PROBLEM # 1 (Valuing an Annuity):

You are working in the Human Resources department of a large Canadian Corporation. One of your employees, Ted, will be turning 60 in one months time and for health reasons, will be taking early retirement from the company. Ted is planning on a combination of company pension, RRSP investments, Canada Pension Plan and Old Age Security to fund his retirement. Luckily, he has a generous indexed company pension and significant RRSP investments and does not need to count on Government pensions.

Ted is unsure of how to handle his Canada Pension Plan (CPP) entitlement. CPP provides a lifetime pension at retirement to Canadians who have worked and paid into the plan. The dollar amount of the pension depends on the individual's earnings and payments into CPP during their working life. Ted has three options:

Option # 1: Ted is entitled to a monthly CPP payment of $500 which will start the month after he turns 65.

Option # 2: However, as an alternative it is possible to start receiving CPP as early as one month after turning 60, albeit at a reduced amount. The CPP payment is reduced by 0.6% for every month before age 65 to a maximum of 36%.

Option # 3: Alternatively, he can wait until age 70 and get a higher monthly amount. If he starts to receive CPP payments sometime after the age of 65, payments will increase by 0.7% each month up to a maximum of 42% at the age of 70.

Payments will not increase after the age of 70.

REQUIRED:

Knowing that you are a whiz at financial matters, Ted has come to you for advice on which option to choose. Assuming that Ted will live to 85 and can earn a 6% return on his money. What is your advice to Ted - which option should he Choose?

For each of the three (3) options described above, calculate the present value of the total Canada Pension Fund (CPP) payments. Make sure you clearly identify the values you are using for interest rate (r), cash payment (C), and the number of payments (t).

• Hint: the cash flows are monthly so you need to convert your interest rate to a monthly rate by dividing by 12.