Morningstar Advisor - Spring 2008 - 33

00000 90000 80000 70000 60000 The shortfall income risk is defined as the shortage of income compared to a target income at the fifth percentile for the same given investment horizon. The fifth percentile is chosen to represent the “worst” market performance scenario for the portfolio. This shortfall income risk is closely related to the well-known value-at-risk (VAR) concept, which has emerged as one of the financial industry’s premier risk-management techniques. VAR is an estimate of the loss that we expect to be exceeded with a given level of probability (e.g., 5%) over a specified time period. Likewise, shortfall income provides valuable information about the tail of the retirementincome distribution, which effectively captures the option features embedded in investment strategies, such as VA+GMWB. These two income measurements depict a more complete picture than the traditional efficient frontier.5 The other key advantage of the new efficient frontier is that it is customized to each individual investor’s financial circumstance, time horizon, target income level, portfolio risk level, and retirement portfolio balance. This advantage is essential. The retirement circumstances of any individual are unique—his or her portfolio analysis should reflect that. In this study, we made the following assumptions to form the case studies: r Retirement age: 65. r Retirement time horizons: 20 and 30 years. r Target income level: $50,000 for 30-year horizon; $60,000 for 20-year horizon. r Initial retirement portfolio balance at age 65: $1 million. r VA allocation: 80% assets in stocks and 20% in bonds. r Fees of asset classes and investment strategies: based on industry average in Morningstar database. To connect to the original efficient frontier, we took the four model portfolios (conservative, moderate conservative, moderate, and moderate aggressive) from the original mean Retirement-Income Efficient Frontier, 20-Year Horizon Median Sustainable Income $100K Stocks and Bonds A New Frontier The standard efficient frontier does not consider two dimensions crucial to retirement income: average sustainable income and shortfall income. To more effectively evaluate the risk-reward trade-off of retirementincome patterns, a new efficient frontier for retirement income had to be created. Ibbotson’s new frontier is now able to: r Model investment strategies that offer nontraditional payoff distributions, such as principal-protected products and VA+GMWB. r Consider each individual investor’s own financial circumstances, such as target income level and investment time horizon. 90 80 70 2 $0K Shortfall Income 4 60/40 40/60 80/20 20/80 6 8 10 Retirement-Income Efficient Frontier, 30-Year Horizon Median Sustainable Income $80K 80/20 70 60/40 40/60 Stocks and Bonds 60 20/80 4 6 8 10 fixed income is not able to generate required returns to meet the income target. The traditional mean-variance efficient frontier and the retirement-income efficient frontier share some similarities. Stock portfolios dominate the upper part of both efficient frontiers; bond portfolios dominate the lower part. In other words, stock portfolios are able to generate higher median income than bond portfolios, but typically with higher shortfall risk. Yet the two efficient frontiers are also different. The retirement-income efficient frontier and portfolio efficiency depend not only on return and risk, but also on the horizon and target income amount. The traditional efficient frontier, meanwhile, does not consider the portfolio balance or target income. Modeling Nontraditional Payoff Distributions $0K 2 Shortfall Income variance efficient frontier and plotted them in the retirement-income efficient frontier. 0 2000 4000 6000 8000 10000 For the 20-year horizon, the conservative 20% stock/80% bond portfolio generates a median income level of roughly $70,000 with a shortfall risk level about $2,000 (target income is $60,000). For the 30-year horizon, the conservative 20/80 portfolio generates a median income level of roughly $60,000 with a shortfall level of $4,000 (target income is $50,000). In fact, the 20/80 portfolio in the 30-year horizon is inferior to the more aggressive 40% stock/60% bond portfolio using the median sustainable income and shortfall risk measures. And it is no longer on 40/60 portfolio 10000 0 the efficient frontier; the6000 2000 4000 8000 generates a higher amount of sustainable income with less shortfall risk level. This is because the portfolio needs to generate enough return to sustain the income levels for a longer horizon. Therefore, the most conservative portfolio with most allocation to One advantage of the new efficient frontier is the ability to model investment strategies that offer nontraditional payoff distributions, such as principal-protected products and VA+GMWB. In this section, we analyze the impact of adding these nontraditional investment strategies into retirement-income portfolios on the sustainable median and shortfall income levels. MorningstarAdvisor.com 33
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Morningstar Advisor - Spring 2008

Table of Contents for the Digital Edition of Morningstar Advisor - Spring 2008

Morningstar Advisor - Spring 2008
Contents
Letter from the Editor
Inbox
Do You Use Annuities with Living Benefit Guarantees?
Managers Who Actively Enrich Shareholders
Staying Out of the Silos
Investment Briefs
Let’s Not All Become Fundamental Indexers Just Yet
Volatility Potential
Adding the Income Dimension
Do’s and Don’ts of RMDs
An Attractive Yield is Only Skin Deep
Mutual Funds Get in the Game
Beyond Target Date
The Last Holdout
A Bird of a Different Feather
First-Class Thinker
Sleep Like a Baby
Is Health Care Immune to a Recession?
Anatomy of a Mutual Fund Disaster
Embrace Your Inner Contrarian
Risks Worth Taking
Mutual Fund Analyst Picks
Undervalued Stocks
Most Popular Variable Annuities
New at Morningstar and on MorningstarAdvisor.com
Back to the Garden
Morningstar Advisor - Spring 2008 - Intro
Morningstar Advisor - Spring 2008 - Morningstar Advisor - Spring 2008
Morningstar Advisor - Spring 2008 - Cover2
Morningstar Advisor - Spring 2008 - 1
Morningstar Advisor - Spring 2008 - 2
Morningstar Advisor - Spring 2008 - Contents
Morningstar Advisor - Spring 2008 - 4
Morningstar Advisor - Spring 2008 - 5
Morningstar Advisor - Spring 2008 - 6
Morningstar Advisor - Spring 2008 - Letter from the Editor
Morningstar Advisor - Spring 2008 - 8
Morningstar Advisor - Spring 2008 - Inbox
Morningstar Advisor - Spring 2008 - Do You Use Annuities with Living Benefit Guarantees?
Morningstar Advisor - Spring 2008 - 11
Morningstar Advisor - Spring 2008 - Managers Who Actively Enrich Shareholders
Morningstar Advisor - Spring 2008 - 13
Morningstar Advisor - Spring 2008 - 14
Morningstar Advisor - Spring 2008 - Staying Out of the Silos
Morningstar Advisor - Spring 2008 - 16
Morningstar Advisor - Spring 2008 - 17
Morningstar Advisor - Spring 2008 - Investment Briefs
Morningstar Advisor - Spring 2008 - 19
Morningstar Advisor - Spring 2008 - 20
Morningstar Advisor - Spring 2008 - 21
Morningstar Advisor - Spring 2008 - Let’s Not All Become Fundamental Indexers Just Yet
Morningstar Advisor - Spring 2008 - 23
Morningstar Advisor - Spring 2008 - 24
Morningstar Advisor - Spring 2008 - 25
Morningstar Advisor - Spring 2008 - Volatility Potential
Morningstar Advisor - Spring 2008 - 27
Morningstar Advisor - Spring 2008 - 28
Morningstar Advisor - Spring 2008 - 29
Morningstar Advisor - Spring 2008 - 30
Morningstar Advisor - Spring 2008 - 31
Morningstar Advisor - Spring 2008 - Adding the Income Dimension
Morningstar Advisor - Spring 2008 - 33
Morningstar Advisor - Spring 2008 - 34
Morningstar Advisor - Spring 2008 - 35
Morningstar Advisor - Spring 2008 - Do’s and Don’ts of RMDs
Morningstar Advisor - Spring 2008 - 37
Morningstar Advisor - Spring 2008 - 38
Morningstar Advisor - Spring 2008 - 39
Morningstar Advisor - Spring 2008 - An Attractive Yield is Only Skin Deep
Morningstar Advisor - Spring 2008 - 41
Morningstar Advisor - Spring 2008 - Mutual Funds Get in the Game
Morningstar Advisor - Spring 2008 - 43
Morningstar Advisor - Spring 2008 - 44
Morningstar Advisor - Spring 2008 - 45
Morningstar Advisor - Spring 2008 - 46
Morningstar Advisor - Spring 2008 - Beyond Target Date
Morningstar Advisor - Spring 2008 - 48
Morningstar Advisor - Spring 2008 - 49
Morningstar Advisor - Spring 2008 - 50
Morningstar Advisor - Spring 2008 - 51
Morningstar Advisor - Spring 2008 - 52
Morningstar Advisor - Spring 2008 - The Last Holdout
Morningstar Advisor - Spring 2008 - 54
Morningstar Advisor - Spring 2008 - 55
Morningstar Advisor - Spring 2008 - 56
Morningstar Advisor - Spring 2008 - 57
Morningstar Advisor - Spring 2008 - 58
Morningstar Advisor - Spring 2008 - 59
Morningstar Advisor - Spring 2008 - A Bird of a Different Feather
Morningstar Advisor - Spring 2008 - 61
Morningstar Advisor - Spring 2008 - 62
Morningstar Advisor - Spring 2008 - 63
Morningstar Advisor - Spring 2008 - First-Class Thinker
Morningstar Advisor - Spring 2008 - 65
Morningstar Advisor - Spring 2008 - 66
Morningstar Advisor - Spring 2008 - 67
Morningstar Advisor - Spring 2008 - Sleep Like a Baby
Morningstar Advisor - Spring 2008 - 69
Morningstar Advisor - Spring 2008 - 70
Morningstar Advisor - Spring 2008 - 71
Morningstar Advisor - Spring 2008 - 72
Morningstar Advisor - Spring 2008 - 73
Morningstar Advisor - Spring 2008 - Is Health Care Immune to a Recession?
Morningstar Advisor - Spring 2008 - 75
Morningstar Advisor - Spring 2008 - Anatomy of a Mutual Fund Disaster
Morningstar Advisor - Spring 2008 - 77
Morningstar Advisor - Spring 2008 - Embrace Your Inner Contrarian
Morningstar Advisor - Spring 2008 - 79
Morningstar Advisor - Spring 2008 - Risks Worth Taking
Morningstar Advisor - Spring 2008 - 81
Morningstar Advisor - Spring 2008 - 82
Morningstar Advisor - Spring 2008 - Mutual Fund Analyst Picks
Morningstar Advisor - Spring 2008 - 84
Morningstar Advisor - Spring 2008 - 85
Morningstar Advisor - Spring 2008 - 86
Morningstar Advisor - Spring 2008 - 87
Morningstar Advisor - Spring 2008 - 88
Morningstar Advisor - Spring 2008 - Undervalued Stocks
Morningstar Advisor - Spring 2008 - 90
Morningstar Advisor - Spring 2008 - 91
Morningstar Advisor - Spring 2008 - Most Popular Variable Annuities
Morningstar Advisor - Spring 2008 - 93
Morningstar Advisor - Spring 2008 - 94
Morningstar Advisor - Spring 2008 - New at Morningstar and on MorningstarAdvisor.com
Morningstar Advisor - Spring 2008 - Back to the Garden
Morningstar Advisor - Spring 2008 - Cover3
Morningstar Advisor - Spring 2008 - Cover4
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