4 Creating a Framework 6 Case Study #1: The Dunbars 8 Case Study #2: Professor Harrison 9 Case Study #3: Jane Leahy Advanced Annuity Strategies to Help Secure Your Retirement
The Paradigm Has Shifted. Generations of Americans have relied on pensions to supplement their Social Security payments and see them through retirement. Over the past several decades, however, the number of defined benefit pension plans offered by US employers has declined precipitously in favor of 401(k) and other defined contribution plans. Participants must now make their own decisions about how much to contribute each year and where to invest their assets. And today s economic environment just adds to this uncertainty. With interest rates forecasted to remain near historic lows, Morgan Stanley Wealth Management s Global Investment Committee (GIC) thinks the prospect for global growth is not as positive as it has been in recent years.
6 creating a framework / p4 / The following case studies illustrate how the GIC s framework might work for hypothetical investors with different combinations of goals, resources, time horizons and risk tolerances. 8 the dunbars / p6 / They ve saved diligently, but with retirement only a few years away, will they be able to meet their objectives? John and Alice Dunbar have tried to do the right thing throughout their careers. professor harrison / p8 / Professor James Harrison is age 65 and nearing the end of a distinguished career. He will miss his students and the intellectual stimulation of academic life, but he looks forward to fulfilling his passions for travel and golf when he finally retires in five years. 9 jane leahy / p9 / Retirement is still another ten years away, but she wants to make certain she s on the right track. At age 55, Jane has no intentions of retiring for another ten years, but she s beginning to worry that she hasn t saved enough.
creating a framework To help investors add a greater degree of certainty to their retirement prospects, the Global Investment Committee embarked on an extensive study to determine whether investors could replicate the benefits of traditional defined benefit pension plans through annuity investments. And if so, how might they go about quantifying their allocation to annuities versus other asset classes like stocks and bonds? The framework provides guidance to investors concerned about managing the risks inherent in a retirement portfolio that consists solely of stocks and fixed-income securities, namely: Retirement Portfolio Market Risk Longevity Risk The possibility that investment returns won t be sufficient to accumulate assets that can be drawn upon to support the investor throughout retirement. JUDGMENT Risk The possibility that investors will retire too early, spend more than their investments earn and fail to withdraw less from their retirement funds when markets turn choppy. The possibility that the investor will outlive his or her assets. Behavioral Risk The possibility that investors will sell holdings out of panic when markets decline and add to their holdings out of exuberance when markets rise in other words, the possibility that investors will buy high and sell low. 4 Morgan Stanley
Why Variable Annuities? Variable annuities offer a good complement to an investment portfolio. Features include: guaranteed benefits Some variable annuities offer what are called living benefits that enable you to generate a specific level of guaranteed income at retirement, even if your investment choices don t perform as anticipated. These benefits vary from annuity to annuity and are available at additional cost when you purchase your contract. As you can imagine, living benefits have become immensely popular with retirement-conscious investors since the recession of 2007 2009. They can provide a level of guaranteed income that most people simply don t have anymore.* longevity With a variable annuity, you can receive income payments guaranteed to last a lifetime. You can also arrange for your spouse to receive payments, if you predecease him or her. known income payments Payments from annuities with guaranteed living benefits are known in advance. By allocating a portion of retirement assets to a variable annuity that guarantees a certain level of lifetime income, retirees are often able to budget expenses more accurately. They know how much is coming in, as opposed to trying to figure out what they can withdraw from a portfolio with uncertain returns over an unknown period of time. Of course, variable annuities are not without their drawbacks. They include higher fees and offer less liquidity than many traditional investments. However, they provide retirement-conscious investors with potential solutions for managing the risk that they ll run out of money due to declining markets, poor investment decisions, overspending or longevity. * Living benefits do not protect the contract value of a variable annuity from market decline. However, they do protect the benefit base by which income benefits are calculated. Determining Your Variable Annuity Allocation The Global Investment Committee s framework for quantifying your allocation to variable annuities versus traditional asset classes considers the following variables: Building a Retirement Framework WHAT ARE YOUR GOALS? ARE YOU ON TRACK? WHEN WILL YOU RETIRE? TARGET ALLOCATION How do you value income security relative to growth potential? What are your bequest objectives? What are your liquidity constraints? How much savings have you accumulated relative to your income needs? In how many years will you need to begin taking distributions from your retirement savings? Source: Morgan Stanley Wealth Management GIC morgan stanley 5
annuities in action The following case studies illustrate how the GIC s framework might work for hypothetical investors with different combinations of goals, resources, time horizons and risk tolerances. Please see End Notes for more information. case study no. 1: the dunbars They ve saved diligently, but with retirement only a few years away, will they be able to meet their objectives? John and Alice Dunbar have tried to do the right thing throughout their careers. They ve contributed regularly to their retirement savings and together have amassed approximately $1 million in their 401(k) plans and other investments. John, however, lost his job recently. He is 60 years old and currently looking for either a new position or consulting assignments. Alice, age 58, continues to work, but she hopes to cut back her hours and earn approximately $40,000 annually until she finally retires at the age of 65. The Dunbars figure they will need approximately $80,000 a year, adjusted annually for inflation, to meet projected retirement expenses. Fortunately, 25% of these expenses will be covered by John s small pension and future Social Security payments. When Alice retires, her pension and Social Security payments will contribute another 10% to what the couple requires. That leaves 65% of expenses to be covered by savings, plus the Dunbars would like to be able to leave their two grandchildren an inheritance that will help pay for college someday. The Dunbars figure they will need approximately $80,000 a year, adjusted annually for inflation, to meet projected retirement expenses. 6 Morgan Stanley
The Dunbars in brief Approximately $1 million saved, 60% of which is invested in stocks with the remainder in bonds $80,000 annually required, plus an inheritance for two grandchildren Seven years until both John and Alice retire Social Security and pensions will eventually cover approximately 35% of the couple s expenses, 25% over the next seven years Moderate risk tolerance What Their Financial Advisor Recommended With the help of the Morgan Stanley Global Investment Committee s new retirement allocation framework, the Dunbars Financial Advisor calculated that the couple s savings provided them with what the Global Investment Committee calls a Funding Ratio of 86%. Funding Ratio is the market value of retirement savings divided by the present value of projected retirement expenses. With a seven-year deferral period during which the assets placed in a variable annuity are allowed to grow before they are withdrawn for expenses, the Financial Advisor determined the following (at right). By reallocating assets, the Dunbars could reduce their retirement income shortfall risk by just under 30%. 1 current asset allocation new asset allocation 40% 38% 37% 60% 25% Stocks Bonds Variable Annuity 1 Shortfall risk is the expected size of the income gap that would arise in the most adverse projected capital market outcomes. Please see End Notes for more information. Source: Morgan Stanley Wealth Management GIC; For illustrative use only morgan stanley 7
case study no. 2: professor harrison professor harrison in brief Wishes to retire in five years Requires $70,000 a year, $47,500 of which will be covered by Social Security, a pension and income from a rental property Has saved approximately $400,000 Modest estate planning goals Conservative risk tolerance Professor James Harrison is age 65 and nearing the end of a distinguished career. He will miss his students and the intellectual stimulation of academic life, but he looks forward to fulfilling his passions for travel and golf when he finally retires in five years. Professor Harrison has done his homework and figures his retirement lifestyle will cost him approximately $70,000 a year. Of this, $45,000 will be covered by Social Security and a pension. In addition, he owns a small lakefront cabin that he rents out in the summer for an additional $2,500 after expenses. The challenge Professor Harrison faces is the financial setbacks he experienced years ago as a result of his divorce and a few ill-advised investment decisions. His portfolio, which is now allocated at a conservative 30% stocks and 70% bonds, has grown slowly but steadily to its current value of $400,000. He anticipates being able to save another $6,500 a year until his retirement at age 70. While Professor Harrison has a daughter, he does not plan to leave her an inheritance beyond his house and cabin. His daughter, a successful IT executive, assures him that she would rather see him leave whatever assets he has to the university where he has taught for 30 years. Professor Harrison has done his homework and figures his retirement lifestyle will cost him approximately $70,000 a year. 8 Morgan Stanley
What His Financial Advisor Recommended Professor Harrison started working with his Financial Advisor after incurring substantial losses during the dot com crisis of 2000 2001. Despite these setbacks, he has managed to grow his portfolio to $400,000 and with the assistance of the Global Investment Committee s allocation framework, his Financial Advisor has determined that the Professor s Funding Ratio is a healthy 104% and that his asset allocation should be altered as follows (at right). By reallocating assets, Professor Harrison could reduce his retirement income shortfall risk by just under 15%. 2 2 Shortfall risk is the expected size of the income gap that would arise in the most adverse projected capital market outcomes. Please see End Notes for more information. current asset allocation new asset allocation 20% 30% 24% 70% 56% Stocks Bonds Variable Annuity Source: Morgan Stanley Wealth Management GIC; For illustrative use only case study no. 3: jane leahy jane leahy in brief Still ten years to go before retirement $750,000 in savings, plus $15,000 a year in estimated Social Security payments. No pension. Projected retirement expenses of $68,000 annually for basic, non-discretionary needs Unmarried, so she has to rely on her own resources Continued on next page u morgan stanley 9
case study no. 3: jane leahy u Retirement is still another ten years away, but she wants to make certain she s on the right track. At age 55, Jane has no intention of retiring for another ten years, but she s beginning to worry that she hasn t saved enough. She estimates that she ll need approximately $68,000 a year to meet basic expenses like rent and health care, and she has managed to save $750,000 in a 401(k) plan, IRA and other investments. Still, she realizes that she will only be able to expect about $15,000 a year in future Social Security payments and she s concerned. Never married, she realized years ago that if she wanted to achieve financial independence, she would have to do it on her own. What Her Financial Advisor Recommended Jane s suspicions proved to be correct. With the help of the Morgan Stanley Global Investment Committee s allocation framework, her Financial Advisor determined that her current Funding Ratio was only 68%. The good news was that she didn t plan to retire for another ten years. Jane s Financial Advisor determined that she could benefit greatly from allocating a portion of her retirement assets to a variable annuity as follows (below). By reallocating assets, Jane could reduce her retirement income shortfall risk by just over 15%. 3 3 Shortfall risk is the expected size of the income gap that would arise in the most adverse projected capital market outcomes. Please see End Notes for more information. At age 55, Jane has no intention of retiring for another ten years, but she s beginning to worry that she hasn t saved enough. current asset allocation new asset allocation 50% 50% 34% 32% 34% Stocks Bonds Variable Annuity Source: Morgan Stanley Wealth Management GIC; For illustrative use only 10 Morgan Stanley
A Framework for More Precise Planning The new Global Investment Committee framework can help you determine whether you re on track for the retirement objectives you envision for yourself and whether you could benefit from allocating a portion of your assets to a variable annuity. To learn more and apply the framework to your own personal situation, contact your Financial Advisor. Glossary Benefit Base: The benefit base is used to index the payments from a variable annuity with an income rider such as a guaranteed lifetime withdrawal benefit. By contrast with the contract value, defined below, the benefit base does not represent the annuity owner s equity in the contract, but is rather an accounting construct by which minimum withdrawal benefits are calculated. During the deferral period, a benefit base will typically grow by a preset roll-up amount regardless of what happens to the investments in the annuity. This feature provides protection from market risk. Most typically, if a contract value increases above the benefit base on the contracts reset date, the benefit base will reset higher to the contract value, proportionally increasing future benefits. CONTRACT VALUE: The contract value of an annuity represents the equity the annuity owner holds in that contract. The initial contract value is equal to the initial premium paid, and it will fluctuate subsequently based on the net of additional premiums, withdrawals and the investment performance net of fees. Contract value defines the upside, liquidity and death benefit dimensions of a variable annuity with guaranteed lifetime withdrawal benefits. This contrasts with the benefit base, which is used only to index regular payments, and cannot be liquidated or transferred to a beneficiary upon death. morgan stanley 11
End NoTES Additional Case Study Assumptions (1) The GIC s strategic (seven years) and secular (20-plus years) assumptions are as of March 2014, and represent reasonable and unbiased estimates of future returns. (2) The GIC forecast assumptions of volatility, skewness, kurtosis and the correlations of asset classes represent reasonable and unbiased estimates of future variability of asset class returns and the potential for diversification. (3) Returns are assumed to be independent and accurately described by our forecast distribution, calibrated to the empirical data based on their variance and lower partial moments. (4) Assumes a simple 7%, noncompounded, annual roll-up rate and that the owner delays withdrawals during the deferral period such that the benefit base will be no less than the original benefit base at contract issuance plus a simple 7% of the original benefit base for each year of deferral. For the contract described, the contract owner is restricted to a limited set of investment options. We assume to hold the maximum equity allocation of 70%, with the remaining 30% invested in bonds. The terms on offer to investors in both in the annuities and capital markets, on which this analysis and that throughout this paper depend, change over time. (5) Portfolios are rebalanced annually. (6) Withdrawals are funded by all asset classes in their proportion in the portfolio. (7) Withdrawals are made at the end of the year. (8) Distributions grow at the forecast rate of inflation, assumed to be 2% over the horizon, to ensure retirement income retains purchasing power. The analysis is based on a Monte Carlo simulation of 10,000 scenarios of potential future market returns. It assumes a planning horizon until age 90 with mortality probability-adjusted income withdrawals thereafter, that income needs are increased for forecasted inflation throughout the planning horizon, and that the portfolio is rebalanced annually back to the target allocation. Monte Carlo simulation involves repeated sampling of asset class returns from a known distribution. It is used here to estimate thousands of different potential future evolutions of various portfolios employing different strategies, from which we can infer the likelihood of various outcomes, and the magnitude of potential shortfall. important: The projections or other information generated by this Monte Carlo simulation analysis regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results and are not guarantees of future results. Results may vary with each use and over time. For more information about the risks to hypothetical performance, please see the Risk Considerations section. RISk Considerations Morgan Stanley Smith Barney llc offers insurance products in conjunction with its licensed insurance agency affiliates. Annuities are long-term investments designed for retirement purposes and are subject to investment risk, including the possible loss of principal. Withdrawals and distributions of taxable amounts are subject to ordinary income tax and, if made prior to age 59½, may be subject to an additional 10% federal income tax penalty. Early withdrawals will reduce the death benefit and cash surrender value of the annuity. Variable annuities are sold by prospectus only. The prospectus contains the investment objectives, risks, fees, charges and expenses, and other information regarding the variable annuity contract and the underlying investments, which should be considered carefully before investing. Prospectuses for both the variable annuity contract and the underlying investments are available from your Financial Advisor. Please read the prospectus carefully before you invest. Optional riders may not be able to be purchased in combination and are available at an additional cost. Some optional riders must be elected at time of purchase. Optional riders may be subject to specific limitations, restrictions, holding periods, costs, and expenses as specified by the insurance company in the annuity contract. All guarantees, including optional benefits, are based on the financial strength and claims-paying ability of the issuing insurance company and do not apply to the underlying investment options. If you are investing in a variable annuity through a tax-advantaged retirement plan such as an IRA, you will get no additional tax advantage from the variable annuity. Under these circumstances, you should only consider buying a variable annuity because of its other features, such as lifetime income payments and death benefits protection. Morgan Stanley Smith Barney llc ( Morgan Stanley ), its affiliates and Morgan Stanley Financial Advisors do not provide tax or legal advice. Clients should consult their personal tax advisor for tax related matters and their attorney for legal matters. Asset allocation and diversification do not as sure a profit or protect against loss in declining financial markets. General: Hypothetical performance should not be considered a guarantee of future performance or a guarantee of achieving overall financial objectives. Hypothetical performance results have inherent limitations. The performance shown here is simulated performance, not investment results from an actual portfolio or actual trading. There can be large differences between hypothetical and actual performance results achieved by a particular asset allocation. Despite the limitations of hypothetical performance, these hypothetical performance results may allow clients and Financial Advisors to obtain a sense of the risk / return trade-off of different asset allocation constructs. Investing in the market entails the risk of market volatility. The value of all types of securities may increase or decrease over varying time periods. The analysis does not purport to recommend or implement an investment strategy. Financial forecasts, rates of return, risk, inflation, and other assumptions may be used as the basis for illustrations in this analysis. They should not be considered a guarantee of future performance or a guarantee of achieving overall financial objectives. No analysis has the ability to accurately predict the future, eliminate risk or guarantee investment results. As investment returns, inflation, taxes, and other economic conditions vary from the assumptions used in this analysis, your actual results will vary (perhaps significantly) from those presented in this analysis. The assumed return rates in this analysis are not reflective of any specific investment and do not include any fees or expenses that may be incurred by investing in specific products. The actual returns of a specific investment may be more or less than the returns used in this analysis. The return assumptions are based on hypothetical rates of return of securities indices, which serve as proxies for the asset classes. Moreover, different forecasts may choose different indices as a proxy for the same asset class, thus influencing the return of the asset class. Bonds are subject to interest rate risk. When interest rates rise, bond prices fall; generally the longer a bond s maturity, the more sensitive it is to this risk. Bonds may also be subject to call risk, which is the risk that the issuer will redeem the debt at its option, fully or partially, before the scheduled maturity date. The market value of debt instruments may fluctuate, and proceeds from sales prior to maturity may be more or less than the amount originally invested or the maturity value due to changes in market conditions or changes in the credit quality of the issuer. Bonds are subject to the credit risk of the issuer. This is the risk that the issuer might be unable to make interest and/or principal payments on a timely basis. Bonds are also subject to reinvestment risk, which is the risk that principal and/or interest payments from a given investment may be reinvested at a lower interest rate. Bonds rated below investment grade may have speculative characteristics and present significant risks beyond those of other securities, including greater credit risk and price volatility in the secondary market. Investors should be careful to consider these risks alongside their individual circumstances, objectives and risk tolerance before investing in high-yield bonds. High yield bonds should comprise only a limited portion of a balanced portfolio. Treasury Inflation Protection Securities (TIPS) coupon payments and underlying principal are automatically increased to compensate for inflation by tracking the consumer price index (CPI). While the real rate of return is guaranteed, TIPS tend to offer a low return. Because the return of TIPS is linked to inflation, TIPS may significantly underperform versus conventional U.S. Treasuries in times of low inflation. Equity securities may fluctuate in response to news on companies, industries, market conditions and general economic environment. Rebalancing does not protect against a loss in declining financial markets. There may be a potential tax implication with a rebalancing strategy. Investors should consult with their tax advisor before implementing such a strategy. 2015 Morgan Stanley Smith Barney LLC. Member SIPC.I ip8114770 CRC 1097597 02/15 CS 8114770 02/15