MINI-COURSE SERIES
RETIREMENT INCOME Part I
Copyright Š 2012 by Institute of Business & Finance. All rights reserved.
RETIREMENT INCOME
1
STANDARD DEVIATION Standard Deviation Standard deviation is a statistical measurement of how far a variable quantity, such as the price of a stock or the return on an investment, moves above or below its average (mean) value. As such, it is considered a good measure of volatility. An investment with high volatility is considered riskier than an investment with low volatility. Therefore, the lower the standard deviation, the lower the risk; the higher the standard deviation, the higher the risk (i.e., the more spread apart the data is, the higher the “deviation�).
The bell curve above will help explain the concept. Assuming normally distributed data, approximately 68% (roughly two-thirds) of the time total returns are expected to differ from the average (mean) total return by not more than plus or minus one standard deviation. And approximately 95% of the time total returns are expected to differ from the mean return by not more than plus or minus two standard deviations.
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If the bell curve is steep and returns are tightly bunched together, standard deviation is small, indicating low volatility and less risk. Alternatively, if the bell curve is relatively flat and returns are spread out, standard deviation is large, signaling high volatility and more risk. Calculation of standard deviation is a bit complex and consists of six distinct steps: (1) calculate the average return; (2) for each period subtract the average from the annual return (this is the deviation for that period); (3) square the deviation for each period; (4) sum the squared deviations; (5) divide the sum by the number of periods (this is known as the variance) and (6) calculate the square root of the sum of the squared deviations. The following table calculates the standard deviation for returns over 10 years. The steps in the process are labeled #1 through #6. Note that the mean (also referred to as the "average") return is 6.2% and the standard deviation is 11.9%. The results are plotted in graph A (see next page).
Calculating Standard Deviation
Period
Annual Return
Deviation For Each Period (step #2)
Deviation Squared (step #3)
1
-3.4
-9.6
92.0
2
9.9
3.7
13.8
3
-2.0
-8.2
67.1
4
21.7
15.5
240.6
5
-6.2
-12.4
153.5
6
11.0
4.8
23.1
7
-9.1
-15.3
233.8
8
13.1
6.9
47.7
9
-1.5
-7.7
59.1
10
28.6
22.2
493.3
sum (1-10)
61.9
1,424.0
sum of squared deviations (step #4)
average (step #1)
6.2%
142.4
divided by number of periods (step #5)
11.9%
Std. dev. (square root of variance) (step #6)
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These swings in annual returns can be dampened while retaining the same average return by adding 5% to each negative return in years 1, 3, 5, 7 and 9, and subtracting 5% from each positive return in years 2, 4, 6, 8 and 10. As expected, average returns remain at 6.2%, but the volatility of returns are lowered as the standard deviation falls from 11.9% to 7.8% (the results are plotted in graph B). The smaller standard deviation indicates a more consistent investment with less risk. Armed with this information an investor would likely chose the less volatile investment (7.8% standard deviation), particularly if it is expected to produce the same 6.2% return rate. Standard deviation is often used in comparing the volatility and risk of various mutual funds. Advisory service mutual fund rating services provide the standard deviation as an annualized statistic based on 36 monthly returns over a three-year period. Assuming a fund’s returns fall within the typical bell-shaped distribution, 68% of the time the fund’s total returns are expected to differ from its average (mean) return by no more than plus or minus one standard deviation; 95% of the time by no more than plus or minus two standard deviations. A fund with a mean of 26.5% and a standard deviation of 20.2% can be expected to return between 6.3% (26.5 – 20.2) and 46.7% (26.5 + 20.2) roughly two-thirds of the time. In general, a wider range of returns can be expected from the fund with the higher standard deviation and a lower range of returns can be expected from the fund with a lower standard deviation. It is important to recognize that by itself a low standard deviation means only that returns have been fairly stable; it does not indicate anything about the absolute amount of expected returns.
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TARGET RETIREMENT MUTUAL FUNDS Also referred to as life-cycle funds, target retirement funds are promoted as “one investment choice for a lifetime.” At first glance, these funds look similar. They consist of a series of funds from the same family. Each fund is identified with a specific retirement year, such as 2020 or 2025. The investor or advisor chooses a target close to the expected retirement date. The fund managers then allocate monies among stocks, bonds and cash equivalents. As the target date approaches, the allocation becomes more conservative, favoring bonds and cash. After the target date passes, most of these funds either merge into a retirement income fund or adopt an allocation that preserves purchasing power.
Target Date Retirement Funds [2031-2035] 2011
2010
2009
2008
3 Year*
5 Year*
10 Year*
-4%
14%
30%
-37%
12.6%
-1.0%
n/a
*annualized
One Size Does Not Fit All There are a number of problems with these funds. First, the financial objectives of people with a similar target date can be quite different. Someone age 65 and in poor health may need more money each year for medical purposes. Another person age 65 may have plenty of current income, but needs something more growth-oriented so that he may leave a large inheritance. Second, most of the fund companies with these programs offer funds based on 10-year intervals instead of five. Third, some fund groups increase expense ratios for these “fund of funds.” Fourth, a number of the “sub” funds have track records less than 10 years, making analysis somewhat limited. Fifth, some companies offer their best funds; others use a mix of some of their good and some of their not-so-good funds.
The Biggest Problem The greatest concern about target retirement is allocations are all over the board. As an example, the AIG SunAmerica High Watermarket fund has a target maturity of 2020 and a stock allocation of just over 86%. The Russell LifePoints Strategy has the same 2020 target date, but its stock allocation is 50%. Similarly, the Seligman TargETFund has a target date of 2025 with over a 94% allocation to stocks. The Vanguard Target Retirement fund has the same 2025 target date, but a stock allocation under 57%.
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CONVERTIBLE SECURITIES Next up on the risk-reward spectrum is the new breed of preferred stock that combines high yields with conversion into common stock. Old-style convertibles offer investors two ways to win. If interest rates fall, the value of their dividends rises; if the underlying stock rises, so will the price of the convertible preferred or bond. Investor can convert into common stock at any time until the converts either mature or are called by the issuer. At that point, she can take either stock or cash. These new-style convertibles, referred to as PEPS and PIES, offer a slightly different risk-reward twist. Instead the investor’s option to convert into stock, there is a set, future date when it will be automatically converted. There is no cash component or fixed dollar value at maturity. Instead, the ultimate return is entirely linked to the price of the underlying common stock. If the common stock rises, the covert’s value will rise. If it falls, so will the convert’s value at maturity. The number of shares in the conversion is determined by the price of the underlying stock and a target value set when the securities are issued. If the common stock stays within a certain price range, the converts will be worth the target value at maturity. If the stock is above the range, the converts will be worth more at maturity. If it falls below it, they will be worthless. In a best-case scenario, the common stock will rise, pushing up the value of the convertible as it nears the exchange date, even while it continues to dish out high income. Like bonds, most preferred stocks are callable. As with bonds, the key is to buy below the call prices, except when the call date is well off in the future and the yield-to-call is high enough to justify the purchase. The table below compares three mutual fund categories.
Moderate Allocation vs. Balanced vs. Utilities [through 2011] 3 Year
5 Year
10 Year
15 Year
Moderate Allocation Funds
11.3%
1.4%
4.0%
5.6%
Balanced Funds
11.8%
1.1%
4.0%
5.4%
Utility Funds
12.9%
2.5%
6.8%
7.2%
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UTILITY STOCKS VS. BONDS Growth has severed the link between utilities and interest rate swings. In 1999, for example, utility stocks barely budged while long-term bond yields soared from 4.7% to over 6% in a matter of months. In contrast, the average utility stock lost nearly 30% in 1994, almost identical to the bond market’s horrendous losses of that year. Dividend growth has slowed. In addition, even first-rate common stocks are not as safe as bonds, preferreds or even convertibles. Because their inflation beating potential is unmatched, stocks are still an integral part of income portfolios.
Utility Mutual Funds vs. World Bond Funds Util. / Bond
Util. / Bond
Util. / Bond
2011
11% / 3%
2006
27% / 6%
3 yrs.
12.9% / 7.9%
2010
9% / 7%
2005
15% / -3%
5 yrs.
2.5% / 6.1%
2009
20% / 13%
2004
24% / 9%
10 yrs.
6.8% / 6.9%
2008
-34% / -1%
2003
27% / 15%
15 yrs.
7.2% / 5.5%
2007
20% / 8%
2002
-24% / 14%
Most common stocks, because of the risks, belong in the aggressive rather than conservative portions of an income portfolio. The exceptions are companies involved in mergers with locked in takeover values. Unlike mergers in other industries, utility deals involve winning numerous regulatory approvals, a process that can take months or even years to complete. The overwhelming majority of utility mergers are approved and completed. Investors who buy into deals in progress can reap big gains, in addition to steady dividends. For mergers with a fixed value—either all cash or a set dollar value of stocks—the payoff is locked in no matter what happens to the economy and markets. Investors who buy will gain the difference between takeover value and their purchase price, plus dividends paid. In some cases, that amounts to an effective double-digit yield in a few months. If a yield looks too good to be true, you can bet it is. Most common stocks paying out double digits yields are not worth the paper they are printed on. Exceptions include limited partnerships, especially those backed by major energy companies. In the past few years, several giants have spun off some of their biggest cash generating assets into partnerships. The companies continue to manage the assets for a fee and can shelter more of the cash flow from taxes. For investors, the key advantage is a substantial yield.
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RETIREMENT INCOME
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THINGS TO DO Your Practice When presenting standard deviation (SD) to clients, show 3- or 5-year annualized figures but also show the most extreme single year for that period. Provide a dollar example—instead of saying, “Your portfolio could drop 12% any given year,” say, “You could lose $83,000 (or whatever 12% represents) in one year.” The Next Installment Your next installment, Part II, covers U.S. Savings Bonds. Although there is no commission or mark-up involved with this investment vehicle, Series EE and Series I Bonds often offer yields that are higher than long-term government bonds without any market or interest rate risk. Moreover, this often-overlooked investment provides one or more tax benefits. Learn Are you ready to take your practice to the next level? Contact the Institute of Business & Finance (IBF) to learn about one of its five designations: o o o o o
Annuities – Certified Annuity Specialist® (CAS®) Mutual Funds – Certified Fund Specialist® (CFS®) Estate Planning – Certified Estate and Trust Specialist™ (CES™) Retirement Income – Certified Income Specialist™ (CIS™) Taxes – Certified Tax Specialist™ (CTS™)
IBF also offers the Master of Science in Financial Services (MSFS) graduate degree. For more information, phone (800) 848-2029 or e-mail adv.inv@icfs.com.
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