Well-Performing Portfolios and Well-Disguised Insolvency. Patrick J. Collins, Steven M. Fast & Laura A. Schuyler

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1 Well-Performing Portfolios and Well-Disguised Insolvency Patrick J. Collins, Steven M. Fast & Laura A. Schuyler

2 The Secret to Life According to Charles Dickens: Annual income 20 pounds, annual expenditure 19 pounds, 19 and 6, result happiness. Annual income 20 pounds, annual expenditure 20 pounds ought and 6, result misery. Page 2

3 The Secret to a Successful Trust Portfolio Trust Assets > Trust Liabilities... Result = Happiness Trust Assets < Trust Liabilities... Result = Misery Page 3

4 Trust Liabilities: Distributions to Current Beneficiaries Capital Preservation/Growth for Remainder Beneficiaries Page 4

5 Key Duties of a Trustee: Monitor the trust portfolio and inform the beneficiaries in a meaningful way. Page 5

6 Key Duties of a Trustee: Monitor the trust portfolio and inform the beneficiaries in a meaningful way. How is the trust portfolio doing relative to its liabilities? NOT how the trust portfolio is doing in relation to the S&P Page 6

How is the trust portfolio doing relative to its

7 Key Duties of a Trustee: Monitor the trust portfolio and inform the beneficiaries in a meaningful way. How is the trust portfolio doing relative to its liabilities? Are there enough assets to distribute amounts to the current beneficiary and preserve capital for the remainder beneficiaries? Sequence Risk Feeding the Bear Page 7

Are there enough assets to distribute amounts to the current beneficiary and

8 1. Use Risk Models Judiciously. Page 8

9 Page 9 Simple, 2-Asset Class Portfolio

10 Page 10 Diversified Portfolio

11 Diversified Portfolio + Fees Page 11

12 Diversified Portfolio + Fees + Longevity Page 12

13 Diversified Portfolio + Fees + Longevity + Taxes Page 13

14 Page 14 Summary

15 Summary: Model Risk Results range from an 8% risk of bankruptcy to a 53% risk of bankruptcy. Page 15

16 Summary: Model Risk Results range from an 8% risk of bankruptcy to a 53% risk of bankruptcy. The NH model (simple Monte Carlo model) produces the most optimistic results in each case, perhaps underestimating risk. Page 16

17 Summary: Model Risk Results range from an 8% risk of bankruptcy to a 53% risk of bankruptcy. The NH model (simple Monte Carlo model) produces the most optimistic results in each case, perhaps underestimating risk. The Bear model (regime-switching model, assuming initial bear market) produces the most pessimistic results in each case, perhaps overstating risk. Page 17

18 2. Locate the Free Boundary. Page 18

19 The Free Boundary Free Boundary Line Unfeasible Feasible Region $0 Wealth Deficit Wealth Surplus Page 19

20 The Free Boundary Present Value of Trust Assets [Stochastic Present Value of Distributions to the Current Beneficiary + Stochastic Present Value of Capital Preserved for Remainder Beneficiaries + Stochastic Present Value of Fees and Investment Expenses.] Page 20

Stochastic Present Value of Capital Preserved for Remainder

21 The Free Boundary Present Value of Trust Assets [Cost of an Annuity for the Current Beneficiary + Stochastic Present Value of Capital Preserved for Remainder Beneficiaries + Stochastic Present Value of Fees and Investment Expenses.] Page 21

22 The Free Boundary Wealth to Annuity Cost Ratio (WACR) = The Ratio of the Trust s Value to the Cost of Purchasing an Annuity for the Current Beneficiary and Returning Capital to the Remainder Beneficiaries Page 22

23 Example 1: Bob & Joanna Assumptions: Bob s Goal: Provide for his wife Joanna for her lifetime. Initial Trust Value = $1 million Joanna is 70 years old. Joanna needs distributions of $61,800 per year. Page 23

24 Example 1: Bob & Joanna Is Bob s goal feasible? Page 24

25 Example 1: Bob & Joanna Is Bob s goal feasible? Page 25

26 Example 1: Bob & Joanna 5 Years Later... Is Bob s goal feasible? Page 26

27 Example 2: Bob, Joanna & Children Assumptions: Bob s Goals: (1) Provide for his wife Joanna for her lifetime and (2) preserve the original principal (as adjusted for inflation) for his children. Initial Trust Value = $1 million Joanna is 50 years old. Joanna needs distributions of $42,000 per year. Page 27

28 Example 2: Bob, Joanna & Children Are Bob s goals feasible? Page 28

29 Example 2: Bob, Joanna & Children 20 Years Later... Are Bob s goals feasible? Page 29

30 Free Boundary: Summary If the only goal is to provide for the current beneficiary, the free boundary is located at a WACR of 1. Page 30

31 Free Boundary: Summary If the only goal is to provide for the current beneficiary, the free boundary is located at a WACR of 1. If there are dual goals of providing for the current beneficiary and preserving capital for the remainder beneficiaries, a higher WACR is necessary because the portfolio must grow to sustain the remainder beneficiaries interest on a constant dollar basis. Page 31

32 What Are My Options? Based on your analysis of the risk models and the location of the free boundary, you know you re in trouble. Page 32

33 What Are My Options? Based on your analysis of the risk models and the location of the free boundary, you know you re in trouble. 1. Stay the course? Page 33

34 What Are My Options? Based on your analysis of the risk models and the location of the free boundary, you know you re in trouble. 1. Stay the course? 2. Change the asset allocation? Page 34

35 What Are My Options? Based on your analysis of the risk models and the location of the free boundary, you know you re in trouble. 1. Stay the course? 2. Change the asset allocation? 3. Reduce distributions to the current beneficiary? Page 35

36 What Are My Options? Based on your analysis of the risk models and the location of the free boundary, you know you re in trouble. 1. Stay the course? 2. Change the asset allocation? 3. Reduce distributions to the current beneficiary? 4. Divide the portfolio into two funds? Page 36

37 What Are My Options? Based on your analysis of the risk models and the location of the free boundary, you know you re in trouble. 1. Stay the course? 2. Change the asset allocation? 3. Reduce distributions to the current beneficiary? 4. Divide the portfolio into two funds? 5. Buy an annuity and invest the balance? Page 37

38 Summary Monitor the trust portfolio and inform the beneficiaries in a meaningful way. Use Risk Models Judiciously. Locate the Free Boundary. Review Options. Page 38

Retirement Income Adequacy With Immediate and Longevity Annuities

May 2011 No. 357 Retirement Income Adequacy With Immediate and Longevity Annuities By Youngkyun Park, Employee Benefit Research Institute UPDATING EARLIER EBRI ANALYSIS: This Issue Brief updates with recent