Engineering a better retirement portfolio · funding gap. By rethinking how to build retirement...

The vast majority of investors approaching retirement are waking up to the sobering reality that their nest egg may fall short of being able to comfortably fund their retirement years. The combination of undersaving, low interest rates and a decade of challenging stock markets has created a personal retirement funding de� cit that has many struggling to � nd a way out. Unfortunately, there is no silver bullet. A solution will likely require pulling a number of different levers; working longer, spending less and relying on greater support from others are just a few of the options, although none are terribly appealing. How you invest your nest egg is one lever you may be able to pull rather painlessly to help improve your retirement funding outlook. Through a more comprehensive understanding of risk — which here assumes various forms — and better portfolio engineering, you may be able to progress toward closing the retirement funding gap. By rethinking how to build retirement portfolios, you may be able to relieve some of the personal austerity pressure that is a persistent worry for many investors as they move into the golden years.

Stretching your nest egg fartherThis paper is intended for investors who may not have saved enough for retirement and need to stretch their nest egg. This pressure is magni� ed by historically low interest rates, which may make collecting coupon payments from bonds or dividend payments from traditional bond mutual funds insuf� cient to meet spending needs. Short of signi� cantly curbing one’s retirement lifestyle, many investors will need to engage in a withdrawal program to supplement Social Security or other sources of retirement income. One way that we can signi� cantly improve our retirement funding outlook is by simply employing better portfolio engineering.

The retirement nest egg “Do I have enough?” testLet’s start with a basic income calculation to help � gure out where an investor may stand. For ease of calculation, we’ll use the following numbers:

Exhibit 1: A rough calculation to gauge your retirement income needsA sample monthly budget

Item ValueMonthly expenses $3,000Monthly Social Security/pension payment $1,500Additional retirement income required $1,500Nest egg $300,00030-year bond yield (annualized) 3%Income tax rate in retirement1 15%Monthly nest egg payment after tax $638Monthly shortfall $862Source: Columbia Management, 12/12This hypothetical chart is for illustrative purposes only.

Engineering a better retirement portfolio

Highlights > Stretching your nest egg farther

> The interaction of portfolio volatility and bad timing increases shortfall risk

> Concentrating your risk in the wrong asset class at the wrong time can be devastating

> Retirement withdrawal success requires reasonable return expectations and portfolio consistency

> Improve your chances of achieving retirement success through better portfolio engineering

When funding retirement, investors care more about not running out of money than maximizing their nest egg.

1 The sample monthly budget uses a federal income tax rate of 15%, which is the rate for individuals with income between $8,925–$36,250 and married couples � ling jointly with income between $17,850–$72,500.

ENGINEERING A BETTER RETIREMENT PORTFOLIO

2

If you put a $300,000 nest egg into a 30-year bond and hold that bond to maturity, it will give you: $300,000 x 3% x (100%–15%) = $7,650 annually, or $638 per month after tax. In the Exhibit 1 test scenario, where the retiree’s monthly expenses are $3,000 and a monthly Social Security and/or pension payment amounts to $1,500, this will leave the retiree about $862 short each month.

Every retiree’s situation is unique, so each should do their own test. But this type of outcome is likely not uncommon — only 10% of current American workers have more than $250,000 saved, and 50% have less than $25,000.2 There aren’t many levers that can be pulled to bridge the gap in the above calculation. Working longer and reducing monthly expenses are chief among them, but both can be dif� cult. The reality is there is no single, easy answer to solving this dilemma. A retiree may be pressed to build a portfolio that targets higher levels of return in order to bridge the gap. And this is where alternatives to the conventional wisdom of building portfolios may provide an opportunity to improve the outcome.

A historical look at market performance shows cash returns have been a tailwindThe traditional starting point for a diversi� ed portfolio has been the 60/40 (i.e., 60% stocks, 40% bonds). For the purposes of this paper, the 60/40 will be represented by the S&P 500 Index and the Barclays U.S. Aggregate Bond Index, respectively. The return on the 60/40 from December 1970 to September 2012 has been 9.8%.

Exhibit 2: Cash has comprised a significant portion of the 60/40’s historical total returnDissecting historical total returns for the 60/40

December 1970– September 2012 =

Risk-free return +

Return from markets

9.8% 6.0% 3.8%

Sources: Columbia Management Investment Advisers, LLC and Datastream, as of 12/12

The 60/40 is de� ned as 60% S&P 500 Index/40% Barclays U.S. Aggregate Bond Index, rebalanced monthly. The risk-free return is the interest one could have earned on cash during the period. For this example we have used the federal funds rate to determine the interest earned. Market returns are derived from the annualized returns of the 60/40 portfolio less the annualized returns on Treasury bills. This illustration assumes reinvestment of all income and does not re� ect sales charges, fees or expenses. This example is for illustrative purposes only and is not representative of the performance of any particular investment or product. It is not possible to invest directly in an index.

We have inserted the risk-free return of cash — in this case we’ve used the federal funds rate — as cash is the ultimate hurdle that investments should outperform over time. If you are going to take � nancial risk, your true reward should be the excess return above a risk-free asset. Said another way, what you would have earned had you taken no risk at all.

This is particularly relevant today because cash rates are near zero, and the higher historical cash rate provided a material tailwind to total returns. Using the 10-year yield as the proxy for cash going forward, should we be expecting something like what’s shown in Exhibit 3 for the 60/40 over the next decade?

Exhibit 3: Low cash rates suggest total return expectations should be adjusted accordingly

Today=

Risk-free return +

Return from markets

5.5% 1.7% 3.8%


Setting return expectations is only one side of the equation. It helps us estimate how much a retiree might be able to withdraw each year given a certain portfolio allocation. We believe this is a reasonable starting point for that exercise, though there will be different schools of thought on ways to potentially improve the expected return.

The other critical component to this analysis, however, is looking at the risk side of the equation. We de� ne risk as the standard deviation of returns, or simply, volatility. Volatility is a measure of how signi� cant a price changes for a security, asset class or portfolio. For example, if a portfolio moves up and down rapidly over short time periods, it has high volatility; if the price tends to change very little, it has low volatility. Another way to look at risk is simply through the length and severity of portfolio losses, also known as “drawdown.” Let’s examine the portfolio risk side of the equation more closely.

2 2012 Retirement Con� dence Survey by the Employee Bene� t Research Institute and Mathew Greenwald & Associates; excludes the value of a primary residence and de� ned bene� t plans.

3

The interaction of portfolio volatility and bad timing increases shortfall riskInvestors need positive returns to increase the probability of meeting their withdrawal needs throughout retirement. The risk of not meeting these needs is known as “shortfall risk.” And once a reasonable withdrawal rate is established, the biggest driver of shortfall risk is a large drawdown early in the retirement years. Withdrawing funds during this early losing period — thus, realizing the losses — means less capital working for the retiree when the portfolio recovers. If these losses are severe and/or prolonged, the long-term effects on the portfolio can be devastating.

Exhibit 4 looks at two scenarios for the full decade from January 2000 to December 2009. The green line represents someone who began their retirement withdrawals from the 60/40 at the beginning of the decade, starting with the $1,500 per month gap we established in Exhibit 1.3 That withdrawal amount is then adjusted for in� ation in subsequent months. The orange line represents the cumulative return of the 60/40 with no withdrawals.

Exhibit 4: Better understanding timing risk associated with retirement withdrawals IComparing returns of the 60/40 on a $300,000 initial investment with and without $1,500/month withdrawals (adjusted for inflation): 2000–2010

60/40 — With withdrawals60/40 — No withdrawals

100,000

200,000

300,000

400,000

500,000

201020052000

$137,877

$376,035


Past performance does not guarantee future results.

The 60/40 is de� ned as 60% S&P 500 Index/40% Barclays U.S. Aggregate Bond Index, rebalanced monthly. This illustration assumes reinvestment of all income and does not re� ect sales charges, fees or expenses. This example is for illustrative purposes only and is not representative of the performance of any particular investment or product. It is not possible to invest directly in an index.

3 For the purposes of our examples going forward, we will not include the impact of taxes because of the variation in rates and likelihood of expected changes to the tax code. This also allows us to convey the concepts of this paper more clearly. However, taxes must be factored into the individual investor’s situation, which can be done easily and will translate into slightly higher withdrawal rates or lower monthly expenditures.


4

The 60/40 with no withdrawals weathered two equity market crises and grew to approximately $376,000 in aggregate. The 60/40 used to fund retirement provided $206,442 in withdrawals. However, the portfolio was drawn down to just under $138,000, which means it missed out on more than $30,000 in portfolio gains ($376K–$206K = $170K vs. $138K actual). Therefore, when the Tech Bubble burst in the early 2000s, the portfolio’s recovery power was meaningfully diminished at an early stage in the investor’s retirement. In other words, shortfall risk was increased and the longevity of the retiree’s nest egg was jeopardized.

What if our retiree was born and retired 10 years earlier? Exhibit 5 includes the full 20-year window of the 1990s and 2000s.

Here, our hypothetical retiree was fortunate. The initiation of their retirement withdrawals happened to coincide with the start of a decade-long equity bull market. The compounding of these strong gains in the early years of retirement meant the retiree built up a signi� cant enough cushion to weather the market downturns of the 2000s. Shortfall risk for this retiree is therefore very low.

Exhibits 4 and 5 show a sharply contrasting experience, one that reveals the marked impact of the second risk to funding our retirement, timing. Obvious questions arise, “Why should my retirement fate be at the mercy of the market environment?” and, “What can I do to minimize this timing risk?” We will address these later on, but � rst let’s look at one more scenario.

Exhibit 5: Better understanding timing risk associated with retirement withdrawals IIComparing returns of the 60/40 on a $300,000 initial investment with and without $1,500/month withdrawals (adjusted for inflation): 1990–2010

0

500,000

1,000,000

1,500,000

2,000,000

20102005200019951990

60/40 — No withdrawals 60/40 — With withdrawals

$1,580,080

$631,053



5

“De-risking” via the traditional glidepath can introduce new risksAssessing the scenario of an investor using the traditional 60/40 as a balanced approach to fund a retirement withdrawal program, one might ask the question, “Isn’t a 60/40 allocation too risky as a retirement portfolio?” In our view, the short answer is yes, though there is nuance to this.

It has been accepted practice that as an investor nears retirement, they have rotated away from higher volatility equities to lower volatility bonds. Exhibit 6 represents a basic ef� cient frontier using the S&P 500 Index, the Barclays U.S. Aggregate Bond Index and different blends of the two. As retirement grows closer, we gradually shift our portfolio from right to left along this curve. And with this reduced expected volatility comes reduced expected return.

Exhibit 6: The traditional efficient frontier can introduce new risks4

Excess return and volatility for different blends of the S&P 500 Index and Barclays U.S. Aggregate Bond Index: December 1970–September 2012

100% S&P 500 Index

80/20

60/40

40/60

20/80

100% Barclays U.S. Aggregate Bond Index

1.0

1.5

2.0

2.5

3.0

3.5

4.0

4.5

5.0

2.0 4.0 6.0 8.0 10.0 12.0 14.0 16.0 18.0 20.0

Exce

ss re

turn

(%

)

Volatility (%)



This example is for illustrative purposes only and is not representative of the performance of any particular investment or product. It is not possible to invest directly in an index.

However, portfolios that have the majority of their risk in � xed-income securities can bring about a different set of issues. Remember, retirees not only need to fund their retirement, but they need to do so on an in� ation-adjusted basis. Let’s look at another example to illustrate this more clearly.

The U.S. stock market, as measured by the S&P 500 Index, averaged nearly a 7% annualized return from January 1960 to its decade peak in November 1968. And in� ation over that same period averaged about 2%. However, the stock market peak also coincided with the beginning of an in� ationary period that would have caused considerable erosion to investors’ real wealth. Indeed, had our retiree “de-risked” entirely into U.S. Treasuries in January 1965, they would have been questioning whether their nest egg would last just ten years in. Turns out the 60/40 portfolio didn’t fare any better.

4 The ef� cient frontier is the result of Harry Markowitz’s Modern Portfolio Theory, established in 1952. The frontier comprises a set of optimal portfolios that offers the highest expected return for a de� ned level of risk or the lowest risk for a given level of expected return using a given set of underlying assets.


6

While the Treasury yield began at 4.2% and averaged 6.1% over the period, the onset of rising in� ation and rising Treasury yields combined with ongoing in� ation-adjusted withdrawals put signi� cant pressure on the portfolio. In

fact, Exhibit 8 extends the scenario another 10 years and shows the nest egg depleted in April 1980, after just 15 years of retirement.

Exhibit 7: Testing retirement portfolios under different market conditions IU.S. Treasuries and the 60/40 on a $300,000 initial investment with and without $1,500/month inflation-adjusted withdrawals: 1965–1975

U.S. Treasuries — With withdrawals 60/40* — With withdrawals60/40* — No withdrawals

100,000

200,000

300,000

400,000

500,000

1975

1974

1973

1972

1971

1970

1969

1968

1967

1966

1965

$159,562

$316,921

$110,710



*We have substituted the Barclays U.S. Treasury Index returns for the � xed-income portion of the 60/40 for Exhibits 7 and 8 due to data availability.

Exhibit 8: Testing retirement portfolios under different market conditions IIU.S. Treasuries and the 60/40 on a $300,000 initial investment with and without $1,500/month inflation-adjusted withdrawals: 1965–1985

U.S. Treasuries — With withdrawalsU.S. Treasuries — Fixed withdrawals** 60/40* — With withdrawals60/40* — No withdrawals

-500,000

-250,000

0

250,000

500,000

750,000

1,000,000

1985

1984

1983

1982

1981

1980

1979

1978

1977

1976

1975

1974

1973

1972

1971

1970

1969

1968

1967

1966

1965

-$411,947

$192,372

$788,345

-$357,122



*We have substituted the Barclays U.S. Treasury Index returns for the � xed-income portion of the 60/40 for Exhibits 7 and 8 due to data availability.

Unlike prior illustrations of the 60/40, here it is de� ned as 60% S&P 500 Index/40% Barclays U.S. Treasury Index (see above footnote), rebalanced monthly. This illustration assumes reinvestment of all income and does not re� ect sales charges, fees or expenses. This example is for illustrative purposes only and is not representative of the performance of any particular investment or product. It is not possible to invest directly in an index.

**Withdrawals not adjusted for in� ation.

7

Notably, had it not been for the corrosive effects of in� ation, the Treasury nest egg would have still had nearly $200,000 after 20 years of retirement. While excessive in� ation affects all assets, it can be particularly harsh on � xed-income securities that do not have in� ation protection built in.

Concentrating your risk in the wrong asset class at the wrong time can be devastatingThrough the examples above, it becomes clear that shortfall risk is a function of timing risk, and timing risk depends on the market environment and how your portfolio is invested at any given point in time. And the intersection of bad timing and portfolio concentration in any single asset class can do irreparable damage when the drivers of that asset class turn sour.

In our paper, Rethinking How We Invest, we introduced the concept of allocating portfolios according to risk rather than dollars. In order to stay focused on retirement income, we will not repeat that analysis here; however, we have summarized the key conclusions below:

> Allocate risk, not dollars, to asset classes that respond independently to different economic and market drivers. The traditional approach to asset allocation has typically resulted in a portfolio in which risk has been dominated by equities. By balancing risk to asset classes that respond independently to different types of economic and market environments, we can build a portfolio that will perform more consistently across the different phases of the economic cycle.

> By balancing risk among asset classes with low correlation, we can improve portfolio consistency.5 A higher Sharpe ratio — the ratio of excess returns above cash divided by the portfolio volatility — means you are rewarded more consistently for the risk you take. The more consistent the return experience, the less painful the periods of losing money, and, in a retirement income context, the lower the timing risk (and, hence, lower shortfall risk).

> The responsible use of leverage can allow you to target higher levels of return without concentrating the portfolio. Targeting higher levels of return has historically meant increasing portfolio concentration in high-risk assets, such as equities. Through better portfolio engineering, we can target higher levels of return without concentrating the portfolio by applying modest amounts of leverage to low volatility, diversifying asset classes.

Exhibit 9 shows the risk allocations for the traditional 60/40 as well as a sample risk-balanced portfolio.

Exhibit 9: Viewing portfolios through a risk-contribution lensContributions to portfolio volatility by asset class

60/40 portfolio

Sample risk-balanced portfolio

90%

10%

33%

33%

33%

Stocks

Stocks

Bonds

Bonds

In�ation-hedgingassets


Based on the Columbia Management proprietary risk management system. This example is for illustrative purposes only and is not representative of any particular investment or product.

The 60/40 is de� ned here as 60% stocks as represented by the S&P 500 Index, 40% bonds as represented by the Barclays U.S. Aggregate Bond Index.

5 Correlation measures the extent to which asset classes move together. A low correlation indicates greater independence to respond differently to economic and market drivers, while a high correlation means the asset classes will often react similarly to these forces.


8

The sample risk-balanced portfolio has had shorter and less severe portfolio drawdowns — periods of losing money (Appendix A) — and has performed more consistently across past market cycles than a portfolio that has concentrated its risks more narrowly, like the 60/40. These are critical factors when building a portfolio to withstand the challenges of funding retirement.

Retirement withdrawal success requires reasonable return expectations and portfolio consistencyIn the retirement income scenario that requires engagement in a withdrawal program, we will assume the funding will come from a tax-exempt vehicle (e.g., 401(k) or IRA rollover) to remove the individual variability associated with taxes.

Determining your withdrawal amount should be a function of your funding gap (Exhibit 1) and the long-term expected return of your portfolio. For the latter, historical excess returns (Appendix B) plus a forward-looking cash return can serve as a guide. However, we would suggest withdrawing an amount at least modestly less than the expected long-term return to help safeguard against unanticipated expenses and/or burdens on the portfolio. Once that withdrawal amount is determined, the retiree’s portfolio should be built to achieve that expected return with the least portfolio volatility possible. Again, think of this as seeking the highest Sharpe ratio portfolio, or the portfolio that performs most consistently.

Let’s return to our Exhibit 1 scenario, which assumes that we need to withdraw $1,500 per month, which is then adjusted for in� ation in subsequent months. With a starting nest egg of $300,000, that would equate to a 6% annualized withdrawal rate, all other factors held constant. Earlier, we showed how this scenario played out in a few different market environments for the 60/40 and U.S. Treasuries. However, since we don’t know how market returns will unfold going forward, we have put the monthly returns (using data from 1975–present) for the S&P 500 Index, the Barclays U.S. Aggregate Bond Index, the 60/40 and the sample risk-balanced portfolio into random order to generate � ve hypothetical 25-year periods and executed on our withdrawal program.

Exhibit 10: Remove time period biases to improve testing validity, a sampling

S&P 500 Index Barclays U.S. Aggregate Bond Index 60/40 Sample risk-balanced portfolio

Random sample 1: 300 months of random returns, March 1975–September 2012

$868,794

-$113,814

$254,958$316,383

-250,000

0

250,000

500,000

750,000

1,000,000

300

275

250

225

200

175

150

125

1007550251

Initial investment = $300,000Monthly withdrawals = $1,500



The 60/40 is de� ned as 60% S&P 500 Index/40% Barclays U.S. Aggregate Bond Index, rebalanced monthly. Please see disclosures on the construction of the sample risk-balanced portfolio at the end of this paper. This illustration assumes reinvestment of all income and does not re� ect sales charges, fees or expenses. This example is for illustrative purposes only and is not representative of the performance of any particular investment or product. It is not possible to invest directly in an index.

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Exhibit 10: Remove time period biases to improve testing validity, a sampling (continued)

S&P 500 Index Barclays U.S. Aggregate Bond Index 60/40 Sample risk-balanced portfolio

-1,000,000

0

1,000,000

2,000,000

3,000,000

4,000,000

5,000,000

6,000,000

300

275

250

225

200

175

150

125

1007550251

$5,005,453

$2,096,857

$740,668-$21,880

$1,899,758

$1,507,473

$1,071,464

$279,411

$735,838

-$287,643

-$160,240-$169,594

0

500,000

1,000,000

1,500,000

2,000,000

300

275

250

225

200

175

150

125

1007550251



-500,000

-250,000

0

250,000

500,000

750,000

1,000,000

300

275

250

225

200

175

150

125

1007550251


0

250,000

500,000

750,000

1,000,000

1,250,000

300

275

250

225

200

175

150

125

1007550251


$705,852

$1,186,111

$665,599

$20,877







The 60/40 is de� ned as 60% S&P 500 Index/40% Barclays U.S. Aggregate Bond Index, rebalanced monthly. Please see disclosures on the construction of the sample risk-balanced portfolio at the end of this paper. This illustration assumes reinvestment of all income and does not re� ect sales charges, fees or expenses. This example is for illustrative purposes only and is not representative of the performance of any particular investment or product. It is not possible to invest directly in an index.


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Under the Exhibit 10 scenarios: > Both the S&P 500 Index and Barclays U.S. Aggregate Bond Index portfolios deplete twice > The 60/40 depletes once > The sample risk-balanced portfolio does not deplete

While any portfolio — including the sample risk-balanced portfolio — can deplete under the wrong conditions, we would expect the most concentrated portfolios to deplete the most frequently and the most diversi� ed portfolios — assuming a reasonably matched expected return and withdrawal rate— to deplete the least frequently. The more concentrated the portfolio, the less consistently it performs, the greater the likelihood of experiencing a signi� cant loss that — when combined with the in� ation-adjusted withdrawals — can overwhelm the portfolio. Exhibit 11 considers different 25-year windows, along with rearranged sampling, in addition to the random samples in Exhibit 10.

Exhibit 11: Testing the longevity of different strategies under different conditions Maximum and minimum portfolio values, incorporating asset class performance and inflation-adjusted withdrawals under different testing environments

25-year time period

Maximum/Minimum principal S&P 500 Index ($)

Barclays U.S. Aggregate Bond

Index ($) 60/40 ($)

Sample risk-balanced portfolio ($)

Jan 76–Dec 00Maximum 3,003,887 326,397 1,076,470 1,037,061 Minimum 270,637 -189,566 270,238 286,939

Jan 79–Dec 03Maximum 4,627,389 421,374 2,011,286 717,240 Minimum 289,600 163,617 276,495 241,709

Jan 82–Dec 06Maximum 4,948,826 1,063,843 3,022,239 3,181,818 Minimum 275,167 300,356 291,375 287,349

Jan 85–Dec 09Maximum 3,235,550 557,723 1,852,652 3,121,720 Minimum 318,695 297,495 313,729 292,430

Jan 88–Dec 12Maximum 1,955,347 392,237 1,119,470 1,707,096 Minimum 310,656 211,039 307,680 301,549

1988–2012 rearranged*

Maximum 307,632 339,038 306,400 1,288,913 Minimum -1,402,587 119,352 -390,710 266,123

25-year random 1Maximum 308,335 438,878 365,248 879,294 Minimum -113,814 297,043 242,548 248,178

25-year random 2Maximum 1,697,895 471,032 1,120,156 1,971,556 Minimum 174,226 279,411 229,194 283,385

25-year random 1Maximum 5,005,453 342,969 2,096,857 740,668 Minimum 280,824 -21,880 283,496 273,712

25-year random 4Maximum 302,769 316,864 301,695 778,672 Minimum -287,643 -169,594 -160,240 284,589

25-year random 5Maximum 1,186,111 363,604 665,857 761,720 Minimum 300,805 20,877 302,281 301,870 Average maximum 2,416,290 457,633 1,267,121 1,471,432 Average minimum 37,869 118,923 178,735 278,894

*Rearranged, the sequence of returns goes from January 2000–September 2012, and then January 1988–December 1999.



11

Note the average maximums and minimums across all samples. While the S&P 500 Index has the highest average maximum, it also has the lowest average minimum. Keep in mind that when funding retirement, investors care more about not running out of money than maximizing their nest egg — protecting the downside is more important than trying to maximize the upside. While the sample risk-balanced portfolio and the 60/40 also have high average maximums, it is the average minimum of the sample risk-balanced portfolio that stands out. This comes back to the greater consistency of returns due to risk diversi� cation, which leads to a lower probability of experiencing a signi� cant and lengthy drawdown, which can be devastating if it occurs early in retirement. This risk diversi� cation, coupled with the modest use of leverage on low volatility, diversifying asset classes, allows the portfolio to target higher levels of return without compromising its consistency.

Introducing the New GlidepathLet’s return to Exhibit 6’s ef� cient frontier. That frontier is widely accepted across the investment community as the foundational basis for portfolio de-risking. However, through more innovative portfolio engineering, we can improve upon the potential pitfalls of investing at either end of that frontier. Along with the traditional ef� cient frontier, Exhibit 12 includes what we would term as the new glidepath.

Exhibit 12: Breaking down traditional barriers can allow investors to avoid some of the pitfalls of the traditional glidepathPlotting different blends of the sample risk-balanced portfolio and risk-free asset versus the traditional efficient frontier, December 1970–September 2012

100% S&P 500 Index80/20

60/40

40/60

20/80

100% Barclays U.S. Aggregate Bond Index

100% Risk balance

80% Risk, 20% RFA*

60% Risk, 40% RFA*

40% Risk, 60% RFA*

20% Risk, 80% RFA*

0.0

1.0

2.0

3.0

4.0

5.0

6.0

7.0

8.0

0.0

2.0

4.0

6.0

8.0

10.0

12.0

14.0

16.0

18.0

Exce

ss re

turn

(%)

Volatility (%)

The New Glidepath

*RFA = Risk-free asset



This illustration assumes reinvestment of all income and does not re� ect sales charges, fees or expenses. This example is for illustrative purposes only and is not representative of the performance of any particular investment or product. It is not possible to invest directly in an index.


12

On the new glidepath, we have established our highest expected Sharpe ratio6 portfolio. The version of that portfolio with the highest expected return and volatility may be the one investors choose to keep when aiming to stretch the nest egg further to fund retirement. If investors don’t need to invest so aggressively, they can reduce the amount of risk they take by simply reallocating away from the sample risk-balanced portfolio and into a risk-free asset (RFA). This is a departure from the traditional de-risking approach of asset class rotation, which can introduce new issues such as reconcentrating risk in bonds (Exhibit 8).

Improve your chances of achieving retirement success through better portfolio engineeringAfter a professional lifetime spent working toward achieving � nancial stability in retirement, the last thing investors want to do is to let their portfolio get blindsided by a market risk that could have been avoided. Experiencing a signi� cant portfolio loss in the early retirement years (timing risk) is one of the greatest risks to the longevity of a retirement nest egg (shortfall risk). This risk is typically a function of being concentrated in the wrong asset class — any asset class — at the wrong time. Investors don’t need to accept this. By looking at a portfolio through a risk lens, gaining a greater understanding of what drives asset classes in order to achieve true economic diversi� cation, and allowing the questioning of conventional portfolio constraints, investors can gain valuable insight into building a portfolio that minimizes concentration risk and can increase the chances of achieving retirement success.

6 Sharpe ratio is de� ned as the ratio of excess return (i.e., returns above cash) to risk. A higher Sharpe ratio can translate as more return at the same level of risk or the same return with less risk.

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Appendix A: Less severe drawdowns for a sample risk-balanced portfolio than the 60/40 (%)7

Sample risk-balanced portfolio Financial Crisis '73–'74 Oil Shock Tech Bubble '87 Market Crash/S&L Crisis

Drawdown -20.9% -14.9% -9.2% -7.6%

Drawdown duration (months) 8 14 11 3

Peak-to-peak duration (months) 30 30 19 14

60/40 Financial Crisis '73–'74 Oil Shock Tech Bubble '87 Market Crash/S&L Crisis

Drawdown -32.3% -29.0% -21.2% -17.5%

Drawdown duration (months) 16 21 25 3

Peak-to-peak duration (months) 38 37 41 17

60

65

70

75

80

85

90

95

100

105

12

/70

12

/75

12

/80

12

/85

12

/90

12

/95

12

/00

12

/05

12

/11

Sample risk-balanced portfolio 60/40

Past performance does not guarantee future results. Source: Columbia Management Investment Advisers, LLC, April 2012. The 60/40 is composed of 60% S&P 500 Index/40% Barclays U.S. Aggregate Index, rebalanced monthly. Please see disclosures on the construction of the sample risk-balanced portfolio at the end of this paper. This example is for illustrative purposes only and is not representative of any particular investment or product. It is not possible to invest directly in an index.

7 A drawdown is the peak-to-trough decline during a speci� c record period of an investment. A drawdown is usually quoted as the percentage between the peak and the trough.


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Appendix B

December 1970–September 2012 Return (%) Excess return (%)8 Risk (%)9 Sharpe ratio

Sample risk-balanced portfolio 12.55 6.68 9.99 0.67

60/40 9.90 3.80 10.10 0.38

U.S. equity 10.70 4.70 15.60 0.30

Non-U.S. developed equity 10.20 4.20 17.40 0.24

Emerging market equity 13.50 7.40 22.20 0.34

U.S. aggregate bond market 7.80 1.80 5.40 0.33

U.S. Treasuries 7.90 1.80 5.40 0.34

Non-U.S. government bonds 7.90 1.90 4.30 0.44

U.S. high-yield bonds 9.50 3.50 9.00 0.39

Commodities 10.30 4.30 17.20 0.25

Gold 8.70 2.60 21.00 0.13



Asset classes are represented by the S&P 500 Index, MSCI EAFE Index, MSCI Emerging Markets, Barclays U.S. Treasury Index, Citigroup World Government Bond Index ex. U.S., BofA Merrill Lynch High Yield Index, Dow Jones/UBS Commodity Index and S&P GSCI Gold Index. The 60/40 is represented by 60% S&P 500 Index/40% Barclays U.S. Aggregate Bond Index, rebalanced monthly. Please see disclosures on the construction of the sample risk-balanced portfolio at the end of this paper. This illustration assumes reinvestment of all income and does not re� ect sales charges, fees or expenses. This example is for illustrative purposes only and is not representative of the performance of any particular investment or product. It is not possible to invest directly in an index.

8 Excess return is any return in excess of the risk-free return one would have earned on cash (for this calculation, the risk-free return is the federal funds rate).9 Risk here equates to the standard deviation. In � nance, standard deviation is applied to the annual rate of return of an investment to measure the

investment’s volatility.

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Columbia Management is committed to delivering insight on subjects of critical importance, including insight on � nancial markets, global and economic issues and investor needs and trends. Our investment team examines the issues from multiple perspectives, and we’re not afraid to take a strong stand or point out opportunities — even when there is no clear consensus.

By turning knowledge into insight, Columbia Management thought leadership can provide:

> A deeper understanding of investment themes, trends and opportunities

> A framework for more informed � nancial decision-making

Access the insight, intellectual strength and practical wisdom of our experienced team.

Find more white papers and commentaries in the market insights section of our website columbiamanagement.com/market-insights

To learn more about the support and services available to you, contact your Columbia Management representative at 800.426.3750.


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The views expressed are as of April 2013, may change as market or other conditions change and may differ from views expressed by other Columbia Management Investment Advisers, LLC (CMIA) associates or af� liates. Actual investments or investment decisions made by CMIA and its af� liates, whether for its own account or on behalf of clients, will not necessarily re� ect the views expressed. This information is not intended to provide investment advice and does not account for individual investor circumstances. Investment decisions should always be made based on an investor’s speci� c � nancial needs, objectives, goals, time horizon and risk tolerance. Asset classes described may not be suitable for all investors. Past performance does not guarantee future results and no forecast should be considered a guarantee either. Since economic and market conditions change frequently, there can be no assurance that the trends described here will continue or that any forecasts are accurate.

Columbia Funds are distributed by Columbia Management Investment Distributors, Inc., member FINRA, and managed by Columbia Management Investment Advisers, LLC.

© 2013 Columbia Management Investment Advisers, LLC. All rights reserved.

The Dow Jones Industrial Average represents large and well-known U.S. companies. The index covers all industries with the exception of transportation and utilities.

The S&P 500 Index is an unmanaged list of common stocks that includes 500 large companies.

The MSCI EAFE Index, an unmanaged index, is compiled from a composite of securities markets of Europe, Australasia and the Far East.

The MSCI Emerging Markets Index, an unmanaged market capitalization-weighted index, is compiled from a composite of securities markets of 26 emerging market countries.

The Barclays U.S. Treasury Index is an unmanaged index of public obligations of the U.S. Treasury with a remaining maturity of one year or more.

The Citigroup World Government Bond Index ex. U.S. is an unmanaged market capitalization-weighted benchmark and tracks the performance of 17 government bond markets around world, excluding the United States.

The BofA Merrill Lynch High Yield Bond Index, an unmanaged index, provides a broad-based measure of performance of non-investment-grade U.S. domestic bond market.

The Dow Jones/UBS Commodity Index is a futures commodity index listing 19 different commodities in the United States. It is designed to be a diversi� ed and liquid index tracking the performance of physical commodities in the United States. It weights the commodities listed according to liquidity and dollar-adjusted production data.

The S&P GSCI Index is a composite index of commodity sector returns representing an unleveraged, long-only investment in commodity futures that is broadly diversi� ed across the spectrum of commodities.

The S&P GSCI Gold Index only considers the gold portion of the larger GSCI index.

The Barclays U.S. Aggregate Bond Index is a market capitalization-weighted index, meaning the securities in the index are weighted according to the market size of each bond type. Most U.S. traded investment-grade bonds are represented. Municipal bonds and Treasury In� ation-Protected Securities are excluded due to tax treatment issues. The index includes Treasury securities, government Agency bonds, mortgage-backed bonds, Corporate bonds and a small amount of foreign bonds traded in the United States.

The sample risk-balanced portfolio was created by allocating volatility contributions equally across three different asset classes — stocks, bonds and in� ation-hedging assets. The portfolio was rebalanced monthly. Volatility estimates were created by Columbia Management using a proprietary risk estimation process to estimate forward looking volatility. Indices used as part of the sample risk-balanced portfolio may include the S&P 500 Index, MSCI EAFE Index, MSCI Emerging Markets Index, GSCI Gold Index, Dow Jones/UBS Commodity Index, Barclays U.S. Treasury Index and the Citigroup World Government Bond Index ex-U.S. The sample risk-balanced portfolio also allowed for the use of leverage. Leveraging can expose a portfolio to greater risks due to unanticipated market movements, which may magnify losses and increase volatility of returns. There is no assurance that a portfolio that uses leverage will be successful.

To learn more about the support and services available to you, contact Columbia Management at 800.426.3750.

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