Retirement Income Planning:
A New Efficient Frontier and Outcome
Based Investment Strategies
Peng Chen, Ph.D., CFA
President
a Morningstar company
Agenda
× Investor
Goals
× Maintain a comfortable lifestyle in retirement
(convert savings into a sustainable lifetime income)
× Bequest
× Shortfall Factors
× Market risk
× Longevity risk
× Inadequate savings
× Solutions
× Controlling the 3 risk factors
× New Efficient Frontier between traditional assets and outcome
based investment products
× Summary
2
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Managing Risks at Different Life Stages
×
Pay Expenses
Î
Human Capital (Current Salary)
×
Savings Risk
Î
Savings Rate
×
Mortality Risk
Î
Life Insurance
×
Market Risk
Î
Asset Allocation
3
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Managing Risks at Different Life Stages
×
Pay Expenses
Î
Human Capital and Financial Capital
×
Longevity Risk
Î
Lifetime Income Products
×
Bequest
Î
Life Insurance
×
Market Risk
Î
4
Asset Allocation & Principal
Protected Products
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Associates. Reproduction, transcription or other use, by any means, in whole or in part, without the prior written consent of Ibbotson Associates, is prohibited.
Retirement Shortfall Factors
× Market
Risk
× Stock and bond market risk, inflation risk, etc.
× Higher risk associated with higher potential payoffs
× Longevity Risk
× Risk of living too long with insufficient resources
× Investor does not want to take financial risk
of longevity
× Inadequate Savings
× Spend first / save last
5
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Case Profile: Couple Age 45, Retirement Age 65
×
Pre-Retirement Income
$100,000 /year
×
Savings (adjusted for inflation)
$10,000 /year
×
Target Retirement Income
$75,000 /year
×
Social Security Benefit
$25,000 /year
×
Portfolio Size
$300,000
× 60/40 stock/bond portfolio
× 8.8% compound return
× 13.2% standard deviation (1926-2007)
× 3% inflation
Illustrations are calculated net of fees*
*Fee numbers are obtained from Morningstar Principia as of March 2007.
1.37% for Mutual Funds & 2.22% for VA.
6
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Illustration with Conventional Approach
Wealth
$1,000,000
Today’s Dollars
$616,156
$100,000
$10,000
Income
$80,000
Today’s Dollars
$60,000
$40,000
$20,000
Social Security
$0
Age 45
7
50
55
60
65
70
75
80
85
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Monte Carlo Forecasting
× Illustrates
× Creates
× Each
8
Market Impact
Many Scenarios
is a Possible Future Return Path
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Illustration with Monte Carlo
Wealth
$1,000,000
Today’s Dollars
1 in 2
Market Risk
Chance that your wealth will
be below the line:
1 in 10
$100,000
1 in 2
1 in 4
1 in 10
1 in 4
$10,000
Income
$80,000
Today’s Dollars
1 in 2
$60,000
1 in 4
$40,000
1 in 10
$20,000
Social Security
$0
Age 45
9
50
55
60
65
70
75
80
85
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Worst Case Scenarios Can Happen: 1999-2002
Wealth
$1,000,000
Today’s Dollars
1 in 2
1 in 10
Market Risk
Chance that your wealth will
be below the line:
$100,000
1 in 2
1 in 4
1 in 10
1 in 4
$10,000
$1 M invested in S&P
500 at the beginning
of 2000
$1,200,000
Annual withdrawal of
$50,000
$800,000
Age 65
$1,000,000
$862,751
$715,011
$600,000
$518,043
$400,00
$200,000
1999
10
2000
2001
2002
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Inc. is a registered investment advisor and wholly owned subsidiary of Morningstar, Inc. The information contained in this presentation is the proprietary material of Ibbotson
Associates. Reproduction, transcription or other use, by any means, in whole or in part, without the prior written consent of Ibbotson Associates, is prohibited.
Retirement Shortfall Factors
× Market
Risk
× Stock and bond market risk, inflation risk, etc.
× Higher risk associated with higher potential payoffs
× Longevity
Risk
× Risk of living too long with insufficient resources
× Investor does not want to take financial risk
of longevity
× Inadequate
Savings
× Spend first / save last
11
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How Long Can You Expect to Live?
Life Expectancy
Women
Men
Age 55
60
65
70
75
80
85
Source: 1996 US Annuity 2000 Table, Society of Actuaries
12
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90
95
Retirees Should Plan to Live to 100
Chance of
65-year-olds
living to various
ages
based on current
annuity mortality tables
Joint
Individual
9 in 10
3 in 4
1 in 2
1 in 4
1 in 10
Age 80
85
90
95
Source: 1996 US Annuity 2000 Table, Society of Actuaries
13
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100
Illustration with Monte Carlo and Longevity
Wealth
$1,000,000
Today’s Dollars
1 in 2
Market Risk
Chance that your
wealth will be
below the line:
1 in 10
$100,000
1 in 2
1 in 4
1 in 10
1 in 4
$10,000
Income
Today’s Dollars
$80,000
$60,000
1 in 10
1 in 4
$40,000
1 in 2
$20,000
Social
Security
$0
Age 45
50
55
60
65
70
75
80
85
90
95
100
Longevity
Chance of living longer
14
9 in 10
3 in 4
1 in 2
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1 in 4 1 in 10
Retirement Shortfall Factors
× Market
Risk
× Stock and bond market risk, inflation risk, etc.
× Higher risk associated with higher potential payoffs
× Longevity
Risk
× Risk of living too long with insufficient resources
× Investor does not want to take financial risk
of longevity
× Inadequate
Savings
× Spend first / save last
15
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Typical Life Cycle of Human Capital and Financial Capital
25
16
45
65
85
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100
Illustration with Adequate Savings
Wealth
$1,000,000
Today’s Dollars
1 in 2
Market Risk
Chance that your
wealth will be
below the line:
1 in 10
$100,000
1 in 2
1 in 4
1 in 10
1 in 4
$10,000
Income
Today’s Dollars
$80,000
$60,000
1 in 10
1 in 4
$40,000
1 in 2
$20,000
Social
Security
$0
Age 45
50
55
60
65
70
75
80
85
90
95
100
Longevity
Chance of living longer
17
9 in 10
3 in 4
1 in 2
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1 in 4 1 in 10
Illustration with Inadequate Savings
Wealth
$1,000,000
Today’s Dollars
Market Risk
Chance that your
wealth will be
below the line:
1 in 2
$100,000
1 in 2
1 in 4
1 in 10
1 in 4
1 in 10
$10,000
Income
Today’s Dollars
$80,000
1 in 2
$60,000
1 in 4
$40,000
1 in 10
$20,000
Social
Security
$0
Longevity
Age 45
50
55
60
65
70
75
80
85
90
95
100
Chance of living longer
9 in 10
18
3 in 4
1 in 2
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1 in 4 1 in 10
Solution
× Shortfall
factors
× Market risk
× Longevity risk
× Inadequate savings
× Can
19
be managed with
× New efficient frontier combining traditional mutual funds &
outcome based strategies
× Principal Protected Products
× Annuities (Payout or VA+GMWB)
× Appropriate savings
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Asset Allocation and Mean-Variance Optimization
MVO Inputs
MVO Optimizer
Expected Return
MVO Efficient Frontier
×
de Finetti / Markowitz Mean-Variance
Optimization (de Finetti [1940],
Markowitz [1952, 1959])
×
Capital Market Assumptions
× Expected Returns
× Standard Deviations (Risk)
× Correlations
Individual Assets
Standard Deviation
20
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Retirement Income Portfolios:
The Traditional Mean-Variance Frontier
12.00%
Aggressive
80/20
10.00%
Average Return
8.00%
Moderate
60/40
6.00%
Conservative
20/80
4.00%
2.00%
0.00%
0.00%
2.00%
4.00%
6.00%
8.00%
10.00% 12.00% 14.00% 16.00% 18.00%
Standard Deviation
21
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New Efficient Frontier for Retirement Income
× Traditional
Mean-Variance Efficient Frontier
× Ignore Skewness, kurtosis
× Does NOT Consider Longevity Risk, and periodic income needs
× New
22
Income Frontier
× Average Sustainable Income vs. Shortfall Income for a given
horizon
× Shortfall Income Æ Value-at-Risk (VAR)
× VAR Æ estimate of the loss that we expect to be exceeded with
a probability (e.g. 5%)
× Shortfall Income Æ shortage of income against a target in the
worst scenario (5th percentile)
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Retirement Income Portfolios:
Redefining the retirement income efficient frontier
Average Income Level and Shortfall Risk, 20-Year Horizon
$100,000
Median Sustainable Income
$90,000
80/20
60/40
$80,000
40/60
20%stocks/
80%bonds
$70,000
$60,000
$0
$2,000
$4,000
$6,000
$8,000
$10,000
Shortfall Risk, 5th Percentile, (Target $60 K)
23
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Retirement Income Portfolios:
Redefining the retirement income efficient frontier
Average Income Level and Shortfall Risk, 30-Year Horizon
Average Income Level
$80,000
80/20
$70,000
60/40
40/60
$60,000
20/80
$50,000
$0
Ibbotson Confidential
24
$5,000
Shortfall Risk (Target $50K)
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$10,000
Retirement Income Solutions with Outcome Based Products
Traditional Products+
Principal Protected Products
25
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Efficient Frontier in Retirement with Principal Guaranteed Products
Adding Equity-Linked CD to Retirement Portfolio, 20-Years
$100,000
80/10/10
Median Sustainable Income
$90,000
60/30/10
80/20
40/45/15
$80,000
20%Stocks/
60%Bonds/
20 ELCD
$70,000
60/40
40/60
20%stocks/80%bonds
Stock & Bonds +Equity-Linked CD
100%Stocks and Bonds
$60,000
$0
$1,000
$2,000
$3,000
$4,000
$5,000
$6,000
$7,000
$8,000
Shortfall Risk, 5th Percentile, (Target $60 K)
26
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$9,000
$10,000
Retirement Income Solutions with Outcome Based Products
Traditional Products+
Immediate Payout Annuities
Or
Variable Annuities + GMWBs
27
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Asset Allocation with Insurance Products
Detailed Asset
Allocation for
Each Product
28
Identify Target
Market Risk
Portfolio
Determine Product
Type Split
Stocks vs. Bonds
Traditional Product
vs.
Guaranteed Products
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Asset Allocation with Annuities*
× Find
the Right Mix Between Assets and
Annuity Products
× Income and bequest goals
× Market and longevity risk
× Optimization
with Annuities and Asset Classes
× Payout annuities
× VA + GMWB for life
*US Patent 7120601B2. Granted October 10, 2006
29
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Traditional Products + Immediate Payout Annuities
Traditional Products+
Immediate Payout Annuities
30
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Asset Allocation with Payout Annuities: Key Factors
Factor
Proportion to
Implement with
Annuities
Reason
Age*
Mortality credit
Irreversibility
Fund (have longer time to live)
Annuitization decision irreversible
Bequest*
Preference to leave more
Income Sustainability*
Preference for personal consumption
Subjective Survival Probability*
Perceived longevity risk / suitability
Fees
Fees reduce returns
Wealth*
Ratio of wealth to income need
Income*
Ratio of wealth to income need
* Factors that are typically solicited using a retirement income questionnaire.
31
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Asset Allocation with Payout Annuities
Map to Portfolio
Financial Wealth
Retirement Income
Need
Subjective Survival
Lifetime Income Ratio:
(W+PVGI)
PVRIN
Preferences and
Subjective
Guaranteed Income
Product
Allocation:
Bond, Stock,
IFA, IVA
32
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Fear of Outliving $
Consumption
Preference
Couple at 65: Including Payout Annuities
33
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Couple at 65 - No Annuities
Significant Probability of Running Out of Money
Wealth
$1,000,000
Today’s Dollars
Market Risk
Chance that your
wealth will be below
the line:
1 in 10
1 in 4
$100,000
1 in 2
1 in 4
1 in 10
1 in 2
$10,000
Income
Today’s Dollars
$80,000
$60,000
1 in 10
1 in 2
$40,000
1 in 4
$20,000
Social Security
$0
Longevity
Chance of living
longer
34
Age 65
70
75
80
85
9 in 10
3 in 4
90
1 in 2
95
100
1 in 4 1 in 10
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Couple at 65 - Including Payout Annuities (moderate bequest)
Including Annuities Reduces the Probability of Running out of Money
Wealth
$1,000,000
Today’s Dollars
1 in 2
1 in 10
Market Risk
Chance that your wealth will
fall below the line:
$100,000
1 in 2
1 in 4
1 in 10
1 in 4
$10,000
Income
Today’s Dollars
$80,000
1 in 2
$60,000
1 in 4
$40,000
1 in 10
$20,000
Social Security
$0
Longevity
Chance of living
longer
35
Age 65
70
75
80
9 in 10
85
3 in 4
90
1 in 2
95
1 in 4
100
1 in 10
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Inc. is a registered investment advisor and wholly owned subsidiary of Morningstar, Inc. The information contained in this presentation is the proprietary material of Ibbotson
Associates. Reproduction, transcription or other use, by any means, in whole or in part, without the prior written consent of Ibbotson Associates, is prohibited.
Traditional Products + VA with Living Benefit Rider
Traditional Products+
Variable Annuities + GMWBs
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Inc. is a registered investment advisor and wholly owned subsidiary of Morningstar, Inc. The information contained in this presentation is the proprietary material of Ibbotson
Associates. Reproduction, transcription or other use, by any means, in whole or in part, without the prior written consent of Ibbotson Associates, is prohibited.
Asset Allocation with VA + GMWB Fund (for Life):
Key Factors
Factor
Proportion to
Implement with
VA + GMWB
Reason
Bequest*
Preference to leave more
Income Sustainability*
Preference for personal consumption
Subjective Survival Probability*
Perceived longevity risk / suitability
Fees
Fees reduce returns
Wealth*
Ratio of wealth to income need
Income*
Ratio of wealth to income need
* Factors that are typically solicited using a retirement income questionnaire.
37
FOR INFORMATION AND/OR ILLUSTRATION PURPOSES ONLY. NOT FOR PUBLIC DISTRIBUTION. ©2008 Ibbotson Associates, Inc. All rights reserved. Ibbotson Associates,
Inc. is a registered investment advisor and wholly owned subsidiary of Morningstar, Inc. The information contained in this presentation is the proprietary material of Ibbotson
Associates. Reproduction, transcription or other use, by any means, in whole or in part, without the prior written consent of Ibbotson Associates, is prohibited.
Asset Allocation with VA + GMWB
Map to Portfolio
Financial Wealth
Retirement Income
Need
Subjective Survival
Lifetime Income Ratio:
(W+PVGI)
PVRIN
Preferences and
Subjective
Guaranteed Income
Product
Allocation:
Traditional,
VA+GMWB
38
FOR INFORMATION AND/OR ILLUSTRATION PURPOSES ONLY. NOT FOR PUBLIC DISTRIBUTION. ©2008 Ibbotson Associates, Inc. All rights reserved. Ibbotson Associates,
Inc. is a registered investment advisor and wholly owned subsidiary of Morningstar, Inc. The information contained in this presentation is the proprietary material of Ibbotson
Associates. Reproduction, transcription or other use, by any means, in whole or in part, without the prior written consent of Ibbotson Associates, is prohibited.
Likelihood of Holding
for Life
Consumption
vs. Bequest
Asset Allocation with GMWB (for life) Riders
× Maximize
investor’s utility
× Features
ƒ
ƒ
ƒ
× Key
ƒ
ƒ
39
of GMWBs
Portfolio Insurance
Longevity Insurance
Auto step-up
Implications
More aggressive target asset allocations
Auto step-up increases portfolio and longevity insurance
FOR INFORMATION AND/OR ILLUSTRATION PURPOSES ONLY. NOT FOR PUBLIC DISTRIBUTION. ©2008 Ibbotson Associates, Inc. All rights reserved. Ibbotson Associates,
Inc. is a registered investment advisor and wholly owned subsidiary of Morningstar, Inc. The information contained in this presentation is the proprietary material of Ibbotson
Associates. Reproduction, transcription or other use, by any means, in whole or in part, without the prior written consent of Ibbotson Associates, is prohibited.
New retirement income efficient frontier including VA+GMWB
Average Income Level and Shortfall Risk, 30-Year Horizon
$80,000
Average Income Level
80/10/10 VA
60/20/20 VA
$70,000
VA + 5% GMWB
40/40/20 VA
80/20
60/40
40/60
20/55/25VA
$60,000
$50,000
$0
20/80
$5,000
Shortfall Risk (Target $50K)
40
FOR INFORMATION AND/OR ILLUSTRATION PURPOSES ONLY. NOT FOR PUBLIC DISTRIBUTION. ©2008 Ibbotson Associates, Inc. All rights reserved. Ibbotson Associates,
Inc. is a registered investment advisor and wholly owned subsidiary of Morningstar, Inc. The information contained in this presentation is the proprietary material of Ibbotson
Associates. Reproduction, transcription or other use, by any means, in whole or in part, without the prior written consent of Ibbotson Associates, is prohibited.
$10,000
Simulation Analysis: Retirement Income Efficient Frontier
Median Income Level (50th Percentile) and
Shortfall Income Risk (5th Percentile), 30-Year Horizon
$80,000
Median Income Level
80/20
60/30/10 VA
$70,000
VA + GMWB
40/45/15 VA
$60,000
40/60
20/60/20 VA
$50,000
60/40
$0
20/80
$5,000
Shortfall Income Risk (Target $50K)
41
FOR INFORMATION AND/OR ILLUSTRATION PURPOSES ONLY. NOT FOR PUBLIC DISTRIBUTION. ©2008 Ibbotson Associates, Inc. All rights reserved. Ibbotson Associates,
Inc. is a registered investment advisor and wholly owned subsidiary of Morningstar, Inc. The information contained in this presentation is the proprietary material of Ibbotson
Associates. Reproduction, transcription or other use, by any means, in whole or in part, without the prior written consent of Ibbotson Associates, is prohibited.
$10,000
Real Median Sustainable Income vs. Real Shortfall Income, 30-Years
$80,000
IVA
$60,000
Real Median Income
IFA
Lifetime GMWB
$40,000
80% Equity & 20% bonds
$20,000
$0
-$20,000
-$10,000
$0
$10,000
$20,000
Shortfall Income at 5-th Percentile (Target Real $50K)
100%TA
42
100%VA+GMWB
100%IFA
100%IVA
FOR INFORMATION AND/OR ILLUSTRATION PURPOSES ONLY. NOT FOR PUBLIC DISTRIBUTION. ©2008 Ibbotson Associates, Inc. All rights reserved. Ibbotson Associates,
Inc. is a registered investment advisor and wholly owned subsidiary of Morningstar, Inc. The information contained in this presentation is the proprietary material of Ibbotson
Associates. Reproduction, transcription or other use, by any means, in whole or in part, without the prior written consent of Ibbotson Associates, is prohibited.
$30,000
Real Median Sustainable Income vs. Real Shortfall Income, 20-Years
$80,000
$60,000
IVA
Lifetime GMWB
IFA
Real Median Income
80% Equity & 20% bonds
$40,000
$20,000
$0
-$20,000
-$10,000
$0
$10,000
$20,000
Shortfall Income at 5-th Percentile (Target Real $50K)
100%TA
43
100%VA+GMWB
100%IFA
100%IVA
FOR INFORMATION AND/OR ILLUSTRATION PURPOSES ONLY. NOT FOR PUBLIC DISTRIBUTION. ©2008 Ibbotson Associates, Inc. All rights reserved. Ibbotson Associates,
Inc. is a registered investment advisor and wholly owned subsidiary of Morningstar, Inc. The information contained in this presentation is the proprietary material of Ibbotson
Associates. Reproduction, transcription or other use, by any means, in whole or in part, without the prior written consent of Ibbotson Associates, is prohibited.
$30,000
Features for Various Retirement Income Options
Inflation
Longevity
Liquidity
Estate
Fees
Immediate
Fixed
Annuities
Low
High
Low
Low
Low
VA+
Median
Median
Median
Median
High
High
Low
High
High
Median
GMWB
Traditional
Assets
(Harlow and Milevsky, 2007)
44
FOR INFORMATION AND/OR ILLUSTRATION PURPOSES ONLY. NOT FOR PUBLIC DISTRIBUTION. ©2008 Ibbotson Associates, Inc. All rights reserved. Ibbotson Associates,
Inc. is a registered investment advisor and wholly owned subsidiary of Morningstar, Inc. The information contained in this presentation is the proprietary material of Ibbotson
Associates. Reproduction, transcription or other use, by any means, in whole or in part, without the prior written consent of Ibbotson Associates, is prohibited.
Summary
×
“VA+GMWB for life” improve retirement income “risk & return” tradeoff
× Protect against market downturns
× Protect against longevity risk
×
Fits the gap between immediate annuities and traditional assets
×
New retirement income efficient frontier is more effective for tradeoffs on retirement income than
traditional mean-variance efficient frontier
×
Caveats
×
×
×
×
45
Default risk in VA contracts
The benefit of GMWB will be lower for investors needing a much lower percentage of
withdrawal
Investor with shorter retirement period
For investors with existing market risk and retirement income risk coverage, the
benefit will be smaller (existing DB)
FOR INFORMATION AND/OR ILLUSTRATION PURPOSES ONLY. NOT FOR PUBLIC DISTRIBUTION. ©2008 Ibbotson Associates, Inc. All rights reserved. Ibbotson Associates,
Inc. is a registered investment advisor and wholly owned subsidiary of Morningstar, Inc. The information contained in this presentation is the proprietary material of Ibbotson
Associates. Reproduction, transcription or other use, by any means, in whole or in part, without the prior written consent of Ibbotson Associates, is prohibited.
Summary
× Shortfall
Factors can be Managed by
Combining Traditional Asset Allocation with outcome based
products
A. Principal Protected Products
B. Payout Annuities or
C. VA + GMWB for Life
× Optimal
Allocations Usually Include Some Annuities
× Retirement
Income Planning and Accumulation Planning can be
Combined to the Advantage of All
46
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Inc. is a registered investment advisor and wholly owned subsidiary of Morningstar, Inc. The information contained in this presentation is the proprietary material of Ibbotson
Associates. Reproduction, transcription or other use, by any means, in whole or in part, without the prior written consent of Ibbotson Associates, is prohibited.
About Ibbotson Associates
47
×
A leading authority on asset allocation
×
Rooted in academic research and founded
in 1977 by Professor Roger Ibbotson
×
Focused on providing global clients with
education and tools to reduce risks and
improve returns for investors
×
Key businesses lines:
× Investment Management Services
Sub-Advisory
Consulting & Research
Plan Sponsor Consulting
× Investment advice
Managed Accounts
×
A Morningstar Company
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Inc. is a registered investment advisor and wholly owned subsidiary of Morningstar, Inc. The information contained in this presentation is the proprietary material of Ibbotson
Associates. Reproduction, transcription or other use, by any means, in whole or in part, without the prior written consent of Ibbotson Associates, is prohibited.
48
FOR INFORMATION AND/OR ILLUSTRATION PURPOSES ONLY. NOT FOR PUBLIC DISTRIBUTION. ©2008 Ibbotson Associates, Inc. All rights reserved. Ibbotson Associates,
Inc. is a registered investment advisor and wholly owned subsidiary of Morningstar, Inc. The information contained in this presentation is the proprietary material of Ibbotson
Associates. Reproduction, transcription or other use, by any means, in whole or in part, without the prior written consent of Ibbotson Associates, is prohibited.