MINICASE: Old Alfred Road
Old Alfred Road, who is well-known to drivers on the MaineTurnpike, has reached his seventieth birthday and is ready toretire. Mr. Road has no formal training in finance but has savedhis money and invested carefully.
Mr Road owns his home-the mortgage is paid off-and dose not want tomove.He is a widower,and he wants to bequeath the house and anyremaining assets to his daughter.
He has accumulated savings of $180,000, conservatively invested.The investments are yielding 9 percent interest. Mr. Road also has$12,000 in a savings account at 5 percent interest. He wants tokeep the savings account intact for unexpected expenses oremergencies.
Mr. Road’s basic living expenses now average about $1,500 permonth, and he plans to spend $500 per month on travel and hobbies.To maintain this planned standard of living, he will have to relyon his investment portfolio. The interest from the portfolio is$16,200 per year (9 percent of $180,000), or $1,350 per month.
Mr. Road will also receive $750 per month in social securitypayments for the rest of his life. These payments are indexed forinflation. That is, they will be automatically increased inproportion to changes in the consumer price index.
Mr. Road’s main concern is with inflation. The inflation rate hasbeen below 3 percent recently, but a 3 percent rate is unusuallylow by historical standards. His social security payments willincrease with inflation, but the interest on his investmentportfolio will not.
What advice do you have for Mr. Road? Can he safely spend all theinterest from his investment portfolio? How much could he withdrawat year-end from that portfolio if he wants to keep its real valueintact?
Suppose Mr. Road will live for 20 more years and is willing to useup all of his investment portfolio over that period. He also wantshis monthly spending to increase along with inflation over thatperiod. In other words, he wants his monthly spending to stay thesame in real terms. How much can he afford to spend per month?
Assume that the investment portfolio continues to yield a 9 percentrate of return and that the inflation rate will be 4 percent.