Briefly, this is a case problem from my Applied Decision Methods course taken from Chapter 12 on Simulation, of the textbook, 12th edition "An Introduction to Management Science, Quantitative Approaches To Decision Making, The chapter deals with approaches management scientists use for risk analysis, inventory simulation, waiting line simulation, and other simulation issues.
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 to lead this effort and decided to begin by developing a financial plan for himself. Thom 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 a $1 million. 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 workshop show in Figure 12.18. 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 12.18, we see that at age 29, Tom is projected t have a portfolio value 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 than took his results to show his boss, Kate Regale.
Although Kat 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 for 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 account firm suggested that the annual portfolio growth rate could be approximated by a normal probability distribution with a mean of 10% and a stand 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.
Financial Planning Worksheet for Tom Gifford attached.
Develop a Simulation model for financial planning and write a report based on the information given.
1. Without considering the random variability in growth rates, extend the worksheet in figure 12.8 to 30 years. Confirm that by using the constant annual salary growth rate and the constant annual portfolio growth rate, Tom can expect to have a 30 year portfolio of $627,937. What would Tom's annual investment rate have to increase to in order for the portfolio to reach a 30-year, $1million goal?
2. 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 million 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 million goal. Discuss the advantage of repeating the simulation numerous times.
3. What recommendations do you have for employees with a current profile similar to Tom's after seeing the impact of the uncertainty in the annual salary growth rate and the annual portfolio growth rate?
4. Assume that Tom is willing to consider working 35 years instead of 30 years. What is your assessment of this strategy if Tom's goal is to have a portfolio worth $1 million?
5. Discuss how the financial planning model developed for Tom Gifford can be used as a template to develop a financial plan for any of the company's employees.
The solution to this case of portfolio projection and management is given as an extensive 6-paged Word document report with the Excel spreadsheet of calculations also attached.