Post-Retirement Risks

1. Longevity

2. Family issues

3. Health and long-term care

4. Business and public policy

5. Investment

1. Longevity Risk

• Outliving your resources

• Problems created when death occurs

• Death of a spouse– First-to-die life insurance

One Way to Plan?

• Use life expectancy to plan– Many expect to outlive average– Many underestimate what is average

• Add 5 or 10 years to the average life expectancy

• Annuitize certain assets to provide lifetime income

Longevity Risk

AgeLife

ExpectancyAge

Life Expectancy

60

61

62

63

64

65

24.2

23.3

22.5

21.6

20.8

20.0

66

67

68

69

70

Etc.

19.2

18.4

17.6

16.8

16.0

Etc.

Source: Unisex Table V

Annual Percentage of DeathsPopulation of 65 Year Olds

0.0%

1.0%

2.0%

3.0%

4.0%

5.0%

6.0%

7.0%

8.0%

65 75 85 95 105

Source: 2000 Individual Annuity Mortality table

Life Expectancy

Life Probabilities at Age 65

01020

3040

506070

8090

100

70 75 80 85 90 95

Male

Female

1 Member ofa Couple

Source: Society of Actuaries RP-2000 Table

Age

%

The Uncertainty of Life

• Highly uncertain variable

• Consider probabilities based on certain ages– Not: “20 years at age 65”– But rather: “a 63% chance at age 65 that

one spouse will live to 90”

Implications for Longevity Risk

• More uncertainty– Order of death for a couple– Women tend to outlive men – Changes in life expectancy of survivor

• Immediate financial needs• Overall capital needs

• Flexibility: update longevity estimates as time passes

Managing Longevity Risk

• Social Security

• Annuities

• Reverse mortgages

2. Family Issues

• Divorce and remarriage

• Unexpected death of the retiree or an adult child with dependents

• Job loss of the retiree, a spouse, or an adult child

Other Family Matters

• Care of a grandchild or other dependent

• Elder care for retiree parents

• Paying for college while in retirement

• Costs– Medicare, insurance premiums and coverage,

prescription drugs, LTC

• Geographic resources– Caregivers, facilities– Ability to live alone

• COBRA• Advance directives

– POAs, living wills

3. Healthcare and Long-Term Care Risks

LTC Needs & Issues

• Assisted living facilities– Average yearly cost: $28,548

• Nursing home facilities– Average yearly cost: $57,000 to $66,000

• Home health care– Average hourly cost: $18.12

• Trading premiums for expected benefits

Source: MetLife 2003 Survey

Types of LTC Insurance

• Indemnity policy – pays fixed benefit amount• Expense-incurred – reimburses for actual

expenses up to a fixed amount• Integrated policy offers a total dollar amount

toward different types of LTC services• Daily benefit amounts for nursing home care:

$50 to $300 per day

LTC Policy Features• Definition of benefit triggers• Inflation protection• Coverages

– ADLs– Adult day care– Assisted living– Nursing home coverage: at least 1 year of coverage– Coverage for Alzheimer’s – Respite care for the caregiver

• Tax treatment: premiums qualify for 7.5% medical expense deduction

Housing Needs

• Downsizing for early retirees

• Relocation issues

• Retiree expectations

• Home as an asset– Natural disasters (e.g., earthquake or flood)

4. Business & Public Policy Risk

• Employer bankruptcy• Employee benefits reduced or eliminated• Insurer solvency• Employment risk

– Physical ability– Job availability

• Diversification– Employer stock concentrations– Annuity insurer diversification

Legislative Changes

• Social Security– Later start ages for boomers

• Medicare

Tax Rate Change Risk

• Rate/rule changes– Income tax– Estate tax

• Imagine making a retirement income plan in 2000– Then EGTRRA 2001– Sunset provisions

Need to monitor proposals

Historical Income Tax Rates

0

10

20

30

40

50

60

70

80

70 74 78 82 86 90 94 98 '02

Income %

Cap gain %

Year

%

2004 top rate: 35%

Historical Income Brackets

0

50000

100000

150000

200000

250000

300000

350000

70 74 78 82 86 90 94 98 '02

Max Income

Client Income

Year

$

2004 top rate: 35%

More Income Tax Rate Variables

• “Assumed” lower tax rate in retirement– Match the tax bracket to the retiree’s

income need

• Bracket change due to death of a spouse– Lower expenses for the surviving spouse– From married filing joint to single

Change in Filing Status

• Married filing joint (MFJ)

• $70,000 = 25% income tax bracket

• If the surviving spouse needs only $50,000, then would be 15% bracket

• Single• $70,000 = 28%

income tax bracket• If the surviving

spouse needs only $50,000, then would be 25% bracket

The Best Tax Income

• Capital gains

• Which spends better: $1 of ordinary income or $1 of capital gain income?

• The challenge: overcoming the “I don’t want to spend principal” mindset

An “Ordinary” IllustrationOrdinary income tax• $142,857• 1% interest annually

($1,428.57)• Lose 30% ($428.57)

to ordinary income tax

• $1,000 left after taxes

• Capital Gain Tax• Same $142,857

grows by 1% to $144,286

• Sell $1,428.57 after one year

• Lose 15% ($214.29) to capital gain tax

• $1,214.28 left after taxes

5. Investment Risk

• Inflation risk

• Interest rate risk

• Market risk

Inflation Risk

• Not of major concern right now

• How you define it matters

• Any fixed income stream is exposed

• Interest in products with cost of living adjustments is low at present

Historical Inflation Rates by Year

0

2

4

6

8

10

12

14

73 75 77 79 81 83 85 87 89 91 93 95 97 99 '01

CPI%

Source: Bureau of Labor Statistics

Rolling Period Historical Inflation Rates

2.35

6.01 6.21

3.13

0

1

2

3

4

5

6

7

%

1953 to1972

1963 to1982

1973 to1992

1983 to2002

20 Year Period

Source: Ibbotson Associates

Defining Inflation for a Retiree

• One rate: CPI

• By expense type– Healthcare– Food/utility– Home value– College– Others

Inflation by Components of CPI

50

100

150

200

250

300

350

78 82 86 90 94 98 '02

Housing

Food

Apparel

Transportation

Medical care

Other goods

CPI: All items

Source: Bureau of Labor Statistics

When Do You Want Your Risk?

Time

Ris

k Principal

Purchasing Power

Source: Nick Murray, The New Financial Advisor. Used with permission. For broker/dealer use only.

Strategies for Handling Inflation Risk

• Control expenses over time• Certain resources are/can be protected

– Social Security– I bonds– Variable annuities– COLA annuities– Real estate and/or REITs– Stocks

Interest Rate Risk

• Fixed income assets exposed

• Interest rates are currently low by historical standards

• Reinvestment rate risk– Call risk

• But low rates are good news and good timing for some income products

Historical Interest Rates

0

2

4

6

8

10

12

14

16

1972

1975

1978

1981

1984

1987

1990

1993

1996

1999

2002

1-Year TreasuryRate

10-Year TreasuryRate

30-Year TreasuryRate

Source: Federal Reserve

Market Risk

• Retirees have a high degree of concern with short-term volatility

• Investment return variability– Ibbotson 5-, 10-, 15- and 20-year rolling

periods

5-year holding periods

1-year holding periods

Each bar shows the range of compound annual returns for each asset class over the period 1926–2002.

Smallcompany

stocks

Largecompanystocks

Governmentbonds

Treasury bills-75%

-50%

-25%

0%

25%

50%

75%

100%

125%

150%

20-year holding periods

10.2%12.1% 5.5% 3.8%

Compound annual return

Reduction of Risk Over Time1926–2002

This is for illustrative purposes only and not indicative of any investment.Past performance is no guarantee of future results. 3/1/2003. © 2003 Ibbotson Associates, Inc.

Spot the Pattern

Market Risk Going Forward

• Future expectations– Equity risk premium

• Predictions & debates

A Deterministic QuizQ. If you had $100,000 averaging 6% per year, and you withdrew 6% per year, what would your balance be at the end of 10 years?

a. $100,000

b. $71,531

c. $0

A. Depends on two factors:

1. Are there any years with negative returns?

2. When do the losses occur?

$100,000 in Hypothetical Investment with 1st Year Loss

Year Rate of Return Withdrawal Ending Balance

1 -15% 6,000 79,900

2 -10% 6,000 66,510

3 10.63 6,000 66,939

4 10.63 6,000 67,414

5 10.63 6,000 67,939

6 10.63 6,000 68,520

7 10.63 6,000 69,163

8 10.63 6,000 69,874

9 10.63 6,000 70,661

10 10.63 6,000 71,531

Average RoR 6%

Recovery Returns

• Average RoR required to get back to $100,000 (while still making withdrawals) is

50% in 1 year

14.1% in 8 years

11% in 18 years

Lessons Learned

• Returns aren’t linear in the securities markets

• Major asset allocation changes (more price/market risk) may be necessary to make up for a bad year early in the distribution years

Retiring in Different Decades

• Retiree has $500,000 portfolio in either– All stocks, or– All bonds, or– 60/40 stocks/bonds

• 5% withdrawal first year, indexed for actual inflation

• Some years are better than others…

1960

$0

$100,000

$200,000

$300,000

$400,000

$500,000

$600,000

$700,000

$800,000

$900,000

1960 1965 1970 1975 1980 1985 1990 1995

Stocks

Bonds

60/40

Withdrawal

1970

$0

$100,000

$200,000

$300,000

$400,000

$500,000

$600,000

$700,000

1970 1975 1980 1985 1990 1995

Stocks

Bonds

60/40

Withdrawal

1980

$0

$1,000,000

$2,000,000

$3,000,000

$4,000,000

$5,000,000

$6,000,000

$7,000,000

$8,000,000

1980 1985 1990 1995 2000

Stocks

Bonds

60/40

Withdrawal

1990

$0

$200,000

$400,000

$600,000

$800,000

$1,000,000

$1,200,000

$1,400,000

$1,600,000

$1,800,000

1990 1995 2000

Stocks

Bonds

60/40

Withdrawal

More Lessons Learned

• The sequence of returns matters—a lot!

• Linear assumptions (x% per year for 25 years) are unrealistic and dangerous to a portfolio’s health

• We can know the past with precision, but the future is unknown

• Monte Carlo simulations

Asset Allocation

• The accumulation years are different from the distribution years.– Conventional wisdom: go more conservative– For a “die broke” mentality, go conservative– For an inheritance mentality, go more

aggressive• More time• Multigenerational investment policy

Investor Characteristics

• Age

• Investment experience

• Risk tolerance

• Personal financial factors

• Risk capacity

Managing Portfolio Risk

• Rebalancing

• Diversification

Techniques for Measuring Risk: Pros and Cons

• Deterministic: single outcome; linear

• Scenario: changes in some variables = what if?

• Stochastic: range of outcomes; Monte Carlo simulation

• GIGO

Monte Carlo Basics

• Considers multiple risk variables at one time– Returns, volatility, correlation, return order,

longevity– Roll the dice

• Produces portfolio values and probabilities

• Monte Carlo illustrated: The iMulator game (courtesy of Financeware)

The iMulator Game• Get into small groups of six• One person is the scorekeeper, aka the financial

advisor, who uses the Scorecard• Another person is the mortician, who uses the

Mortality Table• Another person is the market, who uses the Growth

Factor Table• Two people are the dice; you will be choosing

numbers between 1 and 6 randomly and independently

• One person is the client!

Wealth Forecasting With Cashflows: MC Simulation

Portfolio Balance

$10,000

$100,000

$1,000,000

$10,000,000

$100,000,000

65 70 75 80 85 90 95 100Age

75%

90%

50%25%

10%

Monte Carlo Pros & Cons

Pros• Uses multiple

variables• Shows probabilities• Attempts to deal

with the unexpected• Easy to see results

of variable changes

Cons• Can be interpreted

as certainty• Historical

assumptions• Differences in

probabilities are difficult to grasp

• Can’t predict very unusual events