Estimating the True Cost of Retirement · Source: “Low Bond Yields and Efficient Retirement...

©2016 Morningstar, Inc. All rights reserved.

David Blanchett, CFA, CFP®Head of Retirement ResearchMorningstar Investment Management, LLC

Estimating the True Cost of Retirement

Agenda

2

Retirement

For illustration only.

Relative Importance

3

Retirement

Home


4

Two Sides of the Equation

Liabilities

Assets Liabilities


5

Assets

6


The Past as a Guide

7

Stocks, Bonds, Bills, and Inflation 1926–2013

8

Source: Ibbotson

Stocks Return 10% Per Year?

-10%

-5%

0%

5%

10%

15%

20%

25%

Dec-35 Aug-49 Apr-63 Dec-76 Sep-90 May-04

10 Y

ear A

vera

ge A

nnua

l Com

poun

ded

Real

Retu

rn fo

r the

S&P

500

10 Year Period Ending

9

For illustration only. Source: Author’s Calculations.

How Much Do I Have to Save for Retirement: the 4% Rule

$0

$20,000

$40,000

$60,000

$80,000

$100,000

1 4 7 10 13 16 19 22 25 28

Inco

me

Retirement Year

InflationAdjustments

Initial Income

10

Where the 4% Rule Comes From… Historical US Data

0%

2%

4%

6%

8%

10%

12%

14%

1900 1910 1920 1930 1940 1950 1960 1970 1980

Initial Sustainable Withdrawal Rate

Retirement Year

11

Average annual compounded real return for a 60% stock, 40% bond portfolio: 1900 – 2013. Source: Dimson, Marsh, and Staunton, Morningstar Direct.

An International Perspective on Historical Returns

2.72%

1.84% 2.34%1.28%

4.06% 5.01%

12

An International Perspective

0%

2%

4%

6%

8%

10%

12%

14%

1900 1910 1920 1930 1940 1950 1960 1970 1980

Initi

al S

usta

inab

le W

ithdr

awal

Rat

e

Retirement Year

13

An International Perspective

0%

1%

2%

3%

4%

Austr

iaAu

strali

aBe

lgium

Cana

daDe

nmar

kFin

land

Fran

ceGe

rman

yIre

land

Italy

Japa

nNe

therla

nds

New

Zeala

ndNo

rway

South

Afric

aSp

ainSw

eden

Switz

erlan

d UK US

Initi

al Sa

fe W

ithdr

awal

Rate

99% Success Rate 95% Success Rate 90% Success Rate 80% Success Rate

14

Source: Robert J. Shiller

Where Are We Today?

05101520253035404550

02468

10121416

1881 1931 1981

CA

PE R

atio

Bon

d Yi

eld

Year

10 Year Government Bond Yields Shiller CAPE Ratio

15

Source: Ibbotson

Bond Yields and Future 10 Year Bond Returns

y = 0.9466x + 0.0084R² = 0.9203

0%

3%

6%

9%

12%

15%

0% 3% 6% 9% 12% 15%

Aver

age A

nnua

l 10 Y

ear F

utur

e Co

mpo

unde

d Bo

nd R

etur

n

Current Bond Yield

16

Source: Robert J. Shiller

CAPE Ratios and Future 10 Year Stock Market Returns

y = -0.0035x + 0.1461R² = 0.2384

0%

4%

8%

12%

16%

20%

5 10 15 20 25

Futu

re 10

Yea

r Ann

ualiz

ed R

etur

n

CAPE Ratio

17

A ‘Build Up’ Approach to Forecast Asset Class Returns

Credit spreadTerm spreadReal RateInflation

Equities Fixed Income

18

Our Best Guess on Returns (2015 CMAs)

Asset Class 1-10 11-20 20+ 1-10 11-20 20+US Large Cap Growth Equities 3.32 7.14 7.24 0.98 4.80 4.90US Large Cap Value Equities 3.95 8.67 8.78 1.86 6.58 6.69US Mid Cap Equities 3.93 9.15 9.28 1.68 6.90 7.03US Small Cap Equities 3.68 9.08 9.21 1.22 6.62 6.75US REITs 2.99 8.81 8.91 0.57 6.39 6.49Intl Equities 6.30 7.54 7.63 4.02 5.26 5.35Emerging Markets Equities 10.48 9.76 9.90 7.78 7.06 7.20Long Term Bonds 0.77 1.91 3.91 -0.88 0.26 2.26Intermediate Term Bonds 0.38 1.92 3.04 -0.76 0.78 1.90Short Term Bonds -0.16 1.60 2.69 -1.10 0.66 1.75High Yield Bonds 1.92 4.12 5.66 0.24 2.44 3.98Intl Bonds -0.22 2.42 3.93 -1.89 0.75 2.26Cash -1.06 0.58 1.02 -1.74 -0.10 0.34

Arithmetic GeometricSimulation Years Simulation Years

19

Source: “Low Bond Yields and Efficient Retirement Income Portfolios” by David Blanchett, Journal of Retirement

The Safety of The 4% Rule, Past versus Future

57%

79%90% 93% 93% 93% 93% 92% 91% 90% 88%

3%8%

21%

37%49%

56% 61% 64% 65% 65% 64%

0%

20%

40%

60%

80%

100%

0% 20% 40% 60% 80% 100%

Prob

abili

ty o

f Suc

cess

Portfolio Equity Allocation

Historical Returns Model Forecasted Returns Model

20

Is 4% Safe?

21

Source: “Low Bond Yields and Efficient Retirement Income Portfolios” by David Blanchett, Journal of Retirement

A More Colorful Perspective of 4%

0%

2%

4%

6%

8%

10%

12%

65 70 75 80

4.8%4.0%

6.1% 5.7%4.9%

7.7%

10.0%

Age

Withdrawal Rate

5.3%

6.6%5.7%

9.1%

6.5%

MaleFemaleJoint

22

The Retirement Liability

Common Liability Assumptions

23

80% 30 years

Replacement Rate

Retirement PeriodNeed Change

Inflation


24

Replacement Rate

25

Source: “Estimating the True Cost of Retirement” by David Blanchett, White Paper

Estimating a Replacement Rate

ConsumptionSmoothing

Expenses ChangeAt/During Retirement

$Income Differences

$

26

Earnings Curves

$1.00

$1.20

$1.40

$1.60

$1.80

$2.00

$2.20

25 35 45 55 65Aver

age

Life

time

Gro

wth

in R

eal W

age,

Age

25

= $1

AgeHigh School College Advanced

27

Source: “Replacement Ratio Study” by Aon Consulting

Replacement Rates For Various Households

28

Retirement Consumption

What Drives Retiree Spending?

29

W hat They Buy(Consumption Basket)

How Much the Spend

30


The Retirement Consumption Puzzle

31

Source: “Estimating the True Cost of Retirement” by David Blanchett, Morningstar White Paper

Expenditures as a Percentage of Total Household Consumption by Age

0%10%20%30%40%50%60%70%80%90%

100%

25 30 35 40 45 50 55 60 65 70 75 80 85

% o

f Tot

al

Age

Other

Transportation

Insurance & Pensions

Housing

Healthcare

Food

Entertainment

Clothes

Charity

32


Medical Spending for Different Income Levels

0%

10%

20%

30%

40%

50%

60 65 70 75 80% o

f Tot

al E

xpen

ditu

res

Age

Low Income Mid Income

0%

10%

20%

30%

40%

50%

60 65 70 75 80% o

f Tot

al E

xpen

ditu

res

Age

Low Income Mid Income

Median Spending Highest 1 in 20 Households

General Inflation (CPI-U) versus Medical Inflation

33

gMedical inflation has averaged +5.42% per year from 1948 to 2012, versus +3.63% for the CPI-U, therefore, has been growing about 50% faster than general inflation

y = 0.7011x + 0.0288R² = 0.5907

0%

3%

6%

9%

12%

15%

-3% 0% 3% 6% 9% 12% 15%

Med

ical

Infla

tion

General Inflation (∆ in CPI-U)

Source: Bureau of Labor Statistics.

Different Inflation Baskets

34

gFrom December 1982 to December 2012 the average annual change in the CPI-E has been 3.07% versus 2.92% for CPI-U

Expenditure group CPI-U CPI-W CPI-E CPI-W CPI-EApparel 3.5% 3.6% 2.4% 0.1% -1.1%Education and communication 6.7% 6.7% 3.8% 0.0% -2.9%Food and beverages 15.0% 15.7% 12.8% 0.7% -2.2%Housing 40.2% 39.2% 44.5% -1.0% 4.3%Medical care 6.9% 5.6% 11.3% -1.3% 4.4%Other goods and services 5.3% 5.1% 5.4% -0.2% 0.1%Recreation 5.9% 5.5% 5.3% -0.4% -0.6%Transportation 16.5% 18.7% 14.5% 2.2% -2.0%

∆ from CPI-UExpenditure Weights


2016 Inflation for Social Security Retirement Benefits

35


CPI-W CPI-E CPI-UFood and beverages 1.45% 15.7% 12.8% 15.0%Housing 2.13% 39.2% 44.5% 40.2%Apparel -1.46% 3.6% 2.4% 3.5%Transportation -7.39% 18.7% 14.5% 16.5%Medical care 2.49% 5.6% 11.3% 6.9%Recreation 0.86% 5.5% 5.3% 5.9%Education and communication -0.34% 6.7% 3.8% 6.7%Other goods and services 1.74% 5.1% 5.4% 5.3%

-0.12% 0.43% 0.09%

Sept14-Sept15 ∆

Weighted Average

Weights

Base Expectation of Retiree Spending???

36

Spending Increases Throughout Retirement(because of the changing consumption basket)

Slow-Go: Between the ages of 70 and 84, brought on by the body saying “Slow Down,” 20%-30% budget decline.

No-Go: 85+, significant changes in retirement lifestyle is generally brought on by health issues.

Go-Go: Retirees maintain lifestyle, travel, the group that does not consider themselves "old".

37

Source: "The Prosperous Retirement, Guide to the New Reality", Michael Stein

Inflation Risk: The Three “Stages” of Retirement

Annual Real Change in Expenditures for Retirees

38

R² = 0.3009

R² = 0.5702

-6%

-5%

-4%

-3%

-2%

-1%

0%

1%

2%

60 65 70 75 80 85 90

Ann

ual R

eal C

hang

e in

Tot

al

Expe

nditu

res

Age


39


Lifetime Real Income Need, Age 65 Retiree

$0.5

$0.6

$0.7

$0.8

$0.9

$1.0

$1.1

$1.2

65 70 75 80 85 90 95

Ann

ual R

eal D

olla

r Cha

nge

in

Con

sum

ptio

n

Age

25k Spend 50k Spend 100k Spend

Actual Retiree Spending

40

W hat retirees spend money on costs more

But they actually spend less

+ =

Spending declines… on average

41


Spending Less: Why?

Choice Necessity

42

The Length of Retirement

43


Longevity Risk

44


Inefficient Retirement Planning

Defined Benefit Plans Defined Contribution Plans

45

Life Expectancies Keep Increasing

10

15

20

25

1900 1950 2000 2050 2100

Life Expectancy (Years) for a

65 Year-Old

Year

Female Male

Source: Social Security Administration

46

… but the Gains are being Realized M ostly by the W ealthy

1415161718192021222324

1912 1922 1932

Cohort life expectancy

at age 65

Year

Earnings in top half of distributionEarnings in bottom half of distribution

Source: Waldron (2007)

47

… and Now a Large Gap Exists in Life Expectancies by Income Level

-4.6

-3.1-2.2

-1.5-0.9

0.01.2

2.13.3

5.5

-2.4 -2.0 -1.7-0.9

-0.1

0.4 0.8 1.11.8

3.1

-6

-4

-2

0

2

4

6

8

1 2 3 4 5 6 7 8 9 10

Difference versus Average Life

Expectancy for a 55-Year-Old

Income Decile

Males

(poorest) (richest)

Source: Bosworth and Burke (2014)

7% 13% 1% 19%

20% 29% 6% 43%

Male Female Both ≥1

Average American

Healthy American

25% 33% 8% 50%Healthy American in 2028

48

Source: Social Security Administration, Society of Actuaries

What the are Odds?... The Probability of a 65 Year Old Living to Age 95

Annuities… The Only Way to Guarantee Income for Life

49


65 70 75 85 90 95 100

$Income

65 70 75 85 90 95 100

$Income

Immediate Annuity

Deferred Income Annuity

Age

65 70 75 85 90 95 100

$VA+ GLW B

Income

50


The Best Annuity Around

51

A Better Retirement Spending Model

52


Building a Better Model

Spending Smile Changes in Spending Varies by Consumption Level

True Failure

53


Is this “Failure”?

$0

$2,000

$4,000

$6,000

$8,000

$10,000

1 2 3 4 5 6 7 8 9 10

Income Goal

Income Shortfall

Income Goal

54


What is Failure?

Failure Not Failure

Client Living StatusAlive Dead

â $

0<

$0

Portf

olio

Bal

ance Not Failure Not Failure

55


Probabilities of Success for Different Scenarios

25 30 35 Male Female Joint3.0% 98.9% 95.4% 89.6% 98.3% 97.5% 96.3%4.0% 88.4% 73.3% 58.5% 90.7% 87.0% 81.5%5.0% 61.0% 39.7% 26.3% 76.4% 68.6% 57.4%6.0% 29.9% 14.8% 8.1% 60.0% 49.3% 34.5%

25 30 35 Male Female Joint3.0% 99.7% 98.5% 95.6% 99.3% 99.0% 98.5%4.0% 94.8% 86.0% 75.4% 95.1% 93.0% 89.9%5.0% 75.9% 57.8% 42.8% 84.2% 78.5% 70.3%6.0% 45.3% 28.1% 17.2% 68.4% 59.2% 46.3%

Withdrawal Increases Annually by InflationFixed Period (Years) During Lifetime (Age 65)

Initia

l W

ithdr

awal

Rate

$50k Initial Goal CurveFixed Period (Years) During Lifetime (Age 65)

Initia

l W

ithdr

awal

Rate

56

Retirement Satistfaction

Are Retirees Happy? (Yes)

57

46%54% 58% 62% 62% 62% 57% 55% 56% 54%

36%33%

32% 31% 31% 32%35% 36% 37% 38%

18% 13% 10% 8% 7% 6% 8% 8% 7% 9%

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

1992 1994 1996 1998 2000 2002 2004 2006 2008 2010

% o

f All

Ret

irees

HRS Survey Year

Not at allModeratelyVery

58

Conclusions

Tips/Takeaways

59

gUse expected returns in simulations… not historical… you can’t buy the past

gThe “4% Rule” isn’t nearly as safe data as historical data suggests using forward-looking projections

g Increase the expected length of retirement in your models… your clients aren’t “average” from a life expectancy perspective

/30+ years for a married couple both age 65

gConsider modeling different levels of spending in retirement, where inflation-adjusted consumption decreases as the retiree/s age

gRetirees are a relatively happy bunch… and it’s not the financial stuff that makes them the happiest

Combined Impact of the Cost of Retirement

60

Projected returns are lower

Retirees spend less throughout retirement

+ =

Total cost is lower

Retirees are living longer

+

Disclosures

61

The above commentary is for informational purposes only and should not be viewed as an offer to buy or sell a particular security. The data and/or information noted are from what we believe to be reliable sources, however Morningstar Associates has no control over the means or methods used to collect the data/information and therefore cannot guarantee their accuracy or completeness. The opinions and estimates noted herein are accurate as of a certain date and are subject to change. The indexes referenced are unmanaged and cannot be invested in directly. Past performance is no guarantee of future results. The charts and graphs within are for illustrative purposes only.

Monte Carlo is an analytical method used to simulate random returns of uncertain variables to obtain a range of possible outcomes. Such probabilistic simulation does not analyze specific security holdings, but instead analyzes the identified asset classes. The simulation generated is not a guarantee or projection of future results, but rather, a tool to identify a range of potential outcomes that could potentially be realized. The Monte Carlo simulation is hypothetical in nature and for illustrative purposes only. Results noted may vary with each use and over time.

The results from the simulations described within are hypothetical in nature and not actual investment results or guarantees of future results. This should not be considered tax or financial planning advice. Please consult a tax and/or financial professional for advice specific to your individual circumstances.

Questions

62

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Estimating the True Cost of Retirement · Source: “Low Bond Yields and Efficient Retirement...

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