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Build Your Own Pension FPA Webinar

Slides from the 9/28/2011 FPA webinar "Build Your Own Pension." With the decline of pensions, clients will look to their own accounts to provide predictable retirement income. We show how advisors can create pension-like income using institutional liability driven investing (LDI) strategies.

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© Copyright Asset Dedication 2011




Build Your Own Pension

      Presented By:
    Professor Stephen Huxley
                &
           Brent Burns
© Copyright Asset Dedication 2011




 The Transfer of Retirement Burden
From Corporate Pensions to 401(k)s
© Copyright Asset Dedication 2011




  “The purpose of a pension plan is to
 provide retirement income security for
the remaining life of the plan member.”




Source: Pensions Institute
© Copyright Asset Dedication 2011




 “In short, to eliminate the risk that the
 pensioner outlives his/her resources.”




Source: Pensions Institute
© Copyright Asset Dedication 2011




   Liability-driven investing (LDI) is
   an investment strategy based on
    the cash flows needed to fund
            future liabilities



Source: Wikipedia
© Copyright Asset Dedication 2011




              Income Matching Defined
 “The income matching approach focuses
 on minimizing variation in funding status.
  Through risk-management techniques,
   asset performance is linked to liability
  changes with the goal of ensuring that
  assets are sufficient to pay liabilities at
            each point in time.”


Source: Vanguard Investment Counseling and Research
Ad

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Build Your Own Pension FPA Webinar

  • 1. © Copyright Asset Dedication 2011 Build Your Own Pension Presented By: Professor Stephen Huxley & Brent Burns
  • 2. © Copyright Asset Dedication 2011 The Transfer of Retirement Burden From Corporate Pensions to 401(k)s
  • 3. © Copyright Asset Dedication 2011 “The purpose of a pension plan is to provide retirement income security for the remaining life of the plan member.” Source: Pensions Institute
  • 4. © Copyright Asset Dedication 2011 “In short, to eliminate the risk that the pensioner outlives his/her resources.” Source: Pensions Institute
  • 5. © Copyright Asset Dedication 2011 Liability-driven investing (LDI) is an investment strategy based on the cash flows needed to fund future liabilities Source: Wikipedia
  • 6. © Copyright Asset Dedication 2011 Income Matching Defined “The income matching approach focuses on minimizing variation in funding status. Through risk-management techniques, asset performance is linked to liability changes with the goal of ensuring that assets are sufficient to pay liabilities at each point in time.” Source: Vanguard Investment Counseling and Research
  • 7. © Copyright Asset Dedication 2011 Contrasting Total Return “The skeptical view is that total return ignores liabilities. In reality, the total-return approach is an attempt to grow assets at a faster rate than liabilities.” Source: Vanguard Investment Counseling and Research
  • 8. © Copyright Asset Dedication 2011 De-risking Retirement Income • Reduce uncertainty of funding spending needs • Reduce sensitivity to market risks – Interest rate risk – Equity market risk
  • 9. © Copyright Asset Dedication 2011 Case Study • Client age: 65 • Plan Horizon: 30 years • Portfolio Balance: $2,000,000 • Annual Spending: $100,000 • Expected Inflation: 3%
  • 10. Lifetime Spending Needs $2MM Portfolio, $100K/Yr, 3% Inflation
  • 11. Initial 8 Years of Spending Needs Year 1 8 Years of Income
  • 12. © Copyright Asset Dedication 2011 Building An Income Matching Portfolio Portfolio Target Cash Cash Year Issue Principal Interest Flows Flows 2012 CD $77,000 $22,905 $99,905 $100,000 2013 CD $82,000 $21,416 $103,416 $103,000 2014 CD $86,000 $20,035 $106,035 $106,090 2015 CD $91,000 $17,818 $108,818 $109,273 2016 CD $98,000 $14,855 $112,855 $112,551 2017 CD $104,000 $11,713 $115,713 $115,927 2018 CD $112,000 $7,455 $119,455 $119,405 2019 Agency Bond $121,000 $2,496 $123,496 $122,987 $889,692 $889,234 Quotes: 9/6/2011
  • 13. © Copyright Asset Dedication 2011 Target Income Stream Portfolio Target Cash Cash Year Issue Principal Interest Flows Flows 2012 CD $77,000 $22,905 $99,905 $100,000 2013 CD $82,000 $21,416 $103,416 $103,000 2014 CD $86,000 $20,035 $106,035 $106,090 2015 CD $91,000 $17,818 $108,818 $109,273 2016 CD $98,000 $14,855 $112,855 $112,551 2017 CD $104,000 $11,713 $115,713 $115,927 2018 CD $112,000 $7,455 $119,455 $119,405 2019 Agency Bond $121,000 $2,496 $123,496 $122,987 $889,692 $889,234 Quotes: 9/6/2011
  • 14. © Copyright Asset Dedication 2011 Matching Cash Flows to Spending Needs Portfolio Target Cash Cash Year Issue Principal Interest Flows Flows 2012 CD $77,000 $22,905 $99,905 $100,000 2013 CD $82,000 $21,416 $103,416 $103,000 2014 CD $86,000 $20,035 $106,035 $106,090 2015 CD $91,000 $17,818 $108,818 $109,273 2016 CD $98,000 $14,855 $112,855 $112,551 2017 CD $104,000 $11,713 $115,713 $115,927 2018 CD $112,000 $7,455 $119,455 $119,405 2019 Agency Bond $121,000 $2,496 $123,496 $122,987 $889,692 $889,234 Quotes: 9/6/2011
  • 15. © Copyright Asset Dedication 2011 Timing The Cash Flows Portfolio Target Cash Cash Year Issue Principal Interest Flows Flows 2012 CD $77,000 $22,905 $99,905 $100,000 2013 CD $82,000 $21,416 $103,416 $103,000 2014 CD $86,000 $20,035 $106,035 $106,090 2015 CD $91,000 $17,818 $108,818 $109,273 2016 CD $98,000 $14,855 $112,855 $112,551 2017 CD $104,000 $11,713 $115,713 $115,927 2018 CD $112,000 $7,455 $119,455 $119,405 2019 Agency Bond $121,000 $2,496 $123,496 $122,987 $889,692 $889,234 Quotes: 9/6/2011
  • 16. © Copyright Asset Dedication 2011 Portfolio Costs 8 Years = $829,656 Total Income = $889,692
  • 17. © Copyright Asset Dedication 2011 Portfolio Costs 8 Years = $829,656 (60/40) 10 Years = $1,035,495 (50/50) 30 Years = $2,753,814 (0/100) Quotes: 9/6/2011
  • 18. © Copyright Asset Dedication 2011 Portfolio Costs 8 Years = $829,656 (60/40) 10 Years = $1,035,495 (50/50) 30 Years = $2,753,814 (0/100) 30-year portfolio exceeds resources Quotes: 9/6/2011
  • 19. © Copyright Asset Dedication 2011 Partial Income Matching • Best of Income Matching – Predictable cash flows protected from interest rate risk • Best of Total Return – Higher long term expected return
  • 21. Income Growth Portfolio Portfolio
  • 22. © Copyright Asset Dedication 2011 Protected Principal and Predictable Income
  • 23. © Copyright Asset Dedication 2011 Protected Principal and Predictable Income
  • 24. © Copyright Asset Dedication 2011 Protected Principal Higher Expected Return and but Predictable Income Short-term Volatility
  • 25. © Copyright Asset Dedication 2011 Protected Principal Higher Expected Return and but Predictable Income Short-term Volatility
  • 26. © Copyright Asset Dedication 2011 Protected Principal Higher Expected Return and but Predictable Income Short-term Volatility
  • 27. Lifetime Spending Needs $2MM Portfolio, $100K/Yr, 3% Inflation
  • 28. © Copyright Asset Dedication 2011 Portfolio Critical Path®
  • 29. Year 1 8 Years of 22 Years of Uncertainty Income
  • 30. Year 2 8 Years of 21 Years of Uncertainty Income Roll or Don’t Roll? ? ? ? ?
  • 31. Year 2 8 Years of 21 Years of Uncertainty Income Above CP → Roll 1 Year
  • 32. Year 3 8 Years of 20 Years of Uncertainty Income Above CP → Roll 1 Year
  • 33. Year 4 8 Years of 19 Years of Uncertainty Income Above CP → Roll 1 Year
  • 34. Year 5 8 Years of 18 Years of Uncertainty Income Above CP → Roll 1 Year
  • 35. © Copyright Asset Dedication 2011 Show above
  • 36. Year 6 15 Years of 10 Years of Income Uncertainty Well Above CP → Roll 2 Years
  • 37. © Copyright Asset Dedication 2011 Show above
  • 38. Year 7 9 Years of 15 Years of Income Uncertainty Not Above CP → Don’t Roll
  • 39. © Copyright Asset Dedication 2011 Show above
  • 40. Year 8 8 Years of 15 Years of Income Uncertainty Not Above CP → Don’t Roll
  • 41. © Copyright Asset Dedication 2011 Show above
  • 42. Year 9 8 Years of 14 Years of Income Uncertainty Above CP → Roll 1 Year
  • 43. © Copyright Asset Dedication 2011 Why Not a Bond Ladder? • Cash flows are not tied to actual needs • Income is more expensive
  • 44. © Copyright Asset Dedication 2011 Why Not a Bond Ladder? Bond Income Target Cash Year Ladder Portfolio Flows 2012 $133,636 $103,297 $100,000 2013 $131,428 $108,750 $103,000 2014 $130,452 $111,082 $106,090 2015 $122,982 $113,612 $109,273 2016 $121,468 $116,438 $112,551 2017 $113,690 $119,099 $115,927 2018 $106,378 $121,714 $119,405 2019 $101,330 $124,691 $122,987 2020 $104,576 $127,180 $126,677 2021 $96,636 $130,502 $130,477 Total Cash Flow $1,162,576 $1,176,366 Cost $1,052,363 $1,051,250 Quotes: 9/6/2011
  • 45. © Copyright Asset Dedication 2011 Why Not a Bond Ladder? Bond Income Target Cash Year Ladder Portfolio Flows 2012 $133,636 $103,297 $100,000 2013 $131,428 $108,750 $103,000 $13,790 2014 $130,452 $111,082 $106,090 2015 $122,982 $113,612 $109,273 2016 $121,468 $116,438 $112,551 2017 $113,690 $119,099 $115,927 2018 Greater Total Cash Flow $106,378 $121,714 $119,405 2019 $101,330 $124,691 $122,987 2020 From Income Portfolio $104,576 $127,180 $126,677 2021 $96,636 $130,502 $130,477 Total Cash Flow $1,162,576 $1,176,366 Cost $1,052,363 $1,051,250
  • 46. © Copyright Asset Dedication 2011 Why Not a Bond Fund • Volatility around funding • Sensitivity to rising interest rates
  • 47. 10 Year US Treasury Bond Yields 1800-2010
  • 48. Bond Fund Volatility Revealed Rising Interest Rates 1950-1981 10-year Treasury Index is the proxy for high quality bond funds
  • 49. Bond Fund Volatility Revealed Rising Interest Rates 1950-1981 10-year Treasury Index is the proxy for high quality bond funds
  • 50. Bond Fund Income Variability/Shortfall Comparison Over 8-Year Horizons 1950-1981 Starting value = cost of 8-year Income Portfolio for each year. Target cash flows = $100,000/year plus 3% inflation. 10-year Treasury Index is the proxy for high quality bond funds
  • 51. © Copyright Asset Dedication 2011 Why Not A Period Certain Annuity? • Expensive • Inflexible Quotes: 9/6/2011 www.immediateannuity.com
  • 52. © Copyright Asset Dedication 2011 Why Not A Period Certain Annuity? Year Period Certain Income Portfolio 2012 $95,400 $98,235 2013 $98,262 $104,183 2014 $101,210 $105,590 2015 $104,246 $108,236 2016 $107,374 $110,222 2017 $110,595 $113,056 2018 $113,913 $115,887 2019 $117,330 $118,115 2020 $120,850 $120,837 2021 $124,475 $124,385 Total Cash Flow $1,093,654 $1,118,746 Cost $1,000,000 $999,808 Quotes: 9/6/2011 www.immediateannuity.com
  • 53. © Copyright Asset Dedication 2011 Why Not A Period Certain Annuity? Year Period Certain Income Portfolio 2012 $95,400 $98,235 2013 $98,262 $104,183 2014 2015 $25,092 $101,210 $104,246 $105,590 $108,236 2016 2017 Greater Total Cash Flow $107,374 $110,595 $110,222 $113,056 2018 $113,913 $115,887 2019 From Income Portfolio $117,330 $118,115 2020 $120,850 $120,837 2021 $124,475 $124,385 Total Cash Flow $1,093,654 $1,118,746 Cost $1,000,000 $999,808
  • 54. © Copyright Asset Dedication 2011 The Hidden Risks of Annuities Since 1991 more that 60 life insurance companies offering annuities have become insolvent and come under the control of the state insurance guarantee system. Cost = $2.8 billion Source: National Organization of Life and Health Insurance Guaranty Associations
  • 55. © Copyright Asset Dedication 2011 In 2008, AIG was the largest issuer of fixed annuities. US Govt capital infusion = $182 billion
  • 56. © Copyright Asset Dedication 2011 Insurance Company Failures According to a CitiGroup study of bank and insurance company failures in the Great Depression, 14% of life insurance companies failed and went out of business between 1929 and 1933.
  • 57. © Copyright Asset Dedication 2011 Which is safer? 1. FDIC Insured CDs and Government Agency bonds OR 2. Insurance companies
  • 58. © Copyright Asset Dedication 2011 Questions? Email info@assetdedication.com for more information on Asset Dedication white papers