TriState Corporation What will your portfolio be worth in 10

Tri-State Corporation

What will your portfolio be worth in 10 years? In 20 years? When you stop working? The

Human Resources Department at Tri-State Corporation was asked to develop a financial planning model that would help employees address these questions. Tom Gifford was asked to lead this effort and decided to begin by developing a financial plan for himself. Tom has a degree in business and, at the age of 25, is making $34,000 per year. After two years of contributions to his company’s retirement program and the receipt of a small inheritance,

Tom has accumulated a portfolio valued at $14,500. Tom plans to work 30 more years and hopes to accumulate a portfolio valued at $1,000,000. Can he do it?

Tom began with a few assumptions about his future salary, his new investment contributions, and his portfolio growth rate. He assumed 5% annual salary growth rate as reasonable and wanted to make new investment contributions at 4% of his salary. After some research on historical stock market performance, Tom decided that a 10% annual portfolio growth rate was reasonable. Using these assumptions, Tom developed the Excel worksheet shown in Figure 16.18. Tom’s specific situation and his assumptions are in the top portion of the worksheet (cells D3:D8). The worksheet provides a financial plan for the next five years. In computing the portfolio earnings for a given year, Tom assumed that his new investment contribution would occur evenly throughout the year, and thus half of the new investment could be included in the computation of the portfolio earnings for the year. Using Figure 16.18, we see that at age 29, Tom is projected to have a portfolio valued at $32,898.

Tom’s plan was to use this worksheet as a template to develop financial plans for the company’s employees. The assumptions in cells D3:D8 would be different for each employee, and rows would be added to the worksheet to reflect the number of years appropriate for each employee. After adding another 25 rows to the worksheet, Tom found that he could expect to have a portfolio of $627,937 after 30 years. Tom then took his results to show his boss, Kate Riegle.

Although Kate was pleased with Tom’s progress, she voiced several criticisms. One of the criticisms was the assumption of a constant annual salary growth rate. She noted that most employees experience some variation in the annual salary growth rate from year to year. In addition, she pointed out that the constant annual portfolio growth rate was unrealistic and that the actual growth rate would vary considerably from year to year. She further suggested that a simulation model for the portfolio projection might allow Tom to account for the random variability in the salary growth rate and the portfolio growth rate.

After some research, Tom and Kate decided to assume that the annual salary growth rate would vary from 0% to 10% and that a uniform probability distribution would provide a realistic approximation. Tri-State’s accounting firm suggested that the annual portfolio growth rate could be approximated by a normal probability distribution with a mean of 10% and a standard deviation of 5%. With this information, Tom set off to develop a simulation model that could be used by the company’s employees for financial planning.

Question. Incorporate the random variability of the annual salary growth rate and the annual portfolio growth rate into a simulation model. Assume that Tom is willing to use the annual investment rate that predicted a 30-year, $1,000,000 portfolio in part 1. Show how to simulate Tom’s 30-year financial plan. Use results from the simulation model to comment on the uncertainty associated with Tom reaching the 30-year, $1,000,000 goal. Discuss the advantages of repeating the simulation numerous times.

Solution

Tri-State Corporation - Simulation Model

     A

B

   C

   D

   E

F

   G

H

1

Financial

Analysis Portfolio

Projection

2

Age

25

3

Current

Salary

$34,000

4

Current

Portfolio

$14,500

5

Annual

Salary Growth

Rate

    5%

6

Annual

Investment

Rate

    4%

7

Annual

Portfolio Growth

Rate

   10%

8

Beginning

New

Portfolio

Ending

9

Year

Age

Portfolio

Salary

Investment

Earning

Portfolio

10

1

25

14,500

34,000

1,360

1,518

17,378

11

2

26

17,378

35,700

1,428

1,809

20,615

12

3

27

20,615

37,485

1,499

2,136

24,251

13

4

28

24,251

39,359

1,574

2,504

28,329

14

5

29

28,329

41,327

1,653

2,916

32,898

With the specific financial analysis data input into cells D3:D8, the formulas used to develop the portfolio projection worksheet are shown above. The rows are copied to extend the worksheet to the desired 30-years projection.

A 1% increases in the annual investments rate increase the projected 30-years portfolio by $ 93,730. The annual investment rate would have to be increase to 8% in order to achieve the $1,000,000 goal.

Increasing the annual investment rate in cell D7 will generate the following 30-years portfolio projection:

Rate

Projected Portfolio

5%

$ 721,667

6%

$ 815,397

7%

$ 909,127

8%

$ 1,002,857

The simulated 30-years portfolio amounts will vary considerably from trail to trail. The uncertainty associated with annual salary growth rate and the annual portfolio growth rate will show that there is uncertainty in reaching the $1,000,000 even if the annual investment rate is increased to 8%.

A few simulation trails will not point out that the 30-years portfolio variability and the uncertainty of reaching the $1,000,000 goal. However, repeating the simulation numerous times will be necessary to provide an objective basis for estimating the probability of reaching of $1,000,000.

Performed the simulation of 1000 trails. The probability of reaching $1,000,000 was estimated be 0.48. Thus, the simulation conclusion is that there is less than a 50% chance of reaching $1,000,000 even if an investment rate is used. During the 1000 trails, the 30-years portfolio varied from $550,000 to $1,900,000. There was a 30% chance that the portfolio would not reach $900,000.

	A	B	C	D	E	F	G	H
1	Financial	Analysis Portfolio	Projection
2	Age			25
3	Current	Salary		$34,000
4	Current	Portfolio		$14,500
5	Annual	Salary Growth	Rate	5%
6	Annual	Investment	Rate	4%
7	Annual	Portfolio Growth	Rate	10%
8			Beginning		New	Portfolio	Ending
9	Year	Age	Portfolio	Salary	Investment	Earning	Portfolio
10	1	25	14,500	34,000	1,360	1,518	17,378
11	2	26	17,378	35,700	1,428	1,809	20,615
12	3	27	20,615	37,485	1,499	2,136	24,251
13	4	28	24,251	39,359	1,574	2,504	28,329
14	5	29	28,329	41,327	1,653	2,916	32,898