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Which is the Optimal Portfolio in Retirement?

Which is the Optimal Portfolio in Retirement?. Van Harlow 19 May 2006. FOR DUE DILIGENCE ATTENDEES. Retirement.

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Which is the Optimal Portfolio in Retirement?

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  1. Which is the Optimal Portfolio in Retirement? Van Harlow 19 May 2006 FOR DUE DILIGENCE ATTENDEES

  2. Retirement Which is the optimal portfolio in retirement?orGiven my current assets and retirement expenses, which portfolio provides me with a reasonable probability of funding my retirement years?

  3. Retirement Given my current assets and retirement expenses, which portfolio provides me with a reasonable probability of funding my retirement years? The answer depends on: • Longevity • Distribution Rate • Expected Returnsand Volatility • Portfolio Funding Profile

  4. Longevity Life Expectancy at Birth for Selected Countries: Circa 1998 Circa 1950 Source: U.S. Census Bureau, International Programs Center, International Database, Gender and Aging: Mortality and Health, 1B/98-2. *Population Division of the Department of Economic and Social Affairs of the United Nations Secretariat, 2003. World Population Prospects: The 2002 Revision.

  5. Life Expectancy at Birth for Selected Countries:Males 1950 and 1988 Longevity Source: U.S. Census Bureau, International Programs Center, International Database, Gender and Aging: Mortality and Health, 1B/98-2.

  6. Life Expectancy at Birth for Selected Countries:Females 1950 and 1988 Longevity Source: U.S. Census Bureau, International Programs Center, International Database, Gender and Aging: Mortality and Health, 1B/98-2.

  7. Longevity Life Spans 85 92 95 100 Age MALE AGE 65 25% chance of living to 92 50% chance of living to 85 88 94 100 90 Age FEMALE AGE 65 25% chance of living to 94 50% chance of living to 88 92 97 95 85 COUPLES (BothAGE 65) Age At least one person has a 50% chance of living to 92 At least one person has a 25% chance of living to 92 Source: Annuity 2000 Morality Table. Figures assume you are in good health.

  8. Retirement • Longevity • Distribution Rate • Expected Returns and Volatility • Portfolio Funding Profile

  9. Distribution Rate 9% Withdrawal Rate 8% Withdrawal Rate 7% Withdrawal Rate 6% Withdrawal Rate 5% Withdrawal Rate 4% Withdrawal Rate 85 90 95 Age 70 75 80 COUPLES(Both Age 65) Probability that at least one will be alive: 83% 63% 35% Hypothetical value of assets held in a taxable account of $500,000 invested at year-end 1972. Portfolio: 50% stocks, 40% bonds, 10% cash.

  10. Number of years a portfolio can last in distribution Distribution Rate 0 10 20 30 40 50 10% 9% 8% 7% 6% 5% 4% Years *Hypothetical portfolio of assets held in a taxable account consists of 50% bonds and 50% stocks, assumes average annual return of 8.7%.

  11. Retirement • Longevity • Distribution Rate • Expected Returns and Volatility • Portfolio Funding Profile

  12. Expected Returns • Long-term view of historical returns provides the best estimates for risks and correlations • A risk premium approach is best for estimating asset class returns since it provides a long-term perspective of return expectations consistent with the investment horizon of retirement portfolios

  13. Expected Returns Risk Premium • The risk premium approach to estimating expected returns identifies the market’s required return premium for accepting asset class risk and adds that to the risk-free return (real risk-free return plus inflation) Rt = (1 + Inft) (1 + RRft) (1 + RPt) – 1 where Inft = inflation rate RRft = real risk free rate RPt = risk premium RPt Risk Premium Real risk-free return RRft Inft Inflation

  14. Expected Returns Estimating the Risk Premium • Historical • Fundamental • Economic • Surveys

  15. Other Approaches to Estimating the Risk Premium Literature Review • Historical evidence • Ibbotson Associates (US Markets, 2004) 8.0% • Jorian and Guetzmann (Journal of Finance, 1999) 4.3% • Siegel (Financial Analysts Journal, 1992) 0.6% - 5.9% • Dimson, Marsh and Stanton (Business Strategy Review, 2000) 5.8% • Fundamental Estimates • Fama and French (University of Chicago, 2000) 2.55% - 4.32% • Ibbotson and Chen (Financial Analysts Journal, 2003) 4.0% • Claus and Thomas (Journal of Finance, 2001) 3.0% • Arnott and Bernstein (Financial Analysts Journal, 2002) 0% - 2.4% • Economic Estimates • Mehra and Prescott (Journal of Monetary Economics, 1985) <1.0% • Surveys • Welch (Journal of Business, 2000) 4.0% • Graham and Harvey (Duke University, 2001) 3.9% - 4.7% US EquityRisk Premium Estimates

  16. Historical Real Returns 1993-2006 25% Equities Bonds 20% 15% 10% Annualized Volatility 5% 0% -5% UK Italy USA Chile Israel Spain Japan Austria Ireland Mexico France Finland Greece Norway Canada Belgium Sweden Portugal Australia Denmark Germany Argentina Switzerland Netherlands South Africa New Zealand Source: Global Financial Data

  17. Risk Premium versus Cash 1993-2006 20% Equities-Cash Bonds-Cash 15% 10% 7.17% Annualized Risk Premium, % 5% 3.07% 0% -5% UK Italy USA Chile Israel Spain Japan Austria Ireland France Mexico Finland Greece Norway Canada Belgium Sweden Portugal Australia Denmark Germany Argentina Switzerland Netherlands South Africa New Zealand

  18. Risk Premium versus Bonds 1993-2006 15% 10% Annualized Risk Premium, % 5% 4.21% 0% -5% UK Italy USA Chile Spain Japan Austria Ireland France Finland Norway Canada Belgium Sweden Portugal Australia Denmark Germany Switzerland Netherlands New Zealand

  19. Historical Volatilities 1993-2006 45% Equities Bonds 40% 35% 30% 25% Annualized Volatility 20% 15% 10% 5% 0% UK Italy USA Chile Israel Spain Japan Austria Ireland France Mexico Finland Greece Norway Belgium Canada Sweden Portugal Australia Denmark Germany Argentina Switzerland South Africa Netherlands New Zealand

  20. Risk and Return Assumptions Asset Class Assumptions Note: 10-year CLP bond yield is 6.15% 10-year UF bond yield is 2.85%

  21. Correlations (Unhedged Peso) 1/93 -2/06 Risk and Return Assumptions Domestic Stocks Developed Stocks Emerging Stocks Domestic Bonds Domestic Cash Domestic Stocks 100.0% 35.3% 67.1% 18.3% -0.2% Developed Stocks 100.0% 62.3% 5.1% 6.3% Emerging Stocks 100.0% 23.5% 5.2% Domestic Bonds 100.0% 20.7% Domestic Cash 100.0%

  22. Portfolio Allocations Risk and Return Assumptions Fund A Fund B Fund C Fund D Fund E Stocks - 18.2% 20.2% 18.4% 12.6% 0.0% Domestic Stocks 27.2% 18.9% 11.5% 5.6% 0.0% Developed Stocks 33.4% 21.8% 13.0% 6.2% 0.0% Emerging Markets Bonds 7.8% 19.1% 34.7% 48.4% 86.0% Cash 13.3% 20.0% 22.3% 27.2% 14.0%

  23. Portfolio Risks and Returns Risk and Return Assumptions Fund A Fund B Fund C Fund D Fund E Expected 9.61% 8.73% 7.95% 7.08% 6.37% Nominal Returns Expected 6.15% 5.30% 4.55% 3.70% 3.01% Real Returns Volatility 12.14% 9.63% 4.08% 5.00% 7.33%

  24. Retirement • Longevity • Distribution Rate • Expected Returns and Volatility • Portfolio Funding Profile

  25. Portfolio Funding Profile Portfolio in DistributionFund C with Constant Real Peso Withdrawal (6% initial) • The Profile is determined using historical simulations to understand a portfolio’s ability to fund a retirement horizon of varying lengths and with differing degrees of confidence

  26. Portfolio Funding Profile • A Funding Profile reflects the number of retirement years that a particular portfolio might be expected to support expenses in retirement as a function of inflation-adjusted withdrawal rates • Consistent with Fidelity’s retirement approach, the number of funding years are indicated at the 50% and 90% confidence level, reflecting portfolio longevity in average and extended down markets

  27. 12% Fund E Fund D Fund C Fund B Fund A 10% 8% Inflation-Adjusted Withdrawal Rate 6% 60+ years 4% 2% 0 10 20 30 40 50 60 Years Survived Portfolio Funding Profile The Impact of Withdrawal Rates on Portfolio Longevity inExtended Down Markets and Average Markets 50% Mortality 75% Mortality Note: Fund E is never optimal to hold Solid end points = Average Market Conditions (50% Confidence) Transparent end points = Extended Down Markets (90% Confidence)

  28. Portfolio Funding Profile The Impact of Withdrawal Rates on Portfolio Longevity inExtended Down Markets and Average Markets 8% Fund E Fund D Fund C Fund B Fund A 7% Note: A 5% initial inflation-adjusted withdrawal is probably the maximum distribution 6% Inflation-Adjusted Withdrawal Rate 83 5% 60+ years 4% Note: Funds B, C & D are attractive portfolios for a range of withdrawal rates 3% 0 10 20 30 40 50 60 Years Survived Solid end points = Average Market Conditions (50% Confidence) Transparent end points = Extended Down Markets (90% Confidence)

  29. Portfolio Funding Profile Observations • Fund E does not appear to be attractive to hold • A 5% initial inflation-adjusted withdrawal rate is probably the maximum distribution to fund a retirement beginning at age 65 • Funds B, C and D are attractive portfolios for a broad range of withdrawal rates

  30. Portfolio Funding Profile Sensitivity Analysis • What if the Chilean equity risk premium is 4% instead of 5%? • With if equity volatilities were 20% higher than assumed in the base case? • What if all equity risk premiums were lower than assumed in the base case?

  31. 12% Fund E Fund D Fund C Fund B Fund A 10% 8% Inflation-Adjusted Withdrawal Rate 6% 60+ years 4% 85 2% 0 10 20 30 40 50 60 Years Survived Portfolio Funding Profile The Impact of Withdrawal Rates on Portfolio Longevity inExtended Down Markets and Average Markets 4% Chilean Equity Risk Premium Note: Results similar tobase case Solid end points = Average Market Conditions (50% Confidence) Transparent end points = Extended Down Markets (90% Confidence)

  32. Portfolio Funding Profile The Impact of Withdrawal Rates on Portfolio Longevity inExtended Down Markets and Average Markets 12% Fund E Equity Volatilities 20% Higher than Base Case Fund D Fund C Fund B Fund A 10% Note: Fund D is an attractiveportfolio 8% Inflation-Adjusted Withdrawal Rate 6% 4% 67 2% 0 10 20 30 40 50 60 Solid end points = Average Market Conditions (50% Confidence) Years Survived Transparent end points = Extended Down Markets (90% Confidence)

  33. Portfolio Funding Profile The Impact of Withdrawal Rates on Portfolio Longevity inExtended Down Markets and Average Markets 12% Fund E Fund D Equity Risk Premiums Lower than Base Case Fund C Fund B Fund A 10% Note: Funds C and D areattractive for all withdrawal rates 8% Inflation-Adjusted Withdrawal Rate 6% 98 4% 65 2% 0 10 20 30 40 50 60 Years Survived Solid end points = Average Market Conditions (50% Confidence) Transparent end points = Extended Down Markets (90% Confidence)

  34. Conclusions Which is the Optimal Portfolio in Retirement? • A 5% initial inflation-adjusted withdrawal rate is probably the maximum distribution to fund a retirement beginning at age 65 • In the scenarios examined, Fund E does not appear to be attractive • Funds B, C, and D have attractive funding profiles under the base case assumptions • In scenarios more favorable to bonds, not surprisingly, Funds C and D have attractive profiles

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