Morningstar Retirement Manager SM. Methodology

Transcription

1 Morningstar Retirement Manager SM Methodology Morningstar Retirement Manager is a service provided by Morningstar Associates, LLC, in conjunction with your retirement plan provider or plan sponsor, to help you make better decisions about investing in your employer-sponsored retirement plan. Morningstar Associates is a registered investment advisor and, through Retirement Manager, gives you access to objective, high-quality, independent advisory services. Principles Morningstar Associates advisory services are built on several fundamental principles. These include: Personalized Goals-based Diversified Conservative Forward-looking Institutional-quality We tailor our strategy to the specific circumstances of the individual, including financial situation, future retirement goals, and risk tolerance level. We recognize that a prudent strategy must be built in relation to specific goals, and we help you define those goals and develop a strategy aimed at reaching them. Diversifying your investments is a bedrock principle for assuring long-term safety of capital. Our proprietary approach diversifies you across asset classes as well as investment sectors and styles. Our risk-based approach prioritizes avoiding significant losses in volatile markets. The assumptions we make about portfolio returns in our projections emphasize disciplined saving and investing rather than outsized capital market returns. Rather than relying only on historical data (which may or may not have any relevance to future conditions), we incorporate forward-looking estimates for assumptions about investment returns and performance behavior. All components of Retirement Manager are based on factors generally used by professional money managers and adapted to the needs of the individual investor. Data and Related Assumptions In the Your Information section of Retirement Manager, relevant personal and financial data about you (and, if applicable, your spouse or partner) will be collected. In order for Morningstar Associates to build the most comprehensive and appropriate strategy for you, it is essential for you to provide as complete a set of data as possible. These data may include, but are not limited to, your age, salary, current contribution rate and balance for your employer-sponsored retirement plan, any outstanding loans from your retirement plan, balances and contributions to any other investment accounts intended for retirement, expected pensions, and balances in company stock. Some of these data points may be directly provided to us by your recordkeeper. We strongly encourage you to provide comparable information about your partner, so that we have a complete picture of your household financial situation. Morningstar Associates makes assumptions about certain pieces of information that you are asked to review in Your Information. These assumptions have a significant impact on the strategy that we will create for you. In particular, these assumptions relate to Social Security income, salary growth, retirement income goal, and your risk tolerance level. 1

2 Social Security Retirement Manager presents you with a default assumption about your future Social Security benefits, based on an algorithm published by the Social Security Administration. However, our estimates may vary from those provided by the SSA because we use a different model for projecting your future salary growth, described below. You have the option to reject Morningstar Associates estimate and replace it with your own, including an estimate of zero, as some people prefer not to rely on the future viability of Social Security when planning for their retirement. Salary Growth To estimate an investor s future salary, Morningstar Associates uses a salary growth curve based on academic research rather than assuming a single, fixed growth rate for future salaries (for example, 5% per year). This curve takes into account the fact that salaries tend to grow most rapidly for young employees, and then level off later in life. We assume the strongest rate of salary growth from ages 21 to 35, moderate growth from ages 35 to 50, and from age 50 on, we assume little or no (real) salary growth on top of inflation adjustments. Retirement Income Goal In the Goals section of Your Information, Retirement Manager presents you with a default retirement income goal. This default goal is calculated by taking 70% of your projected salary at retirement, expressed in today s dollars. (If you have a partner, we take 70% of the combined salaries.) Your salary at retirement is determined based on the algorithm described above. We select the 70% figure because it is generally considered a reasonable benchmark by financial planners. However, if you believe a different income goal is more appropriate, you can change it, either by selecting a different salary replacement percentage or setting a specific dollar amount. Retirement Age Retirement Manager assumes a default retirement age of 65, or your current age plus three years if you are older than 62. You have the option to change this to a different retirement age. We define retirement age as the age at which you will begin withdrawing money from your primary employer-sponsored retirement plan. Risk Questionnaire To help Morningstar Associates better understand your ability to tolerate market volatility (the degree to which your investments may go up and down), we ask you to complete a three-question risk questionnaire. Each response is then assigned a certain risk level. The results of the questionnaire are then incorporated as one factor in our overall risk assessment, which is described in the Your Strategy section below. Please note that at maximum, your responses to the risk questionnaire can affect our recommended equity allocation by no more than ten percentage points. Your Strategy Once you have entered all of your relevant data, you can receive a strategy in the Your Strategy section of Retirement Manager. There are four components to Your Strategy: Goals, Risk, Investments, and Savings. (If you hold company stock in your plan, a fifth component, Company Stock, will appear). These components are interrelated; your savings rate and risk level, for instance, help determine the retirement income projected for you as part of your goals. Below, the methodology related to each component is described. 2

3 Star Rating Both your overall strategy and each subcomponent receive a star rating from Morningstar Associates. This star rating is intended to offer you a quick assessment of your Current and Proposed Strategies. The overall star rating is simply an average of the four component ratings. This retirement star rating is completely distinct from the well-known star rating for mutual funds issued by Morningstar, Inc. Whenever we have sufficient data about your current plan, we will provide a comparison of ratings for your Current and Proposed Strategies. Generally speaking, a 4- or 5-star rating indicates a successful strategy; a 3-star rating indicates a fair strategy; and a 1- or 2-star rating indicates a subpar strategy in need of improvement. Annual Retirement Income Goal Annual Retirement Income Outlook Amount Above/Below Goal (Gap Analysis) Goals Strategy Your retirement income goal is the level of income that Morningstar projects you will need to live comfortably throughout retirement. This figure is either the default goal set in Your Information, or an amount adjusted by you. Your retirement income outlook is the level of annual income that Morningstar Associates projects you have a 90% chance of reaching or exceeding. In other words, this is an income level that we believe you have a strong probability of achieving. To come up with your retirement income outlook, Morningstar Associates conducts a cash-flow calculation and a simulation, which together produce projections for your future wealth. The cash-flow calculation takes into account all possible sources of retirement for which we have data, including salary, account balances, your contributions to those accounts, employer contributions, pensions, Social Security benefits, and expected lump-sum distributions. In this calculation, we assume that your pre-tax or Roth contributions to your employer-sponsored plan will increase in value along the path of your salary growth curve (described above), while any post-tax or catch-up contributions are treated as fixed amounts. For employer-sponsored outside accounts, such as 401(k) or 403(b) accounts, we take your dollar contribution amount and convert it to a percentage, then project growth along the salary growth curve. The simulation allows us to model thousands of different possible outcomes for your wealth depending on different economic and financial-market scenarios. To do this, Morningstar Associates uses an enhanced form of Monte Carlo simulation, a mathematical method used to model the probability of outcomes for a given event (such as the future value of a portfolio). When performing the income projections, Morningstar Associates uses its own forecasts for return, risk (measured by standard deviation), and correlation (the degree to which one asset class moves in tandem with others) for each of twelve asset classes. (Stocks and bonds are subdivided into 11 more specific subcategories.) As an additional variable once you reach retirement, we model different scenarios for your life span, based on standard published mortality tables (Based on the Annuity 2000 Basic Table from Transactions, Society of Actuaries Reports, 1998). Morningstar also assumes that your risk level (and corresponding asset allocation) will change over time, generally growing gradually more conservative as you approach retirement. Once we have calculated your Retirement Income Outlook, we simply calculate the difference between that amount and your Retirement Income Goal, to show you the gap (or surplus) that exists. Also, please keep in mind that Retirement Manager shows you a Retirement Income Outlook based on 90% probability, because Morningstar Associates conservative philosophy means that we want you to base your planning on projections for which we have a very high level of confidence. However, we calculate a full range of probabilities, some of which will show that you may earn a higher level of retirement income. 3

4 You can view the broader range of projections by clicking on the Project the growth of your accounts earmarked for retirement link. Goals Star Rating The star rating for your Goals Strategy is based on the degree of the gap between your Retirement Income Outlook and your Retirement Income Goal. The larger the gap between what you need and what Morningstar projects you will receive in annual retirement income, the lower the star rating your strategy will receive. Risk Strategy Based on the information you have provided, including the number of years until you plan to retire, your current financial situation (including all accounts you have told us about), your salary, any expected pensions, and the results of the risk questionnaire, Morningstar Associates assigns you to one of 99 possible risk points, associated in turn with asset mixes (combinations of stocks, bonds, and cash) ranging from 98% stock to 0% stock. Morningstar uses a method known as asset-liability analysis to help determine the level of risk that is appropriate for you. This method incorporates a person s future stream of income into that individual s total current wealth assessment. Using an asset-liability analysis enables us to better understand your ability to withstand financial losses, and therefore to assign the most appropriate asset mix. This asset mix, which we refer to as your household asset mix, considers your entire financial situation, including all accounts you have told us about. Note that your responses to the risk questionnaire act as only one component of your overall risk strategy. The risk questionnaire will at most affect your asset allocation to stocks by ten percentage points up or down. Risk Star Rating The star rating for your Risk Strategy is based on how closely the portfolio in your plan fits the asset mix that has been determined as appropriate for you, as well as how close they match the diversification targets for your stock and bond allocations. Holding any plan assets in company stock can adversely affect your Risk Strategy star rating. Investments Strategy *Note: No Investments Strategy is available if you are on a Managed by You path in which you select your own investments. Also, if you are no longer employed by the company sponsoring this retirement account, Morningstar Associates will not propose any future investment elections, as they are not applicable. Morningstar Associates will build a portfolio of investments designed to meet your assigned asset mix while using the highest-quality funds available in your plan to do so. We seek to build portfolios where the overall stock portion is made up of the following pieces: 4

5 Stock Portfolio % U.S. large-growth stocks 28 U.S. large-value stocks 28 U.S. small or mid-cap-growth stocks 12 U.S. small or mid-cap-value stocks 12 International stocks 20 For U.S. securities, these allocations are based on an equilibrium model. That is, we assume that stockmarket valuations are broadly correct, such that in most cases a prudent investor should not greatly over- or underweight a particular style of stock, such as large or small, value or growth. For purposes of classifying U.S. stock investments, Morningstar Associates assigns large-capitalization, mid-cap, and small-cap stocks their approximate market weightings, allocating 70% of the U.S. stock portfolio to large companies, 20% to mid-caps, and 10% to small-caps. We then divide each of these groups (large and small) between value and growth investment styles. We follow market weightings, dividing assets equally between value and growth styles. A portion of the portfolio is also allocated to foreign stocks. Morningstar Associates advises an allocation of 20% of total assets to foreign stocks--an amount that diversifies the portfolio while remaining reasonable to the majority of investors. We also adjust your plan s domestic-stock sector exposure, aiming for balanced market weightings in the major industry sectors--technology, healthcare, manufacturing, financial services, energy, and services. Finally, Morningstar Associates sets targets for the bond holdings of your investment plan, aiming for a duration of approximately four years and an average credit quality of A for your overall bond portfolio. Stable value funds are modeled with a portfolio of 50% cash, 50% bonds. If your plan offers a stable value fund, the asset-mix graphic will show only stock and fixed-income classes. This is also the case if your plan lacks either a bond or cash option. When selecting investment options for your portfolio, we analyze the underlying holdings of each option and how they would affect the overall portfolio. Because Morningstar Associates collects information on every holding in every investment option, we do not have to treat a vehicle as a one-note investment. For example, a fund consisting primarily of large-growth stocks wouldn t necessarily be considered 100% large growth. In reality, the fund might be 94% stocks and 6% cash, the 94% stock position might be 86% U.S. and 8% foreign, and the 86% U.S. position might be 61% large growth, 14% large value, and 11% small growth. In creating its portfolios, Morningstar Associates considers all of these pieces (as well as several others), so that the resulting portfolio truly reflects the desired composition. Morningstar Quantitative Score To create the most appropriate portfolio from the options in your plan, the quality of each investment is determined using a rating system provided by Morningstar Associates based on a weighted average of several factors Morningstar Associates considers important. (If you receive IRA advice and your available universe of funds numbers more than 50, we will use the quantitative score and applicable minimum purchase requirements to filter the universe down to a manageable number, prior to constructing your portfolio). Following are the factors and their current weights in the Quantitative Score. 5

6 Factor Weights % Performance 40 Risk 30 Cost 30 Performance Score (40%) On each of the three factors, investments receive a score from minus 5 to plus 5. You can find a full explanation of how each factor is scored below. The overall performance score is based on how an investment option has rated relative to other investments in the same category during each of the past 10 years, with more weight being given to recent years. If an investment option is less than 10 years old, it will receive a relative performance score of zero (average) for the years before it existed. This rating approach allows investment options with shorter histories to be compared with investments with longer track records, puts greater emphasis on more-recent records, and avoids giving full credit to investments with short track records. The performance score also accounts for manager tenure. Morningstar Associates assumes that half of an investment option s return owes to the effort of the manager, while the other half is due to the resources provided by the investment company. Thus, for years when the current manager was not in place, the annual performance scores are halved (limiting the contribution of the past managers). Risk Score (30%) Cost Score (30%) The risk score is a weighted average of three volatility scores. The first score measures the standard deviation of an investment option s most recent 36 monthly returns relative to its category. The second covers months 37 through 72, and the last covers months 73 through 108. Incomplete periods receive a relative performance score of minus 2, indicating the extra risk involved with newer investments possessing shorter track records. As with the performance score, greater weight is given to more-recent periods. The cost score is based on the most recently available expense ratio, a measure of how much it costs you each year to own an investment, and is compared with other investments in the same investment category. Investments Star Rating The star rating for your Investments Strategy is based on the fund quality of your investments, using Morningstar s quantitative scoring system. Not every plan will contain all highly rated funds. Therefore, Morningstar Associates sets its star rating in the context of the available investment options. The highest rating implies that the portfolio contains the highest-quality possible funds given the available options. How We Treat Outside Assets Morningstar Associates will only provide an Investments Strategy for assets inside your employersponsored account that do not have any restrictions. Therefore, any outside investment accounts you own, plus any assets designated as restricted or frozen by your employer, as well as any assets you have chosen to retain in company stock or a brokerage window, will be excluded from our investment selection process. However, we do take all of these other assets into consideration when determining a target equity allocation for your retirement account. 6

7 We first determine an appropriate equity mix based upon your estimated year of retirement. We call that the baseline. We then look at the amount you ve already saved toward retirement, your answers to the risk questionnaire, if applicable, and other assets you have earmarked for retirement. Based on that analysis, we adjust the baseline equity mix by up to a maximum of 15% more or 15% less in equity. If you have, for instance, another account earmarked for retirement that s heavily weighted in equity, we will recommend less equity and more fixed-income investments in your retirement account. If you hold frozen assets inside your retirement account that aren t in company stock, we may adjust your equity allocation by more than 15%. Because of the adjustments we are making to your asset mix, you may sometimes find the asset mix accessible from the Risk Strategy page (your total asset mix including all accounts that you ve told us about) differs from the asset mix accessible from the Investments Strategy page (your retirement account asset mix). Custom Funds In some cases, your plan may include a custom fund in essence, a non-public fund created especially for your plan for which Morningstar, Inc. and Morningstar Associates do not have data. In these cases, Morningstar Associates will not provide advice on that custom fund. If you have selected the Managed by You option, you can choose to retain assets in a custom fund, in which case Morningstar will take them into consideration when determining an appropriate asset allocation strategy as outlined in the previous section. If you have selected the Managed by Morningstar option (if applicable), Morningstar will sell off any assets in that custom fund when you enroll in the program. If you do retain the assets in the Managed by You service, Morningstar must make assumptions about the composition of the custom fund. If we do not receive any other information, we assume an asset mix of 50% stock, 41.67% bond, and 8.33% cash. In some cases, however, your plan provider may supply Morningstar with an alternative proxy fund to use as a more accurate representation of the fund s allocation. If this is the case, the allocation assumptions will appear as a footnote on the Investments page. Excluding Funds You have the option to ask Morningstar Associates to exclude a specific fund or funds from consideration when selecting your investments. If you do exclude a fund, it is possible that the portfolio Morningstar Associates builds will not have as high a quality level as it otherwise might. Company Stock Strategy Morningstar Associates believes that holding the stock of one s employer greatly increases an investor s portfolio risk, particularly in large concentrations. This is because prudent financial planning principles hold that any significant investment in a single stock creates a nondiversified situation in your portfolio with greater risk of investment losses. Therefore, Morningstar Associates generally suggests that you gradually sell your holdings in company stock down to zero and avoid making future contributions to company stock. In some cases your employer may restrict you from selling a portion of your company stock. In other cases an employer may provide contribution matches only in the form of company stock; in this case, you have little choice in the matter, and you should continue to take the matches. Retirement Manager s Company Stock Strategy will give you the option to gradually sell of your nonrestricted company stock holdings every three months over seven quarters, selling off the first 1/8 of your balance immediately when you implement your strategy. If at any point during the sell-off period your 7

8 company stock balance reaches $3,000 or 3% of your account balance, Morningstar Associates proposes that you sell of the remainder of the balance at this time. Our wealth projection will take into account any future reduction in company stock. If company stock takes up any portion of your account, we will assume an investment style of small-cap growth in our wealth projection, even if the ticker has been provided. Depending on the service option that you choose, Morningstar Associates may be able to carry out some or all of this strategy automatically for you; or, you may need to perform and monitor the company stock strategy on your own. You also have the opportunity to exclude some or all of your company stock holdings from your Company Stock Strategy. If you choose to do so, Morningstar Associates will not be responsible for that portion of your retirement plan account, although we will take it into consideration when creating your Investments Strategy, as described above. Selecting Investments On Your Own In some configurations of Morningstar Retirement Manager, there is a Managed by You path in which you must select your own investments. If applicable, in such situations we will provide a target risk level (asset mix) as well as proposed sub-asset class allocations, but you will be responsible for selecting the actual investments to meet these targets. You will be able to make your selections once you have entered the Implement Strategy section. The proposed stock sub-asset class allocations are as follows: Sub-Asset Class % U.S. large-cap stocks: 56 U.S. mid-/small-cap stocks: 24 International stocks: 20 Please note that if the investments you actually select deviate significantly from the suggested allocations, other Retirement Manager projections and information related to your Goals and Risk may be rendered invalid. Savings Strategy *Note: No Savings Strategy is available if you are no longer employed by the company that sponsors your retirement account(s). Morningstar Associates believes that increasing the amount you save in your retirement plan is one of the most effective and powerful ways to improve your ability to reach your retirement goal; therefore, whenever possible, our Proposed Strategy will include a recommendation to increase your savings rate. If applicable, we will propose increasing the savings rate to the level of your employer contribution match. If you are already saving at or above the company match, we will propose an increase of two percentage points (or, if contributions are tracked in dollar terms, an increase of the greater of $500 or 20% more than your current level). Employer and federally mandated contribution limits are always taken into account. 8

9 If you are enrolled in a managed savings program, or indicate that you will enroll in one, our projections and Proposed Strategy will take into account your planned future increases to your savings rate. Monitoring and Rebalancing If available, and you have selected the Managed by Morningstar service option, your account will be reviewed and if deemed necessary, rebalanced (typically quarterly). On an annual basis, your portfolio will be rebalanced to its correct target allocations, taking into account your change in age and any other significant personal or financial changes to your situation that you have informed us about. If you have selected a Managed by You service option, it is suggested that you return to the Retirement Manager site every six months to receive an updated strategy, or sooner if you have had any significant changes in your personal or financial situation, or a change to available investment options in your plan lineup. The Retirement Manager methodology has a built-in mechanism to prevent unnecessary trading on your part. Therefore, if Retirement Manager determines that any adjustments to your strategy are relatively small and fall within a predetermined bandwidth, then no changes to your investment allocations will be proposed. If the changes are larger, than an updated strategy may be proposed. 9