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10.23.08 Risk & Volatility
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10.23.08 Risk & Volatility

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Understanding investment risk in a retirement plan using parametric simulation

Understanding investment risk in a retirement plan using parametric simulation

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  • 1. Risk and Volatility What Are The Odds? What Do I Do Now? A discussion of planning for the worst and managing your future. Carey H. McNeal, Partner Buffington Mohr McNeal Registered Investment Advisor © 2008 Morningstar, Inc. All rights reserved. 3/1/2008
  • 2. Types of Risk Market timing Inflation Currency Credit Risk Political/economic Industry/company Liquidity Market Call/reinvestment Interest rate © 2008 Morningstar, Inc. All rights reserved. 3/1/2008
  • 3. Market-Timing Risk The effects of missing the best month of annual returns 40% Return 30 20 10 0 –10 –20 • Annual return • Annual return minus best month –30 –40 1970 1976 1982 1988 1994 2000 2006 Past performance is no guarantee of future results. This is for illustrative purposes only and not indicative of any investment. An investment cannot be made directly in an index. © 2008 Morningstar, Inc. All rights reserved. 3/1/2008
  • 4. Reduction of Risk Over Time 1926–2007 Small stocks Large stocks Government bonds Treasury bills 150% 120 90 60 Compound annual return: 30 12.5% 10.4% 5.5% 3.7% 0 –30 –60 1-year 5-year 20-year 1-year 5-year 20-year 1-year 5-year 20-year 1-year 5-year 20-year Holding period Past performance is no guarantee of future results. Each bar shows the range of compound annual returns for each asset class over the period 1926–2007. This is for illustrative purposes only and not indicative of any investment. An investment cannot be made directly in an index. © 2008 Morningstar, Inc. All rights reserved. 3/1/2008
  • 5. Retirees Face Numerous Risks Longevity Withdrawals „ Long retirement horizons— „ What rate is sustainable? a couple aged 65 has 25% „ Sequencing by tax bucket chance of a survivor living „ Managing RMDs to age 96 Retiree spending Solvency „ Replacement ratio „ Pension plans and retiree „ Essential versus lifestyle benefits—a thing of the past expenses „ Social Security and Medicare „ Medical expenses Retirement income Market volatility Savings „ Uncertain „ Under-funded returns and defined income contribution accounts „ Impact of point in time „ Most Americans have an „ Asset allocation and location enormous savings gap Inflation „ Erodes the value of savings and reduces returns „ Health care inflation 6%+ © 2008 Morningstar, Inc. All rights reserved. 3/1/2008
  • 6. Ibbotson® SBBI® Summary statistics 1926–2007 Compound Arithmetic Risk annual annual (standard return return deviation) Large stocks 10.4% 12.3% 20.0% Small stocks* 12.5% 17.1% 32.6% Government 5.5% 5.8% 9.2% bonds Treasury 3.7% 3.8% 3.1% bills Inflation 3.0% 3.1% 4.2% 0 –90 90 Past performance is no guarantee of future results. *The 1933 small company stock total return was 142.9%. This is for illustrative purposes only and not indicative of any investment. An investment cannot be made directly in an index. © 2008 Morningstar, Inc. All rights reserved. 3/1/2008
  • 7. Discussion of Simulation Criteria and Methodology Many of the following images were created using parametric simulation. This model „ estimates the range of possible outcomes based on a set of assumptions including arithmetic mean (return), standard deviation (risk), and correlation for a set of asset classes. The inputs used herein are the historical 1926–2007 figures. The risk and return of each asset class, cross-correlation, and annual average inflation over this time period follow. Stocks: risk 20.0%, return 12.3%; Bonds: risk 5.7%, return 5.5%; Correlation 0.04; Inflation: return 3.1%. Note that other investments not considered may have characteristics similar or superior „ to those being analyzed. Each simulation produces 35 randomly selected return estimates consistent with the characteristics of the portfolio to estimate the return distribution over a 35-year period. Each simulation is run 5,000 times, to give 5,000 possible 35-year scenarios. A limitation of the simulation model is that it assumes that the distribution of returns is normal. Should actual returns not follow this pattern, results may vary. © 2008 Morningstar, Inc. All rights reserved. 3/1/2008
  • 8. Interpreting Confidence Levels in Simulation Confidence level Chance of exceeding Chance of falling short 50% 50% 50% 75% 75% 25% 90% 90% 10% (More conservative) This table is intended to help interpret 50%, 75%, and 90% confidence levels illustrated in the following images. © 2008 Morningstar, Inc. All rights reserved. 3/1/2008
  • 9. Simulation Can Illustrate the Probability of Achieving Outcomes A visual interpretation of confidence levels in simulation $10 mil 1 mil 100k • 50% confidence level • 75% confidence level • 90% confidence level 10k 65 Years old 70 75 80 85 90 95 100 IMPORTANT: Projections generated by Morningstar regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results, and are not guarantees of future results. Results may vary over time and with each simulation. This is for illustrative purposes only and not indicative of any investment. An investment cannot be made directly in an index. © 2008 Morningstar, Inc. 3/1/2008
  • 10. Ability to Meet Income Need Depends on How Long Portfolio Lasts Simulation of how long a $500,000 portfolio can pay a $30,000 annual need $35k Annual withdrawal/payment (real dollars) 30 25 20 • 50% confidence level • 75% confidence level • 90% confidence level 15 10 5 0 65 years old 70 75 80 85 90 95 100 IMPORTANT: Projections generated by Morningstar regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results, and are not guarantees of future results. Results may vary over time and with each simulation. This is for illustrative purposes only and not indicative of any investment. An investment cannot be made directly in an index. © 2008 Morningstar, Inc. 3/1/2008
  • 11. Probability of Meeting Income Needs Various withdrawal rates and portfolio allocations over a 25-year retirement 4% Withdrawal rate 85% 97% 97% 94% 92% 5% 33% 73% 83% 83% 81% 6% 4% 30% 57% 66% 68% 7% 0% 6% 31% 47% 54% 8% 0% 0% 13% 31% 41% 100% 75% B 50% B 25% B 100% Bonds 25% S 50% S 75% S Stocks IMPORTANT: Projections generated by Morningstar regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results, and are not guarantees of future results. Results may vary over time and with each simulation. This is for illustrative purposes only and not indicative of any investment. An investment cannot be made directly in an index. © 2008 Morningstar, Inc. 3/1/2008
  • 12. Retirees Should Plan for a Long Retirement Probability of a 65-year-old living to various ages 100% • Male • Female • At least one spouse 78 81 86 75 85 88 91 50 91 93 96 25 0 65 years old 70 75 80 85 90 95 100 105 Source: Annuity 2000 Mortality Tables. © 2008 Morningstar, Inc. All rights reserved. 3/1/2008
  • 13. Inflation Significantly Erodes Purchasing Power Over Time Effects of 3% inflation on purchasing power $100k $85,873 80 $73,742 $63,325 $54,379 60 $46,697 $40,101 40 20 0 0 Years 5 10 15 20 25 30 Past performance is no guarantee of future results. This is for illustrative purposes only and not indicative of any investment. © 2008 Morningstar, Inc. All rights reserved. 3/1/2008
  • 14. The Sequence of Returns Can Significantly Affect Your Retirement Sequence of returns matters Actual historical return sequence Reversed historical return sequence $500k $2.5 mil 400 2.0 300 1.5 1.0 200 100 0.5 0 1973 1977 1981 1985 1989 1993 Jul 1993 1989 1985 1981 1977 1973 94 Past performance is no guarantee of future results. Hypothetical value of $500,000 invested at the beginning of 1973 and July 1994. Assumes inflation-adjusted withdrawal rate of 5%. Portfolio: 50% large-company stocks/50% intermediate-term bonds. This is for illustrative purposes only and not indicative of any investment. An investment cannot be made directly in an index. © 2008 Morningstar, Inc. All rights reserved. 3/1/2008
  • 15. Providing for Retirement Income Retirement risks can be managed by intelligent combination of funds, „ stocks and bonds. How do you find the right asset mix for retirement? „ age and risk tolerance „ desire for consumption and bequest „ expenses and fees of investment choices „ © 2008 Morningstar, Inc. All rights reserved. 3/1/2008