Last Updated 22 Feb 2022

Mr Old Alfred Road

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Old Alfred Road, who is well-known to drivers on the Maine Turn-pike, has reached his seventieth birthday and is ready to retire. Mr. Road has no formal training in finance but has saved his money and invested carefully. Mr. Road owns his home—the mortgage is paid off—and does not want to move. He is a widower, and he wants to bequeath the house and any remaining assets to his daughter. He has accumulated savings of $180,000, conservatively invested. The investments are yielding 9% interest. Mr. Road also has $12,000 in a savings account at 5% interest. He wants to keep the savings account intact for unexpected expenses or emergencies. Mr. Road’s basic living expenses now average about $1,500 per month, and he plans to spend $500 per month on travel and hob-bies. To maintain this planned standard of living, he will have to rely on his investment portfolio. The interest from the portfolio is $16,200 per year (9% of $180,000), or $1,350 per month. Mr. Road will also receive $750 per month in Social Security payments for the rest of his life.

These payments are indexed for inflation. That is, they will be automatically increased in propor-tion to changes in the consumer price index. Mr. Road’s main concern is with inflation. The inflation rate has been below 3% recently, but a 3% rate is unusually low by his-torical standards. His Social Security payments will increase with inflation, but the interest on his investment portfolio will not. What advice do you have for Mr. Road? Can he safely spend all the interest from his investment portfolio?

How much could he withdraw at year-end from that portfolio if he wants to keep its real value intact? Suppose Mr. Road will live for 20 more years and is willing to use up all of his investment portfolio over that period. He also wants his monthly spending to increase along with inflation over that period. In other words, he wants his monthly spending to stay the same in real terms. much can he afford to spend per month? Assume that the investment portfolio continues to yield a 9% rate of return and that the inflation rate will be 4% Fundamentals of Corporate Finance, 154.

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