Post on 21-Dec-2015
Which is the Optimal Portfolio in Retirement?
FOR DUE DILIGENCE ATTENDEES
Van Harlow
19 May 2006
For Due Diligence purposes only. Not for distribution to the public in any form.2
Retirement
Which is the optimal portfolio in retirement?
or
Given my current assets and retirement expenses, which portfolio provides me with a reasonable
probability of funding my retirement years?
For Due Diligence purposes only. Not for distribution to the public in any form.3
Retirement
The answer depends on: • Longevity
• Distribution Rate
• Expected Returnsand Volatility
• Portfolio Funding Profile
Given my current assets and retirement expenses, which portfolio provides me with a reasonable
probability of funding my retirement years?
For Due Diligence purposes only. Not for distribution to the public in any form.4
Circa 1950 Circa 1998
Longevity
Source: U.S. Census Bureau, International Programs Center, International Database, Gender and Aging: Mortality and Health, 1B/98-2.
*Population Division of the Department of Economic and Social Affairs of the United Nations Secretariat, 2003. World Population Prospects: The 2002 Revision.
Male Female Male Female
Chile* 52.9 56.8 71.0 78.0
Argentina 60.4 65.1 70.9 78.3
Brazil 49.3 52.8 59.4 69.6
Mexico 49.2 52.4 68.6 74.8
Venezuela 53.8 56.6 69.7 75.9
United States 66.0 71.7 72.9 79.6
Life Expectancy at Birth for Selected Countries:
For Due Diligence purposes only. Not for distribution to the public in any form.5
Life Expectancy at Birth for Selected Countries:Males 1950 and 1988
0
10
20
30
40
50
60
70
80
90
United S
tate
s
Sweden
Greec
e
Norway
Italy
United K
ingdom
Franc
e
Belgium
Austri
a
Germ
any
Spain
Denmar
k
Czech
Rep
ublic
Hungar
y
Male 1950
Male 1998
Source: U.S. Census Bureau, International Programs Center, International Database, Gender and Aging: Mortality and Health, 1B/98-2.
Longevity
For Due Diligence purposes only. Not for distribution to the public in any form.6
Life Expectancy at Birth for Selected Countries:Females 1950 and 1988
0
10
20
30
40
50
60
70
80
90
United S
tate
s
Sweden
Greec
e
Norway
Italy
United K
ingdom
Franc
e
Belgium
Austri
a
Germ
any
Spain
Denmar
k
Czech
Rep
ublic
Hungar
y
Female 1950
Female 1998
Source: U.S. Census Bureau, International Programs Center, International Database, Gender and Aging: Mortality and Health, 1B/98-2.
Longevity
For Due Diligence purposes only. Not for distribution to the public in any form.7
COUPLES(Both
AGE 65)
FEMALEAGE 65
Age 92 95
At least one personhas a 50% chance of living to 92
MALEAGE 65
Age 88 9490 100
Age 85 92 95 100
50% chanceof living to 85
25% chanceof living to 92
50% chanceof living to 88
25% chanceof living to 94
At least one personhas a 25% chance of living to 92
85 97
Life Spans
Source: Annuity 2000 Morality Table. Figures assume you are in good health.
Longevity
For Due Diligence purposes only. Not for distribution to the public in any form.8
Retirement
Longevity
Distribution Rate
Expected Returns and Volatility
Portfolio Funding Profile
For Due Diligence purposes only. Not for distribution to the public in any form.9
$-
$100,000
$200,000
$300,000
$400,000
$500,000
$600,000
$700,000
$800,000
$900,000
$1,000,000
19
72
19
74
19
77
19
79
19
82
19
84
19
87
19
89
19
92
19
94
19
97
19
99
20
02
Distribution Rate
9% Withdrawal Rate
8% Withdrawal Rate
7% Withdrawal Rate
6% Withdrawal Rate
5% Withdrawal Rate
COUPLES(Both Age 65)
Age 85 90
Probability that at least one will be alive:
9570 75 80
83% 63% 35%
4% Withdrawal Rate
Hypothetical value of assets held in a taxable account of $500,000 invested at year-end 1972. Portfolio: 50% stocks, 40% bonds, 10% cash.
For Due Diligence purposes only. Not for distribution to the public in any form.10
0 10 20 30 40 50
*Hypothetical portfolio of assets held in a taxable account consists of 50% bonds and 50% stocks, assumes average annual return of 8.7%.
Number of years a portfolio can last in distribution
10%
9%
8%
7%
6%
5%
4%
Years
Distribution Rate
For Due Diligence purposes only. Not for distribution to the public in any form.11
Retirement
Longevity
Distribution Rate
Expected Returns and Volatility
Portfolio Funding Profile
For Due Diligence purposes only. Not for distribution to the public in any form.12
Expected Returns
Long-term view of historical returns provides the best estimates for risks and correlations
A risk premium approach is best for estimating asset class returns since it provides a long-term perspective of return expectations consistent with the investment horizon of retirement portfolios
For Due Diligence purposes only. Not for distribution to the public in any form.13
Expected Returns
Risk Premium
RPt
RRft
Inft
Risk Premium
Real risk-free return
Inflation
• The risk premium approach to estimating expected returns identifies the market’s required return premium for accepting asset class risk and adds that to the risk-free return (real risk-free return plus inflation)
Rt = (1 + Inft) (1 + RRft) (1 + RPt) – 1
where Inft = inflation rate RRft = real risk free rate RPt = risk premium
For Due Diligence purposes only. Not for distribution to the public in any form.14
Expected Returns
Historical
Fundamental
Economic
Surveys
Estimating the Risk Premium
For Due Diligence purposes only. Not for distribution to the public in any form.15
Other Approaches to Estimating the Risk Premium
• Historical evidence– Ibbotson Associates (US Markets, 2004) 8.0%– Jorian and Guetzmann (Journal of Finance, 1999) 4.3%– Siegel (Financial Analysts Journal, 1992) 0.6% - 5.9%– Dimson, Marsh and Stanton (Business Strategy Review, 2000) 5.8%
• Fundamental Estimates⁃ Fama and French (University of Chicago, 2000) 2.55% - 4.32%⁃ Ibbotson and Chen (Financial Analysts Journal, 2003) 4.0%⁃ Claus and Thomas (Journal of Finance, 2001) 3.0%⁃ Arnott and Bernstein (Financial Analysts Journal, 2002) 0% - 2.4%
• Economic Estimates⁃ Mehra and Prescott (Journal of Monetary Economics, 1985) <1.0%
• Surveys⁃ Welch (Journal of Business, 2000) 4.0%⁃ Graham and Harvey (Duke University, 2001) 3.9% - 4.7%
Literature Review
US EquityRisk Premium Estimates
For Due Diligence purposes only. Not for distribution to the public in any form.16
Historical Real Returns
Source: Global Financial Data
1993-2006
-5%
0%
5%
10%
15%
20%
25%
Austra
liaAus
tria
Belgium
Canad
a
Denmark
Finland
France
German
yIre
land
Italy
Japa
n
Netherl
ands
New Zea
land
Norway
Portug
alSpa
in
Sweden
Switzerla
nd UKUSA
Chile
Argenti
na
Greece
Israe
l
Mexico
South
Africa
Ann
ualiz
ed V
olat
ility
Equities
Bonds
For Due Diligence purposes only. Not for distribution to the public in any form.17
Risk Premium versus Cash
-5%
0%
5%
10%
15%
20%
Austra
liaAus
tria
Belgium
Canad
a
Denmark
Finland
France
German
yIre
land
Italy
Japa
n
Netherl
ands
New Zea
land
Norway
Portug
alSpa
in
Sweden
Switzerla
nd UKUSA
Chile
Argenti
na
Greece
Israe
l
Mexico
South
Africa
Ann
ualiz
ed R
isk
Prem
ium
, %
Equities-Cash
Bonds-Cash
7.17%
3.07%
1993-2006
For Due Diligence purposes only. Not for distribution to the public in any form.18
Risk Premium versus Bonds
-5%
0%
5%
10%
15%
Austra
liaAus
tria
Belgium
Canad
a
Denmark
Finland
France
German
y
Irelan
dIta
lyJa
pan
Netherl
ands
New Zea
land
Norway
Portug
alSpa
in
Sweden
Switzerla
nd UKUSA
Chile
Ann
ualiz
ed R
isk
Prem
ium
, %
4.21%
1993-2006
For Due Diligence purposes only. Not for distribution to the public in any form.19
Historical Volatilities
0%
5%
10%
15%
20%
25%
30%
35%
40%
45%
Austra
liaAus
tria
Belgium
Canad
a
Denmark
Finland
France
German
yIre
land
Italy
Japa
n
Netherl
ands
New Zea
land
Norway
Portug
alSpa
in
Sweden
Switzerla
nd UKUSA
Chile
Argenti
na
Greece
Israe
l
Mexico
South
Africa
Ann
ualiz
ed V
olat
ility
EquitiesBonds
1993-2006
For Due Diligence purposes only. Not for distribution to the public in any form.20
Asset ClassRisk Premium
Risk-Free Return
Expected Nominal Return
Expected Real Return
Volatility (1-93 - 2/06)
Domestic Stocks 5.00% 6.15% 11.15% 7.64% 20.90%Developed Market 4.00% 6.15% 10.15% 6.68% 12.68%Emerging Market 5.00% 6.15% 11.15% 7.64% 20.38%Domestic Bonds 0.54% 6.15% 6.69% 3.32% 4.74%Domestic Short-Term 0.00% 0.00% 4.42% 1.12% 0.53%
Inflation 3.26%
Asset Class Assumptions
Risk and Return Assumptions
Note: 10-year CLP bond yield is 6.15%
10-year UF bond yield is 2.85%
For Due Diligence purposes only. Not for distribution to the public in any form.21
Correlations (Unhedged Peso) 1/93 -2/06
Risk and Return Assumptions
Domestic Stocks Developed Stocks Emerging Stocks Domestic Bonds Domestic Cash
Domestic Stocks 100.0% 35.3% 67.1% 18.3% -0.2%
Developed Stocks 100.0% 62.3% 5.1% 6.3%
Emerging Stocks 100.0% 23.5% 5.2%
Domestic Bonds 100.0% 20.7%
Domestic Cash 100.0%
For Due Diligence purposes only. Not for distribution to the public in any form.22
Portfolio Allocations
Fund A Fund B Fund C Fund D Fund E
Stocks - 18.2% 20.2% 18.4% 12.6% 0.0%Domestic
Stocks 27.2% 18.9% 11.5% 5.6% 0.0%Developed
Stocks 33.4% 21.8% 13.0% 6.2% 0.0%Emerging Markets
Bonds 7.8% 19.1% 34.7% 48.4% 86.0%
Cash 13.3% 20.0% 22.3% 27.2% 14.0%
Risk and Return Assumptions
For Due Diligence purposes only. Not for distribution to the public in any form.23
Portfolio Risks and Returns
Fund A Fund B Fund C Fund D Fund E
Expected 9.61% 8.73%Nominal Returns
Expected 6.15% 5.30%Real Returns
Volatility 12.14% 9.63%
Risk and Return Assumptions
7.95%
4.55%
7.33%
7.08%
3.70%
5.00%
6.37%
3.01%
4.08%
For Due Diligence purposes only. Not for distribution to the public in any form.24
Retirement
Longevity
Distribution Rate
Expected Returns and Volatility
Portfolio Funding Profile
For Due Diligence purposes only. Not for distribution to the public in any form.25
• The Profile is determined using historical simulations to understand a portfolio’s ability to fund a retirement horizon of varying lengths and with differing degrees of confidence
Portfolio Funding Profile
$10,000
$100,000
$1,000,000
$10,000,000
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 36
Horizon
Tota
l Wea
lth
Portfolio in Distribution
Fund C with Constant Real Peso Withdrawal (6% initial)
For Due Diligence purposes only. Not for distribution to the public in any form.26
Portfolio Funding Profile
• A Funding Profile reflects the number of retirement years that a particular portfolio might be expected to support expenses in retirement as a function of inflation-adjusted withdrawal rates
• Consistent with Fidelity’s retirement approach, the number of funding years are indicated at the 50% and 90% confidence level, reflecting portfolio longevity in average and extended down markets
$10,000
$100,000
$1,000,000
$10,000,000
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 36
Horizon
Tota
l Wea
lth
0%
25%
50%
75%
100%
90% 50%
For Due Diligence purposes only. Not for distribution to the public in any form.27
Portfolio Funding Profile
Solid end points = Average Market Conditions (50% Confidence)
Transparent end points = Extended Down Markets (90% Confidence)
2%
4%
6%
8%
10%
12%
0 10 20 30 40 50 60
Years Survived
Infla
tion-
Adj
uste
d W
ithdr
awal
Rat
e
Fund EFund DFund CFund BFund A
60+ years
The Impact of Withdrawal Rates on Portfolio Longevity inExtended Down Markets and Average Markets
Note: Fund E is never optimal to hold
50%
Mo
rta
lity
75%
Mo
rta
lity
For Due Diligence purposes only. Not for distribution to the public in any form.28
Portfolio Funding Profile
Solid end points = Average Market Conditions (50% Confidence)Transparent end points = Extended Down Markets (90% Confidence)
3%
4%
5%
6%
7%
8%
0 10 20 30 40 50 60
Years Survived
Infla
tion-
Adj
uste
d W
ithdr
awal
Rat
e
Fund EFund DFund CFund BFund A
60+ years
83
The Impact of Withdrawal Rates on Portfolio Longevity inExtended Down Markets and Average Markets
Note: A 5% initial inflation-adjusted withdrawal is probably the maximum distribution
Note: Funds B, C & D are attractive portfolios for a range of withdrawal rates
For Due Diligence purposes only. Not for distribution to the public in any form.29
Portfolio Funding Profile
Fund E does not appear to be attractive to hold
A 5% initial inflation-adjusted withdrawal rate is probably the maximum distribution to fund a retirement beginning at age 65
Funds B, C and D are attractive portfolios for a broad range of withdrawal rates
Observations
For Due Diligence purposes only. Not for distribution to the public in any form.30
Portfolio Funding Profile
What if the Chilean equity risk premium is 4% instead of 5%?
With if equity volatilities were 20% higher than assumed in the base case?
What if all equity risk premiums were lower than assumed in the base case?
Sensitivity Analysis
For Due Diligence purposes only. Not for distribution to the public in any form.31
Portfolio Funding Profile
Solid end points = Average Market Conditions (50% Confidence)Transparent end points = Extended Down Markets (90% Confidence)
2%
4%
6%
8%
10%
12%
0 10 20 30 40 50 60
Years Survived
Infla
tion-
Adj
uste
d W
ithdr
awal
Rat
e
Fund EFund DFund CFund BFund A
60+ years85
4% Chilean Equity Risk Premium
The Impact of Withdrawal Rates on Portfolio Longevity inExtended Down Markets and Average Markets
Note: Results similar tobase case
For Due Diligence purposes only. Not for distribution to the public in any form.32
2%
4%
6%
8%
10%
12%
0 10 20 30 40 50 60
Years Survived
Infla
tion-
Adj
uste
d W
ithdr
awal
Rat
e
Fund EFund DFund CFund BFund A
Solid end points = Average Market Conditions (50% Confidence)Transparent end points = Extended Down Markets (90% Confidence)
67
Equity Volatilities 20% Higher than Base Case
The Impact of Withdrawal Rates on Portfolio Longevity inExtended Down Markets and Average Markets
Portfolio Funding Profile
Note: Fund D is an attractiveportfolio
For Due Diligence purposes only. Not for distribution to the public in any form.33
2%
4%
6%
8%
10%
12%
0 10 20 30 40 50 60
Years Survived
Infla
tion-
Adj
uste
d W
ithdr
awal
Rat
e
Fund EFund DFund CFund BFund A
Solid end points = Average Market Conditions (50% Confidence)Transparent end points = Extended Down Markets (90% Confidence)
6598
Equity Risk Premiums Lower than Base Case
The Impact of Withdrawal Rates on Portfolio Longevity inExtended Down Markets and Average Markets
Portfolio Funding Profile
Note: Funds C and D areattractive for all withdrawal rates
For Due Diligence purposes only. Not for distribution to the public in any form.34
Conclusions
A 5% initial inflation-adjusted withdrawal rate is probably the maximum distribution to fund a retirement beginning at age 65
In the scenarios examined, Fund E does not appear to be attractive
Funds B, C, and D have attractive funding profiles under the base case assumptions
In scenarios more favorable to bonds, not surprisingly, Funds C and D have attractive profiles
Which is the Optimal Portfolio in Retirement?