INTEGRATEDICAPITALPORTFOLIOP SOLUTIONSSOL - CFA Montreal€¦ · Do not reproduce content of slides and charts without permission Lets look at 3 different Value Equivalent Savings

CAPITALPORTFOLIOINTEGRATED SOLUTIONSSOLPI

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 b l e o f C o n t e n t s

Confidential – Do not circulate 3

+ A Simple but Unrealistic Example 4

+ Retirement Solutions

What is Offered and Discussed in the Literature9

+ The Impact of Market Risk

- During the Accumulation Period

- During the Transition & Decumulation Periods1420

+ Beware of What Look Too Good to Be True, It’s Not 26

+ What Have we Learned ? 28

A SimpleBut Unrealistic Example

4

Do not reproduce content of slides and charts without permission 5

W h e n We K n ow E ve r y t h i n g

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

6

R e t i re m e n t P l a n n i n g I s E a s y I f We K n ow …

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.

Do not reproduce content of slides and charts without permission

7

T h e C o s t o f C o m p l a c e n c y a n d Fe a r C a n B e H i g 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 30Retirement Age 65Age at Death 85Savings Rate 10%Investment Returns 5.4%Wealth at Retirement – at 65 $777,658Wealth Attributed to Savings $299,967Wealth Attributed to Investment Income $477,691Ratio of Retirement Income to Work Income 44.7%Sustainability Age 85


8

T h e C o s t o f C o m p l a c e n c y a n d Fe a r C a n B e H i g 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 30Retirement Age 65Age at Death 85Savings Rate 10%Investment Returns 5.4%Wealth at Retirement – at 65 $777,658Wealth Attributed to Savings $299,967Wealth Attributed to Investment Income $477,691Ratio of Retirement Income to Work Income 44.7%Sustainability Age 85


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 Offeredand Discussed in the Literature

9

10

W h a t t h e I n d u s t r y I s A d vo c a t i n g ( G l i d e Pa t h s )

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 0 5 7 10 15 35

Equity

Allo

cation

Years Pre and Post Retirement

Least Agressive Most Agressive

Initial

Pre and Post Retirement

Transition


11

I n t h e A b s e n c e o f a D y n a m i c A p p ro a c h T h e re i s n o D e f i n i t e C o n s e n s u s

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.


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.

12

Fo u r G l i d e Pa t h sW h i c h i s t h e M o s t P ro f i t a b l e / t h e L e a s t R i s k y ?

0%

20%

40%

60%

80%

100%

30 35 40 45 50 55 60 65

Equity

Allo

cation

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 ?


51 years and 5 months

13

T h e A r n o t t A r g u m e n t a t i o n I g n o re s t h e I m p a c to f C o m p o u n d e d R e t u r n s a n d B e h av i o r

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

Allo

cation

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


The Impact of Market Risk During the Accumulation Period

14

15

R i s k / Vo l a t i l i t y i s N o t A lw ay s 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


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

16

H ow M u c h R i s k a n d fo r H ow L o n g ?

-25%

-20%

-15%

-10%

-5%

0%

5%

10%

30 35 40 45 50 55 60 65

Exce

ss W

eal

th

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


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 M o re R e a l i s t i c E nv i ro n m e n t

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


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 90/10allocation for “X” years will underperform a stable 60/40

allocation as “X” increases?

18

E q u i t y R i s k a s a S h a re o f Po r t fo l i o We a l t ha n d H u m a n C a p i t 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%

0

100,000

200,000

300,000

400,000

500,000

600,000

700,000

800,000

30 35 40 45 50 55 60 65

Dolla

r A

mount

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


This example ignores the impact of Social Security

19

T h e L e s s Yo u H ave S ave dt h e L a t e r i n T i m e R i s k C a n B e To l e r a t e d ! ! !

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


# of Years at 90% Equity allocation

What is the likelihood that a portfolio with a 90/10allocation 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

20

21

W h a t A b o u t t h e R i s k Tr a n s i t i o n

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

+ How to manage risks but keep a high income payout?

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

– Risk has more adverse consequences during Decumulation

A lower risk can cost years of sustainability.


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

22

Tr a d i t i o n a l G l i d e Pa t h H ave a M o re ap p ro p r i a t e R a t i o o f E q u i t y A s s e t s t o To t a l We a l t h

The declining glide path (from 90% to 60%) allows for

a more stable allocation to equity without using leverage.


0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

30 35 40 45 50 55 60 65

Dolla

r A

mount

Age

Equity as a % of Total Wealth (Portfolio Wealth and Human Capital)

Flat at 60% Traditional

This example ignores the impact of Social Security

23

M o re R i s k C a n L e a d t o G re a t e r S u s t a i n a b i l i t y o f E x p e c t e d I n c o m e b u t …


-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

Allo

cation

Age

Flat at 60% Traditional Known Glide Path

Sustainability

How can we tolerate greater risk to achieve greater sustainability ?

24Do not reproduce content of slides and charts without permission

I n t e g r a t i n g Po r t fo l i o & S o c i a l S e c u r i t y

The analysis

must include the

impact of SS

25

Break-even

point + 14Y


I n t e g r a t i n g Po r t fo l i o , A n nu i t i e s & S o c i a l S e c u r i t y

Well-Known Path

Beware of What Looks Too GoodTo Be True, It’s Not!

26

27

I m p a c t o f U s i n g a C o s t l y I n s u r a n c e P ro d u c t ( G LW B )

High fees neutralize the benefits of the guarantees.


Probability that Wealth is Greater than the 90% to 60%

Glide Path with 30% Annuity

At Age

Probability based on

Normal Terms Better GLWB Terms

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 ?

28

29

W h a t H ave We L e a r n e d ?

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.


30

W h a t E l s e C a n We I m p rove

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.


Documents

INTEGRATEDICAPITALPORTFOLIOP SOLUTIONSSOL - CFA Montreal€¦ · Do not reproduce content of slides and charts without permission Lets look at 3 different Value Equivalent Savings