The promise and perils of lifecycle investing
Although lifecycle investing may hold the solution to one set of problems, it also has the potential to lift the lid on another Pandora’s box, writes Renato Mota.
As superannuation funds prepare for the emergence of MySuper, we have seen increased interest and promotion of ‘lifecycle’ investment strategies. These are being positioned as a ‘set and forget’ asset allocation solution for inactive (or disengaged) investors.
While on the surface lifecycle may seem an elegantly simple solution, it introduces a range of other risks. Ultimately, lifecycle funds have failed to deliver on their promise and represent an overly simplistic solution to a complex problem.
While referred to by many names (lifecycle, lifestages, target date – we will use lifecycle for the purpose of this article), managing investment asset allocation based on an expected retirement date is not a new concept.
With origins back to the 1990s, they gained popularity as a means of dealing with inactive investors and mitigating exposure to investment risk as investors approached retirement.
In contrast, the financial planning community has successfully been dealing with issues of retirement adequacy for decades. While product providers play a role in developing solutions for retirement, some form of personalised financial advice remains the most sustainable solution to this challenge.
Why a lifecycle fund?
The development of lifecycle funds has emerged from the proposition that an individual’s investment strategy needs to cater for an individual’s circumstances – particularly investment time horizon (and therefore age when saving for retirement).
Lifecycle funds have evolved from traditional diversified funds which manage investments to a fixed strategic asset allocation (SAA).
These funds typically invest in a diversified range of assets including domestic and international equities, fixed interest, and cash, and can also include property and other real assets.
These SAAs are established based on empirical research around the optimal asset mix for a given risk tolerance over the life of the investment – 20 years-plus.
Lifecycle funds look to lower the risk profile of the fund (by reducing exposure to growth assets) as the investor approaches retirement (or the ‘decumulation’ phase of their investment).
This is designed to minimise the impact of any adverse market movement, acknowledging that there is less likelihood to recover the value of the investment over a shorter investment time horizon.
In other words, lifecycle funds have been designed to improve the risk management framework for retirement investing.
In the US, lifecycle funds have proved to be a popular vehicle for retirement savings because of their ease of implementation and intuitive appeal.
But have they worked?
Under the stress of the global financial crisis (GFC), the effectiveness of these structures was severely tested and failed to meet their objective.
Studies have shown that “target date funds labelled 2000 to 2010 lost an average of 23 per cent in 2008, with some falling by as much as 41 per cent”. The Standard and Poor’s 500 index by comparison, fell 38 per cent.
By comparison, the Morningstar Peer Average return for Australian multi-sector growth funds was -25 per cent over the same period.
In other words, lifecycle funds failed to protect investors from the market volatility they purport to mitigate.
In Australia, recent analysis from Rice Warner suggests that there is “little difference between a fixed balanced option and a lifecycle option”.
The question this raises is, why, as part of MySuper, are we so willing to embrace a concept that seems to have failed elsewhere?
Let’s go back to basics
The basic challenge that lifecycle funds attempt to address is to maximise retirement savings as the working population approaches and enters retirement. This is the same challenge to which financial advisers devote themselves – and as most advisers know, it is a complex issue.
In addressing this, there are a number of questions to be considered:
- Are we managing investments to retirement or through retirement?
- Do we understand the risks we are exposed to?
- What does it mean for the investor?
To retirement vs through retirement
While the date of retirement is a key inflection point for most people who have spent the prior 40 years working and saving for retirement, it is in fact the most important phase of the investment journey, rather than the end of it.
While the cashflow profile for most investors will change, the importance of generating a return on investment does not. Studies have shown that up to 60 per cent of your investment earnings can come from post-investment returns.
Based on the Russell Investments 10/30/60 retirement rule, the profile of investment earnings over the life of investing is:
- 10 per cent from money saved (or contributions)
- 30 per cent from earnings (prior to retirement)
- 60 per cent from earnings (post-retirement)
Considering this in the context of lifecycle investing reinforces the importance of growth asset allocation during retirement.
A reduction in exposure to growth assets can significantly impact the earning capacity of accumulated wealth during retirement.
Do we understand the risks we are exposed to?
The two primary risks which we face at retirement are:
- Longevity risk – are we going to run out of money?
- Investment risk – what is the value of my investments?
While these may seem simple in their impact, the underlying factors that influence an individual’s circumstances and exposure to these risks are many. For example:
- What are the cashflow requirements in retirement?
- What will you require for medical care or aged accommodation in retirement?
- How much has been accumulated in savings?
- What return would be required to achieve the cashflow requirement?
- What is the investor’s risk profile?
- Is social security or pension a factor?
- What other assets (outside of super for example) are there?
- Are there any outstanding liabilities (for example home loan)?
- How do you deal with inflation?
- How long until you reach retirement?
Most current lifecycle models address only a single element of the investor’s circumstances without consideration of the broader picture.
Some may argue that addressing one risk is better than not addressing any. That may be true; however, lifecycle’s approach to mitigating investment risk does so at the opportunity cost of investment earnings in retirement – the single most important contributor to an investor’s retirement savings.
Most common lifecycle funds have adopted an overly simplistic and flawed approach of using generic asset characteristics as a proxy for investment risk – volatility.
Simply shifting a portfolio away from ‘growth’ assets such as equities to ‘defensive’ assets such as cash and bonds can, depending on the valuation cycle, do little to actually reduce risk.
In some cases such as where bond valuations are at extreme highs, a shift from equities to more ‘defensive’ bonds could in fact increase the risk of the portfolio without prospects of improved returns.
This is the scenario that occurred in the US in the mid-1990s and arguably this could repeat itself globally given current bonds markets.
Ultimately, lifecycle funds fail to adequately address this challenge: simply using predetermined asset allocation shifts to manage volatility in a dynamic investment environment has failed.
What does it mean for the investor?
Whether we are investment managers, superannuation funds or financial planners, our goals revolve around the betterment of the financial wellbeing of our investors. So what are they to make of lifecycle investing?
MySuper has been designed as a simple and low cost solution for disengaged or default members. While lifecycle strategies may be an approved form of investment strategy for MySuper, currently the age of the investor is the only nominated factor on which to base one’s lifecycle – the use of other factors are subject to approval or changes in legislation.
A recent article in The Age newspaper commented, in reference to some of the recent MySuper offers with life stages, “adjusting your investments as you get older – to less risk, more cash – so you never have to worry about it.”
Ultimately, in their current form, lifecycle investment strategies are a flawed and overly simplistic solution to a complex problem.
Positioning lifecycle products as a ‘set and forget’ strategy risks creating a false sense of security in investors, with significantly adverse consequences to their wellbeing.
The solution to this challenge remains better member or investor engagement and providing access to the appropriate level of personalised financial advice. As an industry, I believe there is more we can do to support Australians with one of their most significant assets – superannuation.
Renato Mota is the general manager for distribution at IOOF.
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