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I CAPITALPORTFOLIO P INTEGRATED SOLUTIONS SOL Integrating All Sustainable Sources of Performance to Build the Most Efficient Portfolio Solutions Designing A Better Retirement Solution Jacques Lussier, Ph.D., CFA Chief Investment Officer

  1. I CAPITALPORTFOLIO P INTEGRATED SOLUTIONS SOL Integrating All Sustainable Sources of Performance to Build the Most Efficient Portfolio Solutions

  2. Designing A Better Retirement Solution Jacques Lussier, Ph.D., CFA Chief Investment Officer November 2017

  3. Ta ble of C ontents + A Simple but Unrealistic Example 4 + Retirement Solutions 9 What is Offered and Discussed in the Literature + The Impact of Market Risk - During the Accumulation Period 14 - During the Transition & Decumulation Periods 20 + Beware of What Look T oo Good to Be True, It’s Not 26 + What Have we Learned ? 28 Confidential – Do not circulate 3

  4. A Simple But Unrealistic Example 4

  5. When We Know Ever ything  John is 30 years old & starts savings  He invests in a 60/40 portfolio that generates a stable 5.4% !  He earns $60,000  He retires at 65  His income increases yearly by 2%  Inflation is 2%  He systematically saves 10%  He lives up to age 85 117,641 53,657 John will generate an inflation adjusted income of 44.7% of his final salary. Without investment returns, he would run out of capital by age 70 + 5 months. Do not reproduce content of slides and charts without permission 5

  6. Retirement P la nning I s Ea sy I f We Know…  Savings starting date  Evolution of real income  The pattern of savings rate  Average and pattern of portfolio’s real returns  Retirement age  Health condition  Age of death  Cost of desired lifestyle after retirement  Reactions to extreme financial risks Otherwise it is a challenge, but a complex problem may have simpler solutions. Do not reproduce content of slides and charts without permission 6

  7. The C ost of C ompla c ency a nd Fea r C a n B e Hig h Base Scenario Age at which Savings Starts 30 Retirement Age 65 Age at Death 85 Savings Rate 10% Investment Returns 5.4% Wealth at Retirement – at 65 $777,658 Wealth Attributed to Savings $299,967 Wealth Attributed to Investment Income $477,691 Ratio of Retirement Income to Work Income 44.7% Sustainability Age 85 Lower returns alone would have reduced sustainability to 32.0% or 78Y and 4months. How can we deal with returns (investment policy and fears)? Do not reproduce content of slides and charts without permission 7

  8. The C ost of C ompla c ency a nd Fea r C a n B e Hig h Making All the Base Scenario Wrong Choices Age at which Savings Starts 40 30 Retirement Age 63 65 Age at Death 95 85 Savings Rate 10% 10% Investment Returns 4.2% 5.4% Wealth at Retirement – at 65 $338,524 $777,658 Wealth Attributed to Savings $210,971 $299,967 Wealth Attributed to Investment Income $127,553 $477,691 Ratio of Retirement Income to Work Income 44.7% 44.7% Sustainability Age 69 & 10 Months 85 Ratio of Retirement Income to Work Income 12.8% Sustainability Age 95 Lower returns alone would have reduced sustainability to 32.0% or 78Y and 4months. How can we deal with returns (investment policy and fears)? Do not reproduce content of slides and charts without permission 8

  9. Retirement Solutions What is Offered and Discussed in the Literature 9

  10. Wha t the I ndustr y I s Advoc a ting (Glide Pa ths) 100% Initial 90% 80% Transition Equity Allocation 70% 60% 50% Pre and Post Retirement 40% 30% 20% -35 -30 -25 -20 -15 -10 -5 0 5 7 10 15 35 Years Pre and Post Retirement Least Agressive Most Agressive Little difference between the least and most aggressive glide paths. All favor a conservative portfolio at least 5 years before retirement. Do not reproduce content of slides and charts without permission 10

  11. I n the Absenc e of a Dyna mic Approa c h There is no Definite C onsensus  Esch & Michaud - Among 101 glide paths (rising, stable and declining) having the same volatility of final wealth, there are no clear winners. This ignores investor behavior.  Arnott – It makes little sense to have the highest allocation to equity when wealth is small and the least when wealth is high. This ignores investor behavior and this study compares portfolio allocations that have significantly different risk profile. Do not reproduce content of slides and charts without permission 11

  12. Four G lide Pa t hs Whic h is the Most P rofita ble / the Lea st Risky? 100% 51 years and 5 months 80% Equity Allocation 60% 40% Evolution of Equity Allocation Across Time 20% Flat at 60% From 80% to 40% 40 % to 80% Traditional 0% 30 35 40 45 50 55 60 65 Age Dollar Weighted Average Equity Average Equity Equity Allocation Path Final Wealth at Retirement Percentage Allocation Allocation Flat at 60% $777,658 60.0% 60.0% From 80% to 40% $744,928 60.0% 50.8% From 40% to 80% $811,852 60.0% 69.6% Traditional Glide Path $812,181 72.9% 59.1% Which Glide Path is most likely to be feared & challenged by the participant as he approaches retirement ? Do not reproduce content of slides and charts without permission 12

  13. The Ar nott Ar g umenta tion I g nores the I mpa c t of C ompounded Retur ns a nd B ehavior 700,000 $ Evolution of Equity Allocation Across Time Equity Allocation 600,000 $ Flat at 60% From 80% to 40% 40% to 80% Traditional 500,000 $ 400,000 $ 300,000 $ 200,000 $ 100,000 $ 0 $ 30 35 40 45 50 55 60 65 Age Wealth at 51 Years and 5 Wealth at 65 Wealth at 65 Equity Allocation Path Months if 40/80 A fter 51 Years if Traditional After 51 years From 40% to 80% $276,168 $811,852 $715,100 Traditional Glide Path $313,660 $922,067 $812,181 Difference $37,392 $110,215 $97,181 No reasonable individual would prefer maximum exposure to equity just before retirement even if the argument could be made that the distribution of expected wealth 35 years from now would be the same. Do not reproduce content of slides and charts without permission 13

  14. The Impact of Market Risk During the Accumulation Period 14

  15. Risk/Vola tility is Not Always B a d Lets look at 3 different Value Equivalent Savings patterns Savings Cash Flows Cash Flows Cash Flows Patterns Year = 0 Year = 1 Year = 2 # 1 $3,000 # 2 $1,500 $1,581 # 3 $1,000 $1,054 $1,110.90 And 3 different Market environments Market Returns Returns Returns Compounded environment Year 1 Year 2 Year 3 Returns # A 5,40% 5,40% 5,40% 5.40% # B -14,60% 30,08% 5,40% 5.40% # C -14,60% 17,09% 17,09% 5.40% Savings Final Wealth Δ Final Wealth Δ Final Wealth Patterns Market # A Market # B Market # C # 1 $3,512.72 $0.00 $0.00 # 2 $3,512.72 + $411.33 + $411.33 # 3 $3,512.72 + $274.22 + $404.12 Risk can be a good thing. But what if there is significant wealth already ? Do not reproduce content of slides and charts without permission 15

  16. How Muc h Risk a nd for How Long ? Impact of a 20% Under Performance at Different Point in time With and Without Market Recovery 10% 5% Excess Wealth 0% 30 35 40 45 50 55 60 65 Age at which market downturn occurs -5% -10% -15% Length of market recovery -20% 1 Year 3 Years 5 Years No Recovery -25% No recovery implies 4.73% compounded return vs. 5.4 % If your accumulated wealth is small, you are better off if market downturn happens early and if market recovery is long. Do not reproduce content of slides and charts without permission 16

  17. A More Rea listic Environment What is the likelihood that a portfolio with a 90/10 allocation for “X” years will underperform a stable 60/40 allocation as “X” increases? Vide The longer the horizon, the greater the benefit of taking risk during accumulation The level of wealth at the 1 % probability level, when the allocation is 60/40 for 40 years is identical to that of an allocation maintained at 90/10 for 20 years and 60/40 for another 20 years. The shorter the remaining horizon, the greater the likelihood the expected return will not be met 40 Monte Carlo based on the same 30,000 scenarios # of Years at 90% Equity allocation High risk can be sustained for up to 15 to 20 years prior to retirement. Do not reproduce content of slides and charts without permission 17

  18. Equity Risk a s a Sha re of Por tfolio Wea lth a nd Hum a n C apit a l Evolution Wealth & Human Capital (Present Value of Future Savings) and Implicit Equity Exposure 70% 800,000 Portfolio Wealth - L 700,000 60% Human Capital - L Dollar Amount 600,000 50% Equity / [Port. Wealth + Human Capital] - R 500,000 40% 400,000 30% 300,000 20% 200,000 10% 100,000 0% 0 30 35 40 45 50 55 60 65 Age This example ignores the impact of Social Security This is why some authors argue for leveraging the retirement portfolio. However, the issue is how to optimize without leverage. Do not reproduce content of slides and charts without permission 18

  19. The Less You Have Saved the La ter in Time Risk C a n B e Toler a ted!!! What is the likelihood that a portfolio with a 90/10 allocation for “X” years will underperform a stable 60/40 allocation as “X” increases? The level of wealth at the 1% probability level, when the allocation is 60/40 for 15 years is identical to that of an allocation maintained at 90/10 for 6 years and 60/40 for another 9 years. # of Years at 90% Equity allocation Based on 30,000 scenarios High risk can be sustained for up to 8 to 10 years prior to retirement. Do not reproduce content of slides and charts without permission 19

  20. The Impact of Market Risk During the Transition & Decumulation Periods 20

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