creating sustainable retirement solutions a global perspective ghalid bagus, fia fsa cfa principal...

Creating Sustainable Retirement Solutions

A Global Perspective

Ghalid Bagus, FIA FSA CFA

Principal

March 2013

For investment professional use only. Not for public use or distribution. Past performance is not indicative of future results. Recipients must make their own independent decisions regarding

any strategies or securities or financial instruments mentioned herein. Milliman, Inc. does not make any representations that products or services described or referenced herein are suitable

or appropriate for the recipient. Many of the products and services described or referenced herein involve significant risks, and the recipient should not make any decision or enter into any transaction unless the recipient has fully understood all such risks and has independently determined that such decisions or transactions are appropriate for the recipient.

Any discussion of risks contained herein with respect to any product or service should not be considered to be a disclosure of all risks or a complete discussion of the risks involved.

The recipient should not construe any of the material contained herein as investment, hedging, trading, legal, regulatory, tax, accounting or other advice. The recipient should not act on any information in this document without consulting its investment, hedging, trading, legal, regulatory, tax, accounting and other advisors.

Milliman, Inc. does not ensure a profit or guarantee against loss. Nothing herein should be construed as a solicitation or offer or recommendation to buy or sell any security or to make

any transaction. The information contained herein is derived from sources who are believed reliable, but the accuracy of data or advice cannot be guaranteed. No chart, strategy or tactic guarantees gains or losses. No assurances can be given that objectives will be met.

Limitations and disclosures

Some background

US retirement assets

Performance is hypothetical and does not represent the holdings of any particular investment. Past performance is not indicative of future results. There is no assurance that the investment process will consistently lead to successful investing.

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

Q3

-

2,000

4,000

6,000

8,000

10,000

12,000

14,000

16,000

18,000

20,000 Total US Retirement Assets ($m's)

Annuities

Government DB Plans

Private DB Plans

DC Plans

IRAs

Aging populations … impact on investors

Traditional retirement systems breaking down

Investors forced to take on investment and longevity risk


What are the top investor concerns?


What are the top investor concerns?− Investment losses− Outliving investments− Inflation− Medical care during retirement− Taxes

Four of the five are risk management issues

Investors are concerned about both pre- and post-retirement issues

How has the industry responded?


Static Diversification

CPPI

Guarantee Products

Target Maturity Funds

Dynamic Balanced Funds

The focus has been mainly on investment risk

Issues have come to the fore


CPPI− A method of portfolio insurance where the investor sets a floor on the portfolio value− Many products were cash locked during the financial crisis

Guarantee products− Guarantee provider credit risk has come to the fore− Capital requirements have increased for providing guarantee products− Designs have become more opaque as interest rates have declined

Target date funds


Naked 2020 2030 2040

Average Annual Return 3.0% 4.5% 4.3% 4.0%

Volatility 18.5% 8.2% 9.9% 11.7%

Probability of Negative Return 42.4% 40.2% 40.9% 40.9%

Average Negative Monthly Return -4.3% -1.7% -2.2% -2.7%

Maximum Drawdown -58.2% -27.9% -34.3% -40.2%

Projection based on quarterly rebalance between EAFE Index and Barclays Capital Aggregate Bond Index over the period 1 Jan 2003 to 31 Dec 2012.

Target Date Funds evolved from the need to offer more tailored solutions to investors planning for retirement

Funds tailor their risk profile by reducing holdings of risky assets as retirement approaches

Using risky assets as a risk proxy ignores− volatility and correlation changes− the length of the retirement time

horizon

0 10 20 30 400%

20%

40%

60%

80%

100%

BondsEquities

Years until retirement

Balanced funds


Similar to asset allocation models but within a fund structure

Fund invests in a mixture of bonds and equities and dynamically rebalance between to avoid market declines

Benchmark allocations are not wide enough to provide suitable protection during a financial crisis

Large return effect due to decline in interest rates on bond portion of the fund – may not be the case going forward

Diversification is still the primary risk management tool


Diversification is still the primary risk management tool− Diversification fails during crises when all asset

classes decline together (i.e. 2008 plunge)

− Trading equity exposure for bond exposure may be unappealing in down markets with low interest rates

Investors are challenged to find effective investment risk management approaches

Source: Milliman, Inc. 2010

Problems for investors


2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012

59 59 59

5350

53

46

4146

4238

32

36 35

4043 42

44

5248

53 55

When you retire, do you think you will have enough money to live comfortably, or not?

YesNo

Source: gallup.com, 2012This chart is from Gallup's annual Economy and Personal Finance survey, conducted April 9-12, 2012, available at http://www.gallup.com/poll/154178/Expected-Retirement-Age.aspx

The need for better risk management

Unbundling the key concerns


Asset Allocation

Asset Allocation

• Fits existing process

• Manages inflation risk and

long-term return generation

• Aligned to internal investment

options

Protection Account

• Provided as a separate

account to Asset Allocation

• Operates at an individual level

• Protection against short-term

volatility & market “events”

Longevity Account

• Independent of Asset

Allocation and the Protection

Account

• Tailored at an individual level

• Protection against longevity

risk

Existing solution New solutions to capture market and longevity risks

Investment strategies with protection


Two risk management techniquesAdding a protection strategy can reduce downside exposure - it aims to provide investors with much greater

certainty that they can achieve retirement funding objectives

Current asset allocation

– Target a specific equity allocation (i.e., 60%) as a proxy for risk

– Maintain constant equity allocation regardless of market conditions

Target volatility asset allocation

– Target a specific volatility level– Aims to prevent portfolio volatility from dramatically

increasing during market crises

Attempts to cushion losses

– Aims to cushion losses in market downturns– Amount of cushion customizable to plan needs

Keep protection relevant

– Ratchet protection level up to preserve gains– Reset protection level down after extreme market

declines to harvest gains

Capital Protection StrategyVolatility Management

Volatility spikes frequently


How do investors react to volatility?


US Stock International Stock Moderate Allocation

1 Jan 2007 to 31 Dec 2012

Morningstar category return 0.8% -5.4% 3.0%

Investor return -1.8% -8.9% 4.1%

Differential -2.6% -3.5% 1.1%

Category volatility 19.3% 23.7% 13.5%

1 Jan 2002 to 31 Dec 2012

Morningstar category return 10.3% 16.1% 10.3%

Investor return 7.6% 12.0% 13.5%

Differential -2.7% -4.1% 3.2%

Category volatility 14.9% 18.6% 10.4%

Source: Morningstar 2012. Returns and volatilities are annualized.

Investor return versus Morningstar Category return

Investor return: not all investors bought shares at the beginning of a period and held them until the end

More volatile funds tend to show the greatest differential between Investor return and Morningstar Category return

Investors tend to buy high and sell low

Capital protection strategy characteristics


Use dynamic rebalancing to replicate a put option inside the portfolio The value of a put is asymmetric – market downturns result in large gains,

market upturns result in small losses

-50%

-45%

-40%

-35%

-30%

-25%

-20%

-15%

-10% -5% 0% 5% 10

%15

%20

%25

%30

%35

%40

%45

%50

%

Impact of Protection Strategy on Portfolio Re-turns

Protection strategy across market cycles


Bull/Bear Market Examples

Bear Market Bull Market

NORMAL MARKET

-15% BEAR MARKET

-30% BEAR MARKET

NORMAL MARKET

30% BULL MARKET

-5% DROP (STOP LOSS)

Low Vol Funds

Low Vol Funds

Low Vol Funds

Low Vol Funds

Low Vol Funds

Low Vol Funds

High Vol Funds

High Vol Funds

High Vol Funds

High Vol Funds

High Vol Funds

High Vol Funds

Protection increased in bear marketsto preserve gains

Low volatility

Sell equities to capture gains and ratchet up

protection

Who’s out there?


Sustainable Opportunities Fund Retail Mutual Fund

Presidential Protected Profile 2010





Huntington Wealth Preservation Conservative Fund

Huntington Wealth Preservation Moderate Fund

Huntington Wealth Preservation Growth Fund

TOPS Protected Balanced

TOPS Protected Moderate Growth

TOPS Protected Growth

Protected American Asset Allocation Fund Variable Annuity

Protected American Balanced Allocation

Protected American Growth Allocation

Protected Profile Conservative

Protected Profile Moderate

Protected Profile Growth

Protected Profile 2010





401(k)

401(k)

Variable Annuity

Variable Annuity

Variable Annuity

Variable Annuity

Historical backtest


Benchmark Protection Strategy

Average Return 7.0% 8.5%

Average Volatility 9.7% 8.4%

Average Equity 60% 58%

Maximum Drawdown -34.5% -18.0%

Sharpe Ratio 52% 77%

The Protection Strategy reduces the drawdown and improves the

Sharpe Ratio while maintaining the same average level of equity

exposure

-40%

-30%

-20%

-10%

0%

Drawdowns

Protection Strategy

Benchmark

0

50

100

150

200

250

Performance

Protection Strategy

Benchmark

Low Risk

Benefits when making withdrawals


Unprotected Volatility Managed Only Protected

Value of portfolio before crisis $100k $100k $100k

Return in first six months -46% -23% -10%

Value of portfolio before disbursement $54k $77k $90k

Value of portfolio after $4k disbursement $50k $73k $86k

Return in next six months +55% +28% +13%

Final value of portfolio $78k $93k $97k

Portfolio return net of disbursement -22% -7% -3%

Protected portfolios are especially valuable when investors are making withdrawalsBefore crisis: September 9, 2008

First six months of crisis: September 9, 2008 to March 9, 2009 (bottom of market) Next six months of crisis: March 9, 2009 to September 9, 2009 (recovery)

Outliving assets is a real risk


75 80 85 90 95

79%

62%

41%

20%

5%

Probability of a 65-year-old male reaching milestone ages

Life expectancy: 83 years

Significant probability of living longer than the average life expectancy

Longevity account


Longevity risk is addressed by making small annual allocations to deferred income annuities for a period before retirement

During retirement, income sources are diversified

Protection + Longevity Account = Member Goals


In summary


Individual investors more focused on risk management than in the past

Existing investment solutions − Continue to focus on diversification− Do not address risks investors view as major concerns

Next generation investment solutions are more attuned to investor concerns focusing on

− Volatility management− Capital protection− Longevity

addressing pre- and post-retirement needs


Milliman Pty. Ltd.L5, 32 Walker Street

North Sydney NSW, 2060

Phone: +61 2 8090 9100Email: [email protected]

www.milliman.com/frm

creating sustainable retirement solutions a global perspective ghalid bagus, fia fsa cfa principal...

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