Financial Institutions Instruments and

Markets 8th Edition Viney Solutions

Manual
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 Financial Institutions, Instruments and Markets
8th edition
Instructor's Resource Manual

Christopher Viney and Peter Phillips

Chapter 8
Mathematics of finance: an introduction to basic concepts and calculations
The following symbols are used in the formulae:
i current nominal interest rate, per period, expressed as a decimal
n number of interest periods
A principal or present value
S accumulated amount or future value
I total dollar amount of interest paid or received
P price or value
d number of days
ie effective rate of interest
C coupon or interest payment
m compounding periods per year

Learning objective 1: Understand and carry out simple interest calculations, including:
• simple interest accumulation
• present value with simple interest
• initial yields
• holding period yields

1
 Simple interest

• Businesses and governments require access to both short-term debt funding and longer-term
debt funding.

• Debt must be repaid, but the structure of the debt instrument will affect the amount of funds
raised, and the cash flows associated with interest payments and principal repayment.

• Formulae are used to calculate the interest and principal repayment cash-flow requirements; the
formulae are represented by a set of symbols; each symbol denotes an input into a formula.

• Simple interest calculations are based on the original principal amount; interest receipts or
payments do not affect the principal amount of a simple interest loan or investment.

• The amount of interest received on an investment or paid on a loan, based on the original
principal amount, is:

8.1

• Therefore, the amount of simple interest plus the principal amount is:
8.2

• What is an amount due at a future date worth today? The present value of a single cash flow
with simple interest is:

8.3

• What is the present value of a money-market discount security? The discount security formula
is:

8.4

• The yield is the return on an investment or the cost of borrowing. The calculation of the yield,
or the holding period yield, on an investment is the interest earned divided by the amount
invested, adjusted for the number of days the investment is held:

8.5

Learning objective 2: Understand and carry out compound interest calculations, including:

2
 • compound interest accumulation (future value)
• present value with compound interest
• present value of an annuity
• accumulated value of an annuity (future value)
• effective rates of interest

Compound interest

• Compound interest occurs where interest payments accumulate onto the principal amount.
The interest for each ensuing interest period is calculated on the increased (compounded)
principal amount.

• The accumulated or future value of a single cash flow using compound interest is:
8.6

• The present value of a single cash flow using compound interest is:

8.7a

or
8.7b

• An annuity is a series of regular equal cash flows. Cash flows that occur at the end of an
interest period are called an ordinary annuity. The present value of an ordinary annuity is:

8.8

• An annuity where the cash flows occur at the beginning of an interest period is called an
annuity due. The present value of an annuity due is:

8.9

• A straight bond pays periodic fixed-interest coupons and the principal is repaid only at
maturity. The price of the bond is the present value of the cash flows, being the present value
of the interest coupons plus the present value of the principal (face value). The price of a bond
(at a coupon date) is:

3
 8.10

• The accumulated or future value of an ordinary annuity is:

8.11

• The nominal interest rate is the annual interest rate, typically the advertised interest rate on
an investment or a loan. However, when compounding occurs more often than annually, it is
necessary to calculate the effective interest rate to compare advertised nominal interest rates.
The effective rate of interest is:

8.12

• It is important to note that there are many complicating factors that are relevant in real-world
situations that have not been incorporated into our introduction of the basics of financial
mathematics, such as taxation and transaction costs. Importantly, the timing of transactions,
relative to the timing of fixed cash flows, requires certain adjustments to formulae which are
given in Chapter 10.

Review questions
1. Formulae symbols
A number of symbols are used to represent inputs to a formula. Briefly describe each
of the following symbols.

LIST OF SYMBOLS

i current nominal interest rate expressed as a decimal

n number of interest periods

A principal or present value

S accumulated amount or future value

I total dollar amount of interest paid or received

P price or value

4
 d number of days

C coupon or interest payment

m compounding periods per year

ie effective rate of interest

2. Simple interest accumulation

(a) Define and explain the notion of simple interest.
• The calculation of interest is based on the initial principal amount invested or borrowed.
• For example, funds invested in a bank term deposit for six months where simple interest is paid
monthly. The investor will receive the interest payment each month by cash and the amount invested
in the term deposit will remain the same. The principal will be repaid at maturity

(b) An investor makes a $3500 deposit from 1 June to 31 August at 4.25 per cent per annum
simple interest. How much interest will the investor earn?
I = A x d/365 x i
= $3500 x 92 x 0.0425
365
= $37.49

(c) A bank accepts a $5000 term deposit to mature in 547 days and pays 5.75 per cent per
annum. How much interest will the bank have to pay?
I = A x d/365 x i
= $5000 x 547 x 0.0575
365
= $430.86

(d) A bank accepts a deposit of $6500 for a term of one year and 90 days, with an interest rate of
5.95 per cent per annum simple interest. Interest is payable six monthly and at the maturity date.

5
What amount will be paid at each interest date and at the maturity date? (assume the deposit is
made on 1 July 2016)
• First six-monthly interest payment (184 days)
I = A x d/365 x i
= $6500 x 184 x 0.0595
365
= $194.96
• Second six-monthly interest payment (181 days)
I = A x d/365 x i
= $6500 x 181 x 0.0595
365
= $191.79
• Amount paid at maturity
S = A [1 +( n x i)]
= $6500 [1 + (90/365 x 0.0595)]
= $6595.36
Note: both the principal amount of $6500 plus interest for the 90 day period will be
paid at the maturity date.

(e) What is the future value of $10 000 invested for 270 days at a current yield of 6.50 per cent
simple interest?
S = A [1 +( n x i)]
= $10 000[1 + (270/365 x 0.065)]
= $10 480.82

3. Present value with simple interest

(a) Explain the concept of present value. What is the relationship between the present value and
future value of an amount?
• The present value is the current amount, or value, that is derived by discounting a future cash flow
by a required rate of return. Specifically, what is a known amount that is due in the future worth
today?

6
• The discount rate used to calculate the required rate of return is the current yield applicable for that
type of investment.
• For example, you hold an investment that you know will pay the sum of $5500 in one year. Yields
on this type of investment are currently 8.50 per cent per annum. Therefore, you are able to calculate
what that investment is worth today by discounting the future sum of $5500 by 8.50 per cent. The
investment has a present value of $5 069.12.
• On the other hand, the future value is the amount payable at a date in the future on a sum known
today.
• For example, an amount of $5069.12 invested today, yielding 8.50 per cent per annum, will have a
future, or accumulated, value in one year of $5500.

(b) What amount did an investor lodge in a term deposit that has a maturity value in 270 days of
$27 470.34 if the term deposit earns 4.95 per cent per annum simple interest?
A= S
[1 + (n x i)]

= $27 470.34
[1 + (270/365 x 0.0495)]

= $27 470.34
1.03661644

= $26 500.00

(c) A customer has received an invoice for $23 000 due in 30 days. The supplier offers a 2.50 per
cent per annum discount for payment within 7 days. If the customer accepts the early payment
offer, what amount would be due?
A= S
[1 + (n x i)]

= $23 000

7
 [1 + (30/365 x 0.025)]

= $23 000
1.00205479

= $22 952.84

(d) An investor currently holds a financial asset that has a maturity value of $125 000 in 125 days.
The investor decides to sell the asset today at a current market yield of 9.45 per cent per annum.
What is the present value of the asset?
A= S
[1 + (n x i)]

= $125 000
[1 + (125/365 x 0.0945)]

= $125 000
1.03236301

= $121 081.44

(e) A company issues a bank bill with a face value of $1 million and a term to maturity of 180 days
at a yield of 8.25 per cent per annum. The company discounts the bill today. What amount will
the company raise?
A = 365 x face value
365 + (i x days to maturity)

= 365 x $1 000 000

365 + (0.0825 x 180)

= $960 905.62

8
4. Yields
(a) Explain the meaning of the term yield within the context of (1) a bank term deposit, and (2) the
present and future values of discount securities
• The yield is the effective return received on an investment.
• Yield includes both interest received and capital gains (or losses) received on an investment.
• With a bank term deposit the investor will receive interest payments. If the interest is only payable
at maturity, say for a one-year term deposit, then the yield will equal the interest rate paid (note: if
interest is paid more frequently, then the yield will equal the effective rate paid which is discussed
later).
• With a discount security there is no interest payment. The investor buys the security for less than its
face value and receives the face value back at maturity. The yield, if the security is held to maturity,
is the return (face value minus the buy price) divided by the amount invested (buy price), adjusted
for the number of days invested. If the security is not held to maturity then face value becomes the
sell price.

(b) You are advised by a bank that a deposit of $5000, with a term to maturity of 180 days, will
have a maturity value of $5215. What is the yield on the deposit?
i = 365 x I
d A

= 365 x $215
180 $5000

= 8.72% p.a.

(c) You have $3000 to invest in a term deposit and your selection of the term is totally dependent
on the higher per cent per annum yield. Which of the following deposits would you select:
(i) a 90-day deposit that has a maturity value of $3075?
(ii) a 130-day deposit that has a maturity value of $3110?
(iii) a 145-day deposit that has a maturity value of $3120?

9
 i = 365 x I
d A

(i) = 365 x $75

90 $3000
= 10.1389% p.a.

(ii) = 365 x 110

130 $3000
= 10.2949% p.a.

(iii) = 365 x $120

145 $3000
= 10.0690% p.a.

Invest in option (ii) at a yield of 10.2949% per annum.

(d) What is the yield on a discount security bought at $97.80 (per $100 face value) and held 65
days to maturity?
i = 365 x I
d A

= 365 x $2.20
65 $100

= 12.3539% p.a.

5. Holding period yield (HPY)

(a) What is meant by the HPY, and how does it differ from yield to maturity?
• Yield to maturity refers to the return received when an investment is held until it matures.

10
• For example, a 180-day bank bill is purchased at the discounted price and, if held for the 180 days,
the face value is paid at maturity. The yield to maturity is the cost of issuing the bill by the
borrower; that is, the discount divided by the discounted amount adjusted for the 180 days.
• Holding period yield refers to the return received by an investor for the period over which an
investment is actually held.
• For example, a 180-day bank bill is purchased at a discount price, but is later sold (rediscounted)
before the maturity date. The rediscounted price will be based on current yields in the market at sale
date. The difference between the sale price and the purchase price is the return to the investor. The
return divided by the purchase price, and adjusted for the number of days the security was held,
represents the HPY.

(b) A 90-day discount security with a face value of $500 000 is purchased to yield 8.23 per cent
per annum. After 55 days it is sold at a yield of 8.45 per cent per annum. What is the HPY for the
original purchaser?
Purchase price = 365 x face value
365 + (i x days to maturity)

= 365 x $500 000

365 + (0.0823 x 90)
= $490 055.24

Sale price = 365 x $500 000

365 + (0.0845 x 35)
= $495 981.19

Return to original investor = sale price – purchase price

= $495 981.19 – $490 055.24
= $5 925.95

HPY = 365 x I
d A

11
 = 365 x $5 925.95
55 $490 055.24

= 8.03% p.a.

(c) An existing discount security, with a face value of $750 000 and with 60 days to maturity, was
purchased at a yield of 8.15 per cent per annum. After 21 days it is sold at a yield of 8.50 per cent
per annum. What is the rate of return earned over the 21-day holding period?
Purchase price = 365 x face value
365 + (i x days to maturity)

= 365 x $750 000

365 + (0.0815 x 60)
= $740 084.89

Sale price = 365 x $750 000

365 + (0.085 x 39)
= $743 249.66

Return to original investor = sale price – purchase price

= $743 249.66 – $740 084.89
= $3 164.77

HPY = 365 x I
d A

= 365 x $3 164.77
21 $740 084.89

= 7.43% p.a.

12
(d) The new holder of the security in (c) above sells it into the money market after 7 days at the
current yield of 7.90 per cent per annum.
(1) What is the holding period yield received by the seller?
(2) If the buyer holds the security to maturity, what is the holding period yield?
Purchase price = 365 x $750 000
365 + (0.085 x 39)
= $743 249.66

Sale price = 365 x $750 000

365 + (0.0790 x 32)
= $744 841.21

Return to the current seller = sale price – purchase price

= $744 841.21 – $743 249.66
= $1 591.55

HPY = 365 x I
d A

= 365 x $1 591.55
7 $743 249.66

= 11.17% p.a.

• The HPY differ because yields on this discount security have moved at the end of the holding
period.
• In example (c) the yield had moved to 8.50 per cent per annum, whereas in (d) the yield had moved
to 7.90 per cent per annum.
• In (d), because the current market yield had fallen, the price of the discount security has increased in
value, thus raising the HPY to the investor.
13
6. Compound interest accumulation
(a) Explain what is meant by the term compounding of interest. In your answer explain the
relationship between present values, future values and compounding.
• Compounding refers to the situation where interest earned in one period is added to the principal.
Interest in the next period is then earned on the larger total amount (principal + interest earned) and
is also added to the total amount at the end of the next period.
• For example, an original investment of $1000 earns 10 per cent per annum compounding annually.
At the end of the first year the interest earned is 10% of $1000 = $100. The $100 interest is added to
the original principal amount. During the second year interest is earned on the new accumulated
principal amount of $1100. Interest earned is 10% of $1100 = $110. The $110 is then added to the
existing $1100 to give a new balance of $1210. And so the process proceeds until maturity.
• The present value is the value today of an entitlement to a future cash flow or set of cash flows,
discounted at the current yield or required rate of return.
• The future value is the value at a specified date in the future of a determinable cash flow or set of
cash flows, discounted at the current yield or required rate of return.
• The calculation of a present value or future value recognises the compounding of the associated cash
flows over time.

(b) What is the accumulated value of a $3150 deposit made for four years with a yield of 5.25 per
cent per annum, compounding annually?
S = A (1 + i)n
= $3150 (1 + 0.0525)4
= $3150 (1.22712391)
= $3865.44

(c) What is the future value of the deposit described in (b) if interest is compounded quarterly?
S = A (1 + i)n
Where: n = 16; i = 1.5625% quarterly
= $3150 (1 + 0.0131250)16
= $3150 (1.23199378)

14
 = $3880.78

(d) What is the maturity value of a $5000 deposit made for one year and 60 days with a yield of
7.45 per cent per annum compounded annually?
S = A (1 + i)n
= $5000 (1 + 0.0745)1.16438356
= $5000 (1.08726709)
= $5436.34

7. Present value with compound interest

(a) What is the present value of $5000 due in five years at an annually compounded rate of 6.33
per cent per annum?
A = S or A = S (1 + i)-n
(1 + i)n

= $5000 (1 + 0.0633)-5
= $5000 (0.73573418)
= $3678.67

(b) Calculate the present value of $7000, due in three years at 5.40 per cent per annum
compounded quarterly.
A = S (1 + i)-n
Where: n = 12; i = 1.35% (quarterly)
= $7000 (1 + 0.0135)-12
= $7000 (0.85136338)
= $5959.54

(c) Calculate the present value of $7000, due in three years at 5.40 per cent per annum
compounded monthly.
A = S (1 + i)-n
Where: n = 36 ; i = 0.45% p.a. (monthly)

15
 = $7000 (1 + 0.0045)-36
= $7000 (0.85075032)
= $5955.25

(d) Compare the answers in (b) and (c) above and explain the difference in the present value
amounts.
• The difference in the present value of (b) and (c) relates to the frequency of compounding of the
interest payments; that is, (b) quarterly and (c) monthly.
• The more frequently the compounding occurs, the greater the accumulated amount.
• In the examples, the future accumulated value is the same ($10 000), therefore a lesser amount is
required in (c) to achieve that result because compounding occurs more frequently.

8. Present value of an annuity

(a) Explain what is meant by an annuity, an ordinary annuity and an annuity due. Draw a timeline
of the cash flows associated with an annuity of $5000 per year for four years, with the first
payment to be received at the end of the first year. Why is understanding the timing of annuity
cash flows important?
• An annuity is a series of cash flows of equal amounts, paid at equal (regular) time periods, and for a
specified number of periods.
• An ordinary annuity is an annuity where the periodic cash flows occur at the end of each period.
• An annuity due is an annuity where the periodic cash flows occur at the beginning of each period.
• In the example, an annuity of $5000 per year for four years means that the recipient will receive the
sum of $5000 at the end of each year (ordinary annuity).

$5000 $5000 $5000 $5000

annuity

t0 1 2 3 4 years

• Recognising the timing of an annuity payment is important; that is, does the cash flow occur at the
beginning or end of the period, as it effects the present value and future value annuity calculations?

16
(b) What is the present value of an annuity of $2500 paid annually over four years, with the first
payment to be received at the end of the first year, and with a yield currently of 6.30 per cent per
annum compounded annually?
A = C [ 1 – (1 + i)-n ]
i
= $2500 [ 1 – (1 + 0.0630)-4 ]
0.063
= $2500 [3.44143406]
= $8603.59

(c) What is the present value of an annuity of $1250 paid at the end of each half-year over four
years, with yields currently of 6.30 per cent per annum compounded half-yearly?
A = C [ 1 – (1 + i)-n ]
i
Where: n = 8; i = 3.15% (half-yearly)
= $1250 [1 – (1 + 0.0315)-8 ]
0.0315
= $1250 [0.21972779]
0.0315
= $1250 [6.97548528]
= $8719.36

(d) Explain why the present values of the annuities described in (b) and (c) are different.
• Both examples (b) and (c) are paying the same annuity amount; however, the
timing of the cash flows is different: (b) $2500 annually; (c) $1250 half-yearly.
• The difference in the present values of the two annuity streams reflects the
frequency of the payments.
• The payments for (c) compound more regularly (quarterly) and this is reflected in
a higher present value.

17
(e) What is the present value of an annuity of $1250 paid at the beginning of each half-year over
four years, with yields currently of 6.30 per cent per annum compounded half-yearly?
A = C [ 1 – (1 + i)-n ] (1 + i)
i
Where: n = 8; i = 3.15% (half-yearly)
= $1250 [ 1 – (1 + 0.0315)-8 ] (1 + 0.0315)
0.0315
= $1250 [0.21972779] (1.0315)
0.0315
= $1250 [6.97548528] (1.0315)
= $8719.35659841 (1.0315)
= $8994.02

(f) Why is there a difference in the answers between (c) and (e) above?
• The higher present value in (e) recognises the benefit of the earlier receipt of the
$1250 cash flow at the beginning of each quarter.

(g) What price would you pay for a corporate bond with a face value of $500 000, maturing in 7
years and paying 7.00 per cent per annum coupons semi-annually, if current market yields for
this type of security are 5.00 per cent per annum?
• to calculate the price of the bond it is necessary to calculate the present value of both the coupon
stream and the face value payable at maturity.

(i) coupon stream: A = C [ 1 – (1 + i)-n ]

plus i
(ii) face value: A = S (1 + i)-n

Therefore (coupon stream):

(i) C = $17 500
i = 5.00/2 = 2.50% (half yearly)
n = 14

18
 A = $17 500 [ 1 – (1 + 0.025)-14 ]
0.025
= $17 500 [11.69091217]
= $204 590.96
Therefore (face value):
(ii) S = $500 000
i = 2.50% half yearly = 0.025
n = 14

A = $500 000 (1+ 0.025)-14

= $500 000 (0.70772720)
= $353 863.60
therefore:
Price = $204 590.96 + $353 863.60
= $558 454.56

(h) What price would you pay for a corporate bond with a face value of $500 000, maturing in 7
years and paying 6.00 per cent per annum coupons semi-annually, if current yields are 6.60 per
cent per annum?
• To calculate the price of the bond it is necessary to calculate the present value of both the coupon
stream and the face value payable at maturity.

(i) coupon stream: A = C [ 1 – (1 + i)-n ]

plus i
(ii) face value: A = S (1 + i)-n
Therefore (coupon stream):
(i) C = $15 000
i = 3.30% (half yearly) = 0.033
n = 14

19
 A = $15 000 [ 1 – (1 + 0.033)-14]
0.033
= $15 000 [11.06850118]
= $166 027.52
Therefore (face value):
(ii) S = $500 000
i = 3.3% (half yearly) = 0.033
n = 14

A = $500 000 (1 + 0.033)-14

= $500 000 (0.63473946)
= $317 369.73

Price = $166 027.52 + $317 369.73

= $483 397.25

(i) Explain the price difference between (g) and (h). What generalisation emerges from the
examples concerning the response in the price of coupon instruments when there is a change in
current market yields?
• The instruments in (g) and (h) were both corporate bonds that pay a fixed coupon payment for the
term of the bonds.
• Current market yields on bonds issued by each of the corporate issuers has changed since they were
first issued. In question (g) above yields have fallen from 7.00 per cent to 5.00 per cent per annum
and the price of the existing bond has risen. In question (h) above yields have risen from 6.00 per
cent to 6.60 per cent per annum and the price of the existing bond has fallen.
• As shown in the examples above, the generalisation that can be made in relation to the pricing of
fixed interest securities is that there is an inverse relationship between price and interest rates; that
is, as yields fall the price of an existing bond will rise, or vice versa.

9. Accumulated value of an annuity (future value)

(a) Explain the concept of the accumulated value of an annuity (future value).

20
• An annuity is a series of regular equal cash flows that will occur over a defined period.
• The accumulated value, or future value, of an annuity is the total amount (principal plus interest)
that the regular cash flow stream will accumulate to, taking into account the expected current yield.
• For example, if you expect to deposit $1000 into an investment account for the next five years and
you expect that account to earn 5.00 per cent per annum return, then the expected future value of the
investment account in five years is $5838.89.

(b) You are the winner of a lottery that pays a quarterly cash payment of $3000 to you for the next 7
years. You decide that the funds should be paid directly into a cash management trust held with an
investment bank. The account is expected to earn 6.05 per cent per annum, compounding quarterly.
What will be the accumulated value of the cash management trust at the end of the 7 years?
A = C [ (1 + i)n – 1 ]
i
Therefore:
C = $3000
i = 6.05% / 4 = 1.51250% = 0.015125 (quarterly)
n = 7 x 4 = 28

A = $3000 [(1 + 0.015125)28 – 1 ]

0.015125
= $3000 [34.54298765]
= $103 628.96

(c) The grandparents of a new baby decide that they will try and provide funds for the
grandchild’s education. They set up an education savings account with their local credit union.
They commit to pay $200 into the account monthly for the next 10 years. The account will yield
5.90 per cent per annum, compounding monthly. How much will be available for the grandchild’s
education in 10 years?
A = C [ (1 + i)n – 1 ]
i
Therefore:

21
 C = $200
i = 5.90% / 12 = 0.49166667% (monthly) = 0.00491667
n = 10 x 12 = 120

A = $200 [ (1 + 0.00491667)120 – 1 ]
0.00491667
= $200 [162.992902]
= $32 598.58

10. Effective rates of interest

(a) Explain the difference between nominal interest rates and effective rates of interest.
• A nominal interest rate is the annual interest rate, not adjusted for compounding periods.
• The nominal rate is usually advertised by financial institutions; for example, a housing loan may
have a nominal interest rate of 6.00 per cent per annum. However, as the loan will require monthly
instalments it is beneficial to consider the effective interest rate.
• The effective interest rate is the actual rate of interest earned incorporating an adjustment for the
number of compounding periods in a year, for example, quarterly or monthly.
• The effective rate recognises that with frequent compounding, interest is being earned, or paid, on
the accumulating principal and interest amount.

(b) You have $6000 to deposit for one year and you have the choice of three accounts:
(i) one that pays 5.25 per cent per annum, with interest paid on maturity
(ii) one that pays 5.18 per cent per annum, with interest paid quarterly
(iii) one that pays 5.20 per cent per annum, with interest paid semi-annually.
Which account would you prefer if the objective is to obtain the highest dollar amount return on
your deposit?
(i) S = A (1 + i)n
= $6000 (1 + 0.0525) 1
= $6315.00

(ii) S = $6000 (1 + 0.012950)4

22
 = $6316.89

(iii) S = $6000 (1 + 0.0260)2

= $6316.06

• Therefore an investor would choose option (ii) at $6316.89.

(c) What is the effective rate of interest on each of the three accounts described in (b) above?
(i) ie = ( 1 + i/m )m – 1
= (1 + 0.0525/1)1 – 1
= 5.2500 %

(ii) ie = ( 1 + 0.0518/4 )4 – 1
= 5.2815%

(iii) ie = ( 1 + 0.0520/2 )2 – 1
= 5.2676%
The answer confirms your answer in (b) above as (ii) also has the highest effective
interest rate at 5.2815 per cent per annum.

FINANCIAL NEWS CASE STUDY

In Chapter 8 we introduced the basic concepts of financial mathematics and their calculations.
Understanding these concepts enables you to identify cash flows and calculate present and future
values of those cash flows using appropriate formulae. This case study moves beyond basic
calculations and requires you to critically analyse a set of figures relevant to a real-life situation.
Theoretically, individuals should save for their retirement over their full working life. In Australia,
this savings regime is supported by legislated compulsory superannuation savings (discussed in
Chapter 3). Once an individual retires from the workforce he or she must live off their accumulated

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superannuation savings. This may be supplemented by a government aged pension. Two questions
arise: (1) how long will a person live after retirement, and (2) what amount will be required to meet
ongoing retirement needs. The answers may vary considerably from one person to the next.
These are very important questions in that it is probably too late at say, age 85, to go back to work
and top up retirement savings. Therefore, does a person with $450 000 in super have sufficient
funds to retire on, or should that figure really be $1 million? The table below, prepared by HLB
Mann Judd, provides an indication regarding how long retirement savings will last.

TABLE: YEARS YOUR SAVINGS WILL LAST

Drawdown
percentage rate Effective earning rate on capital*

3.00 6.00 9.00

5.00 31.00

7.00 18.93 33.40

9.00 13.72 18.85

11.00 10.77 13.53 19.78

13.00 8.88 10.62 13.68

15.00 7.55 8.77 10.63

* Assumes constant annual drawdown rate and constant

yearly effective earning rate, net of taxes and fees.
SOURCE: This is an edited version of a table that first
appeared in HLB Mann Judd’s newsletter

The figures work for any amount and reveal how long your money will last, depending on what
your funds are earning and the rate at which you draw down. For example, if you earn 3.00 per
cent but draw down at a rate of just 5.00 per cent, your funds will last 31 years. However, if you
increase that to a 15.00 per cent drawdown rate, they will last only 7.55 years. Now that’s some
food for thought.
SOURCE: Adapted from ‘Retirement: Forever and a Day’, Financial Review Smart Investor,
February 2011, p. 12.

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DISCUSSION POINTS

• The above table assumes that a superannuation fund will have a constant earning rate
and, at the same time, a constant drawdown rate. Within the context of our learning in
this chapter, how would we define these cash flows?
The cash flows exhibit some of the characteristics of an annuity.
However, one should recognise that there are three sets of cash flows: (1) the contributions to the
fund, (2) the earnings of the fund and (3) the payment of an income stream from the fund.
The timing of the cash flows will vary considerably. For example:
o Contributions may occur at each pay cycle over the person’s working life. The
contributions will change as a person’s salary changes. It is also possible to make
additional contributions.
o The earnings of the fund will vary depending on the types of investments held in the
fund, prevailing interest rates and the economic cycle.
o Generally, an income stream is only paid once the superannuant retires from the
workforce. Currently, the superannuant is able to vary the percentage of a fund that is
withdrawn each year, above a minimum set by the government. Also, it is possible to
withdraw a lump sum over and above the amount paid as a self-funded pension.

• Under the concessional taxation regime for Australian superannuation funds that are in
pension mode, a superannuant (at age 60) is required to draw down a minimum of 4.00
per cent annually of the value of the fund. This drawdown rate increases with the age of
the superannuant. Why might the government have introduced this rule, and why is it
important that a superannuant understands the implications of this requirement?
When a super fund is in the accumulation mode (typically before retirement) the fund receives
a concessional taxation rate of 15 per cent. At retirement, when the fund is in account based
pension mode, the earnings of the fund are tax free. The minimum drawdown requirement is
designed to ensure superannuants progressively drawdown on those tax free funds in their
retirement.
The drawdown rate increases with age:
55–64 4%

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 65–74 5%
75–79 6%
80–84 7%
85–89 9%
90–94 11%
95+ 14%
It is important to understand this drawdown/age-based relationship because the period funds
will last diminishes more rapidly as a superannuant grows older. A super fund in the early
stages of retirement may look like it will last, but as the minimum drawdown rate increases the
fund may begin to look like it may not last a lifetime.

• As a finance student, and within the context of the above table, consider what other
important issues you should provide as advice to a superannuant in relation to the long-
term adequacy of his/her superannuation fund?
The superannuant must resist the temptation to drawdown excessive lump sum amounts
because the fund may not be able to support the superannuant in later life.
The greatest problem is not knowing how long a superannuant will live. For example, a
superannuant will need a much larger super fund if he/she lives to 95 than will someone who
only lives to 80.
Importantly, the effective earnings rate on capital will change over time, and depending on
investments held, may at times be negative.
Another issue is the possibility that the government will change the rules; for example the
government may change the minimum drawdown rates, introduce a maximum drawdown
rate or remove the option of lump sum withdrawals altogether.

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