Asset Allocation in Retirement Portfolios American Association of Individual Investors Washington, D.C. May 19, 2007 Craig L. Israelsen, Ph.D. Brigham Young University

Overview Historical performance of major assets, the value of diversification, and the “Small Cap Premium” Target Date Funds The “Value Premium” Alternative assets in a portfolio (commodities, real estate) A tale of two portfolios (if we have time)

The real reason we diversify…

Analysis of Accumulation Portfolios 25-year old participant $45,000 starting annual income Annual savings rate of 6% of income Income increases 4% annually 40-year investment period (age 25-64) This analysis examines 8 40-year periods (from )

Various Accumulation Portfolios Portfolio #1: 100% Large Cap US Equity Portfolio #2: 60% Equity/40% Fixed Income (40% Lrg US, 10% Sml US, 10% Non-US, 30% Bonds, 10% Cash) (40% Lrg US, 10% Sml US, 10% Non-US, 30% Bonds, 10% Cash) Portfolio #3: Target Date Fund Glidepath from age 25 to 65 (portfolio moves from high equity to high fixed income using all five asset classes) (portfolio moves from high equity to high fixed income using all five asset classes) Portfolio #4: 100% Bonds

40% Equity 25% Equity Typical Target Date Fund Methodology

The ending date of the “Accumulation” period is critical (i.e. 2002)

Will an investor endure the setbacks in “equity heavy” portfolios?

Analysis of Portfolio Drawdown during Retirement $500,000 Portfolio at age 65 5% Annual Withdrawal Rate ($25,000) 3% Inflation Rate of Annual Withdrawals 20-year analysis period (age 65-84) This analysis examines year periods (from )

40% Equity 25% Equity Typical Target Date Fund Methodology

Drawdown Retirement Portfolios at age 65 Target Date Fund (“Glidepath” after age 65) (Average Equity Allocation of 35%/Average Fixed Income Allocation of 65%) 40% Equity/60% Fixed Income (20% Lrg US, 10% Sml US, 10% Non-US, 50% Bonds, 10% Stable Value) 25% Equity/75% Fixed Income (15% Lrg US, 5% Sml US, 5% Non-US, 50% Bonds, 25% Stable Value) 100% Fixed Income (100% Bonds)

Maximum Drawdown Risk Retirement Portfolio in Withdraw Mode The timing of negative returns is the key issue. If the negative returns occur early, the outcome can be disastrous. If the negative returns occur later, chances of recovery are much higher.

All’s well that ends well?

Early years with negative returns cause the decline in a withdrawal portfolio account balance

The sensitivity of WHEN returns occur shows up in the drawdown phase

The Mathematics of Recovery

Portfolio Return from which a Recovery is Needed Needed Average Annual % Return to Restore Original Portfolio Balance WITHDRAWAL Portfolio $500,000 initial balance, First Year Withdrawal of 5% of initial balance, 3% increase of annual withdrawal Within 1 YearWithin 2 Years Within 3 Years Within 4 Years Within 5 Years 5%5.2% 5.3%5.4%5.5% 2%8.4%6.9%6.4%6.3%6.2% 0%10.7%8.0%7.2%6.9%6.7% -2%13.1%9.2%8.0%7.5%7.2% -5%16.8%11.1%9.3%8.4%8.0% -10%23.7%14.4%11.5%10.1% 9.4% -15%31.4%18.0%13.9%12.0%10.9% -20%40.2%22.0% 16.5% 14.0%12.5% -25%50.2%26.4%19.4%16.1%14.3% -30%61.8%31.3%22.6%18.5%16.2% -35%75.3%36.9%26.1%21.2%18.4% Portfolio Return from which a Recovery is Needed BUY-and-HOLD Portfolio Within 1 Year Within 2 Years Within 3 Years Within 4 Years Within 5 Years -2%2.0%1.0%0.7%0.5%0.4% -5%5.3%2.6%1.7%1.3%1.0% -10%11.1%5.4%3.6%2.7% 2.1% -15%17.6%8.5%5.6%4.1%3.3% -20%25.0%11.8% 7.7% 5.7%4.6% -25%33.3%15.5%10.1%7.5%5.9% -30%42.9%19.5%12.6%9.3%7.4% -35%53.8%24.0%15.4%11.4%9.0%

Target Date Funds

Target Date of Fund (as stated in name of the fund) Total Assets ($ Million) (Includes All Share Classes) Number of Distinct Target-Date Funds 20001, , , , , , , , , , TOTAL$109,454168

The “Non-Target Date Funds” is a comparison group consisting of 72 funds which have the Dow Jones Moderate Portfolio as their “best-fit” index. Among target date funds, the most common best-fit index was the Dow Jones Moderate Portfolio.

Target Year Comparison of DJ Target Date Indexes And Averages of Target Date Funds in 2006 Portfolio Allocation Sub-allocation within the US Stock Portion of the Portfolio % Cash % US Stock % Non-US Stock % Bonds % Large US Stock % Mid US Stock % Small US Stock 2010 Dow Jones Target Indexes 20.2%14.1%7.1%58.6% 33.1%33.4%33.5% 2010 Target Funds Average (n=24) 11.3%32.8%9.9%44.3%71.8%21.1%7.1% 2020 Dow Jones Target Indexes 4.0%34.2%17.2%44.6% 33.1%33.4%33.5% 2020 Target Funds Average (n=23) 8.5%47.2%15.3%27.4%70.0%22.7%7.3% 2030 Dow Jones Target Indexes 4.0%51.8%26.1%18.2% 33.1%33.4%33.5% 2030 Target Funds Average (n=21) 4.7%60.1%19.2%14.4%69.2%22.7%8.1% 2040 Dow Jones Target Indexes 4.0%59.3%29.9%6.8% 33.1%33.4%33.5% 2040 Target Funds Average (n=20) 3.8%65.1%20.7%8.9%69.3%22.7%7.9%

Observations… Compared to the Dow Jones Target Date Indexes, the typical target date fund is underweighted in mid cap and small cap stocks. Therefore, it’s not surprising that the average target fund has underperformed the DJ Target Indexes in recent years.

The “Value Premium”

Large Cap US Equity ( ) Growth = Average of Dow Jones Large Growth Index and DJ Wilshire Large Growth Index Value = Average of Dow Jones Large Value Index and DJ Wilshire Large Value Index

Mid Cap US Equity ( ) Growth = Average of Dow Jones Mid Growth Index and DJ Wilshire Mid Growth Index Value = Average of Dow Jones MidValue Index and DJ Wilshire Mid Value Index

Small Cap US Equity ( ) Growth = Average of Dow Jones Small Growth Index and DJ Wilshire Small Growth Index Value = Average of Dow Jones Small Value Index and DJ Wilshire Small Value Index

Frequency of Premium over Various Time Frames LGLVMGMVSGSV 27 1-Year Rolling Periods 41%59%37%63%33%67% 26 2-Year Rolling Periods 31%69%35%65%27%73% 25 3-Year Rolling Periods 28%72%28%72%24%76% 23 5-Year Rolling Periods 30%70%22%78%17%83% Year Rolling Periods 17%83%6%94%6%94%

Observation… The typical target date fund is underweighted in value stocks, at least based on the performance of value- oriented stocks over the past 27 years.

Irony Based on the typical composition of existing target date funds, “alternative” asset classes would include increased exposure to… mid and small cap stocks AND stocks with a value tilt… Or at least increased exposure.

Two classic “alternative” assets in a retirement (i.e. withdrawal) portfolio Commodities& Real estate

In light of the needed returns to recover from a loss… Retirement portfolios that are sustaining systematic withdrawals have two main goals: 1) Avoid large losses and and 2)Produce a sufficiently high return to maximize the likelihood of not maximize the likelihood of not outliving the portfolio. outliving the portfolio.

The risk/return characteristics of The risk/return characteristics of major asset classes from (adding commodities and REITs) ASSUMING BUY-and-HOLD

Withdrawal Portfolio: Historical Performance from $500,000 initial balance with a 5% Initial Withdrawal 3% increase in Annual Withdrawal Amount ($25,000 1 st year, $25,750 2 nd year, etc.) Portfolio 37-Year IRR (%) Year Standard Deviation of Return (%) Probability of Recovery within 5 Years from a 10% loss Probability of a One-Year Loss of 10% or more Maximum One Year % Drawdown 100% Large US Stock % Bond Bond/40 Equity 20% Lrg US 10% Sml US 10% Non-US 50% Bond 10% Cash Equity/40 Bond 40% Lrg US 10% Sml US 10% Non-US 30% Bond 10% Cash Multi-Asset 60 Eq/40 Bond 20% Lrg US 10% Sml US 10% Non-US 10% Commodities 10% REIT 30% Bond 10% Cash Aggressive Equity 20% Lrg US 20% Sml US 20% Non-US 20% Commodities 20% REIT % REIT % Commodities

Multi-Asset 60 Eq/40 Bond = 20% Lrg US, 10% Sml, 10% Non-US, 10% Comm, 10% REIT, 30% Bond, 10% Cash Aggressive Equity = 20% Lrg US, 20% Sml, 20% Non-US, 20% Commodities, 20% REIT Multi-Asset 60 Eq/40 Bond = 20% Lrg US, 10% Sml, 10% Non-US, 10% Comm, 10% REIT, 30% Bond, 10% Cash Aggressive Equity = 20% Lrg US, 20% Sml, 20% Non-US, 20% Commodities, 20% REIT

A Tale of Two Portfolios Vanguard & Homestead Alternative “pathways” to investing

The Vanguard Portfolio $3,000 required to open each fund 1999 Return 2000 Return 2001 Return 2002 Return 2003 Return 2004 Return 2005 Return 2006 Return 8-Year Average Return 8-Year Std Dev Vanguard 500 Index 21.1%-9.1%-12.0%-22.2%28.5%10.7%4.8%15.6%3.3%17.6% Vanguard Small Cap Index 23.1%-2.7%3.1%-20.0%45.6%19.9%7.4%15.7%10.0%19.5% Vanguard Total Bond Index -0.8%11.4%8.4%8.3%4.0%4.2%2.4%4.3%5.2%3.9% Vanguard Total International Stock Index 29.9%-15.6%-20.2%-15.1%40.3%20.8%15.6%26.6%8.0%23.7% VANGUARD PORTFOLIO 18.3%-4.0%-5.2%-12.2%29.6%13.9%7.5%15.6%7.1%14.1%

The Homestead Portfolio $1 minimum requirement to open each fund (automatic monthly investment) 1999 Return 2000 Return 2001 Return 2002 Return 2003 Return 2004 Return 2005 Return 2006 Return 8-Year Average Return 8-Year Std Dev Homestead Value-3.2%9.6%5.9%-11.6%26.2%14.7%10.9%17.8%8.2%11.9% Homestead Small Company Stock -0.6%15.2%11.2%-0.6%32.4%13.2%9.5%16.7%11.7%10.5% Homestead Short- Term Bond 3.2%7.8%7.1%5.3%1.9%1.7%2.3%4.1% 2.4% Homestead International Value 25.5%-15.7%-22.9%-17.6%35.9%17.9%14.3%25.8%5.6%23.0% HOMESTEAD PORTFOLIO 6.2%4.3%0.3%-6.1%24.1%11.9%9.3%16.1%7.9%9.4%

Vanguard: $12,000 up front OR Homestead: $4 per month Vanguard Portfolio: 80 bps lower return, 470 bps higher volatility