Morningstar Advisor - Spring 2008 - 34

Spotlight A principal-protected strategy offers investors the ability to participate in the upside of the equity market, with downside protection that guarantees the return of principal after a certain investment period.6 In exchange for the downside protection, investors give up some upside and liquidity for a period of time or pay an annual fee. Retirement-Income Efficient Frontier with Principal Guaranteed Products, 20-Year Horizon Median Sustainable Income $100K 90 60/30/10ELCD 40/45/15ELCD 80 20/60/20ELCD 70 20/80 40/60 60/40 Stocks and Bonds + ELCD Stocks and Bonds 80/10/10ELCD 80/20 For a standalone VA+GMWB, the shortfall income is $0 because the income is at least 5% of the initial investment of $1 million ($50,000). For the conservative 20/80 portfolio with the 30-year horizon, the income is only $45,956 at the fifth percentile; thus, the shortfall income is $4,044 ($50,000 - $45,956). However, in a combined 20/60/20 portfolio (the fixed-income allocation of 20% was replaced by 20% VA+GMWB in the conservative portfolio), the shortfall income declined to $2,642. Retirement-Income Efficient Frontier with VA+GMWB, 30-Year Horizon Median Sustainable Income $80K VA+GMWB 70 40/45/15VA 20/60/20VA 60/30/10VA 60/40 40/60 20/80 4 6 8 10 Stocks and Bonds + VA Stocks and Bonds 80/20 analysis and investment strategies with embedded options that provide nontraditional payout distribution. In addition, the new efficient frontier is able to take each individual investor’s own financial circumstance into consideration, such as target income level and investment horizon.8 Because of these advantages, we believe that the new efficient frontier, used together with the traditional mean-variance efficient frontier, is more effective for helping financial advisors analyze the appropriate portfolio allocation for retirement-income purposes than the traditional mean-variance frontier alone. K Peng Chen, Ph.D., CFA, is president and chief investment officer of Ibbotson Associates. James X. Xiong is a research consultant at Ibbotson. 80000 70000 60000 2 $0K Shortfall Income 4 6 8 10 60 Intuitively, we’d expect that the impact of a principal guarantee product would most significantly be felt on the conservative portfolios on the lower end of the efficient frontier, because of these products’ ability to improve the returns of conservative portfolios without causing principal losses. We reallocated some of the fixed-income allocations in each of the four model portfolios to equity-linked CDs (ELCD). The figure above shows that the portfolios with allocations to principal-protected strategies are able to provide higher median income with slightly higher shortfall risk for conservative (20/80) and moderate conservative (40/60) portfolios. A VA+GMWB gives investors the ability to protect their retirement investments against 0 2000 4000 6000 8000 10000 downside market risk by allowing them to in 0 withdraw a fixed percentage (5%, 8000this 10000 2000 4000 6000 paper) of the benefits base each year until death. The best aspect of this guarantee is that it protects annuitants against any nominal investment losses that would have been incurred without losing the benefit of upside gain. In exchange for this benefit, the annuitant pays an annual fee of 0.3% to 0.7%. 2 $0K Shortfall Income The figure above shows that the three combined portfolios (20/60/20, 40/45/15, and 60/30/10) have higher average income levels than stand-alone traditional mutual fund portfolios. For conservative (20/80) and moderate conservative (40/60) portfolios, additions of VA+GMWB even lead to a reduction in shortfall income risk due to the guaranteed income feature in the VA+GMWB. In other words, adding VA+GMWB to the conservative and moderate conservative model portfolios enhances average income and reduces shortfall risk for investors needing 0 2000 4000 6000 8000 roughly 5% from their portfolios to sustain 10000 retirement income for 30 years or more.7 Stocks and Bonds + ELCD Stocks and Bonds Conclusion Our new efficient frontier for retirement income has two dimensions: average sustainable income and shortfall income for a given horizon. The shortfall income risk captures the tail of the retirement-income distribution, similar to value-at-risk, which captures the tail loss for return distributions. Therefore, the new income frontier is able to incorporate both longevity Footnotes 1 This article is a version of the February 2008 Ibbotson Associates working paper “New Efficient Frontier for Retirement Income Portfolios.” Please refer to the working paper for more details. The authors would like to thank Kevin Zhu, Thomas Idzorek, Roger Ibbotson, and Moshe A. Milevsky. 2 Harry Markowitz, “Portfolio Selection,” Journal of Finance, September 1952, pp.77-91. 3 This new retirement efficient frontier framework is an extension of the work by Peng Chen and Moshe A. Milevsky, ”Merging Asset Allocation and Longevity Insurance: An Optimal Perspective on Payout Annuities,” Journal of Financial Planning, (June 2003): 64-72; and Peng Chen, Roger G. Ibbotson, Moshe A. Milevsky, and Ken X. Zhu, “Lifetime Financial Advice,” CFA Institute Research Foundation Monograph (2007). 4 We ran 5,000 simulation runs for each analysis. 5 We can also gauge the risk-reward trade-off of the portfolio using other measures instead of median income and shortfall level. The results are similar. 6 The principal-protected product is conceptually similar to buying a put on a portfolio. In this paper, we analyze an equity-linked CD product that matches the return of S&P 500 index price return and guaranteed principal return in seven years. 7 Investors needing much higher or much lower percentage of withdrawal from their portfolio to sustain retirement income would still benefit from including VA+GMWB; however, the benefit might not be as much as those illustrated in this article. 8 The analysis here is based on nominal dollars; we also conducted inflation-adjusted studies in the full paper. The results are similar. 34 Morningstar Advisor Spring 2008

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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