Income Solutions Framework

Transcription

1 Income Solutions Framework GWM Investment Management & Guidance summer 2015 Yago Gonzalez, CFA, Director, Senior Portfolio Manager Himanshu Almadi, Director, Senior Portfolio Manager Rajesh Kohli, CFA, Director, Senior Portfolio Manager Income from investments is an important objective for many investors, not only individuals entering retirement but also institutions such as endowments and foundations. The demand for income-generating solutions will likely grow, driven by demographic trends such as the aging baby boomer generation. Investors who have generally relied on fixed income high-quality securities, however, are entering an investment landscape far different than in the past, and many must seek a wider range of assets, at varying levels of risk, to achieve and maintain desired levels of income. To help investors deal with these complexities as they build income solutions, GWM Investment Management & Guidance (IMG) outlines an approach to building income in this paper. Specifically, we seek to help Financial Advisors and their clients: Understand the value of diversification and how to implement it in income-oriented solutions; Develop a strategy to mitigate downside risk during shifting market cycles through dynamic asset allocation; and Better achieve objectives such as capital appreciation, income growth and keeping pace with inflation while maintaining the ability to generate their desired level of income. Key Considerations Investors should keep the following points in mind in constructing income-oriented solutions: Yields for the Various Income-Generating Asset Classes Can Vary Significantly: A multiasset class solution gives investors the flexibility to match income requirements through active management of allocations. Downside Risk Management Comes with Certain Costs: A strategy to mitigate downside risks through dynamic asset allocation may help preserve capital but can lower the overall yield and lag in terms of capital appreciation. Equities Can Play an Important Role in Income Portfolios: Although they typically have higher risks and lower yields than most fixed income sectors, equities, when properly employed, may provide diversification and enable investors to meet important objectives such as capital appreciation, income growth and mitigating the effects of inflation. The Wealth Allocation Framework LIFE PRIORITIES The Wealth Allocation Framework helps you put your goals and aspirations at the center of decisions about allocating your financial resources. This paper focuses on strategies that may be appropriate for the Personal and Market asset categories. Personal: Individual investors have a desire for safety and personal financial obligations they want to meet regardless of market conditions. To safeguard essential goals, investors can hold lower-risk assets but they have to accept lower returns in exchange. Market: When we invest, we strive to capture market growth most efficiently. Today, access to a broadening array of asset classes and types makes diversifying beyond stocks and bonds easier than ever before. To learn more, read the whitepaper, Investing in a Transforming World: The Wealth Allocation Framework Merrill Lynch makes available products and services offered by Merrill Lynch, Pierce, Fenner & Smith Incorporated (MLPF&S) and other subsidiaries of Bank of America Corporation ( BAC ). Investment products: Are Not FDIC Insured Are Not Bank Guaranteed May Lose Value MLPF&S is a registered broker-dealer, Member SIPC and a wholly owned subsidiary of BAC Bank of America Corporation. All rights reserved.

2 Faced with a low interest-rate environment and higher market volatility, investors are finding it increasingly more difficult to generate adequate levels of income through traditional investment-grade fixed income strategies. The search for yield has led investors to unfamiliar strategies with inherently more risky and complex instruments. Many investors seek capital appreciation and/or income growth from their investments in addition to their primary objective of income. In particular, income growth can be an objective for investors seeking to keep pace with inflation. We believe, however, that investors are not protecting their portfolios from the long-term threat posed by inflation. To help face these challenges, we believe investors today will need to build income solutions based on a broader, more comprehensive approach to income generation than in the past. This framework, in our view, should include 1 : Diversification of sources of income - We believe clients need broad diversification across asset classes, regions, sectors, managers, and investment vehicles for flexibility and to help mitigate the additional risk taken on by investors as they invest outside of high-quality fixed income. Downside risk management - In our view, a strategy to manage downside risk is crucial as investors take on additional risk to meet their income needs. Moreover, the markets have become more volatile over the past several years and a continuation of this volatility further emphasizes the need for protecting principal. Capital Appreciation and Income Growth - We believe income investors who also need to grow the value of their investment portfolio should incorporate holdings that have the potential to provide capital appreciation such as equities in their income portfolios. For investors seeking income growth What Are Income-Oriented Investments? Investors have traditionally considered income-oriented (or simply income ) investments to be relatively consistent, reliable sources of cash. As a result, income investments have enjoyed popularity among foundations, endowments and retirees. In fact, a massive wave of baby boomers exiting the workforce is driving demand for retirement income and hence income investments sharply higher. Income investments have also been utilized as a hedge against riskier assets such as certain equities in traditional portfolios. to combat inflation, we believe inflation-linked bonds as well as dividend growth equities may be a part of the income solution. This paper provides an in-depth examination of these issues and explains how investors can approach income today and implement a robust income solution that meets their needs. In addition, GWM Investment Management & Guidance (IMG) has, in the course of its research on this topic, developed a set of model portfolios that illustrate our framework for constructing optimal and flexible income solutions. 1. Diversifying Sources of Income Creating Levers of Income Traditionally, fixed income, or bonds, has been the major source of income for income-oriented investors. Exhibit 1 (on the next page) identifies the different sub-asset classes within fixed income and their yield ranges over the past 14 years. However, after three decades of declining interest rates, current yields available are not sufficient to meet income needs. Hence, investors should consider multiple sources of portfolio income (please refer to whitepaper on Generating Portfolio Income ). As seen in Exhibit 1, there can be significant variability in the yield provided by the various fixed income sectors. For example, high yield has ranged between 5% and 22% over the past 14 years. This variance implies that income investors cannot typically rely on a single asset class to meet their income needs but rather a multi-asset class solution, even within fixed income, that gives them the flexibility to match their income requirements through allocation choices. We view the inclusion of a broader set of income generating investments in an income solution as creating levers of income, which portfolio managers can pull to actively manage and match yield levels. Certain equities can also provide an important source of income for investors with the added benefits of potential for capital appreciation and income growth. Exhibit 2 (on the next page) identifies the different sub-asset classes within equities and their yield ranges over the past nine years. As with fixed income, we note the significant variability in yield for the various asset classes/sectors. Hence a multiasset class solution would offer investors the flexibility to match their income needs while diversifying risk. Besides choosing mutual funds and exchange-trade funds (ETFs) which target a broad range of dividend-paying stocks on a domestic or global scale, investors should also consider investing in 1 Diversification does not ensure a profit or a guarantee against loss in declining market. Income Solutions Framework 2

3 Exhibit 1: Yield Range on Fixed Income Assets: 9/2006-6/ % 20% 15% 10% 5% 0% -5% 18% 16% 14% 12% 10% 8% 6% 4% 2% 0% Median Merrill Lynch U.S. Broad Agency MBS Dividend-Paying Stocks Median High Yield Preferreds Emerging Market Debt IG Corporates U.S. Treasuries REITs MLPs Utility Stocks International Sovereign Exhibit 2: Yield Range on Equity Income Assets: 9/2006-6/2015 narrower strategies that target sectors or asset classes ideally suited to income generation, such as utilities, Master Limited Partnerships (MLPs), real estate investment trusts (REITs), financials and consumer staples stocks. Utilizing appropriate Deciding Whether to Include MLPs in Your Equity Allocation Master Limited Partnerships (MLPs) is a sub-asset class often overlooked in broad equity-based strategies. These have offered some of the highest yields within the equity space and higher growth compared to other dividend-paying securities. While the tax treatment may potentially be advantageous, the tax treatment is also complex. Investors can access MLPs through separately managed accounts (SMAs), mutual funds and ETFs. There are significant differences in terms of tax treatment and after-tax returns as well as fees and investment minimums for these vehicles, and investors should take these into account when choosing a MLP-focused strategy. TIPS Preferred Stock Source: IMG Investment Analytics, 2015 * The value of equity securities may be more volatile and U.S. Treasuries are guaranteed as to the timely payment of principal and interest. For Index Definitions see page 7. sector funds can allow the investor to create portfolios where he or she can make active-sector allocation decisions rather than delegating that decision to a broad-based equity investment manager. This again would enhance the flexibility of investors as they reach for their desired yield level. Diversifying Risk As investors tap into higher yielding sectors within fixed income into asset classes like equities to meet their income requirements or capture income growth and capital appreciation, they should also be aware that these assets may carry higher risk. Exhibit 3 shows the median yield and volatility of different sectors. Median Yield (%) Exhibit 3: Median Yield vs. Standard Deviation: 9/2006-6/ Annualized Standard Deviation (%) Source: IMG Investment Analytics, Dividend-Paying Stocks Utility Stocks MLPs REITs Preferreds U.S. Treasuries U.S. TIPS Investment Grade Corporates Agency Mortage-Backed U.S. High Yield International Sovereign Emerging Market Debt ML US Broad S&P 500 Because of the higher volatility (as measured by an annualized standard deviation) of certain fixed income sectors like high yield, investors should diversify their exposure by sourcing income from multiple sectors and using pooled investment vehicles. When deciding allocations to multiple asset classes, it is important to consider metrics such as correlations. For instance, the correlation of monthly returns over the past 10 years between the U.S. High Yield sector and the Emerging Markets Debt sector, two commonly used sectors in income-oriented portfolios, is quite high at The additional yield that these sectors offer over U.S. Treasuries is driven by similar factors. In periods when risk-aversion is increasing, traditionally highyielding sectors typically lose value. Better diversification can be achieved by combining risky sectors with those having less credit risk, such as government debt. While inclusion of these Asset Class Indices: ML US Broad: ML US Broad Index (US00); Agency MBS: ML Mortgage Master (M0A0); High Yield: ML US High Yield Master II (H0A0); Preferreds: ML Fixed Rate Preferred Securities Index (P0P1); Emerging Market Debt: ML Global Emerging Market Sovereign Debt Plus (IP00); IG Corporates: ML US Corporate Master (C0A0); US Treasuries: ML US Treasury Master (G0Q0); International Sovereign: ML Global Government Bond II Excluding US (N0G1); TIPS: ML US Treasuries Inflation Linked (G0QI); Dividend-Paying Stocks: Dow Jones US Select Dividend TR Index; REITs: FTSE NAREIT Total Return Index; MLPs: Alerian MLP Index; Utility Stocks: Dow Jones Utility Index; Preferred Stocks: ML Fixed Rate Preferred Securities Index (P0P1) Income Solutions Framework 3

4 diversifying sectors can lower overall yield (because their yields lack the additional risk premium paid by higher-yielding sectors), they can significantly lower a portfolio s overall level of risk. Another component of mitigating risk through diversification is the use of pooled vehicles of securities such as mutual funds, ETFs and closed-end funds. Fixed-income mutual funds and ETFs are generally managed with a total return 2 objective, meaning that the manager (or benchmark in the case of an ETF) is not seeking specifically to deliver stable income. Although the total return objective does have an implicit income component through the yield of the securities, this may fluctuate significantly as the investment environment changes. Similarly, equity mutual funds are often managed with a total return objective, with income as a component/ secondary objective. Even though these funds can be used in income-generating portfolios because of their higher yields, investors should be aware of a potential divergence between their objectives and those of the portfolio managers. The main advantages of fixed-income and equities mutual funds and ETFs are liquidity and diversification. Closed End Funds Closed-end funds tend to provide a stable source of income because the manager s objective is to deliver a targeted yield, and the volatility of principal is mitigated by the fact that they are closed (set number of shares). The main disadvantage of this vehicle is its relative illiquidity (vis-à-vis mutual funds and ETFs) and the dislocation that often occur between the value of the underlying holdings and that of the closed-end fund in the open market. IMG s Guidance to Risk Diversification We believe that the following practices are paramount considerations in managing risk: Limiting exposure to narrow sectors to minimize concentration; Optimizing diversification by allocating between the various asset classes/sectors with the objective of maintaining desired yield levels while minimizing volatility. With this approach, where several allocation mixes can match the yield needed, we prefer the allocation mix that provides the lowest volatility; and Employing a downside risk management strategy. Other considerations in building income-oriented solutions While diversification may help an income solution mitigate risk and provide flexibility in reaching the investor s yield target, it should not be the only consideration in choosing which incomeoriented investments are selected. Valuations, both at a security, sector and regional level, are important for an equity income portfolio. For example, at the end of the first quarter in 2014, we found that dividend growth stocks had lower valuations versus stocks that had high dividend yields. Similarly, at the same time certain sectors like utilities seem overvalued versus sectors like healthcare. Fundamental metrics such as valuation, earnings growth and dividend growth are important considerations in building income portfolios in addition to yield and volatility. Based on the need for diversification as well as an analysis of fundamental metrics from the point of view of attractive yields, diversification, valuations and dividend growth, we believe that equity income portfolios should incorporate the following sectors domestic dividend-paying stocks, international dividend-paying stocks, REITs and MLPs. In fixed income, the fundamental considerations will be different. In this current environment, we believe strategic fixed income portfolios should own mortgages, high yield, preferreds and Emerging Market debt. The percentage size of this must be consistent with your risk tolerance and time horizon. 2. Downside Risk Management While risk in general investment terms is defined as a measure of the variability of returns from an investment, we believe that what matters most to income-oriented investors is downside risk, which refers to the potential for a portfolio to suffer material losses in adverse market conditions. The source of downside risk depends on the composition of the portfolio. Most portfolios contain two broad sources of risk: equities and fixed income. Interestingly, the risk allocation between equities and fixed income is usually not the same as the asset allocation. For example, in a portfolio comprising 60% equities and 40% fixed income, more than 90% of the total risk is contributed by equities. As a crucial component of an income-oriented portfolio, downside mitigation can serve to protect principal in periods of rising interest rates (for fixed-income portfolios) and in periods of sharp decline in prices (for equity portfolios). A steep decline in principal can lead to lower income after reinvestment. 2 A security s Total Return equals its capital appreciation plus the income it provides from the coupon or dividends. Income Solutions Framework 4

5 Example of the impact of downside risk on an income-oriented portfolio A client invests $100 into an income-oriented portfolio with a 4% annualized yield. In other words, she would receive $4 income for Year 1, with a high degree of confidence. The portfolio declines by 30% at the end of Year 1, with yield going up to 5%. The new income for Year 2 would be $3.50 (or 3.5% of original investment) due to a steep decline in the portfolio s principal, resulting in a lower income amount. IMG s Approach to Downside Risk Management We measure downside risk as the maximum decline of a portfolio s net asset value (NAV) from the beginning of the calendar year. Our Downside Risk Management Strategy (DRM) seeks to keep the NAV of a portfolio above a fixed floor by allocating to higher quality short duration fixed income and cash and away from riskier assets such as equities and lower quality fixed income securities in down markets. The sharper the downturn, the greater the allocation to higher quality fixed income and cash. In up markets, the strategy is designed to cycle back into the riskier assets and reduce the allocation to higher quality fixed income and cash. DRM is a variation of the Constant Proportion Portfolio Insurance (CPPI) 3 strategy that seeks to allocate dynamically between a risky investment (e.g., equities) and a risk-free investment (e.g., cash or T-bills). DRM also bears close resemblance to a version of CPPI based on a dynamic adjustment of the proportions invested in a core versus satellite portfolio. 4 The method is best understood through an illustration (see Exhibit 4). The portfolio s initial NAV is assumed to be $100, with a conceptual floor equal to $80, so that there is a cushion (equal to NAV floor) of $20. The maximum anticipated loss for the risky portfolio is assumed to be 25%, and the rate of return for the less risky portfolio is assumed to be zero for the sake of simplicity. By design, the proportion invested in the risky asset is cushion maximum anticipated loss = $20 25% = $80, leaving $20 in the less risky asset. Exhibit 4 shows that in the event of a 20% decline in the risky asset, the portfolio declines by 16%. Subsequently, the risky investment recovers 5% in the next month, moving the portfolio s NAV back to $85, compared to $84 for the risky-asset NAV. Typically, rising markets favor allocation to the riskier assets, whereas allocation to the riskier assets would decrease if markets were declining. However, the downside mitigation feature at times leads to underperformance relative to the risky asset in rising markets because there can be a lag in the time it takes to reinvest in the risk asset. This underperformance can be significant, particularly if risky assets rise sharply, and should be considered by investors as a cost. Another cost is a lowering of the yield as the allocation to higher quality fixed income and cash increases. We believe, however, that over the longer term the benefits of downside protection in preserving invested capital outweigh the costs. 3. Capital Appreciation and Income Growth Income investors often have secondary objectives besides yield from their investments, such as capital appreciation and income growth. Capital appreciation is often sought by investors who believe that their saved capital is below levels needed for retirement. A young beneficiary of an inheritance is another type of investor seeking to increase the value of their principal while utilizing the income generated for their living expenses. Income growth is often a key objective for investors worried about inflation and its impact on the purchasing power of their income. Exhibit 4: Illustration of Downside Risk Management (DRM) Date 31-Jan 29-Feb 29-Feb 31-Mar 31-Mar Risky asset NAV $100-20% $80 DRM $80 +5% $84 DRM $84 Adjustments Adjustments Portfolio NAV $100 $84 $84 $85 $85 Risky asset $80 $64 $16 $17 $19 Less Risky asset $20 $20 $68 $68 $66 Cushion $20 $4 $4 $5 $5 % Risky asset 80% 76% 19% 20% 23% Note: For Illustrative Purposes Only. 3 Fischer Black and André Perold. Theory of Constant Proportion Portfolio Insurance, Journal of Economic Dynamics and Control, Vol. 16, Noël Amenc, Philippe Malaise and Lionel Martellini. Revisiting Core-Satellite Investing A Dynamic Model of Relative Risk Management, EDHEC Risk and Asset Management Research Centre, Income Solutions Framework 5

6 Exhibit 5: Total Return for Equities and Fixed Income % 12% 10% 8% 6% 4% 2% 0% 12.2% S&P Dividend Aristocrats Index Source: IMG Investment Analytics, % S&P 500 Index 7.8% BarCap Aggregate Index In general, the inclusion of equities in an income solution can offer a higher potential for capital appreciation and income growth. Exhibit 5 shows the total return offered by equities and fixed income over the past 44 years. Although equities offer higher total return, this does come at a price higher risk. Dividend focused equities also offer greater capital appreciation potential and tend to have lower risk versus broad market equities but still substantially greater risk than high quality fixed income. Hence the utilization of downside risk management strategy is recommended to defray the higher risk. Income growth in the case of dividend-paying equities comes from earnings growth and when payout ratios are high. Exhibit 6 illustrates how an allocation to dividend-paying equities can provide the income growth needed to keep pace with inflation. Besides dividend-paying equities, investors can also employ inflation-linked fixed income securities in their portfolios. Exhibit 6: Example of Income Growth to Combat Inflation A client invests $100 into an income-oriented portfolio. The asset allocation of the portfolio is 50% equities and 50% fixed income. The yield on the portfolio is 5% ($5 income) with the equity portion yielding 4% ($2 contribution) and fixed income portion at 6% ($3 contribution). If the combined forward earnings growth of the stocks owned in the equity allocation was projected at 10%, then assuming a constant dividend payout ratio, this would translate into dividend growth of 10%. Assuming the fixed income allocation does not have any inflation-linked bonds or floaters, the entire income growth of the portfolio, i.e., $0.20 ($2 x 10%), would come from the equity allocation. Hence the overall portfolio would see $0.20/$5.00 or 4% income growth which would enable the client to withstand inflation up to that level. If the Consumer Price Index (CPI) were higher than 4% the equity allocation could be increased or the underlying equity investments could be changed to target stocks with higher dividend growth. A Framework for Building Income Portfolios Our framework for income solutions calls for the creation of a suite of model income portfolios that feature: Multiple asset classes/sectors and multiple investment managers/vehicles to achieve broad diversification in terms of income sources. This will enable the investor to maintain their desired level of income through different market cycles while mitigating and balancing the associated risks. Of course, diversification does not protect an investment against loss. Downside risk management overlay to mitigate losses in down markets and enhance stability of invested capital. Exhibit 7: Framework for Income Portfolios IMG Strategic Fixed Income 9% 9% 23% IMG Global Equity Income 25% 19% IMG Total Income 4% 9% 6% 21% 2% 4% 9% 19% 47% 14% 16% 16% 10% Mortgage-Backed High Yield Emerging Market Debt Preferred Stock Global Dividend-Paying Stocks MLP 18% International Dividend-Paying Stocks Global Real Estate U.S. Dividend-Paying Stocks 9% 14% Downside Risk Management Overlay Note: For Illustrative Purposes Only. Data as of March 10, Income Solutions Framework 6

7 Strategies to enable capital appreciation and income growth. Based on this framework, we have developed three model portfolios. Exhibit 7 (on the previous page) illustrates these portfolios and their asset class/sector constituents. Of the three model portfolios that define the income solutions framework, the equity income portfolio typically offers the greatest potential for capital appreciation and income growth but with lower yields, higher volatility and greater instability in invested capital while the strategic fixed income portfolio offers higher yields, lower volatility and better capital preservation but without income growth and lesser potential for capital appreciation. The total income portfolio falls in between these two portfolios in terms of its characteristics. Conclusion Income from investments is critically important objective for many investors. When investing for income and identifying the right income solution for themselves, investors should become familiar with the various investments that can be used to generate income and risks associated with them. Diversification and downside risk management can play a key role in managing risk. Strategies to mitigate downside risk developed in consultation with one s Financial Advisor should be a key component of an investor s income solution. Risks The investments discussed have varying degrees of risk. Some of the risks involved with equities include the possibility that the value of the stocks may fluctuate in response to events specific to the companies or markets, as well as economic, political or social events in the U.S. or abroad. Bonds are subject to interest rate, inflation and credit risks. In addition to the risks associated with direct ownership in real estate, REITs may carry additional risks because they are dependent upon management skills, may not be diversified, are less liquid and are subject to heavy cash flow dependency, defaults by borrowers and self-liquidation. A REIT could also fail to qualify for tax-free pass-through of income under the Internal Revenue Code or fail to maintain its exemption from registration under the Investment Company Act. Investments in MLPs in the energy sector will be subject to more risks than if the investment were broadly diversified over numerous sectors of the economy. A downturn in the energy sector of the economy could have a larger impact than on an investment that does not concentrate in the sector. At times, the performance of securities of companies in the sector may lag the performance of other sectors or the broader market as a whole. In addition, there are several specific risks associated with investments in the energy sector, including the commodity price risk, depletion risk, supply and demand risk, and catastrophic event risk, among others. Definitions BofA Merrill Lynch US Broad Market Index (US00): The BofA Merrill Lynch US Broad Market Index tracks the performance of US dollar denominated investment grade debt publicly issued in the US domestic market, including US Treasury, quasi-government, corporate, securitized and collateralized securities. BofA Merrill Lynch US Mortgage Backed Securities Index (M0A0): The BofA Merrill Lynch US Mortgage Backed Securities Index tracks the performance of US dollar denominated fixed rate and hybrid residential mortgage pass-through securities publicly issued by US agencies in the US domestic market. BofA Merrill Lynch US High Yield Index (H0A0): The BofA Merrill Lynch US High Yield Index tracks the performance of US dollar denominated below investment grade corporate debt publicly issued in the US domestic market. Qualifying securities must have a below investment grade rating (based on an average of Moody s, S&P and Fitch), at least 18 months to final maturity at the time of issuance, at least one year remaining term to final maturity as of the rebalancing date, a fixed coupon schedule and a minimum amount outstanding of $100 million. BofA Merrill Lynch Fixed Rate Preferred Securities Index (P0P1): The BofA Merrill Lynch Fixed Rate Preferred Securities Index tracks the performance of fixed rate US dollar denominated preferred securities issued in the US domestic market. Qualifying securities must have an investment grade rating (based on an average of Moody s, S&P and Fitch) and must have an investment grade rated country of risk (based on an average of Moody s, S&P and Fitch foreign currency long term sovereign debt ratings). BofA Merrill Lynch Global Emerging Markets Sovereign Plus Index (IP00): The BofA Merrill Lynch Global Emerging Markets Sovereign Plus Index tracks the performance of USD and EUR denominated emerging market and cross-over sovereign debt publicly issued in the eurobond, euro domestic or US domestic markets. Qualifying countries must have a BBB1 or lower foreign currency long-term sovereign debt rating (based on an average of Moody s, S&P and Fitch). BofA Merrill Lynch US Corporate Index (C0A0): The BofA Merrill Lynch US Corporate Index tracks the performance of US dollar denominated investment grade corporate debt publicly issued in the US domestic market. Qualifying securities must have an investment grade rating (based on an average of Moody s, S&P and Fitch), at least 18 months to final maturity at the time of issuance, at least one year remaining term to final maturity as of the rebalancing date, a fixed coupon schedule and a minimum amount outstanding of $250 million. BofA Merrill Lynch US Treasury Index (G0Q0): The BofA Merrill Lynch US Treasury Index tracks the performance of US dollar denominated sovereign debt publicly issued by the US government in its domestic market. Qualifying securities must have at least one year remaining term to final maturity, a fixed coupon schedule and a minimum amount outstanding of $1 billion. Qualifying securities must have at least 18 months to final maturity at the time of issuance. BofA Merrill Lynch Global Government Excluding the US Index (N0G1): The BofA Merrill Lynch Global Government Excluding the US Index is a subset of The BofA Merrill Lynch Global Government Index excluding all securities denominated in US dollars. BofA Merrill Lynch US Inflation-Linked Treasury Index (G0QI): The BofA Merrill Lynch US Inflation-Linked Treasury Index tracks the performance of US dollar denominated inflation=linked sovereign debt publicly issued by the US government in its domestic market. Qualifying securities must have at least 18 months to maturity at point of issuance, at least one year remaining term to final maturity, interest and principal payments tied to inflation and a minimum amount outstanding of $1 billion. Dow Jones US Select Dividend TR Index: The selection of stocks to the Dow Jones U.S. Select Dividend Index is based almost entirely on dividend yield and dividend history. Stocks are also required to have an annual average daily dollar trading volume of more than $1.5 million. These criteria help to ensure that the index represents the most widely traded of the market s highest-yielding stocks. This is a total return index. Income Solutions Framework 7

8 Definitions (cont d) FTSE NAREIT Total Return Index: FTSE NAREIT Equity REITs Total Return Index USD. This investment sector includes all Equity REITs not designated as Timber REITs or Infrastructure REITs. Alerian MLP Index: The Alerian MLP Index is the leading gauge of large- and mid-cap energy Master Limited Partnerships. The capitalization-weighted index, which includes 50 prominent companies, was developed with a base level of 100 as of December 29, Dow Jones Utility Index: The Dow Jones Utilities Average is a price-weighted average of 15 utility companies that are listed on the New York Stock Exchange and are involved in the production of electrical energy. The average as it is known today began on January 2, 1929 with a base value of 50. BofA Merrill Lynch Fixed Rate Preferred Securities Index (P0P1): The BofA Merrill Lynch Fixed Rate Preferred Securities Index tracks the performance of fixed rate US dollar denominated preferred securities issued in the US domestic market. Qualifying securities must have an investment grade rating (based on an average of Moody s, S&P and Fitch) and must have an investment grade rated country of risk (based on an average of Moody s, S&P and Fitch foreign currency long term sovereign debt ratings). The S&P 500 Dividend Aristocrats: The index is designed to measure the performance of S&P 500 index constituents that have followed a policy of consistently increasing dividends every year for at least 25 consecutive years. The Barclays US Aggregate Bond Index: The index is a broad-based flagship benchmark that measures the investment grade, US dollar-denominated, fixed-rate taxable bond market. The index includes Treasuries, government-related and corporate securities, MBS (agency fixed-rate and hybrid ARM pass-throughs), ABS and CMBS (agency and non-agency). Merrill Lynch offers clients some of the world s best intellectual capital on topics that complement our traditional investment management and portfolio construction advice. Merrill Lynch helps clients and advisors create holistic and customized solutions by combining Merrill Lynch s expertise in managing wealth for individuals, families and institutions with our internal thought leadership and professional network of industry luminaries and leading academics. All Merrill Lynch thought leadership is driven and vetted by the Investment Management & Guidance leadership team. This article is provided for information and educational purposes only. The opinions and views expressed do not necessarily reflect the opinions and views of Bank of America or any of its affiliates. Any assumptions, opinions and estimates are as of the date of this material and are subject to change without notice. Past performance does not guarantee future results. The information contained in this material does not constitute advice on the tax consequences of making any particular investment decision. This material does not take into account a client s particular investment objectives, financial situations or needs and is not intended as a recommendation, offer or solicitation for the purchase or sale of any security, financial instrument or strategy. Before acting on any recommendation, clients should consider whether it is suitable for their particular circumstances and, if necessary, seek professional advice. GWM Investment Management & Guidance (IMG) provides industry-leading investment solutions, portfolio construction advice and wealth management guidance. Diversification and dollar cost averaging do not guarantee a profit or protect against a loss in declining markets. 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You should consult your legal and/or tax advisors before making any financial decisions. Investing involves risk, including the possible loss of principal. All opinions are subject to change due to market conditions and fluctuations. Past performance is no guarantee of future results. This material does not take into account your particular investment objectives, financial situations or needs and is not intended as a recommendation, offer or solicitation for the purchase or sale of any security, financial instrument, or strategy. Before acting on any information in this material, you should consider whether it is suitable for your particular circumstances and, if necessary, seek professional advice. Any opinions expressed herein are given in good faith, are subject to change without notice, and are only correct as of the stated date of their issue. Asset allocation, diversification and rebalancing do not ensure a profit or protect against loss in declining markets. 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