Paul Kaplan, Ph.D., CFA Director of Research Morningstar Canada
© 2014 Morningstar. All Rights Reserved. These materials are for information and/or illustrative purposes only. The Morningstar Investment Management division is a division of Morningstar and includes Morningstar Associates, Ibbotson Associates, and Morningstar Investment Services, which are registered investment advisors and wholly owned subsidiaries of Morningstar, Inc. All investment advisory services described herein are provided by one or more of the U.S. registered investment advisor subsidiaries. The Morningstar name and logo are registered marks of Morningstar. This presentation includes proprietary materials of Morningstar. Reproduction, transcription or other use, by any means, in whole or in part, without the prior, written consent of Morningstar is prohibited.
<#>For financial professional use only. Why Do People Seek Help?
2 Morningstar Associates, LLC Alpha, Beta, and Now…Gamma
Alpha
Beta
Gamma
3 Morningstar Associates, LLC Different Types of Gamma
Total Wealth Asset Allocation Dynamic Withdrawal Strategy Annuity Allocation
Asset Location and Withdrawal Sourcing
Liability Relative Optimization
4 Morningstar Associates, LLC Total Wealth Asset Allocation
5 Morningstar Associates, LLC Individual Portfolio Assignment
Financial Capital × Tradable assets such as stocks and bonds have traditionally been used when constructing an asset allocation × Incomplete without considering Human Capital
Human Capital × An individual’s ability to earn and save × Present value of all your expected future wages including pension and social securities
6 Morningstar Associates, LLC Life Cycle of Human Capital and Financial Capital
Human Capital Financial Capital An individual’s ability An individual’s total to earn and save saved assets
7 Morningstar Associates, LLC How Risky is Human Capital?
8 Morningstar Associates, LLC Dynamic Withdrawal Strategy
9 Morningstar Associates, LLC Two Key Unknowns. . .
× Life expectancy × Returns
10 Morningstar Associates, LLC A Balancing Act: Income Early in Retirement
More
Optimal Retirement Income Retirement Less
65 95 Age
For illustrative purposes only.
11 Morningstar Associates, LLC A Balancing Act: Income Late in Retirement
More
Optimal Retirement Income Retirement Less
65 95 Age
For illustrative purposes only.
12 Morningstar Associates, LLC A Balancing Act: Just Right
More
Optimal Retirement Income Retirement Less
65 95 Age
For illustrative purposes only.
13 Morningstar Associates, LLC Change is Good Thing
Market Income
14 Morningstar Associates, LLC Better Outcomes
4 Repeat 1 Determine annually retirement period
3 Determine withdrawal 2 Determine percentage portfolio for a given equity target allocation
15 Morningstar Associates, LLC “4%” for All Ages
12.0% Male 10.0% 10.0% Female 9.1% Joint 8.0% 7.7% 6.6% 6.5% 6.1% 6.0% 5.3% 5.7% 5.7% 4.8% 4.9% 4.0% 4.0%
Withdrawal Rate Withdrawal 2.0% 0.0% 65 70 75 80 Age
For illustrative purposes only.
16 Morningstar Associates, LLC Where You Start Matters
× Probability of success for a 4% initial withdrawal rate over 30 years for a 40% stock portfolio
Initial CAPE Ratio
10 15 20 25 30 35
1.0% 67.1% 58.1% 46.8% 35.4% 26.1% 17.7%
2.0% 71.6% 62.3% 51.0% 41.6% 29.7% 21.9%
3.0% 75.4% 66.5% 55.9% 45.6% 34.8% 25.7%
4.0% 78.3% 70.8% 62.1% 50.2% 38.3% 29.5% Initial Bond Yield InitialBond 5.0% 82.1% 74.0% 65.2% 54.7% 43.7% 32.6%
6.0% 85.0% 78.4% 69.1% 60.3% 49.0% 37.1%
Source: “Market Valuations, Bond Yields, and Retirement Success”
17 Morningstar Associates, LLC Defining “Failure” for a Retiree
$10,000 Income Goal $9,000 $8,000 Income $7,000 Shortfall $6,000 $5,000 $4,000 Annual Income Annual $3,000 $2,000 $1,000 $0 1 2 3 4 5 6 7 8 910 Year
× You can achieve 99% of your goal and still “fail” For illustrative purposes only.
18 Morningstar Associates, LLC What is True Failure?
Current Living Status
Alive Dead
Not Failure Not Failure ≥$0
Portfolio Balance Portfolio Failure Not Failure <$0
19 Morningstar Associates, LLC Annuity Allocation
20 Morningstar Associates, LLC Who Cares About Guaranteed Income?
Your Client?
21 Morningstar Associates, LLC Annuity Allocation: What Do Retirees Fear More?
Outliving Death Their Retirement 39% Money 61%
Source: https://www.allianzlife.com/content/public/Literature/Documents/ent-1154.pdf
22 Morningstar Associates, LLC Inefficient Retirement Planning
Defined Benefit Plans DC Plans
23 Morningstar Associates, LLC Research Perspectives
Portfolio Withdrawal Strategies Annuities
24 Morningstar Associates, LLC Retirement Income Efficient Frontier
High Low Annuity Allocation Wealth Low High Annuity Allocation
Low High Income Risk
For illustrative purposes only.
25 Morningstar Associates, LLC Incorporating Guaranteed Income
Research published in CFA Award-winning paper on the Research paper focused on Institute Monograph integration of human capital a methodology reflecting the and asset allocation features of variable annuities with GMWB for life
26 Morningstar Associates, LLC A Holistic Perspective
Collect Inputs Determine Asset Allocations
Human Capital Traditional Funds, ETFs
Financial Capital Life Insurance/Annuities and Current Savings
Life Insurance INS Annuities
27 Morningstar Associates, LLC Asset Location and Withdrawal Sourcing
28 Morningstar Associates, LLC Alpha Spectrum
Certain Uncertain
fee alpha
tax alpha the alpha everyone talks about
For illustrative purposes only.
29 Morningstar Associates, LLC Tax Drag and Account Growth
$400 $388 × Analysis assumes a 35% tax rate, where taxes are paid annually in the $304 taxable account, but not $300 $255 until the end of the period in an RSP $222 $200 $162 $171
$100 Growth of $100 After After Years 25 Growth of $100
$0 3% 5% 7% Annual Realized Return
30 Morningstar Associates, LLC Asset Location and Withdrawal Sourcing
Inefficient Asset Location Efficient Asset Location
Taxable RSP RSP Taxable Account Account
31 Morningstar Associates, LLC Asset Location and Withdrawal Sourcing
Inefficient Moderate Efficient Allocating and withdrawing Allocating stocks to taxable Allocating and withdrawing stock from RSP first account and withdrawing stocks from taxable account from RSP first
32 Morningstar Associates, LLC Liability Relative Optimization
33 Morningstar Associates, LLC What is Risk?
× What is the TRUE risk for a portfolio that exists to fund (pay for) a liability? × It is NOT the standard deviation of the asset portfolio × It is NOT the performance of your asset portfolio relative to the asset portfolios of your peers × The TRUE risk is that it won’t be able to pay for the liability
34 Morningstar Associates, LLC Improving Portfolio Health
Value of Liabilities Portfolio vs. Value of Assets Health/Funding Costs Value of Assets Value of Liabilities Asset-only Portfolio Health Approach
Liability- relative Approach
35 Morningstar Associates, LLC What is Surplus Optimization?
× A special case (or extension) traditional mean-variance optimization in which the optimizer is constrained to hold a combination of assets representing the liability short × One element of broader approach called liability-relative investing or asset-liability management (ALM), which can include 1. duration matching (a.k.a. immunization) 2. convexity matching 3. cash flow matching × Focuses on the entire portfolio–assets and liabilities–not just the assets of a portfolio
36 Morningstar Associates, LLC Different Efficient Frontiers
MV Frontier Surplus Frontier
Expected Expected Return Minimum Surplus Variance Portfolio
Risk
Liability
× Surplus optimization considers both the amount and investment characteristics of the liability (funding ratio)
For illustrative purposes only.
37 Morningstar Associates, LLC Different Portfolios
Liability Relative Optimization Asset-Only Optimization
IPS Bond
38 Morningstar Associates, LLC Return and Risk Impact
Asset Only Surplus
Return Risk Return Risk Liability-Relative Optimization 6.00 7.45 3.74 6.79
Asset-Only Optimization 6.00 6.71 3.66 7.38
For illustration purposes only. Source: “Alpha, Beta, … and Now Gamma” by David Blanchett and Paul D. Kaplan
39 Morningstar Associates, LLC More Consistent Success Rates
100%
90%
80% Liability-Relative Portfolio Asset-Only Portfolio
Probabilityof Success 70%
60%
50% Low Low/Mid Mid Mid/High High Inflation
For illustration purposes only. Source: “Alpha, Beta, … and Now Gamma” by David Blanchett and Paul D. Kaplan
40 Morningstar Associates, LLC Generalized Ibbotson Target Maturity Glide Path
41 Morningstar Associates, LLC Results
42 Morningstar Associates, LLC Using Utility to Estimate Retiree Preferences
3.00 2.68 2.78 2.50 × 50% (1.00 utils) and 2.50 2.11 150% (2.78 utils) results in average 2.00 utility of 1.89 versus 1.50 2.50 for a consistent Utility 100% replacement 1.00 1.00
0.50
0.00 50 75 100 125 150 Retirement Goal Replacement Percentage
For illustrative purposes only.
43 Morningstar Associates, LLC Different Types of Gamma
Total Wealth Asset Allocation Dynamic Withdrawal Strategy Annuity Allocation
Asset Location and Withdrawal Sourcing
Liability Relative Optimization
44 Morningstar Associates, LLC Impact
45 Morningstar Associates, LLC More Income
For illustration purposes only. Source: “Alpha, Beta, … and Now Gamma” by David Blanchett and Paul D. Kaplan
46 Morningstar Associates, LLC An Alpha Perspective of More Income
× +28.8% in 3.0% retirement 2.0 income is equivalent to a return increase 1.0 of +1.82% (i.e., ”Gamma 0.0 equivalent alpha”)
Change in Return in Change -1.0
-2.0 -20% -10% 0% 10% 20% 30% 40% 50% Median Change in Retirement Income
For illustration purposes only. Source: “Alpha, Beta, … and Now Gamma” by David Blanchett and Paul D. Kaplan
47 Morningstar Associates, LLC Other Types of Gamma: Social Insurance
2.0 1.5 1.0 0.5 0.0 -0.5 -1.0 -1.5
Change in Return (%) Return in Change -2.0 -20 -10 010 20 30 Median Change in Retirement Income (%)
× Optimal social insurance benefit claiming can increase income by 9.15%, which creates “Gamma equivalent alpha” of +0.75%
For illustration purposes only.
48 Morningstar Associates, LLC Gamma Conclusions
× Value is more than Alpha and Beta × Creating retirement income from a portfolio is complicated × There are a number different risks that need to be considered when building an “optimal” retirement income portfolio × An optimized retirement income plan (i.e., Gamma-optimized) can potentially generate more retirement income than a naïve approach × This creates “Gamma equivalent alpha” of ~2.00%, based on the factors considered so far
49 Morningstar Associates, LLC Our Approach to Those in Retirement Helping Individuals Make Better Financial Decisions
Dynamic Annuity Tax-Efficient Liability Driven Holistic View Withdrawal Recommendation Investing Investing
× More than risk × Go beyond the × Not a “one-size- × How to place × Account for tolerance “4% rule” fits-all” approach assets inflation × Human capital × Based on returns × Wealth × How to withdraw × Risk capacity and life × Time horizon assets expectancy × Income sources × Account for all income sources
Potentially 23% more income
Source: Through a series of simulations, researchers estimate a hypothetical retiree may generate 28.8% more income on a utility-adjusted basis utilizing a Gamma-efficient retirement income strategy that incorporates the concepts total wealth, dynamic withdrawal, annuity allocation, asset location and withdrawal sourcing, and liability-relative optimization, when compared to a base scenario which assumes a 4% withdrawal rate and a 20% equity allocation portfolio. The results from these simulations are hypothetical in nature, not actual investment results, and not guarantees of future results. For more information and to receive a copy of the 2012 study, “Alpha, Beta, and Now Gamma,” please contact Nadine Pizarro at [email protected].
50 Morningstar Associates, LLC Important Disclosures
The information, data, analyses, and opinions presented herein do not constitute investment advice; are provided as of the data written and solely for informational purposes only and therefore are not an offer to buy or sell a security; and are not warranted to be correct, complete, or accurate. Past performance is not indicative and not a guarantee of future results.
Author’s calculations slides are based upon Monte Carlo simulations. Monte Carlo is an analytical method used to simulate random returns of uncertain variables to obtain a range of possible outcomes. Such probabilistic simulation does not analyze specific security holdings, but instead analyzes the identified asset classes. The simulation generated is not a guarantee or projection of future results, but rather, a tool to identify a range of potential outcomes that could be realized. The Monte Carlo simulation is hypothetical in nature and for illustrative purposes only. Results noted may vary with each use and over time
Indexes shown are unmanaged and not available for direct investment. Although index performance data is gathered from reliable sources, the Morningstar Investment Management division cannot guarantee its accuracy, completeness, or reliability. Except as otherwise required by law.
51 Morningstar Associates, LLC Finally
Past Present Future One North Kitchen & Bar The Roof at the Wit
52 Morningstar Associates, LLC