a memo.
