Retirement

• Security analysis was a two-dimensional process focusing on the risk/return characteristics of individual securities. Modern portfolio theory added a third dimension to this process, which evaluates a security’s “diversification effect” on a portfolio.
• Diversification effect considers the impact that the inclusion of a particular asset class or security will have on both the volatility and return characteristics of the overall portfolio. In an efficient capital market, security prices are always fair.
• Modern portfolio theory stresses that it is wise to simply “buy and hold” a broad array of diverse investments.
• Covariance
• MPT is based upon the concepts of covariance and diversification.
• Covariance is a measure of the degree to which random variables move in a systematic way, either positively or negatively. By combining securities that are negatively covariable, investors can reduce the variability of outcomes without sacrificing expected returns.
• Efficient Frontier
• Any portfolio that offers the highest return for a given amount of risk must lie on the efficient frontier.
• A portfolio is considered efficient if no other portfolio offers (i) higher returns for a given level of risk or (ii) lower risk for a given level of expected returns.

• Asset allocation is the distribution of client’s funds among various types of assets to achieve diversification, that is, to lower risk and/or to increase potential return.  
• The three major objectives are:  
• 􏰃 It minimizes client’s fear;
• 􏰃 It helps clients make sense of the market; and
• 􏰃 It helps clients maintain confidence in their investment positions
• Asset allocation can be used to prevent clients from suffering sharp losses over prolonged periods of time and will help to ensure that they are safely progressing toward their retirement goals.
• Risk Return Trade off : Lowest to Highest Risks:
• Deposits
• Bonds
• Unit Trust
• Common Stocks
• Options
• Commodities
• Risk Return Considerations:
• The first consideration is the trade-off between what is acceptable to the client and what is appropriate for the client. → Affect Annual Savings.
• The second consideration is not what level of risk a client can withstand but what level of risk is appropriate for retirement planning purposes.
• An accurate assessment of a client’s risk-return expectations is needed in the following situations:  

• when preparing a financial or retirement plan

• major changes in the economy

• as a result of increases or reductions in family obligations

• changes in client’s goals and objectives

• whenever circumstances causes changes in client’s risk-return expectations.

• Measuring Risk Tolerance
• (a) The context of the risk-taking, and (b) the format used to gauge the client’s risk-taking propensity.
• Four major contexts or categories of situations in which decisions are made involving risk.
• Monetary Risk: Examples include situations involving gambling, investments, and job security.
• Physical Risk: Situations involving risk of bodily harm are examples of this type of risk.
• Social Risk: Potential loss of esteem in the eyes of another typifies this risk category. 
• Ethical Risk: The compromise of one’s standards or religious beliefs or a conflict of interest are common examples of this type of risk
• Methods used to assess client’s risk tolerance:
• 1) Self-Reported Preferences for Selected Investment Products
• The advantages are that these kinds of measurement tools are relatively easy. The Disadvantages do not appreciate or who are unaware of the problems and nuances inherent in measuring attitudes. Most only have what is called “face validity”.
• 2) Self-Reports of Attitudes toward risk
• Select one of the two options e.g. risk-taker or risk-avoider, or is asked to rate himself on a scale with opposite points labelled risk-taker and risk-avoider.  The advantage of this method is that it is very easy to administer and appears to give very realistic and personal appraisal.
• Its disadvantage is that often people tend to consider and rate themselves as greater risk-takers than they are in reality.
• People who tend to be more risk-aversive include;
• 􏰃 females, in general;
• 􏰃 first-born in a family;
• 􏰃 married individuals;
• 􏰃 people who work on a straight salary; and
• 􏰃 individuals who are not successful in their work.
• Thrill seekers - Consistently high risk taking
• Defensive Anxious - Consistently risk avoider or risk taker
• Mental Processing

• Risk-tolerant investors will settle for a disproportionately smaller increase in expected return with each increase in the risk they are willing to assume.  

• Risk-Indifferent investors require only a proportional increase in expected return with each increase in the risk they assume.  

• Risk-Aversive investors demand a disproportionately larger expected return with each increase in the risk they will undertake.

• Life Cycle Investing (LCI) describe the process of matching investment portfolios to the clients’ different life phases. It entails adjusting the investment portfolio to suit the changes in the clients’ life objectives as they pass through different life phases.
• Life Cycle Investing has gained in importance in recent years due to the following factors:

• Demographic trends
• Higher awareness
• Changing goals/needs
• Discretionary funds
• Myriad of products
• Purchasing parity  (returns relative to inflation)
• Emergence of the financial planning profession

• Factors affecting LCI considerations:
• Age: a younger client would have a higher risk tolerance than an older client.
• Funding: the stability of the sources of an income stream will dictate the type of  suitable investments.
• Family commitments: commitments such as establishing an education fund, health  care costs for aged parents, career changes, upgrading of residence.
• Debt levels: A client with high liquidity and low gearing will have a better appetite for a riskier portfolio as compared to a highly geared person with a deteriorating  liquidity ratio.
• Investment experience: A novice investor should not commit large sum of savings  into high-risk investments as any ‘catastrophic’ losses early on will have detrimental effect on building an effective long-term investment program; the power of compounding is a double edged sword.
• Risk propensities: Usually, rational investors are risk aversive or at best risk tolerant. They will only accept high-risk investments if they are compensated proportionately by higher returns. Depends on:

• Proportion of high risk vs. low risk investments in existing portfolio
• Proportion of liabilities to net worth
• Proportion of life insurance to annual salary
• Type of job and industry

• During the four phases, financial planners must perform the following:
• Assess and take into account the client’s risk profile to ensure that the investment vehicles are appropriate;
• Actively monitor the investment portfolio’s performance;
• Revise the investment portfolio to account for changes in the client’s financial  status, risk profile and changes in economic environment in general;
• Assess the impact of inflation on the client’s retirement funding requirements.
• Portfolio design should not be swayed by short-term changes. Long-term goals are more likely to be achieved by using a buy-and-hold strategy that includes periodic monitoring and selective repositioning.
• Therefore, the proverbial dollar-cost averaging approach, in which a fixed-dollar amount is invested in a security in each period, is consistent with a buy-and-hold strategy.
• Need for Financial Review:
• As the standard of living improves, the need for additional savings to fund the increased standard of living also increases;
• Financial planners may want to suggest that as real income grows, the current standard of living should grow at a somewhat reduced pace; and
• Financial planners must consider downward revisions of funding goals because of job-related or other economic changes for the worse.

• Step 1: Decide the asset classes that will be represented in the retirement portfolio.
• Step 2: Determine the long-term desired percentage of the portfolio to allocate to each of these asset classes.

• - determine the allocation percentage of the asset classes in the portfolio.
• - consider other factors unique to each client, such as time horizon and risk tolerance.
• The first two steps form the foundation for the portfolio’s volatility/return characteristics and are referred to as investment policy decisions.
• Step 3: State the range in which the allocation of the asset classes in the portfolio can be altered so as to take advantage of the possibility of the better performance of any one-asset class
• if bonds are extremely unattractive as compared to stocks, the percentage allocated to bonds should be reduced to the lower limit.
• Market Timing

• Step 4: Select securities within each asset class.
• - Either actively or passively
• Step 5: Monitor the Portfolio

• Historical Returns
• Past performance statistics for different assets are reliable guides of future performance only if the investments are held over a sufficiently long holding period.

Market Indices

Quantitative Methods

• Sharpe index, which evaluates the performance by dividing the portfolio’s return in excess of the risk free rate by the standard deviation of the portfolio.
• Treynor index, which evaluates the performance by dividing the portfolio’s return in excess of risk free rate by the beta of the portfolio.
• The higher the ratios calculated in both methods, the greater the excess returns of the retirement portfolio relative to its risk, and thus the better performance.
• Jensen index evaluates the performance by taking the difference between the actual return of the retirement portfolio and the expected return of the portfolio.
• The performance of the retirement portfolio will be acceptable if the alpha is positive, as the portfolio would have outperformed the market.

• Conservation Strategy
• The portfolio is not very aggressive and at retirement and thereafter, the portfolio becomes very conservative. The stock allocation is conservative from the outset and falls gradually during the period up to retirement and then drops when the retirement age is reached. This strategy applies to clients who generally have a low risk tolerance.
• Moderate Strategy
• The portfolio gradually becomes more conservative both before and after retirement. The stock allocation falls gradually throughout the entire life of the retirement portfolio. This strategy generally applies to moderate risk investors.
• Aggressive Strategy
• Aggressive approach prior to retirement by having the highest allocation to stocks which then slowly reduces. If the aggressive approach to portfolio management before retirement did not produce good results, retirement will most likely be deferred.
• The stock allocation during the post-retirement period will usually be the same as that adopted by the moderate approach. This strategy is most appropriate for clients with a high risk tolerance.
• Rule of thumb formula
• Factors that a financial planner would need to carefully consider prior to making specific asset allocation recommendations

• Total asset value relative to income requirements
• Overall financial requirements
• Attitude toward risk
• Rates of return
• Stage of economic cycle
• Market conditions

• Portfolio with minimum 10 years horizon should have reason equity allocation. 15 to 20 years should have significant equity allocation.
• Rule of Thumb Asset Allocation Formula:
• Allocation of stock (%) = 100 - Retiree’s age
• Conservative Retirees: Allocation of stocks (%) = 115 – Retiree’s age
• Balanced Retirees: Allocation of stocks (%) = 128 – Retiree’s age
• Growth Retirees: Allocation of stocks (%) = 140 – Retiree’s age
• Limitations
• Firstly, it is assumed that the portfolio will be depleted after a 30-year period. This means that there will not be any assets left to leave to family members.
• The second limitation, also related to the 30- year period, is that the withdrawal rate may be too low for clients who require a larger annual distribution for living expenses. These clients would therefore require a higher payout and the retirement fund’s duration would likely be less than 30 years.

• Variable Annuities help to keep pace with inflation.
• Open ended Unit Trust are high liquid.
• Either the net annual value of the taxpayer’s property or $150,000, whichever is less, is excluded from the assessable income of the taxpayer if the property is occupied by the tax payer for residential purposes.
• If own 2 residence, residence which he lives is considered for purposes of exclusion from AI. Better to stay in a higher net Annual Value.

• Immediate Annuity - Income payments start within a short time after single payment is made, usually within six months.
• Deferred Annuity - Income payments will not start until a later date, usually a year or more into the future.
• Pure Life Annuity - Income payments last for the lifetime of the annuitant. It leaves no residual estatevalue, which would increase estate duty.
• Joint Life Annuity - Income payment lasts as long as both annuitants are alive. Payments cease when one of the annuitants passes away.
• Joint and Survivor Annuity - Income payments are made when both annuitants are alive and adjusted payments are made to the surviving annuitant.
• Life and Period Certain (Guaranteed) - Income payments last for the lifetime of the annuitant, with a guaranteed minimum for a specified period.
• Annuity Certain - Income payments are for a given period regardless of whether the annuitant is still living within that period. No payments will be made after that given period even if the person is living beyond that contract period.
• Refund Annuity - If the income payments over the life of the annuitant do not equal the value of the annuity at the date of annuitisation, the balance is paid to the beneficiary either as continued payments or a lump sum.
• Fixed Annuity - Guarantees a certain interest on invested fund with additional interest payments depending on the performance of the investments.
• Variable Annuity - Funds are invested as directed by annuity holder with no guaranteed rate of return.
• Taxability
• Restrict the assessability of an annuity to 3 percent of the total consideration paid or payable for the purchase of the annuity in most cases. However, the 3 percent limitation does not apply when:
• 1. The person deriving income from the annuity has previously received sums equal to the consideration paid for the annuity (exclusive of the amounts deemed to be income).
• 2. The  annuity was purchased by the taxpayers’ employer in lieu of pension or other retirement benefits on or after 1 January 1993.
• With effect from 1 January 2004 Annuities resulting from investment income in Singapore from the ownership of financial instruments are tax exempted. However income resulting from the following is taxable:
• 1. through partnership
• 2. Supplementary Retirement Scheme
• 3. from an employer who purchased the annuity for an employee in place of a pension or other employment benefits payable during employment or upon retirement.