BlogNISM Series XB Investment Advi...Chapter 4: Retirement Planning...

Chapter 4: Retirement Planning Basics

Need for Retirement Planning:

Retirement planning is essential due to the increase in life expectancy.
Life expectancy is the number of years an individual is expected to live.
It is difficult to estimate accurately and is dependent on various factors such as health condition, scientific advancements, etc.
With the increase in average life expectancy, retirement planning is needed to sustain expenses post-retirement.
Retirement planning is not only about money accumulation but living a life of one’s choice post-retirement.
The biggest roadblock for retirement planning is accumulating enough money at retirement.
Retirement planning has various phases: preparation stage, period of initial retirement/pre-retirement stage, and final retirement.
Retirement planning is important regardless of what stage of life one is in.
Retirement planning should start early to take steps towards the retirement income one wants.

Retirement Planning:

Retirement planning is the process of determining the income required to meet living expenses in the period when there is no income being earned from employment, and then planning how to accumulate the corpus required and use it to generate the income.

Determine expenses in retirement:

Housing (including utilities, maintenance cost, taxes)
Living expenses (food and personal upkeep)
Medical care
Transportation
Recreational expenses
Insurance (life, health, disability)
Taxes

2. Determine income requirement in retirement:

Maintain standard of living in retired life
Consider expenses to be incurred in retirement
Take into account inflation rates

3. Time horizon:

Years to retirement: The period from the current point in time to the year of retirement or the period between current age and retirement age
Years in/during retirement: The number of years from the beginning of retirement to the end of life for which an income has to be secured

4. Determine the retirement corpus:

Variables considered:
- The periodic income required
- The expected rate of inflation
- The rate of return expected to be generated by the corpus
- The period of retirement, i.e. the period for which income has to be provided by the corpus

Impact of inflation:

Inflation eats away the purchasing power of money over time
At the time of calculating the income required, the value of the current expenses has to be adjusted for inflation to arrive at the cost of the expense at the time of retirement
The income required to meet the same level of expenses during retirement would go up due to inflation, which has to be considered while calculating the retirement corpus

Note: Retirement planning is important to secure one’s financial future during the post-retirement phase. It is important to determine the retirement goal with adequate rigour and periodically monitor and incorporate changes, if any, into the goal. The retirement corpus has to be calculated taking into account the variables mentioned above. Inflation is an important factor that affects retirement planning and has to be considered while determining the retirement corpus.

Estimating Retirement Corpus

Estimating retirement corpus involves determining the income required post-retirement to maintain one’s standard of living. There are two methods to estimate retirement corpus: Replacement Ratio Method and Expense Protection Method.

Replacement Ratio Method
The replacement ratio method assumes that an individual’s standard of living remains the same before and after retirement. This method helps to define the target income more accurately. The replacement income is calculated based on the pre-retirement income and the assumed replacement ratio.

Formula:
Replacement Income (Year 1) = Pre-retirement Income * Replacement Ratio
Replacement Income (each subsequent years) = Pre-retirement Income * Annual rate of Inflation * Replacement Ratio

Limitations:

The longer the period of retirement, the less accurate the income replacement estimate becomes.
Speculation is involved in estimating future retirement expenses.

2. Expense Protection Method
The expense protection method determines the retirement income based on an individual’s retirement expenses. This method involves tracking monthly expenses to estimate the retirement corpus accurately.

Formula:
Retirement Income = Retirement Expenses / (1 – Tax Rate)

Limitations:

Estimation of future retirement expenses becomes difficult with a longer period to retire.
Speculation is involved in estimating future retirement expenses.

Employee Benefits and Superannuation Benefits:

Employee benefits refer to non-wage compensation provided to employees in addition to their regular salary or wages. These benefits can take many forms and may include insurance, retirement benefits, leave policies, and other perks. Superannuation is a specific type of employee benefit that is designed to provide retirement income for employees.

Superannuation

Superannuation is a type of pension program established by an employer to provide retirement income for employees. These programs are also known as company pension plans. Funds are deposited into a superannuation account and typically grow without tax implications until the employee retires or withdraws the funds.

Employers have a legal liability to meet the superannuation benefits they have promised to their employees. In India, there is no legislation providing statutory superannuation benefits except to those employees covered under the Employees’ Pension Scheme, 1995. Therefore, employers can arrange for superannuation benefits either through payment or through a trust.

Payment by the Employer

Employers can arrange to pay superannuation benefits to their employees through two methods:

Lump sum contribution: Employers can choose to arrange for superannuation benefits for one or a few employees as a reward for their dedicated services by paying a lump sum contribution out of current revenue to buy an immediate annuity from a Life Insurance Company.
Pensionary benefits: Employers can establish a superannuation scheme for their employees and pay pensionary benefits out of current revenue. However, this method is not satisfactory as it depends on the financial health of the employer, and the likelihood of payment of pension to retired employees may be in jeopardy if the employer does not make enough profits in a given year to pay the pension disbursements.

Funding through a Superannuation Trust

The second method for administering a superannuation scheme is to do it through a trust. The employer should create an irrevocable trust for funding the pension liability and appoint trustees for the purpose. The employer should transfer the contributions for the superannuation benefit (both that of the employer and employees, if the scheme were to be contributory) to the trust fund.

Approved Superannuation Funds

Employers can get tax exemptions for contributions made to approved superannuation funds. These funds must be approved by the Commissioner of Income Tax in order to receive tax exemptions. Once the fund is approved, employers can treat the contributions made to the fund within the limits prescribed in the Income Tax Act as business expenses and deduct them from profits made for income tax purposes.

Mock Tests-

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Investment Advisor Level 2

Chapter 4: Retirement Planning Basics

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1. What is the trade-off between expected rate of return and risk in retirement planning?

a. Expected rate of return and risk have no relationship

b. Higher expected rate of return comes with higher risk

c. Expected rate of return eliminates risk

d. Higher expected rate of return comes with lower risk

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2. What are the different phases/stages of retirement planning?

a. Accumulation stage, Distribution stage, Utilization stage

b. Initial stage, Intermediate stage, Advanced stage

c. Preparation stage, Pre-retirement stage, Final Retirement

d. Saving stage, Spending stage, Investment stage

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3. What is the purpose of Section 88(2)(vii) of the Income Tax Act?

a. Allows tax-free withdrawal of funds from an approved superannuation fund

b. Provides tax exemptions for employer contributions to a superannuation fund

c. Allows employee contributions to an approved superannuation fund to be eligible for a tax rebate

d. Allows tax deductions for employer contributions to a superannuation fund

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4. Which section of the Income Tax Act provides the tax exemption for payments from an approved superannuation fund upon the death of a beneficiary?

a. Section 10(13)

b. Section 88(2)(vii)

c. Section 10(25)(iii)

d. Section 36(iv)

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5. Which method assumes that the standard of living remains the same in retirement?

a. Replacement Ratio Method

b. Inflation Adjustment Method

c. Savings Accumulation Method

d. Expense Protection Method

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6. What are the two arrangements an employer can have for providing superannuation benefits?

a. Payment by the employer and funding through a trust

b. Government-sponsored pension plans and employee savings plans

c. Individual retirement accounts and employee contributions

d. Annuity purchases and tax-exempt investment accounts

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7. What are some expenses that tend to reduce during retirement?

a. All of the above

b. Income tax, house maintenance

c. Housing loan repayment, children education expenses

d. Medical expenses, travel expenses

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8. How do trustees ensure pension benefits for employees or beneficiaries?

a. By providing financial counseling to employees

b. By making arrangements with life insurance companies

c. By investing trust money in government bonds

d. By deducting taxes from annuity payments

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9. What is the biggest roadblock for retirement planning?

a. Job loss or layoff

b. Physical and psychological changes

c. Retirement regulations and procedures

d. Accumulating enough money at retirement

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10. What is the Expense Protection Method based on?

a. Tracking expenses and budgeting

b. Speculation about retirement age

c. Estimating future income

d. Investment growth rate

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11. What are some responsibilities of the trustees of an approved Superannuation Trust Fund?

a. Managing company finances, conducting audits, making tax payments

b. Holding periodic meetings, collecting contributions, investing trust money

c. Reviewing employee performance, providing legal advice, preparing annual accounts

d. Providing employee benefits, overseeing HR functions, ensuring compliance

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12. What variables are considered in calculating the retirement corpus?

a. Years to retirement, years in/during retirement, years to achieve financial goals

b. Retirement expenses, life expectancy, average income, retirement age

c. Periodic income required, expected rate of inflation, expected rate of return, period of retirement

d. Health condition, genetic factors, lifestyle habits, inflation rate

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13. Why is it challenging to plan for retirement compared to other financial goals?

a. Retirement goals have defined horizons and timeframes

b. No loans available for retirement needs

c. Retirement goals have the longest accumulation and distribution periods

d. Retirement goals do not require a large corpus

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14. What happens to tax liabilities just after retirement?

a. They tend to increase

b. They tend to decrease

c. They remain the same

d. They become unpredictable

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15. Which section of the Income Tax Act provides tax exemptions for income received by trustees on behalf of an approved superannuation fund?

a. Section 36(iv)

b. Section 88(2)(vii)

c. Section 10(25)(iii)

d. Section 10(13)

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16. Which expenses tend to reduce at the retirement stage?

a. Medical expenses, travel expenses, long-term savings requirements

b. Housing loan, children education, work-related expenses

c. Children education, work-related expenses, long-term savings requirements

d. Housing loan, medical expenses, travel expenses

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17. What is the benefit of an approved superannuation fund in terms of tax exemptions?

a. Employer contributions are fully deductible

b. Employee contributions receive a tax rebate

c. All income received by trustees is tax-free

d. Payments to beneficiaries upon death and commuted value of pension are exempt

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18. How does the real rate of return impact retirement savings?

a. It has no impact on retirement savings

b. It makes retirement savings more unpredictable

c. It reduces the required retirement savings

d. It increases the required retirement savings

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19. What is the purpose of establishing a superannuation trust for funding pension liability?

a. To provide additional employee benefits

b. To ensure employee contributions are properly managed

c. To reduce the employer's tax obligations

d. To create a separate fund for retirement benefits

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20. What is a limitation of the Income Replacement Ratio method?

a. It has no limitations

b. It only applies to high-income individuals

c. It becomes less accurate for longer retirement periods

d. It becomes more accurate for longer retirement periods

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21. What are some expenses that may increase during retirement?

a. Medical expenses, travel expenses, gifting

b. All of the above

c. Housing loan repayment, children education expenses

d. Income tax, house maintenance

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22. How do funds deposited in a superannuation account typically grow?

a. Without any tax implications

b. With high-risk investments

c. By investing in government bonds

d. Through employer contributions only

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23. What should be periodically reviewed when using the Expense Protection Method?

a. Future retirement expenses

b. Investment growth rate

c. Inflation rate

d. Current household expenses

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24. According to the Accounting Standard 15 in India, how should retirement benefits be accounted for?

a. Provided for in the year of retirement

b. Provided for at the employee's request

c. Provided for when the benefits become due

d. Provided for in the respective year of accrual

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25. What are the two methods used to estimate retirement income?

a. Replacement Ratio Method and Expense Protection Method

b. Inflation Adjustment Method and Tax Reduction Method

c. Savings Accumulation Method and Investment Growth Method

d. Income Projection Method and Expense Reduction Method

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26. Which factor has led to the need for retirement planning?

a. Inflation

b. Increase in life expectancy

c. Change in retirement age

d. Availability of loans

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27. How does inflation impact retirement planning?

a. Increases the value of money over time

b. Makes retirement planning more complicated

c. Has no impact on retirement planning

d. Decreases the value of money over time

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28. What factors can lead to a reduction in retirement income?

a. Increase in living expenses and higher tax liabilities

b. Reduction in living expenses and lower tax liabilities

c. Reduction in living expenses and higher tax liabilities

d. Increase in living expenses and lower tax liabilities

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29. What income received by trustees on behalf of an approved superannuation fund is exempt from income tax?

a. Income from investments only

b. Income from employer contributions only

c. All income received by the trustees

d. Income from employee contributions only

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30. How does the expected rate of return and inflation interact in retirement planning?

a. They both increase the required retirement corpus

b. They have no relationship in retirement planning

c. They act in opposite directions on the required retirement corpus

d. They make retirement planning more unpredictable

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31. What is the drawback of the employer paying superannuation benefits directly from the current revenue?

a. Retired employees may receive more than the pension fund

b. The pension liability decreases over time

c. The employer can choose to skip payments

d. The employer's financial health determines pension payments

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32. How does inflation affect the cost of expenses in retirement?

a. Has no impact on the cost of expenses

b. Decreases the cost of expenses

c. Increases the cost of expenses

d. Makes expenses unpredictable

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33. What are some factors that have made retirement planning more critical than before?

a. Shorter life expectancy, increasing retirement benefits, declining healthcare costs

b. Higher interest rates, stable job market, low inflation

c. Longer life expectancy, decreasing retirement benefits, rising healthcare costs

d. Limited job opportunities, decreasing life expectancy, technological advancements

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34. Why is retirement planning important at a younger age?

a. To avoid inflation and taxes

b. To fulfill immediate financial responsibilities

c. To take advantage of retirement benefits

d. To have sufficient time for fund accumulation

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35. In which situation does an employer pay a lump sum contribution for superannuation benefits?

a. As a reward for dedicated services to specific employees

b. For all employees annually

c. When employees reach a certain age

d. When the company's profits increase

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36. What impact does the expected rate of return have on retirement planning?

a. It affects the amount of savings required

b. It determines the inflation rate

c. It has no impact on retirement planning

d. It makes retirement planning more complex

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37. What is superannuation in the context of employee benefits?

a. A tax-exempt investment account

b. A pension program created by a company for its employees

c. A retirement savings account managed by employees

d. An insurance plan offered to employees

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38. What is an approved superannuation fund in terms of tax exemptions?

a. A fund that is managed by the government

b. A fund that provides maximum tax benefits to employees

c. A fund that allows early withdrawals without penalties

d. A superannuation fund approved by the Commissioner of Income Tax

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39. What is the purpose of preparing annual accounts for an approved Superannuation Trust?

a. To ensure compliance with legal and tax requirements

b. To calculate trustee fees and expenses

c. To track employee contributions and investments

d. To evaluate the performance of the company

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40. What are the benefits of an approved superannuation fund under the Income Tax Act? (Choose all that apply.)

a. Any sum paid by the assessee as an employer by way of contribution towards an approved superannuation fund is allowed as deduction in the computation of business income of the employer.

b. The funds of an approved superannuation fund are accumulated in a tax free environment.

c. Payments made out of an approved superannuation fund to the beneficiaries upon the death of the member are exempt from Income Tax.

d. All of the above

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41. What is the real rate of return in retirement planning?

a. Expected rate of return adjusted for taxes

b. Inflation-adjusted rate of return

c. Rate of return without considering inflation

d. Rate of return adjusted for market conditions

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42. Why is the time horizon important in retirement planning?

a. It impacts the retirement age

b. It affects the cost of expenses in retirement

c. It determines the inflation rate

d. It determines the expected rate of return

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43. How does inflation impact the retirement corpus?

a. It has no impact on the retirement corpus

b. It increases the required retirement corpus

c. It makes the retirement corpus unpredictable

d. It decreases the required retirement corpus

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44. How is the replacement income calculated using the Replacement Ratio Method?

a. Pre-retirement Income * (1 + Replacement Ratio)

b. Pre-retirement Income * (1 - Replacement Ratio)

c. Pre-retirement Income * Inflation Rate

d. Pre-retirement Income * Replacement Ratio

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45. What is the relationship between early calculation and interest rate in retirement planning?

a. Earlier calculation increases the required interest rate

b. Earlier calculation has no impact on the interest rate

c. Earlier calculation reduces the required interest rate

d. Earlier calculation makes the interest rate unpredictable

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46. What does the replacement income increase by each year in the Replacement Ratio Method?

a. Inflation Rate

b. Increases by a fixed percentage

c. Investment Growth Rate

d. Decreases by a fixed percentage

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47. What is the first step in retirement planning process?

a. Determine income requirement in retirement

b. Determine expenses in retirement

c. Calculate the retirement corpus

d. Assess the impact of inflation

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48. What are the responsibilities of the trustees of an approved Superannuation Trust Fund? (Choose all that apply.)

a. To collect the amount of contributions from the employer as per the rules of the scheme or get it calculated by an Actuary in case of a defined benefit scheme and then requests the employer to pay it.

b. To have periodical meetings of the Trustees to review the performance of the Trust and to keep records of the minutes.

c. To keep in touch with the Company and inform the employer the decisions taken by the Trustees.

d. All of the above

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49. What is the role of years in/during retirement in retirement planning?

a. It affects the cost of expenses in retirement

b. It impacts the retirement age

c. It determines the years for which funding has to be provided

d. It determines the expected rate of return

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50. In India, which employees are covered under the Employees' Pension Scheme?

a. All public and private sector employees

b. Employees covered by statutory superannuation laws

c. Government bodies and nationalized banks

d. Employees of specific organizations approved by IRDAI

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51. What is the relationship between the expected rate of return and the required retirement corpus?

a. Higher expected rate of return increases the required retirement corpus

b. Expected rate of return makes the retirement corpus unpredictable

c. Higher expected rate of return reduces the required retirement corpus

d. Expected rate of return has no impact on the required retirement corpus

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52. What is another term used to describe a superannuation program?

a. Retirement savings scheme

b. Company pension plan

c. Employee stock ownership plan

d. Government-sponsored pension

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53. What happens to the required income in retirement due to inflation?

a. It increases over time

b. It remains constant

c. It decreases over time

d. It fluctuates randomly

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54. How can the total retirement expense be calculated using the Expense Protection Method?

a. Difference between current income and projected retirement income

b. Product of current expenses and retirement factor

c. Sum of current household expenses and additional retirement expenses

d. Average of current and projected expenses

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55. Which section of the Income Tax Act allows employers to deduct contributions made towards an approved superannuation fund?

a. Section 10(25)(iii)

b. Section 36(iv)

c. Section 10(13)

d. Section 88(2)(vii)

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56. Which method accounts for the increase in expenses and reduction in income during retirement?

a. Expense Protection Method

b. Inflation Adjustment Method

c. Replacement Ratio Method

d. Savings Accumulation Method

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57. What is a drawback of the expense method for those who are many years away from retirement?

a. It does not account for inflation

b. Estimating future retirement expenses becomes difficult

c. It requires excessive tracking of expenses

d. It only applies to individuals nearing retirement age

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58. What are trustees required to do regarding tax deductions from annuity payments?

a. Obtain tax clearance certificates

b. Hire tax consultants for assistance

c. Deduct tax at source and remit to IT authorities

d. Notify employees about tax obligations

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59. What is the liability of an employer once a superannuation benefit is in place?

a. To meet the superannuation benefit obligations

b. To offer retirement counseling

c. To pay all employees' taxes

d. To provide investment advice

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