Page 535 - Introduction to Business

CHAPTER 14 Understanding the Financial System, Money, and Banking 509

Social security taxes are a controversial issue due to the aging of the so-called
baby boom generation born after the end of World War II in 1945. Given that social
security is an unfunded pension plan, as increased numbers of baby boomers
retire, the tax paid by working individuals must increase. However, due to low birth
rates over the last 30 years in the United States as well as in many major industrial
countries around the world, the number of working people is decreasing relative to
the number of retired people. Of course, this means that the social security tax rate
will have to be increased to pay retiree benefits in the years to come. At some point,
working individuals will not be able to bear the high taxes, with the result that pen-
sion benefits will have to be cut. To offset this risk, the U.S. government is encour-
aging individuals to invest savings by giving tax incentives. For example, if you put
$1000 in an IRA, this money cannot be taxed by the government until you later
withdraw the money in your retirement years. This is a big tax break. If you had a 20
percent income tax rate, you would have avoided $200 in taxes. Keogh plans and
defined contribution pension plans are eligible for similar income tax breaks. A
Roth IRA allows you to pay taxes now but not later; that is, the $1000 income in the
previous example would be taxed at your current income tax rate, say 20 percent,
so that you can put $800 of this income in a Roth IRA that will not be taxed when
you withdraw the funds in retirement years. If you have a low tax rate now, the Roth
IRA may be a better choice than a standard IRA.

Investment Companies. Firms that offer investors unit shares of ownership
in portfolios of stocks, bonds, real estate, and money market securities are known
as investment companies. These firms pool the savings of thousands of customers, investment companies or mutual funds
issue unit shares of ownership to their customers, and invest the savings in securi- Financial institutions that pool the
savings of thousands of customers,
ties portfolios. Actively managed funds employ professional investment managers
issue unit shares of ownership to their
to choose the securities and seek to maximize the return per unit risk for their cus- customers, and invest the savings in
tomers. Passively managed funds invest in well-defined securities portfolios, such securities portfolios
as market indexes like the Standard & Poor’s 500 index, comprised of the largest 500
firms’ common stocks in the United States, or high quality corporate bonds in a
bond index. Actively managed funds charge customers higher fees than passively
managed funds due to the higher costs of professional investment managers. In
these funds, portfolio managers seek to pick the highest-earning investment secu-
rities per unit of risk for their customers.
Investment companies, sometimes called mutual funds, have been extremely
successful due to the many advantages that they offer customers. Most customers
benefit from lower transactions costs, financial expertise, diversification in a large
number of different securities, international investment, convenient access via 800
telephone numbers and Internet accounts, and accurate record keeping. Funds can
be easily and rapidly transferred from one type of security to another. In general,
customers have tremendous control over how their savings are invested at any
moment in time. Most mutual fund shares are owned by households, with pension
funds and banks a distant second and third, respectively.
The large number of these mutual funds and the incredible variety of investment
options can be a confusing experience for all but the most knowledgeable investor.
However, some good rules of thumb to follow in using investment companies are
• Choose three to five different investment companies to spread your savings
across a number of different investment management teams.
• Spread your savings across different kinds of securities, with a target mix of
stocks, bonds, and money market securities; for example, 50, 40, and 10 per-
cent, respectively.
• Rebalance your mix of investments every year or two. Over time, if the value
of stocks increases faster than bonds and money market securities, your
Copyright 2010 Cengage Learning, Inc. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part.