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RETIREMENT AND INVESTING

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Title: RETIREMENT AND INVESTING


1
RETIREMENT AND INVESTING
  • B C I - E

2
OVERVIEW
  • BASIC RETIREMENT MATH
  • Benefits Contributions Investment Expenses
  • Should Liabilities be discounted at the risk-free
    rate?
  • BASIC INVESTMENT PRINCIPLES
  • Standard Approach Modern Portfolio Theory
  • Core Index in 5-6 Basic Public Assets for Long
    Term
  • Survive Short Term Wildness (Manage Liquidity and
    Leverage)
  • Watch Expenses
  • Avoid the Big Mistake
  • Did Modern Portfolio Theory Fail? Should
    everyone be doing hedge funds?
  • CURRENT INVESTMENT OUTLOOK
  • Stocks OK, Bonds Dead Money
  • Should we be scared of the new normal?

3
BENEFITS CONTRIBUTIONS INVESTMENTS - EXPENSES
Benefits Expressed as of final
salary Contributions Level of total annual
salary Investments annual real return (above
inflation) Expenses Assume Index Fund
(essentially zero)
4
GENERAL ASSUMPTIONS
  • Work for 30 years
  • Goal 60 replacement ratio of final salary
  • 2 for each service year
  • Social Security replaces 20, for 80 goal
  • Live for 25 years after retirement
  • 0.5 Real Salary increase
  • 3.5 inflation (4.0 total salary increase)
  • 7.25 return (3.75 real return)
  • 60-70 equities, 30-40 fixed

5
B C BENEFITS CONTRIBUTIONS

6
1 COLA increases needed amount at retirement and
slight increase in level amount (to 48). 0.5
Real Salary puts curve in savings rate and
increases level salary amount (more at end,
less early) 3.5 inflation has no impact
outside COLA (all dollars are in retirement year
dollars)
7
B C ASSUME NO INVESTMENTS BENEFITS
CONTRIBUTIONS Dropping 100 replacement to 60
brings savings rate back to 50
8
B C I ASSUME 7.25 NOMINAL RETURN 3.75
REAL RETURN
9
Worst 2.73 (1929 1983) (3.1 Inflation) 60
replacement would have required 19 savings
rate Example 1932-1986 Real Return 3.92 with
3.44 Inflation 14 Savings
10
POLICY ISSUE DISCOUNT OR INVESTMENT RATE TO
MEASURE FUNDING OBLIGATION
  • Financial Economics Use Riskless Rate
  • Promise is a government obligation that is
    riskless
  • Therefore value to a recipient is priced at that
    rate
  • Private company would price using riskless rate
  • Example Government rate at 2.0 vs Actuarial
    Assumption of 7.25
  • Impact B C I means with lower investment
    either
  • SAME BENEFIT WITH HIGHER CONTRIBUTION
  • Need 1.7 times more to deliver same 60 benefit
  • Contribution rises from 14 to 38
  • SAME CONTRIBUTION WITH LOWER BENEFIT
  • 14 Contribution supports only 7 replacement
    benefit

11
IMPACT OF INVESTING AT 2 TREASURY (OR DISCOUNT
AT TREASURY) Increase needs by 1.7 times Option
1 increase contributions by almost 3X
12
OPTION 2 REDUCE BENEFITS FROM 60 REPLACEMENT TO
7
13
WOULD GREECE HAVE A LOWER FUNDING NEED?
  • Financial economics equates value or price
    with funding obligation
  • Riskier obligor would have perceived lower
    funding obligation for same benefit
  • A bonding rate of 34 would value liabilities at
    near 0, while government pensions would be large
  • Shifting obligations from government to
    individuals would say tiny retirement need but
    obviously not true
  • Should that drive behavior in investing for
    retirement?

14
Worst 2.73 (1929 1983) (3.1 Inflation) 60
replacement would have required 19 savings
rate Example 1932-1986 Real Return 3.92 with
3.44 Inflation 14 Savings
15
INDIVIDUAL ISSUES
  • PRACTICAL BEHAVIOR
  • Saving Enough
  • DC Plans put half needed contribution levels
  • 7.5 vs 14
  • Making Enough
  • DC Participant returns 2-4 lower
  • Higher costs and fees
  • Poor portfolio construction and management
  • THEORETICAL RISK
  • Mortality Risk
  • Increased Market Risk (particularly in
    retirement)
  • DB Plans pool and reduce Mortality and Market
    risk
  • Individual needs to save around 5 more to insure
    against risks

16
3.5 inflation, 0.5 real salary increase, 1 COLA
17
Worst 2.73 (1929 1983) (3.1 Inflation) 60
replacement would have required 19 savings
rate Example 1932-1986 Real Return 3.92 with
3.44 Inflation 14 Savings
18
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19
Expected Return for 1932-1978 7.3 Actual
Return 5.8 (2.5 real)
INDIVIDUAL (AND CLOSED PLAN) FUNDS RAN OUT BEFORE
GREAT YEARS
20
0.5 Real Salary Increase 1 COLA
21
IS MODERN PORTFOLIO THEORY DEAD?
22
BASIC MPT PRINCIPLES
  • Start with Long-Term (5-10 year ) time frame
  • Modern Portfolio Theory
  • 5-6 Asset Types
  • US Equities, International Equities, REITS,
    Emerging Market Equities, US Investment Grade
    Bonds, TIPS
  • Core Index
  • Adjust for Short Term Wildness
  • Survive Attend to Liquidity
  • Control Leverage
  • Keep Broad Diversification
  • AVOID THE BIG MISTAKE
  • In order to get market returns, need to be in the
    markets
  • Avoid tactical asset allocation
  • NEVER make a major move in the middle of a crisis
  • Add investments where think have advantage or
    insight, if any
  • Be careful with active management and fees
  • Beware turnover and related costs

23
SUMMARY OF BASIC PORTFOLIO THEORY
  • Looks to three factors
  • Expected Returns of assets
  • the volatility (standard deviation) in those
    returns (this is risk)
  • the co-movement (correlation) of the returns with
    other assets
  • The primary principle is DIVERSIFICATION
  • The main purpose is to put together a mix of
    different assets in a manner that
  • reduces the volatility (risk) without
  • lowering unnecessarily the expected return

24
ASSUMPTIONS OF MPTNORMAL MARKETS IN LONG TERM
  • Return is generally linearly related to risk
    (volatility)
  • Higher returns associated with higher volatility
    or risk
  • Returns normally (coin-tossing) random
  • Bell shaped curve Gaussian
  • Allows Standard deviation to be a generally
    accurate representation of risk (volatility)
  • DIVERSIFICATION REDUCES RISK
  • Correlations or co-movements arent in lockstep
  • Holds for long-term (5-10 year rolling time
    frames)

25
HISTORIC RETURNS AND RISKS 1926 - 20101 Standard
Deviation
26
Annual Returns
Ibbotsen SBBI 2010 Classic Yearbook
27
Source Yale University Professor Robert
Shillers website, as of 12/31/08 Past
performance is not a guarantee of future
results. Rolling periods represent a series of
overlapping, smaller time periods within a
single, longer-term time period. A hypothetical
example is the 20-year time period from 12/31/82
through 12/31/02. This long-term period consists
of 16 smaller five-year rolling segments. The
first segment is the five-year period from
12/31/82 to 12/31/87. The next rolling segment is
the five-year period from 12/31/83 to 12/31/88,
and so on.
27
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31
MEDIAN CONSULTANT ESTIMATES1995
CORRELATIONS
32
STANDARD DEVIATIONS OFEFFICIENT PORTFOLIO MIXES
- 1995
Efficient Portfolios - 9.2 Return Expected
Inflation 3.75 Expected Geometric Return
8.6 nominal 4.9 real
33
Growth of 1 January 1995 June 2011 44 R3000,
21 EAFE, 35 Aggregate 8.4 return 10.3
Standard Deviation
FY 2009 - 16.6 FY 2010 12.0 FY 2011 21.7
2.5 Inflation 7.8 Geometric 5.3 Real
34
BASIC INVESTMENT POSITION
  • Need at least 5-10 in an asset class to make a
    difference
  • No more than 5-6 asset classes
  • Need an expected return
  • No commodities
  • Active management reduces diversification
  • No hedge funds or intense opportunistic
    management
  • No tactical asset allocation (over betting)
  • Free lunch of diversification requires ability
    to rebalance
  • Few private assets

35
DAVID SWENSEN UNCONVENTIONAL SUCCESS A
FUNDAMENTAL APPROACH TO PERSONAL INVESTMENT, Free
Press, 2005
36
44/21/35 Swensen Yale FY 2009 -
16.6 -22.1 -24.6 FY 2010 12.0 13.0
8.9 FY 2011 21.7 24.2 21.9 3
Year 13.7 16.6 0.1
44/21/35 Swensen Expected Geometric 7.8
8.9 8.6 Real 5.3 6.4 4.9
37
PROBLEMS WITH STANDARD APPROACH EMOTIONAL
EXHAUSTION
  • Need to wait 5-20 years for results
  • Dependence on Equity Risk and Return
  • Accept short term roller coaster volatility
  • Hard to do nothing rather than something
  • Abandon quest for higher than market returns
  • The Vegas Effect

38
WHO NEEDS MORE?
  • When Market returns are not enough
  • Liability needs are more than 3-5 real
  • Endowments with higher education inflation
  • Pension funds in too big a whole
  • When 1-5 year normal volatility still too high
  • Corporations with quarterly earnings reports
  • Pension funds near the edge
  • If have short term attention span CNBC
    disease
  • Rotating Boards, CIOs, Politics, etc.
  • If have special insight or advantage over others

39
SHORT TERM Danger Will Robinson
  • The Abnormal is Normal
  • Expect not only the unexpected, but also the
    impossible

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27 days of 7 Standard deviation movements. If
missed all, only 32.81
47
Hedge FundsA Sheep in Wolfs Clothing
  • Average institutional experience has been dismal
  • Particularly in last five years
  • Need superb skills at picking best hedge fund
    managers
  • Generally, have acted exactly like a reallocation
    of basic asset classes, specifically
  • A giant short of Large Cap (SP 500) stocks with
    an increase in general EAFE, emerging market, and
    small cap stocks, plus
  • Mostly cash returns
  • Alpha has largely been negative
  • ONLY ADVANTAGE IS THAT ONE OF FEW WAYS TO
    SIGNIFICANTLY OUTPERFORM MARKET
  • Odds are 31 against but may be only game in
    town

48
BOND RETURNS WITH EQUITY VOLATILITY
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WORLD REBALANCING
  • Great Deleveraging continues
  • World is Restructuring
  • US Debt reduction and consolidation
  • Europe fiscal integration
  • China and developing world rebalancing economies
    between exports and consumption
  • Process will take years, not months

53
BASIC CAPITAL MARKET CONCEPTS
  • EXPECTATIONS
  • Not Current Conditions
  • Current Expectations Moderate
  • PROFITS
  • Not general economy
  • Good balance sheets, lean operating conditions,
    growth overseas (x Europe), little pressure on
    labor costs
  • RELATIVE VALUE
  • Not absolute value in itself
  • What are people willing to pay for expected
    earnings
  • Current alternative bonds -- unattractive

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Current P/E Ratio (13.1) will probably
rise Corporate Profit Share of GDP (12.9) will
probably drop
58
Expected 70/30 Return 7.6 Nominal 5.2 Real
Expected Geometric Returns
59
US GDP (Billions) Profits (Billions) SP 500 EPS SP 500 Price P/E Ratio
2001 (1/1) 10,130 790 54.44 1320 24.3
2011 (9/30) 15,181 1,977 94.81 1131 11.9
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