mini-course series - income (part 1)

Copyright © 2012 by Institute of Business & Finance. All rights reserved.

MINI-COURSE SERIES

RETIREMENT INCOME

Part I

RETIREMENT INCOME 1

PART I

IBF | MINI-COURSE SERIES

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 vola-

tility. Therefore, the lower the standard deviation, the lower the risk; the higher the stand-

ard 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 devia-

tion. 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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PART I


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 re-

turn (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 "av-

erage") 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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PART I


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 ex-

pected 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 stand-

ard deviations.

A fund with a mean of 26.5% and a standard deviation of 20.2% can be expected to re-

turn 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 stand-

ard 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 ex-

pected returns.

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PART I


TARGET RETIREMENT MUTUAL FUNDS

Also referred to as life-cycle funds, target retirement funds are promoted as “one invest-

ment 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. Af-

ter 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 plen-

ty 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 ra-

tios 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 Retire-

ment fund has the same 2025 target date, but a stock allocation under 57%.

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PART I


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 un-

derlying 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 in-

come.

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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PART I


UTILITY STOCKS VS. BONDS

Growth has severed the link between utilities and interest rate swings. In 1999, for exam-

ple, 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, pre-

ferreds 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 conserva-

tive 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 divi-

dends.

For mergers with a fixed value—either all cash or a set dollar value of stocks—the pay-

off 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 lim-

ited 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 part-

nerships. 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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PART I


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 Annuities – Certified Annuity Specialist® (CAS

®)

o Mutual Funds – Certified Fund Specialist® (CFS

®)

o Estate Planning – Certified Estate and Trust Specialist™

(CES™

)

o Retirement Income – Certified Income Specialist™

(CIS™

)

o 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 [email protected].

mailto:[email protected]

mini-course series - income (part 1)

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