Income Matching Using Bonds NorCal 2011
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© Copyright Asset Dedication 2011
Income Matching Using Individual Bonds
An Alternative to Annuities and Bond Funds
Presented by:
Stephen Huxley, PhD
Brent Burns
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RISKThings may not always turn out
the way you planned© Asset Dedication, LLC 2011
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MARKET TIMINGSometimes it’s hard to guess where the market is going.
© Asset Dedication, LLC 2011
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HOT STOCKSJust because Cramer says it’s a
good idea doesn’t mean it’s right for you © Asset Dedication, LLC 2011
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RISKThe worst case scenario seemed a
lot less likely a few minutes ago© Asset Dedication, LLC 2011
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STOCK PICKINGMuch more scientific than
chimpanzees throwing darts
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FINANCIAL PLANNING
It is a lot easier to get where you are going if you have someone to help steer you in
the right direction © Asset Dedication, LLC 2011
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UNCERTAINTYIt turns out that the stock market
doesn’t always go up© Asset Dedication, LLC 2011
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© Copyright Asset Dedication 2011
Decline in Traditional PensionsFortune 100 Companies 1985-2010
1985 1998 20100%
25%
50%
75%
100%
89%
67%
17%
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© Copyright Asset Dedication 2011
Liability-driven investing (LDI) is an investment strategy of a
company or individual based on the cash flows needed to fund
future liabilitiesSource: Wikipedia
cash flowsfuture liabilities
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© Copyright Asset Dedication 2011
Behavioral Finance Meets
Asset Allocation
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© Copyright Asset Dedication 2011
Clients with multiple goals and varying timelines have trouble relating to stocks, bonds and cash are blended into a single portfolio. People tend to use mental accounts to manage various goals in their head. A pure Total Return approach creates a single portfolio that isn’t intuitively linked to the underlying goals.
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Client Needs1. Liquidity for current expenses
2. Predictable near-term cash flows to cover near-term expenses (usually 8-10 years for those in retirement)
3. Long-term growth to ensure sufficient growth to cover future needs
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Total Return Asset Allocation
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© Copyright Asset Dedication 2011
Splitting assets into multiple sub-portfolios helps clients better understand and stick to an allocation strategy. Bonds are specifically allocated to predictable current or future income (LDI). Equities are dedicated to long term growth, but are given time to ride through bad markets (long-term total return). Each asset class is dedicated to the function it best serves.
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© Copyright Asset Dedication 2008
Bonds
TotalReturn
Liability Driven Investing
Stocks
Total PortfolioSplit into sub-portfolios to serve different purposes
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Today -Prefers
liquidity of money market
Next Year – Prefers
predictable bonds
7 Years – Prefers
predictable bonds
8 Years – Prefers
predictable bonds
9 Years – Prefers
higher return prospects of
stocks
Asset Allocation and Time Horizon
Using Asset Classes That Fit How Clients Think About Their Money
Time
StocksBondsCash
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Parallels Between MPT and DPT
Modern Portfolio Theory Dedicated Portfolio Theory
Risk Risk
Retu
rn
Retu
rn
Risk-free asset = T-billsRisk-free asset = Fully immunized cash flow stream
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How Often Bonds Beat Stocks
S&P 500 and Intermediate Treasury Bond Index 1927-2009
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Worst and Average Spread
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30-60.00%
-50.00%
-40.00%
-30.00%
-20.00%
-10.00%
0.00%
10.00%
S&P 500 and Intermediate Treasury Bond Index 1927-2009
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Using Individual Bonds to Build Income-Matching LDI
Portfolios
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© Copyright Asset Dedication 2011
Income-Matching “Paycheck” Portfolios
1. Immediate Income Portfolio – Cash flows begin now
2. Deferred Income Portfolio – Cash flows begin later, when the client retires
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© Copyright Asset Dedication 2011
Example:
1. $100,000 per year
2. 3% inflation adjustment
3. 8 year time horizon
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© Copyright Asset Dedication 2011
8-Year Income Portfolio (Initial 8-years)
Year Issue YTM Principal Interest
Portfolio Cash Flows
Target Cash Flows
2012 CD 0.6% $79,000 $21,025 $100,025 $100,000
2013 CD 1.1% $87,000 $17,299 $104,299 $103,000
2014 CD 1.9% $93,000 $13,295 $106,295 $106,090
2015 CD 2.3% $99,000 $10,005 $109,005 $109,273
2016 Agency 2.2% $107,000 $5,160 $112,160 $112,551
2017 Agency 2.6% $111,000 $5,160 $116,160 $115,927
2018 Agency 3.0% $114,000 $5,160 $119,160 $119,405
2019 Agency 3.1% $118,000 $5,160 $123,160 $122,987
$890,264 $889,234
Timing Cash Flows
Bond quotes 5/12/2011
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© Copyright Asset Dedication 2011
Cost = $800,220 Duration = 4.3 Years
IRR = 2.6%(Fully Immunized)
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© Copyright Asset Dedication 2011
Immunization Definition
“When a bond portfolio is immunized, the
investor receives a specific rate of return
over a given time period regardless of what
happens to interest rates during that time.”
Morningstar Bond Course 104
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© Copyright Asset Dedication 2011
8-Year Bond Ladder
Year Issue YTM Principal Interest
Portfolio Cash Flows
Target Cash Flows
Excess/ Shortfall
2012 CD 0.6% $95,000 $17,895 $112,895 $100,000 $12,895
2013 CD 1.1% $93,000 $13,594 $106,594 $103,000 $3,594
2014 CD 1.9% $94,000 $9,833 $103,833 $106,090 ($2,257)
2015 CD 2.3% $90,000 $6,051 $96,051 $109,273 ($13,222)
2016 Agency 2.2% $112,000 $3,913 $115,913 $112,551 $3,362
2017 Agency 2.6% $116,000 $3,913 $119,913 $115,927 $3,986
2018 Agency 3.0% $122,000 $3,913 $125,913 $119,405 $6,508
2019 Agency 3.1% $91,000 $1,957 $92,957 $122,987 ($30,031)
$874,067 $889,234 ($15,166)
Why Not a Bond Ladder?
Bond quotes 5/12/2011
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© Copyright Asset Dedication 2011
Cost = $800,865 Duration = 4.2 Years
IRR = 2.4%Income Shortfall = $15,166
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Tale of Two Allocations
Total Return
LDI
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Standard Benefits• Beta exposure to fixed
income• Diversification• Dampen volatility
Unique LDI Benefits• Predictable cash flows• Immunization from rising
interest rates
Double Duty From Bonds
8
Years of Income
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100/0 3 Yr. 90/10 4 Yr. 80/20 5 Yr. 6 Yr. 7 Yr. 70/30 8 Yr. 60/40 9 Yr. 10 Yr. 50/50 40/60 30/70 20/80 10/90 0/100
9.5%9.2% 9.1%
8.8% 8.6% 8.6% 8.4% 8.2% 8.2%7.7%
7.3% 7.2%6.8%
5.8%
Asset Dedication vs. Total Return40 Year Internal Rate of Return Since 1927
Source: Asset Dedication, 2009. Data set 1927-2008. Indices used for comparison: Equities (both models)—Standard and Poors 500 Index; Total Return Fixed Income Allocation—Barclays Capital US Intermediate Government Index; Asset Dedication Fixed Income—1975-2008 Treasury Bond quotes (source WSJ), 1927-1974 prices backcast against Treasury yield curve.
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Monitoring Progress
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The Dynamic Dimension -“Flexible” Rolling Horizons
Years
Using time to ride out bad markets
Taking more off the table when markets have been good
Do Not Roll . . .
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Immediate vs. DeferredIncome Portfolios
1. Immediate Income Portfolio – Cash flows begin now
2. Deferred Income Portfolio – Cash flows begin later, when the client retires
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Deferred Income Portfolio: Leveraging the Yield Curve
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Deferred Income Portfolio: Leveraging the Yield Curve
$770,911
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De-
Risk
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Interest Rate Risk
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Timing Risk
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Planning Risks
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Behavioral Risks
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Why Individual Bonds?
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Individual Bonds
Vs.
Bond Funds
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Legal Obligation
Vs.
Mutual Fund
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Decomposing Bond Fund Total Return
Price Return• Bond prices are inversely
related to interest rates
• Bond prices fall as rates rise
Income Return• Income return represents
the sum of portfolio’s coupon payments
• Income is never negative
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Impact of Interest Rates on Total Return
Bond Funds Individual Bonds
Falling Rates
Price Return
Income Return
Total Return > Income Return
Price Return
Income Return
Total Return > Income Return
Flat Rates
Price Return
Income Return
Total Return = Income Return
Price Return
Income Return
Total Return = Income Return
Rising Rates
Price Return
Income Return
Total Return < Income Return
Price Return
Income Return
Total Return = Income Return
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Impact of Interest Rates on Total Return
Bond Funds Individual Bonds
Falling Rates
Price Return
Income Return
Total Return > Income Return
Price Return
Income Return
Total Return > Income Return
Flat Rates
Price Return
Income Return
Total Return = Income Return
Price Return
Income Return
Total Return = Income Return
Rising Rates
Price Return
Income Return
Total Return < Income Return
Price Return
Income Return
Total Return = Income Return
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30 Years of Tailwinds
Source: United States Treasury 10-year constant maturity yield 1962-2009, Global Financial Data 1800-1962. 5-year rolling average
Total Return 11.3%
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of taxable bond funds were started after 1981
97%
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Impact of Interest Rates on Total Return
Bond Funds Individual Bonds
Falling Rates
Price Return
Income Return
Total Return > Income Return
Price Return
Income Return
Total Return > Income Return
Flat Rates
Price Return
Income Return
Total Return = Income Return
Price Return
Income Return
Total Return = Income Return
Rising Rates
Price Return
Income Return
Total Return < Income Return
Price Return
Income Return
Total Return = Income Return
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Impact of Interest Rates on Total Return
Bond Funds Individual Bonds
Falling Rates
Price Return
Income Return
Total Return > Income Return
Price Return
Income Return
Total Return > Income Return
Flat Rates
Price Return
Income Return
Total Return = Income Return
Price Return
Income Return
Total Return = Income Return
Rising Rates
Price Return
Income Return
Total Return < Income Return
Price Return
Income Return
Total Return = Income Return
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Rising Rates 1950-1981
Source: United States Treasury 10-year constant maturity yield 1962-2009, Global Financial Data 1800-1962. 5-year rolling average
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Rising Rates 1950-1981
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Rising Rates 1950-1981
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Rising Rates 1950-1981
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S&P 500:
10 Yr. Treasury:
-9.0%
-5.1%
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Catch-22 for Bond Fund Investors
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Keep Duration Short and Rates Stay Flat (Japan)
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Japanese Interest Rates Since 1985
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Historical Interest Rates Average Yield 1800-2010
Source: United States Treasury 10-year constant maturity yield 1962-2009, Global Financial Data 1800-1962. 5-year rolling average
Long D
epre
ssio
n
Gre
at
Depre
ssio
n
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Extend Duration and Rates Rise
Duration ≈ 5 yearsEstimated loss ≈ -2%
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Headwind of Rising Rates
Source: United States Treasury 10-year constant maturity yield 1962-2009, Global Financial Data 1800-1962. 5-year rolling average
Total Return 2.2%Average Coupon 5.6%
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Total Return Shortfall with Withdrawals
Source: United States Treasury 10-year constant maturity yield 1962-2009, Global Financial Data 1800-1962. CRSP 10-year Treasury Index total return
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“People have unrealistic expectations of what a portfolio manager can do in a rising-rate environment.”
Jim Jessee, president of MFS Fund Distributors Inc. Investment News mutual fund round table in New York on Feb. 9, 2010
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© Copyright Asset Dedication 2011
Other Income Strategies
• Annuities• Dividend paying stocks• Real Estate/REITs
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© Copyright Asset Dedication 2011
Other Income Strategies
• Annuities• Dividend paying stocks• Real Estate/REITs
![Page 71: Income Matching Using Bonds NorCal 2011](https://reader035.fdocuments.net/reader035/viewer/2022070315/5550f016b4c905387d8b52c3/html5/thumbnails/71.jpg)
© Copyright Asset Dedication 2011
Based on the Treasury yield curve and standard mortality tables,
annuitants can expect to only receive
81%-85% of their premium in return.
Annuities for an Ageing World, Olivia S. Mitchell and David McCarthy, June 9, 2002
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© Copyright Asset Dedication 2011
Challenges for Annuities
• Passing assets on to heirs• Managing inflation• Flexibility• Expenses, commissions, and fees• Counterparty risk
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© Copyright Asset Dedication 2011
Insurance Company Failures California 1991-2008
Confederation Life Insurance & Annuity Company
Standard Life Insurance Company of Indiana
Lincoln Memorial Life Insurance Company
London Pacific Life & Annuity Company
Legion Insurance Company
Reliance Insurance Company
Combined Benefits Insurance Company
American Chambers Life Insurance Company
International Financial Services Life Insurance Company
First National Life Insurance Company of America
Centennial Life Insurance Company
American Western Life Insurance Company
National American Life Insurance Company of Pennsylvania
Summit National Life Insurance Company
Confederation Life Insurance Company (CLIC)
Old Colony Insurance Company
Consumers United Insurance Company
Mutual Benefit Life Insurance Company
Investment Life Insurance Company of America
Fidelity Bankers Life Insurance Company
Inter-American Insurance Company of Illinois
Executive Life Insurance Company
Mutual Security Life Insurance Company
Midwest Life Insurance Company
Legacy Life Insurance Company
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© Copyright Asset Dedication 2011
Other Income Strategies
• Annuities• Dividend paying stocks• Real Estate/REITs
![Page 75: Income Matching Using Bonds NorCal 2011](https://reader035.fdocuments.net/reader035/viewer/2022070315/5550f016b4c905387d8b52c3/html5/thumbnails/75.jpg)
© Copyright Asset Dedication 2011
Dividend payments from companies in the S&P
500 dropped by…
January 2008 to January 2009
Standard and Poors S&P 500 Market Attributes SnapshotJanuary 2009
23.9%
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© Copyright Asset Dedication 2011
Other Income Strategies
• Annuities• Dividend paying stocks• Real Estate/REITs
![Page 77: Income Matching Using Bonds NorCal 2011](https://reader035.fdocuments.net/reader035/viewer/2022070315/5550f016b4c905387d8b52c3/html5/thumbnails/77.jpg)
© Copyright Asset Dedication 2011
of REITs followed by Morningstar cut or suspended their
dividends in 2009
Morningstar Industry Report 2010
70%
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© Copyright Asset Dedication 2011
Key Points
1. Individual bonds can immunize against interest rate risk
2. Individual bonds are uniquely suited to delivering predictable income
3. Bond funds will lose value when rates rise
4. Annuities can be expensive and inflexible
5. Dividends and REITs can be unreliable just when your clients need them most
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© Copyright Asset Dedication 2011
Questions?
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© Copyright Asset Dedication 2011
Disclosures
Past performance may not be indicative of future results. Therefore, no current or prospective client should assume
that future performance of any specific investment or investment strategy (including the investments and/or investment
strategies recommended or undertaken by Asset Dedication) made reference to directly or indirectly by Asset
Dedication in their literature or otherwise will be profitable or equal the corresponding indicated performance level(s).
Different types of investments involve varying degrees of risk, and there can be no assurance that any specific
investment will either be suitable or profitable for a client or prospective client’s investment portfolio. Historical
performance results for investment indices and/or categories generally do not reflect the deduction of transaction
and/or custodial charges, the deduction of an investment management fee, nor the impact of taxes, the incurrence of
which would have the effect of decreasing historical performance results.
Please remember that different types of investments involve varying degrees of risk, and there can be no assurance
that the future performance of any specific investment or investment strategy (including those undertaken or
recommended by Asset Dedication), will be profitable or equal any historical performance level(s).