Retirement Planning

CASES Retirement Planning Bob Davidson is a 46-year old tenured professor of marketing at a small New England business school. He has a daughter Sue, age 6 and a wife Margaret, age 40. Margaret is a potter, a vocation from which she earns no appreciable income. Before she was married and for the first few years of her marriage to Bob (she was married once previously), she worked at a variety of jobs, mostly involving software programming and customer support.

Bob’s grandfather died at age 42; Bob’s father died in 1980 at the age of 58. Both died from cancer, although unrelated instances of that disease. Bob’s health has been excellent; he is an active runner and skier. There are no inherited diseases in the family with the exception of glaucoma. Bob’s most recent serum cholesterol count was 190.

Bob’s salary from the school where he works consists of a nine-month salary (currently $95,000), on which the school pays an additional 10% into a retirement fund. He also regularly receives support for his research, which consists of an additional 2/9ths of his regular salary, although the college does not pay retirement benefits on that portion of his income. (Research support is additional income; it is not intended to cover the costs of research.) Over the twelve years he has been at the college his salary has increased by 4- 15% per year, although faculty salaries are subject to severe compression, so he expects not to receive such generous increases into the future. In addition to his salary, Bob typically earns $10-20,000 per year from consulting, executive education, and other activities.

In addition to the 10% regular contribution the school makes to Bob’s retirement savings, Bob also contributes a substantial amount. He is currently setting aside $7,500 per year (before taxes). The maximum tax-deferred amount he can contribute is currently $10,000; this limit rises with inflation. If he were to increase his savings toward retirement above the limit, he would have to invest after-tax dollars. All of Bob's retirement savings are invested with TIAA-CREF (Teachers Insurance and Annuity Association-College Retirement Equities Fund; home page: www.tiaa-cref.org), which provides various retirement, investment and insurance services to university professors and researchers. Bob has contributed to Social Security for many years as required by law, but in light of the problems with the Social Security trust fund he in uncertain as to the level of benefits that he will actually receive upon retirement (the Social Security Administration's web site is www.ssa.gov).

Bob’s TIAA-CREF holdings currently amount to $137,000. These are invested in the TIAA long-term bond fund (20%) and the Global Equity Fund (80%). The Global Equity Fund is invested roughly 40% in US equities and 60% in non-US equities. New contributions are also allocated in these same proportions.

In addition to his retirement assets, Bob's net worth consists of his home (purchase price $140,000 in 1987; Bob’s current equity is $40,000), $50,000 in a rainy-day fund (invested in a short-term money market mutual fund with Fidelity Investments), and $24,000 in a Fidelity Growth and Income Fund for his daughter’s college tuition. He has a term life insurance policy with a value of $580,000; this policy has no asset value but pays its face value (plus inflation) as long as Bob continues to pay the premiums. He has no outstanding debts in addition to his mortgage, other than monthly credit card charges.

Should Bob die while insured, the proceeds on his life insurance are tax free to his wife. Similarly, if he dies before retirement, his retirement assets go to his wife tax free. Either one of them can convert retirement assets into annuities without any immediate taxation; the monthly income from the annuities is then taxed as ordinary income.

Bob’s mother is 72 and in good health. She is retired and living in a co-op apartment in Manhattan. Her net worth is on the order of $300,000. His mother-in-law, who is 70, lives with her second husband. Her husband is 87 and has sufficient assets to pay for nursing home care, if needed, for his likely remaining lifetime. Upon her husband’s death, Bob’s mother-in-law will receive ownership of their house in Newton, Massachusetts, as well as one-third of his estate (the remaining two thirds will go to his two children). Her net worth at that point is expected to be in the $300,000-400,000 range.

Bob’s goals are to work until he is 60 or 65. He would like to save enough to pay for his daughter’s college expenses, but not for her expenses beyond that point. He and his wife would like to travel, and do so now as much as his job and their family responsibilities permit. Upon retirement he would like to be able to travel extensively, although he would be able to live quite modestly otherwise. He does not foresee moving from the small town where he now lives.

Bob has a number of questions about how he should plan for his retirement. Will the amount he is accumulating at his current rate of savings be adequate? How much should he be setting aside each year? How much will he have to live on when he retires? How long after retirement will he be able to live comfortably? What are the risks he faces, and how should his retirement planning take these risks into account?

Draft TV Commercials Source: Tom Willemain

Your client directs TV advertising for a large corporation that currently relies on a single outside advertising agency. For years, ads have been created using the same plan: the agency creates a draft commercial and, after getting your client's approval, completes production and arranges for it to be aired.

Your client's budget is divided between creating and airing commercials. Typically, about 5% of the budget is devoted to creating commercials and 95% to airing them. Lately he has become dissatisfied with the quality of the ads being created. Along with most advertising people, he believes that the ultimate profitability of an advertising campaign is much more strongly influenced by the content of the advertisement than by the level of expenditure on airing or the media utilized (assuming reasonable levels of expenditure). Thus he is considering increasing the percentage of his budget devoted to the first, “creative” part of the process.

One way to do this is to commission multiple ad agencies to each independently develop a draft commercial. He would then select the one for completion and airing that he determines would be most effective in promoting sales. Of course, since his budget is essentially fixed, the more money he spends on creating draft commercials the less he has to spend on airing commercials. Note that he will have to pay up front for all of the draft commercials before he has a chance to evaluate them.

The standard technique for evaluating a draft commercial involves showing it to a trial audience and asking what they remembered about it later (this is known as “next day recall”). Ads with higher next day recall are generally those with higher effectiveness in the marketplace, but the correlation is far from perfect. A standard method for assessing the effectiveness of a commercial after it has been aired is to survey those who watched the show and estimate “retained impressions.” Retained impressions are the number of viewers who can recall the essential features of the ad. Ads with higher retained impressions are usually more effective in generating sales, but again the correlation is not perfect. Both the effectiveness of a commercial (the number of retained impressions it creates) and the exposure it receives (the number of times it is aired) will influence sales.

How would you advise your client on the budget split between creating and airing a commercial?

Icebergs for Kuwait Source: Cross and Moscardini, 1985

The cost of desalinating seawater using conventional technology in the Persian Gulf is high (around 0.1£ per cubic meter) and requires extensive amounts of oil. Some time ago scientists suggested that it could well prove both practically feasible and less expensive to tow icebergs from the Antarctic, a distance of about 9600 km. Although some of the ice would undoubtedly melt in transit, it was thought that a significant proportion of the iceberg would remain intact upon arrival in the Gulf. Bear in mind that since water expands upon freezing, 1 cubic meter of ice produces only 0.85 cubic meter of water.

A study was carried out to evaluate the practical problems associated with such a proposal and to quantify the factors that were likely to influence the economics of such a venture. One factor was the difference in rental costs and capacities of towing vessels (summarized in Table 1). Note that each vessel has a maximum iceberg it can tow (measured in cubic meters). It was found that the melting rate of the iceberg depends on both the towing speed and the distance from the South Pole (see Table 2). The data in this table represents the rate at which a hypothetical spherical iceberg shrinks in radius over a day at the given distance from the Pole and at the given towing speed. Finally, fuel cost was found to depend on the towing speed and the (current) size of the iceberg (see Table 3).

Determine whether it is economically feasible to produce water from icebergs in the Persian Gulf, and if it is, determine the best means to do so.

Table 1 Towing Vessel Data Ship size Small Medium Large Daily rental (£) 400 600 800 Maximum load (cu. meter) 500,000 1,000,000 10,000,000

Table 2 Melting Rates (meter/day) Distance from Pole (km) 1000 2000 3000 >4000 Speed 1 km/hr 0.06 0.12 0.18 0.24 3 km/hr 0.08 0.16 0.24 0.32 5 km/hr 0.10 0.20 0.30 0.40

Table 3 Fuel Costs (£/km) Current Volume (cu. meter) 100,000 1,000,000 10,000,000 Speed 1 km/hr 8.4 10.5 12.6 3 km/hr 10.8 13.5 16.2 5 km/hr 13.2 16.5 19.8

The Racquetball Racquet Source: Dick Smallwood and Peter Morris

It is early in 1999, and a friend of yours has invented a new manufacturing process for producing racquetballs. The resulting high-quality ball has more bounce, but slightly less durability, than the currently popular high-quality ball, which is manufactured by Woodrow, Ltd. The better the player the more they tend to prefer a lively ball. The primary advantage to the new ball is that it can be manufactured much more inexpensively than the existing ball. Current estimates are that full variable costs for the new ball are $0.52 per ball as compared to $0.95 for the existing ball. (Variable costs include all costs of production, marketing, and distribution that vary with output. It excludes the cost of plant and equipment, overhead, etc.) Because the new process is unlike well-known production processes, the only reasonable alternative is to build a manufacturing plant specifically for producing these balls. Your friend has calculated that this would require $4-6 million of initial capital. He figures that if he can make a good case to the bank, he can borrow the capital at about a 10% interest rate, and start producing racquetballs in a year.

Your friend has offered to make you a partner in the business, and has asked you in return to perform a market analysis for him. He has already hired a well-known market research firm, Market Analysis, Ltd., to do some data gathering and preliminary market analysis. The key elements of their final report are given in the attachments.

Your problem is to determine how the new balls should be priced, what the resultant market shares will be, and whether the manufacturing plant is a good investment. Your friend is especially concerned about the risks involved, and would like some measures of how solid the investment appears to be. He would like you to make a formal presentation of your analysis. RACQUETBALL MARKET ANALYSIS Market Analysis, Ltd. January 20, 2000 a. The market for this type of high-quality ball is currently dominated by a single major competitor, Woodrow, Ltd. Woodrow specializes in manufacturing balls for all types of sports. They have been the only seller of high-quality racquetballs since the late 1970s. Their current price to retail outlets is $1.25 per ball (the retail mark-up is typically 100%, so these balls retail around $2.50 each, or $5.00 for the typical pack of two). b. Historical data on the number of people playing the sport, the average retail price of balls, and the (estimated) total sales of balls is given in the following table.

Number of Retail Balls Players Price Sold Year (thousands) (per ball) (millions)

1985 600 $1.75 5.932 1986 635 $1.75 6.229 1987 655 $1.80 6.506 1988 700 $1.90 6.820 1989 730 $1.90 7.161 1990 762 $1.90 7.895 1991 812 $2.00 7.895 1992 831 $2.20 8.224 1993 877 $2.45 8.584 1994 931 $2.45 9.026 1995 967 $2.60 9.491 1996 1020 $2.55 9.996 1997 1077 $2.50 10.465 1998 1139 $2.50 10.981 c. According to industry trade association projections, the total number of players will grow about 10% a year for the next ten years, and then stabilize at a relatively constant level. d. In order to assess relative preferences in the marketplace, a concept test was performed. In this test, 200 customers were asked to use both balls over a three-month period, and then specify which ball they would buy at various prices. Many customers indicated they would pay a premium for the Woodrow ball, based on their satisfaction with it and its better durability. Nevertheless, about 11% of the customers interviewed indicated a preference for the new bouncier ball at equal prices. The actual observed distribution of price premiums is tabulated below: Price Ratio* Percent Who Would Buy New Ball

0.5 0 1.0 11 1.5 41 2.0 76 2.5 95 3.0 100

*Price of Woodrow ball / Price of new ball