Understanding investment risk in a retirement plan using parametric simulation

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