I CAPITALPORTFOLIO P INTEGRATED SOLUTIONS SOL Integrating All - - PowerPoint PPT Presentation

CAPITALPORTFOLIO INTEGRATED SOLUTIONS SOL P I

Integrating All Sustainable Sources of Performance to Build the Most Efficient Portfolio Solutions

November 2017

Jacques Lussier, Ph.D., CFA

Chief Investment Officer

Designing A Better Retirement Solution

Ta ble of C ontents

Confidential – Do not circulate 3

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A Simple but Unrealistic Example

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Retirement Solutions What is Offered and Discussed in the Literature

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The Impact of Market Risk

• During the Accumulation Period
• During the Transition & Decumulation Periods

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Beware of What Look T

• o Good to Be

True, It’s Not

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What Have we Learned ?

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A Simple But Unrealistic Example

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When We Know Ever ything

 John is 30 years old & starts savings  He earns $60,000  His income increases yearly by 2%  He systematically saves 10%  He invests in a 60/40 portfolio that generates a stable 5.4% !  He retires at 65  Inflation is 2%  He lives up to age 85

John will generate an inflation adjusted income of 44.7% of his final salary. Without investment returns, he would run out of capital by age 70 + 5 months.

117,641 53,657

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Retirement P la nning I s Ea sy I f We Know…

 Savings starting date  Evolution of real income  The pattern of savings rate  Average and pattern of portfolio’s real returns  Retirement age  Health condition  Age of death  Cost of desired lifestyle after retirement  Reactions to extreme financial risks

Otherwise it is a challenge, but a complex problem may have simpler solutions.

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The C ost of C ompla c ency a nd Fea r C a n B e Hig h

Lower returns alone would have reduced sustainability to 32.0% or 78Y and 4months. How can we deal with returns (investment policy and fears)?

Base Scenario

Age at which Savings Starts

30

Retirement Age

65

Age at Death

85

Savings Rate

10%

Investment Returns

5.4%

Wealth at Retirement – at 65

$777,658

Wealth Attributed to Savings

$299,967

Wealth Attributed to Investment Income

$477,691

Ratio of Retirement Income to Work Income

44.7%

Sustainability Age

85

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8

The C ost of C ompla c ency a nd Fea r C a n B e Hig h

Lower returns alone would have reduced sustainability to 32.0% or 78Y and 4months. How can we deal with returns (investment policy and fears)?

Base Scenario

Age at which Savings Starts

30

Retirement Age

65

Age at Death

85

Savings Rate

10%

Investment Returns

5.4%

Wealth at Retirement – at 65

$777,658

Wealth Attributed to Savings

$299,967

Wealth Attributed to Investment Income

$477,691

Ratio of Retirement Income to Work Income

44.7%

Sustainability Age

85

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Making All the Wrong Choices 40 63 95 10% 4.2% $338,524 $210,971 $127,553 44.7% 69 & 10 Months 12.8% 95

Ratio of Retirement Income to Work Income Sustainability Age

Retirement Solutions What is Offered and Discussed in the Literature

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Wha t the I ndustr y I s Advoc a ting (Glide Pa ths)

Little difference between the least and most aggressive glide paths. All favor a conservative portfolio at least 5 years before retirement.

20% 30% 40% 50% 60% 70% 80% 90% 100%

• 35
• 30
• 25
• 20
• 15
• 10
• 5

5 7 10 15 35

Equity Allocation

Years Pre and Post Retirement

Least Agressive Most Agressive

Initial Pre and Post Retirement Transition

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I n the Absenc e of a Dyna mic Approa c h There is no Definite C onsensus

This ignores investor behavior and this study compares portfolio allocations that have significantly different risk profile.

 Esch & Michaud - Among 101 glide paths (rising, stable and declining) having the same volatility of final wealth, there are no clear winners.

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This ignores investor behavior.

 Arnott – It makes little sense to have the highest allocation to equity when wealth is small and the least when wealth is high.

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Four G lide Pa t hs Whic h is the Most P rofita ble / the Lea st Risky?

0% 20% 40% 60% 80% 100% 30 35 40 45 50 55 60 65

Equity Allocation Age

Flat at 60% From 80% to 40% 40 % to 80% Traditional

Evolution of Equity Allocation Across Time Equity Allocation Path Final Wealth at Retirement Average Equity Percentage Allocation Dollar Weighted Average Equity Allocation Flat at 60%

$777,658 60.0% 60.0%

From 80% to 40%

$744,928 60.0% 50.8%

From 40% to 80%

$811,852 60.0% 69.6%

Traditional Glide Path

$812,181 72.9% 59.1%

Which Glide Path is most likely to be feared & challenged by the participant as he approaches retirement ?

Do not reproduce content of slides and charts without permission 51 years and 5 months

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The Ar nott Ar g umenta tion I g nores the I mpa c t

• f C ompounded Retur ns a nd B ehavior

No reasonable individual would prefer maximum exposure to equity just before retirement even if the argument could be made that the distribution of expected wealth 35 years from now would be the same.

0 $ 100,000 $ 200,000 $ 300,000 $ 400,000 $ 500,000 $ 600,000 $ 700,000 $ 30 35 40 45 50 55 60 65

Equity Allocation Age

Flat at 60% From 80% to 40% 40% to 80% Traditional

Evolution of Equity Allocation Across Time Equity Allocation Path Wealth at 51 Years and 5 Months Wealth at 65 if 40/80 After 51 Years Wealth at 65 if Traditional After 51 years From 40% to 80%

$276,168 $811,852 $715,100

Traditional Glide Path

$313,660 $922,067 $812,181

Difference

$37,392 $110,215 $97,181 Do not reproduce content of slides and charts without permission

The Impact of Market Risk During the Accumulation Period

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Risk/Vola tility is Not Always B a d

Market environment Returns Year 1 Returns Year 2 Returns Year 3 Compounded Returns # A 5,40% 5,40% 5,40% 5.40% # B

• 14,60%

30,08% 5,40% 5.40% # C

• 14,60%

17,09% 17,09% 5.40%

Risk can be a good thing. But what if there is significant wealth already ?

Savings Patterns Cash Flows Year = 0 Cash Flows Year = 1 Cash Flows Year = 2 # 1 $3,000 # 2 $1,500 $1,581 # 3 $1,000 $1,054 $1,110.90

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Lets look at 3 different Value Equivalent Savings patterns

Savings Patterns Final Wealth Market # A Δ Final Wealth Market # B Δ Final Wealth Market # C # 1 $3,512.72 $0.00 $0.00 # 2 $3,512.72 + $411.33 + $411.33 # 3 $3,512.72 + $274.22 + $404.12

And 3 different Market environments

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How Muc h Risk a nd for How Long ?

• 25%
• 20%
• 15%
• 10%
• 5%

0% 5% 10% 30 35 40 45 50 55 60 65

Excess Wealth

Age at which market downturn occurs

Impact of a 20% Under Performance at Different Point in time With and Without Market Recovery

1 Year 3 Years 5 Years No Recovery

Length of market recovery

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No recovery implies 4.73% compounded return vs. 5.4%

If your accumulated wealth is small, you are better off if market downturn happens early and if market recovery is long.

# of Years at 90% Equity allocation 17

A More Rea listic Environment

High risk can be sustained for up to 15 to 20 years prior to retirement.

40 Monte Carlo based on the same 30,000 scenarios

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The longer the horizon, the greater the benefit of taking risk during accumulation The shorter the remaining horizon, the greater the likelihood the expected return will not be met

The level of wealth at the 1% probability level, when the allocation is 60/40 for 40 years is identical to that of an allocation maintained at 90/10 for 20 years and 60/40 for another 20 years.

Vide

What is the likelihood that a portfolio with a 90/10 allocation for “X” years will underperform a stable 60/40 allocation as “X” increases?

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Equity Risk a s a Sha re of Por tfolio Wea lth a nd Hum a n C apit a l

This is why some authors argue for leveraging the retirement portfolio. However, the issue is how to optimize without leverage.

0% 10% 20% 30% 40% 50% 60% 70%

100,000 200,000 300,000 400,000 500,000 600,000 700,000 800,000 30 35 40 45 50 55 60 65

Dollar Amount

Age

Evolution Wealth & Human Capital (Present Value of Future Savings) and Implicit Equity Exposure

Portfolio Wealth - L Human Capital - L Equity / [Port. Wealth + Human Capital] - R Do not reproduce content of slides and charts without permission

This example ignores the impact of Social Security

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The Less You Have Saved the La ter in Time Risk C a n B e Toler a ted!!!

High risk can be sustained for up to 8 to 10 years prior to retirement.

Do not reproduce content of slides and charts without permission # of Years at 90% Equity allocation

What is the likelihood that a portfolio with a 90/10 allocation for “X” years will underperform a stable 60/40 allocation as “X” increases?

The level of wealth at the 1% probability level, when the allocation is 60/40 for 15 years is identical to that of an allocation maintained at 90/10 for 6 years and 60/40 for another 9 years.

Based on 30,000 scenarios

The Impact of Market Risk During the Transition & Decumulation Periods

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Wha t About the Risk Tr a nsition

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Having too many (up to 12) transition points is useless

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How to manage risks but keep a high income payout?

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30% to 40% equity vs. 60% equity has a significant impact over 30 years

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Risk has more adverse consequences during Decumulation A lower risk can cost years of sustainability.

Do not reproduce content of slides and charts without permission 0% 20% 40% 60% 80% 100% 30 35 40 45 50 55 60 65 70 75 80

Equity Allocation of Different Glide Path

Flat at 60% Traditional (from 90% to 60%) Known Glide Path

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Tr a ditiona l Glide Pa th Have a M ore appropr ia te Ra tio

• f Equity Assets to Tota l Wea lth

The declining glide path (from 90% to 60%) allows for a more stable allocation to equity without using leverage.

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0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100% 30 35 40 45 50 55 60 65

Dollar Amount

Age

Equity as a % of T

• tal Wealth (Portfolio Wealth and Human Capital)

Flat at 60% Traditional This example ignores the impact of Social Security

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More Risk C a n Lea d to Grea ter Susta ina bility of Expec ted I nc ome but…

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• 1,500,000 $
• 1,000,000 $
• 500,000 $

0 $ 500,000 $ 1,000,000 $ 30 35 40 45 50 55 60 65 70 75 80 85 90

Equity Allocation Age

Flat at 60% Traditional Known Glide Path

Sustainability

How can we tolerate greater risk to achieve greater sustainability ?

24 Do not reproduce content of slides and charts without permission

I nteg r a ting Por tfolio & Soc ia l Sec ur ity

The analysis must include the impact of SS

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Break-even point + 14Y

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I nteg r a ting Por tfolio, Annuities & Soc ia l Sec ur ity

Well-Known Path

Beware of What Looks T

• o Good

T

• Be

True, It’s Not!

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I mpa c t of Using a C ostly I nsur a nc e P roduc t (GLWB )

High fees neutralize the benefits of the guarantees.

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Probability that Wealth is Greater than the 90% to 60% Glide Path with 30% Annuity

At Age Probability based on Normal T erms Better GLWB T erms 60 0.06% 0.09% 65 17.56% 17.76% 70 9.86% 9.85% 75 2.96% 3.55% 80 0.48% 1.11% 85 0.00% 1.91% 90 0.04% 6.08% 95 0.18% 12.24% 100 0.42% 18.93%

Source : IPSOL Capital Based on 50,000 scenarios

What Have We Learned ?

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Wha t Have We Lea r ned ?

 The traditional glide path that allows for a high equity allocation early on is the right one. The issue is the path of the transition and the “lower” level of risk when the transition is completed.  Having too many transitions points in a static process brings no benefit.  A higher level of risk can be maintained later in time for individuals with low level of current wealth.  Social Security must be included to do a proper sustainability analysis – because of the inflation protection property of SS benefits.  It is beneficial to include single premium annuities with a ten-year guarantee.  These few changes can extend income sustainability by 3 to 6 years (assuming equal fees) against a standard low-cost product.  Higher fees can reduce sustainability by 3 to 4 years against a standard low-cost product.

The cumulative impact of a better retirement strategy has a significant impact on retirement income.

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Wha t Else C a n We I mprove

 Linking timing and size of annuities purchase to market conditions  Combining annuities having different characteristics  Optimizing asset allocation considering existing vs. future wealth  Building a decumulation engine - Decumulating smartly in crises time  Linking retirement income to lifestyle  Optimizing Social Security timing  Optimizing from a household perspective  Optimizing allocation across different investment vehicles: taxable, tax deferred, tax- exempt  …  More efficient assets is last aspect to be optimized !!! Using more efficient investment products should be an option.

We are far from the most efficient solution but we will likely have a more comprehensive model by end of 2018.

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