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Which is the Optimal Portfolio in Retirement? Van Harlow 19 May 2006 Not for sale in the U.S. or to U.S. persons. NOT GOVENMENT INSURED MAY LOSE VALUE NO BANK GUARANTEE FOR DUE DILIGENCE ATTENDEES Retirement Which is the optimal portfolio in retirement? or Given my current assets and retirement expenses, which portfolio provides me with a reasonable probability of funding my retirement years? For Due Diligence purposes only. Not for distribution to the public in any form. 2 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 Returns and Volatility • Portfolio Funding Profile For Due Diligence purposes only. Not for distribution to the public in any form. 3 Longevity Life Expectancy at Birth for Selected Countries: Circa 1950 Circa 1998 Male Female Male Female Chile* 52.9 56.8 71.0 78.0 Argentina 60.4 65.1 70.9 78.3 Brazil 49.3 52.8 59.4 69.6 Mexico 49.2 52.4 68.6 74.8 Venezuela 53.8 56.6 69.7 75.9 United States 66.0 71.7 72.9 79.6 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. For Due Diligence purposes only. Not for distribution to the public in any form. 4 Longevity Life Expectancy at Birth for Selected Countries: Males 1950 and 1988 90 80 70 60 50 Male 1950 Male 1998 40 30 20 10 y Hu ng ar Re pu bl ic ar k Cz ec h De nm Sp ai n a an y G er m Au st ri Be lg iu m Ki Fr an ce ng do m ly No rw ay G re ec e Sw ed en Ita te d Un i Un i te d St at es 0 Source: U.S. Census Bureau, International Programs Center, International Database, Gender and Aging: Mortality and Health, 1B/98-2. For Due Diligence purposes only. Not for distribution to the public in any form. 5 Longevity Life Expectancy at Birth for Selected Countries: Females 1950 and 1988 90 80 70 60 50 Female 1950 Female 1998 40 30 20 10 y Hu ng ar Re pu bl ic ar k Cz ec h De nm Sp ai n an y G er m a Au st ri Be lg iu m Ki Fr an ce ng do m ly No rw ay G re ec e Sw ed en Ita te d Un i Un i te d St at es 0 Source: U.S. Census Bureau, International Programs Center, International Database, Gender and Aging: Mortality and Health, 1B/98-2. For Due Diligence purposes only. Not for distribution to the public in any form. 6 Longevity Life Spans MALE AGE 65 85 Age 92 88 Age 90 94 Age 85 92 100 25% chance of living to 94 50% chance of living to 88 COUPLES (Both AGE 65) 100 25% chance of living to 92 50% chance of living to 85 FEMALE AGE 65 95 95 At least one person has a 50% chance of living to 92 97 At least one person has a 25% chance of living to 92 Source: Annuity 2000 Morality Table. Figures assume you are in good health. For Due Diligence purposes only. Not for distribution to the public in any form. 7 Retirement Longevity Distribution Rate Expected Returns and Volatility Portfolio Funding Profile For Due Diligence purposes only. Not for distribution to the public in any form. 8 Distribution Rate $1,000,000 $900,000 $800,000 $700,000 9% Withdrawal Rate $600,000 8% Withdrawal Rate $500,000 7% Withdrawal Rate $400,000 6% Withdrawal Rate 5% Withdrawal Rate $300,000 4% Withdrawal Rate $200,000 $100,000 COUPLES (Both Age 65) Age 70 75 Probability that at least one will be alive: 80 2002 1999 1997 1994 1992 1989 1987 1984 1982 1979 1977 1974 1972 $- 85 90 95 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. For Due Diligence purposes only. Not for distribution to the public in any form. 9 Distribution Rate Number of years a portfolio can last in distribution 10% 9% 8% 7% 6% 5% 4% Years 0 10 20 30 40 50 *Hypothetical portfolio of assets held in a taxable account consists of 50% bonds and 50% stocks, assumes average annual return of 8.7%. For Due Diligence purposes only. Not for distribution to the public in any form. 10 Retirement Longevity Distribution Rate Expected Returns and Volatility Portfolio Funding Profile For Due Diligence purposes only. Not for distribution to the public in any form. 11 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 For Due Diligence purposes only. Not for distribution to the public in any form. 12 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 riskfree 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 For Due Diligence purposes only. Not for distribution to the public in any form. RPt Risk Premium RRft Real riskfree return Inft Inflation 13 Expected Returns Estimating the Risk Premium Historical Fundamental Economic Surveys For Due Diligence purposes only. Not for distribution to the public in any form. 14 Other Approaches to Estimating the Risk Premium Literature Review • • • • US Equity Historical evidence Risk Premium Estimates – 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) ⁃ Ibbotson and Chen (Financial Analysts Journal, 2003) ⁃ Claus and Thomas (Journal of Finance, 2001) ⁃ Arnott and Bernstein (Financial Analysts Journal, 2002) Economic Estimates ⁃ Mehra and Prescott (Journal of Monetary Economics, 1985) Surveys ⁃ Welch (Journal of Business, 2000) ⁃ Graham and Harvey (Duke University, 2001) For Due Diligence purposes only. Not for distribution to the public in any form. 2.55% - 4.32% 4.0% 3.0% 0% - 2.4% <1.0% 4.0% 3.9% - 4.7% 15 Historical Real Returns 1993-2006 25% Equities Bonds 20% Annualized Volatility 15% 10% 5% 0% -5% Source: Global Financial Data For Due Diligence purposes only. Not for distribution to the public in any form. 16 Risk Premium versus Cash 1993-2006 20% Equities-Cash Bonds-Cash Annualized Risk Premium, % 15% 10% 7.17% 5% 3.07% 0% -5% For Due Diligence purposes only. Not for distribution to the public in any form. 17 Risk Premium versus Bonds 1993-2006 15% Annualized Risk Premium, % 10% 5% 4.21% 0% -5% For Due Diligence purposes only. Not for distribution to the public in any form. 18 Historical Volatilities 1993-2006 45% Equities Bonds 40% 35% Annualized Volatility 30% 25% 20% 15% 10% 5% 0% For Due Diligence purposes only. Not for distribution to the public in any form. 19 Risk and Return Assumptions Asset Class Assumptions Asset Class Domestic Stocks Developed Market Emerging Market Domestic Bonds Domestic Short-Term Risk Premium Risk-Free Return Expected Nominal Return Expected Real Return Volatility (1-93 - 2/06) 5.00% 6.15% 11.15% 7.64% 20.90% 4.00% 6.15% 10.15% 6.68% 12.68% 5.00% 6.15% 11.15% 7.64% 20.38% 0.54% 6.15% 6.69% 3.32% 4.74% 0.00% 0.00% 4.42% 1.12% 0.53% Inflation 3.26% Note: 10-year CLP bond yield is 6.15% 10-year UF bond yield is 2.85% For Due Diligence purposes only. Not for distribution to the public in any form. 20 Risk and Return Assumptions Correlations (Unhedged Peso) 1/93 -2/06 Domestic Bonds Domestic Stocks Domestic Cash Developed Stocks Emerging Stocks Domestic Stocks Developed Stocks 100.0% 35.3% 67.1% 18.3% -0.2% 100.0% 62.3% 5.1% 6.3% 100.0% 23.5% 5.2% 100.0% 20.7% Emerging Stocks Domestic Bonds Domestic Cash For Due Diligence purposes only. Not for distribution to the public in any form. 100.0% 21 Risk and Return Assumptions Portfolio Allocations Fund A Fund B Fund C Fund D Fund E Stocks Domestic 18.2% 20.2% 18.4% 12.6% 0.0% Stocks Developed 27.2% 18.9% 11.5% 5.6% 0.0% Stocks Emerging Markets 33.4% 21.8% 13.0% 6.2% 0.0% Bonds 7.8% 19.1% 34.7% 48.4% 86.0% Cash 13.3% 20.0% 22.3% 27.2% 14.0% For Due Diligence purposes only. Not for distribution to the public in any form. 22 Risk and Return Assumptions Portfolio Risks and Returns Fund A Fund B Fund C Fund D Fund E Expected Nominal Returns 9.61% 8.73% 7.95% 7.08% 6.37% Expected Real Returns 6.15% 5.30% 4.55% 3.70% 3.01% Volatility 12.14% 9.63% 7.33% 5.00% 4.08% For Due Diligence purposes only. Not for distribution to the public in any form. 23 Retirement Longevity Distribution Rate Expected Returns and Volatility Portfolio Funding Profile For Due Diligence purposes only. Not for distribution to the public in any form. 24 Portfolio Funding Profile $10,000,000 Portfolio in Distribution Fund C with Constant Real Peso Withdrawal (6% initial) Total Wealth $1,000,000 $100,000 $10,000 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 36 Horizon • 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 For Due Diligence purposes only. Not for distribution to the public in any form. 25 Portfolio Funding Profile $10,000,000 100% 75% Total Wealth $1,000,000 50% $100,000 25% 90% 50% $10,000 0% 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 36 Horizon • 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 For Due Diligence purposes only. Not for distribution to the public in any form. 26 Portfolio Funding Profile The Impact of Withdrawal Rates on Portfolio Longevity in Extended Down Markets and Average Markets Inflation-Adjusted Withdrawal Rate 10% Fund E Fund D Fund C Fund B Fund A 75% Mortality 50% Mortality 12% Note: Fund E is never optimal to hold 8% 6% 60+ years 4% 2% 0 10 Solid end points = Average Market Conditions (50% Confidence) Transparent end points = Extended Down Markets (90% Confidence) 20 30 40 50 60 Years Survived For Due Diligence purposes only. Not for distribution to the public in any form. 27 Portfolio Funding Profile The Impact of Withdrawal Rates on Portfolio Longevity in Extended Down Markets and Average Markets 8% Fund E Fund D Fund C Fund B Fund A Inflation-Adjusted Withdrawal Rate 7% Note: A 5% initial inflation-adjusted withdrawal is probably the maximum distribution 6% 83 5% 60+ years 4% Note: Funds B, C & D are attractive portfolios for a range of withdrawal rates 3% 0 10 Solid end points = Average Market Conditions (50% Confidence) Transparent end points = Extended Down Markets (90% Confidence) 20 30 40 50 60 Years Survived For Due Diligence purposes only. Not for distribution to the public in any form. 28 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 For Due Diligence purposes only. Not for distribution to the public in any form. 29 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? For Due Diligence purposes only. Not for distribution to the public in any form. 30 Portfolio Funding Profile The Impact of Withdrawal Rates on Portfolio Longevity in Extended Down Markets and Average Markets 12% Fund E Fund D Fund C Fund B Fund A 4% Chilean Equity Risk Premium Inflation-Adjusted Withdrawal Rate 10% Note: Results similar to base case 8% 6% 60+ years 85 4% 2% 0 10 Solid end points = Average Market Conditions (50% Confidence) Transparent end points = Extended Down Markets (90% Confidence) 20 30 40 50 60 Years Survived For Due Diligence purposes only. Not for distribution to the public in any form. 31 Portfolio Funding Profile The Impact of Withdrawal Rates on Portfolio Longevity in Extended Down Markets and Average Markets 12% Fund E Fund D Fund C Fund B Fund A Equity Volatilities 20% Higher than Base Case Inflation-Adjusted Withdrawal Rate 10% Note: Fund D is an attractive portfolio 8% 6% 4% 67 2% 0 10 20 Solid end points = Average Market Conditions (50% Confidence) Transparent end points = Extended Down Markets (90% Confidence) 30 40 50 60 Years Survived For Due Diligence purposes only. Not for distribution to the public in any form. 32 Portfolio Funding Profile The Impact of Withdrawal Rates on Portfolio Longevity in Extended Down Markets and Average Markets 12% Fund E Fund D Fund C Fund B Fund A Equity Risk Premiums Lower than Base Case Inflation-Adjusted Withdrawal Rate 10% Note: Funds C and D are attractive for all withdrawal rates 8% 6% 98 65 4% 2% 0 10 Solid end points = Average Market Conditions (50% Confidence) Transparent end points = Extended Down Markets (90% Confidence) 20 30 40 50 60 Years Survived For Due Diligence purposes only. Not for distribution to the public in any form. 33 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 For Due Diligence purposes only. Not for distribution to the public in any form. 34