Creating Sustainable Retirement Solutions A Global Perspective Ghalid Bagus, FIA FSA CFA Principal March 2013

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Some background

US retirement assets Performance is hypothetical and does not represent the holdings of any particular investment. Past performance is not indicative of future results. There is no assurance that the investment process will consistently lead to successful investing.

Aging populations … impact on investors  Traditional retirement systems breaking down  Investors forced to take on investment and longevity risk Performance is hypothetical and does not represent the holdings of any particular investment. Past performance is not indicative of future results. There is no assurance that the investment process will consistently lead to successful investing.

What are the top investor concerns? Performance is hypothetical and does not represent the holdings of any particular investment. Past performance is not indicative of future results. There is no assurance that the investment process will consistently lead to successful investing.  What are the top investor concerns? −Investment losses −Outliving investments −Inflation −Medical care during retirement −Taxes  Four of the five are risk management issues  Investors are concerned about both pre- and post-retirement issues

How has the industry responded? Performance is hypothetical and does not represent the holdings of any particular investment. Past performance is not indicative of future results. There is no assurance that the investment process will consistently lead to successful investing. Static Diversification CPPI Guarantee Products Target Maturity Funds Dynamic Balanced Funds The focus has been mainly on investment risk

Issues have come to the fore Performance is hypothetical and does not represent the holdings of any particular investment. Past performance is not indicative of future results. There is no assurance that the investment process will consistently lead to successful investing.  CPPI −A method of portfolio insurance where the investor sets a floor on the portfolio value −Many products were cash locked during the financial crisis  Guarantee products −Guarantee provider credit risk has come to the fore −Capital requirements have increased for providing guarantee products −Designs have become more opaque as interest rates have declined

Target date funds Performance is hypothetical and does not represent the holdings of any particular investment. Past performance is not indicative of future results. There is no assurance that the investment process will consistently lead to successful investing. Naked Average Annual Return3.0%4.5%4.3%4.0% Volatility18.5%8.2%9.9%11.7% Probability of Negative Return42.4%40.2%40.9% Average Negative Monthly Return-4.3%-1.7%-2.2%-2.7% Maximum Drawdown-58.2%-27.9%-34.3%-40.2% Projection based on quarterly rebalance between EAFE Index and Barclays Capital Aggregate Bond Index over the period 1 Jan 2003 to 31 Dec  Target Date Funds evolved from the need to offer more tailored solutions to investors planning for retirement  Funds tailor their risk profile by reducing holdings of risky assets as retirement approaches  Using risky assets as a risk proxy ignores −volatility and correlation changes −the length of the retirement time horizon

Balanced funds Performance is hypothetical and does not represent the holdings of any particular investment. Past performance is not indicative of future results. There is no assurance that the investment process will consistently lead to successful investing.  Similar to asset allocation models but within a fund structure  Fund invests in a mixture of bonds and equities and dynamically rebalance between to avoid market declines  Benchmark allocations are not wide enough to provide suitable protection during a financial crisis  Large return effect due to decline in interest rates on bond portion of the fund – may not be the case going forward

Diversification is still the primary risk management tool Performance is hypothetical and does not represent the holdings of any particular investment. Past performance is not indicative of future results. There is no assurance that the investment process will consistently lead to successful investing.  Diversification is still the primary risk management tool −Diversification fails during crises when all asset classes decline together (i.e plunge) −Trading equity exposure for bond exposure may be unappealing in down markets with low interest rates  Investors are challenged to find effective investment risk management approaches Source: Milliman, Inc. 2010

Problems for investors Performance is hypothetical and does not represent the holdings of any particular investment. Past performance is not indicative of future results. There is no assurance that the investment process will consistently lead to successful investing. Source: gallup.com, 2012 This chart is from Gallup's annual Economy and Personal Finance survey, conducted April 9-12, 2012, available at

The need for better risk management

Unbundling the key concerns Performance is hypothetical and does not represent the holdings of any particular investment. Past performance is not indicative of future results. There is no assurance that the investment process will consistently lead to successful investing. Existing solution New solutions to capture market and longevity risks

Investment strategies with protection Performance is hypothetical and does not represent the holdings of any particular investment. Past performance is not indicative of future results. There is no assurance that the investment process will consistently lead to successful investing. Two risk management techniques Adding a protection strategy can reduce downside exposure - it aims to provide investors with much greater certainty that they can achieve retirement funding objectives  Current asset allocation –Target a specific equity allocation (i.e., 60%) as a proxy for risk –Maintain constant equity allocation regardless of market conditions  Target volatility asset allocation –Target a specific volatility level –Aims to prevent portfolio volatility from dramatically increasing during market crises  Attempts to cushion losses –Aims to cushion losses in market downturns –Amount of cushion customizable to plan needs  Keep protection relevant –Ratchet protection level up to preserve gains –Reset protection level down after extreme market declines to harvest gains Capital Protection Strategy Volatility Management

Volatility spikes frequently Performance is hypothetical and does not represent the holdings of any particular investment. Past performance is not indicative of future results. There is no assurance that the investment process will consistently lead to successful investing.

How do investors react to volatility? Performance is hypothetical and does not represent the holdings of any particular investment. Past performance is not indicative of future results. There is no assurance that the investment process will consistently lead to successful investing. US StockInternational StockModerate Allocation 1 Jan 2007 to 31 Dec 2012 Morningstar category return 0.8%-5.4%3.0% Investor return -1.8%-8.9%4.1% Differential -2.6%-3.5% 1.1% Category volatility 19.3%23.7% 13.5% 1 Jan 2002 to 31 Dec 2012 Morningstar category return 10.3%16.1%10.3% Investor return 7.6%12.0%13.5% Differential -2.7%-4.1% 3.2% Category volatility 14.9%18.6% 10.4% Source: Morningstar Returns and volatilities are annualized.  Investor return versus Morningstar Category return  Investor return: not all investors bought shares at the beginning of a period and held them until the end  More volatile funds tend to show the greatest differential between Investor return and Morningstar Category return  Investors tend to buy high and sell low

Capital protection strategy characteristics Performance is hypothetical and does not represent the holdings of any particular investment. Past performance is not indicative of future results. There is no assurance that the investment process will consistently lead to successful investing.  Use dynamic rebalancing to replicate a put option inside the portfolio  The value of a put is asymmetric – market downturns result in large gains, market upturns result in small loss es

Protection strategy across market cycles Performance is hypothetical and does not represent the holdings of any particular investment. Past performance is not indicative of future results. There is no assurance that the investment process will consistently lead to successful investing. Bull/Bear Market Examples Bear MarketBull Market NORMAL MARKET -15% BEAR MARKET -30% BEAR MARKET NORMAL MARKET 30% BULL MARKET -5% DROP (STOP LOSS) Low Vol Funds High Vol Funds Protection increased in bear markets to preserve gains Low volatility Sell equities to capture gains and ratchet up protection

Who’s out there? Performance is hypothetical and does not represent the holdings of any particular investment. Past performance is not indicative of future results. There is no assurance that the investment process will consistently lead to successful investing.

Historical backtest Performance is hypothetical and does not represent the holdings of any particular investment. Past performance is not indicative of future results. There is no assurance that the investment process will consistently lead to successful investing. BenchmarkProtection Strategy Average Return 7.0%8.5% Average Volatility 9.7%8.4% Average Equity 60%58% Maximum Drawdown -34.5%-18.0% Sharpe Ratio 52%77% The Protection Strategy reduces the drawdown and improves the Sharpe Ratio while maintaining the same average level of equity exposure

Benefits when making withdrawals Performance is hypothetical and does not represent the holdings of any particular investment. Past performance is not indicative of future results. There is no assurance that the investment process will consistently lead to successful investing. Unprotected Volatility Managed Only Protected Value of portfolio before crisis $100k Return in first six months -46%-23%-10% Value of portfolio before disbursement $54k$77k$90k Value of portfolio after $4k disbursement $50k$73k$86k Return in next six months +55%+28%+13% Final value of portfolio $78k$93k$97k Portfolio return net of disbursement -22%-7%-3% Protected portfolios are especially valuable when investors are making withdrawals Before crisis: September 9, 2008 First six months of crisis: September 9, 2008 to March 9, 2009 (bottom of market) Next six months of crisis: March 9, 2009 to September 9, 2009 (recovery)

Outliving assets is a real risk Performance is hypothetical and does not represent the holdings of any particular investment. Past performance is not indicative of future results. There is no assurance that the investment process will consistently lead to successful investing. Life expectancy: 83 years Significant probability of living longer than the average life expectancy

Longevity account Performance is hypothetical and does not represent the holdings of any particular investment. Past performance is not indicative of future results. There is no assurance that the investment process will consistently lead to successful investing.  Longevity risk is addressed by making small annual allocations to deferred income annuities for a period before retirement  During retirement, income sources are diversified

Protection + Longevity Account = Member Goals Performance is hypothetical and does not represent the holdings of any particular investment. Past performance is not indicative of future results. There is no assurance that the investment process will consistently lead to successful investing.

In summary Performance is hypothetical and does not represent the holdings of any particular investment. Past performance is not indicative of future results. There is no assurance that the investment process will consistently lead to successful investing.  Individual investors more focused on risk management than in the past  Existing investment solutions −Continue to focus on diversification −Do not address risks investors view as major concerns  Next generation investment solutions are more attuned to investor concerns focusing on −Volatility management −Capital protection −Longevity addressing pre- and post-retirement needs

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