income matching using individual bonds

Income Matching Using Individual Bonds

An Alternative to Annuities and Bond Funds

Presented by:

Stephen Huxley, PhD

Brent Burns

RISKThings may not always turn out

the way you planned© Asset Dedication, LLC 2011

MARKET TIMINGSometimes it’s hard to guess where the market is going.

HOT STOCKSJust because Cramer says it’s a

good idea doesn’t mean it’s right for you © Asset Dedication, LLC 2011

RISKThe worst case scenario seemed a

lot less likely a few minutes ago© Asset Dedication, LLC 2011

STOCK PICKINGMuch more scientific than

chimpanzees throwing darts

FINANCIAL PLANNING

It is a lot easier to get where you are going if you have someone to help steer you in

the right direction © Asset Dedication, LLC 2011

UNCERTAINTYIt turns out that the stock market

doesn’t always go up© Asset Dedication, LLC 2011

Decline in Traditional PensionsFortune 100 Companies 1985-2010

1985 1998 20100%

Liability-driven investing (LDI) is an investment strategy of a

company or individual based on the cash flows needed to fund

future liabilitiesSource: Wikipedia

cash flowsfuture liabilities

Behavioral Finance Meets

Asset Allocation

PortfolioTotal

Return

Liability Driven

Investing

Today’sMoney

Next Year’sMoney

7th Year’sMoney

8th Year’sMoney

9th Year’sMoney

Parallels Between MPT and DPT

Modern Portfolio Theory Dedicated Portfolio Theory

Risk Risk

Risk-free asset = T-billsRisk-free asset = Fully immunized cash flow stream

How Often Bonds Beat Stocks

S&P 500 and Intermediate Treasury Bond Index 1927-2009

Worst and Average Spread

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 30-60.00%

-50.00%

-40.00%

-30.00%

-20.00%

-10.00%

10.00%

S&P 500 and Intermediate Treasury Bond Index 1927-2009

Using Individual Bonds to Build Income-Matching LDI

Portfolios

Income-Matching “Paycheck” Portfolios

1. Immediate Income Portfolio – Cash flows begin now

2. Deferred Income Portfolio – Cash flows begin later, when the client retires

Example:

1. $100,000 per year

2. 3% inflation adjustment

3. 8 year time horizon

8-Year Income Portfolio (Initial 8-years)

Year Issue YTM Principal Interest

Portfolio Cash Flows

Target Cash Flows

2012 CD 0.6% $79,000 $21,025 $100,025 $100,000

2013 CD 1.1% $87,000 $17,299 $104,299 $103,000

2014 CD 1.9% $93,000 $13,295 $106,295 $106,090

2015 CD 2.3% $99,000 $10,005 $109,005 $109,273

2016 Agency 2.2% $107,000 $5,160 $112,160 $112,551

2017 Agency 2.6% $111,000 $5,160 $116,160 $115,927

2018 Agency 3.0% $114,000 $5,160 $119,160 $119,405

2019 Agency 3.1% $118,000 $5,160 $123,160 $122,987

$890,264 $889,234

Timing Cash Flows

Bond quotes 5/12/2011

Cost = $800,220 Duration = 4.3 Years

IRR = 2.6%(Fully Immunized)

Immunization Definition

“When a bond portfolio is immunized, the

investor receives a specific rate of return

over a given time period regardless of what

happens to interest rates during that time.”

Morningstar Bond Course 104

8-Year Bond Ladder

Year Issue YTM Principal Interest

Portfolio Cash Flows

Target Cash Flows

Excess/ Shortfall

2012 CD 0.6% $95,000 $17,895 $112,895 $100,000 $12,895

2013 CD 1.1% $93,000 $13,594 $106,594 $103,000 $3,594

2014 CD 1.9% $94,000 $9,833 $103,833 $106,090 ($2,257)

2015 CD 2.3% $90,000 $6,051 $96,051 $109,273 ($13,222)

2016 Agency 2.2% $112,000 $3,913 $115,913 $112,551 $3,362

2017 Agency 2.6% $116,000 $3,913 $119,913 $115,927 $3,986

2018 Agency 3.0% $122,000 $3,913 $125,913 $119,405 $6,508

2019 Agency 3.1% $91,000 $1,957 $92,957 $122,987 ($30,031)

$874,067 $889,234 ($15,166)

Why Not a Bond Ladder?

Bond quotes 5/12/2011

Cost = $800,865 Duration = 4.2 Years

IRR = 2.4%Income Shortfall = $15,166

Tale of Two Allocations

Total Return

• Beta exposure to fixed income

• Dampen volatility• Diversification

• Predictable cash flows• Immunization from rising

interest rates

Double Duty From Bonds

Years of Income

100/0 3 Yr. 90/10 4 Yr. 80/20 5 Yr. 6 Yr. 7 Yr. 70/30 8 Yr. 60/40 9 Yr. 10 Yr. 50/50 40/60 30/70 20/80 10/90 0/100

9.5%9.2% 9.1%

8.8% 8.6% 8.6% 8.4% 8.2% 8.2%7.7%

7.3% 7.2%6.8%

Asset Dedication vs. Total Return40 Year Internal Rate of Return Since 1927

Source: Asset Dedication, 2009. Data set 1927-2008. Indices used for comparison: Equities (both models)—Standard and Poors 500 Index; Total Return Fixed Income Allocation—Barclays Capital US Intermediate Government Index; Asset Dedication Fixed Income—1975-2008 Treasury Bond quotes (source WSJ), 1927-1974 prices backcast against Treasury yield curve.

Monitoring Progress

The Dynamic Dimension -“Flexible” Rolling Horizons

Using time to ride out bad markets

Taking more off the table when markets have been good

Do Not Roll . . .

Immediate vs. DeferredIncome Portfolios

1. Immediate Income Portfolio – Cash flows begin now

2. Deferred Income Portfolio – Cash flows begin later, when the client retires

Deferred Income Portfolio: Leveraging the Yield Curve

$770,911

Interest Rate Risk

Timing Risk

Planning Risks

Behavioral Risks

Why Individual Bonds?

Individual Bonds

Bond Funds

Legal Obligation

Mutual Fund

Decomposing Bond Fund Total Return

Price Return• Bond prices are inversely

related to interest rates

• Bond prices fall as rates rise

Income Return• Income return represents

the sum of portfolio’s coupon payments

• Income is never negative

Impact of Interest Rates on Total Return

Bond Funds Individual Bonds

Falling Rates

Price Return

Income Return

Total Return > Income Return

Price Return

Income Return

Flat Rates

Price Return

Income Return

Total Return = Income Return

Price Return

Income Return

Rising Rates

Price Return

Income Return

Total Return < Income Return

Price Return

Income Return

Falling Rates

Price Return

Income Return

Price Return

Income Return

Flat Rates

Price Return

Income Return

Price Return

Income Return

Rising Rates

Price Return

Income Return

Price Return

Income Return

30 Years of Tailwinds

Source: United States Treasury 10-year constant maturity yield 1962-2009, Global Financial Data 1800-1962. 5-year rolling average

Total Return 11.3%

of taxable bond funds were started after 1981

Falling Rates

Price Return

Income Return

Price Return

Income Return

Flat Rates

Price Return

Income Return

Price Return

Income Return

Rising Rates

Price Return

Income Return

Price Return

Income Return

Falling Rates

Price Return

Income Return

Price Return

Income Return

Flat Rates

Price Return

Income Return

Price Return

Income Return

Rising Rates

Price Return

Income Return

Price Return

Income Return

Rising Rates 1950-1981

S&P 500:

10 Yr. Treasury:

Catch-22 for Bond Fund Investors

Keep Duration Short and Rates Stay Flat (Japan)

Japanese Interest Rates Since 1985

Historical Interest Rates Average Yield 1800-2010

Long D

Extend Duration and Rates Rise

Duration ≈ 5 yearsEstimated loss ≈ -2%

Headwind of Rising Rates

Total Return 2.2%Average Coupon 5.6%

Total Return Shortfall with Withdrawals

Source: United States Treasury 10-year constant maturity yield 1962-2009, Global Financial Data 1800-1962. CRSP 10-year Treasury Index total return

“People have unrealistic expectations of what a portfolio manager can do in a rising-rate environment.”

Jim Jessee, president of MFS Fund Distributors Inc. Investment News mutual fund round table in New York on Feb. 9, 2010

Other Income Strategies

• Annuities• Dividend paying stocks• Real Estate/REITs

Based on the Treasury yield curve and standard mortality tables,

annuitants can expect to only receive

81%-85% of their premium in return.

Annuities for an Ageing World, Olivia S. Mitchell and David McCarthy, June 9, 2002

Challenges for Annuities

• Passing assets on to heirs• Managing inflation• Flexibility• Expenses, commissions, and fees• Counterparty risk

Insurance Company Failures California 1991-2008

Confederation Life Insurance & Annuity Company

Standard Life Insurance Company of Indiana

Lincoln Memorial Life Insurance Company

London Pacific Life & Annuity Company

Legion Insurance Company

Reliance Insurance Company

Combined Benefits Insurance Company

American Chambers Life Insurance Company

International Financial Services Life Insurance Company

First National Life Insurance Company of America

Centennial Life Insurance Company

American Western Life Insurance Company

National American Life Insurance Company of Pennsylvania

Summit National Life Insurance Company

Confederation Life Insurance Company (CLIC)

Old Colony Insurance Company

Consumers United Insurance Company

Mutual Benefit Life Insurance Company

Investment Life Insurance Company of America

Fidelity Bankers Life Insurance Company

Inter-American Insurance Company of Illinois

Executive Life Insurance Company

Mutual Security Life Insurance Company

Midwest Life Insurance Company

Legacy Life Insurance Company

Dividend payments from companies in the S&P

500 dropped by…

January 2008 to January 2009

Standard and Poors S&P 500 Market Attributes SnapshotJanuary 2009

of REITs followed by Morningstar cut or suspended their

dividends in 2009

Morningstar Industry Report 2010

Key Points

1. Individual bonds can immunize against interest rate risk

2. Individual bonds are uniquely suited to delivering predictable income

3. Bond funds will lose value when rates rise

4. Annuities can be expensive and inflexible

5. Dividends and REITs can be unreliable just when your clients need them most

Questions?

Disclosures

Past performance may not be indicative of future results. Therefore, no current or prospective client should assume

that future performance of any specific investment or investment strategy (including the investments and/or investment

strategies recommended or undertaken by Asset Dedication) made reference to directly or indirectly by Asset

Dedication in their literature or otherwise will be profitable or equal the corresponding indicated performance level(s).

Different types of investments involve varying degrees of risk, and there can be no assurance that any specific

investment will either be suitable or profitable for a client or prospective client’s investment portfolio. Historical

performance results for investment indices and/or categories generally do not reflect the deduction of transaction

and/or custodial charges, the deduction of an investment management fee, nor the impact of taxes, the incurrence of

which would have the effect of decreasing historical performance results.

Please remember that different types of investments involve varying degrees of risk, and there can be no assurance

that the future performance of any specific investment or investment strategy (including those undertaken or

recommended by Asset Dedication), will be profitable or equal any historical performance level(s).

income matching using individual bonds

bond portfolio

rates average yield

rates riseduration

income matching

treasury yield curve

bond fundspresented

bond ladder

rates8years of income

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