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RETIREMENT AND INVESTING

RETIREMENT AND INVESTING. B = C + I - E. 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

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RETIREMENT AND INVESTING

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  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. Expected Return for 1932-1978 : 7.3% Actual Return: 5.8% (2.5% real) INDIVIDUAL (AND CLOSED PLAN) FUNDS RAN OUT BEFORE GREAT YEARS

  19. 0.5% Real Salary Increase 1% COLA

  20. IS MODERN PORTFOLIO THEORY DEAD?

  21. 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 • KNOW WHAT YOU OWN

  22. 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

  23. ASSUMPTIONS OF MPT:“NORMAL” 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 aren’t in lockstep • Holds for long-term (5-10 year rolling time frames)

  24. HISTORIC RETURNS AND RISKS 1926 - 20101 Standard Deviation

  25. Annual Returns Ibbotsen SBBI 2010 Classic Yearbook

  26. Source: Yale University Professor Robert Shiller’s 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

  27. MEDIAN CONSULTANT ESTIMATES1995 CORRELATIONS

  28. STANDARD DEVIATIONS OFEFFICIENT PORTFOLIO MIXES - 1995 Efficient Portfolios - 9.2% Return Expected Inflation – 3.75% Expected Geometric Return – 8.6% nominal 4.9% real

  29. 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

  30. 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

  31. DAVID SWENSEN UNCONVENTIONAL SUCCESS: A FUNDAMENTAL APPROACH TO PERSONAL INVESTMENT, Free Press, 2005

  32. 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%

  33. 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

  34. 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, CIO’s, Politics, etc. • If have special insight or advantage over others

  35. SHORT TERM “Danger Will Robinson” The Abnormal is “Normal” Expect not only the unexpected, but also the impossible

  36. 27 days of 7 Standard deviation movements. If missed all, only $32.81

  37. Hedge FundsA Sheep in Wolf’s 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 (S&P 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 3:1 against but may be “only game in town”

  38. BOND RETURNS WITH EQUITY VOLATILITY

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