Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 1

An introduction to lifecycle theory

Lifecycle theory is one of the more exciting and applicable research fields in financial academia, yet it receives little discussion in Australia’s superannuation industry. This is unfortunate as the findings have the potential to improve outcomes for Australian households.  The insights from lifecycle theory are full of common sense and are valuable to managers of superannuation funds, financial planners, individuals managing their own money and the financial services industry at large. In this article, I will introduce the background and framework of lifecycle theory. In subsequent articles, I will return to this framework to discuss specific issues.

Before we enter this journey, let’s first reflect on the theories which presently guide the way we construct portfolios. Our industry is built on the foundations of what is known as Modern Portfolio Theory (MPT).  We come across terms such as the ‘Markowitz framework’, from his pioneering 1952 paper, and the associated Efficient Frontier, and we commonly use metrics such as the Sharpe Ratio and Information Ratio to assess outcomes. The MPT framework considers the range of forecast return and risk outcomes that can be derived from different portfolio asset allocations.  These outcomes are commonly plotted on a chart with return on the vertical axis and risk (estimated by standard deviation) on the horizontal axis. The relationship is generally concave upwards sloping. This implies that as we take more risk we expect higher returns but at some point the additional return for taking on more risk diminishes. There are many critiques of this framework, such as how risk is measured and how we account for liquidity in portfolio construction. However in practice most investment products are constructed broadly on this basis.

MPT is a portfolio-centric approach where the characteristics and desires of individual investors are ignored. MPT implies that we should all have the same mix of risky assets, however we may have varying levels of exposure to this risky portfolio based on how risk averse we are. MPT is also time agnostic. It recommends the same portfolio regardless of the investment timeframe.

Are portfolio outcomes the most important measure of success? When individuals look back on their lives will they reflect on the peak balance achieved by their superannuation fund? Most likely not. And this is the essence of lifecycle theory: portfolio outcomes should contribute to the attainment of goals and desires in life.

And so an introduction to lifecycle theory. The essence of this theory is that there are a number of important objectives in life which we strive to achieve. The performance of a portfolio is not a direct objective. Rather, it contributes to the attainment of these objectives. The portfolios we construct should help us obtain those objectives cognisant of the risks we are exposed to through our lifecycle. As lifecycle theory has developed, since Paul Samuelson’s and Robert Merton’s 1969 seminal papers, it has become clear that everyone should hold a unique portfolio specific to their personal objectives and characteristics.

Consumption and leisure across a lifetime are the key objectives in lifecycle theory. Working, saving and investment decisions are the levers we have at our disposal, and work outcomes (for example, pay levels or periods of unemployment), investment returns and mortality are the unknowns. Consumption smoothing over time is a common objective in lifecycle theory. If the savings pool is too little we spend our retirement years on a lower than desired standard of living, and if our savings pool proves more than required we may regret that we sacrificed too much during our working years. Similarly, leisure has a value attached to it. We can experience more leisure by reducing our workload.  However this reduces our income and our ability to consume, both presently and in retirement. Saving for retirement reduces consumption during the working years with the intention to build a pool which supports consumption in retirement. So there exists trade-offs between consumption, savings and leisure. The level of investment risk may increase the expected outcome but some of the possible adverse outcomes may be unpalatable.

Lifecycle theory takes into account our preferences for consumption and leisure as well as our tolerance for risk and other household characteristics (such as age, household structure, etc), and then determines the appropriate level of labour provision, savings and optimal exposure to different assets through time. The outcome is not simply a portfolio construction recommendation, as this is not the only lever available to households.  It generally emerges (there is rarely full consensus in academia) that every household, because it has a unique combination of preferences and characteristics, will have a unique labour provision, savings and asset allocation through time. Compare this to the MPT framework where each individual has the same mix of risky assets regardless of their individual characteristics. It also emerges that the improvement in outcomes across households, commonly labelled ‘welfare improvement’ in academia, are significant when households are given tailored plans and portfolios.

Labour characteristics differ across households. An obvious difference is the variation in salaries earned by different people in different occupations. There are also more subtle differences, including the risk of unemployment, wage growth potential, the relationship between wage outcomes and investment outcomes and the flexibility in working age (some people may be in the position to work beyond the standard retirement age). Taking these features into account will result in different savings and asset allocations across households.

Lifecycle theory could be akin to high quality financial planning assisted by powerful software that can conduct the appropriate analysis.  However the ‘scoreboard’ in our industry tends to be solely financial outcomes. The superannuation industry has much to learn from lifecycle theory. The design of default funds could be improved by incorporating some of the findings of lifecycle theory. Target-date funds, which  typically reduce their allocation to growth assets as retirement approaches, are an initial example of such work.

Lifecycle theory does take a shot across the bow of much of the financial services industry and particularly the design of default superannuation funds. By treating all default members the same, we are not realising the maximum welfare potential of our superannuation system. The two problems that I see for super funds are:

1. the collection and processing of personal information (although some important information such as age and contribution amount is already known); and

2. the need to change objectives to one which is less clear but more important (lifecycle outcomes as opposed to super fund balance).

Sometimes, our industry appears to have a preference for clear objectives and measures of accountability at the expense of the correct measures.

Lifecycle theory has been developing for over 40 years, and I will discuss some more useful lessons in future articles.

 

  •   1 February 2013
  • 2
  •      
  •   
banner

Most viewed in recent weeks

It’s time for LICs to die

A high-profile dividend cut and a prominent fund manager’s apology have reignited a long-running debate. If investors can access similar exposures more cheaply and efficiently elsewhere, what exactly is keeping LICs alive?

Testamentary trusts survived the trust tax. The drafting battle has just begun.

The fight over testamentary trusts looked settled. Then the draft legislation arrived. Hidden in a technical detail is a question that could force many families to rethink wills they thought were already future-proof.

The new capital gains tax trap for your portfolio

Investors have long accepted one portfolio rule without much question. A major tax shift could change that calculation entirely, forcing difficult trade-offs between risk, discipline and an overlooked cost lurking beneath.

The retirement scorecard: how many of these questions can you answer?

From the maths of retirement, estimating spending and picking the right asset allocation to survive a poor decade, here are the questions every retiree – current or future – should be able to answer for themselves.

How the typical Australian Family could save $844,350 in taxes

The value of a testamentary trust is not determined by wealth alone. Depending on circumstances, it can reduce the tax burden on inherited income, create efficiencies and help build intergenerational wealth.

The housing slide could become a crash

House prices are sliding across Australia, yet the most dangerous ingredient for a housing crash is still missing. If job losses surge amid growing economic risks, today's correction could become a historic property downturn.

Latest Updates

Testamentary trusts: Treasury has picked the wrong reading

A decades-old estate planning tool has survived one tax crackdown only to be caught by another. The surprise isn't who the reform is targeting, but who could end up paying the price for drafting choices made years ago.

Latest from Morningstar

Does an American retirement rule work for Australians?

The 4% rule has survived decades of scrutiny, but Australia's retirement system changes the equation in ways most overlook. Before accepting or rejecting this rule of thumb, it pays to understand what really drives retirement outcomes.

Shares

Glencore lands on the ASX. Should BHP and Rio shareholders switch?

A coal-heavy miner with governance concerns isn't the obvious choice for investors. Yet, Glencore's ASX listing may offer something BHP and Rio can't. The challenge is working out whether the opportunity outweighs the risks.

Why does the system treat capital gains and losses differently?

Investors are often told not to let tax policy drive their investment decisions. Yet, under the new CGT rules, portfolio construction, volatility and even how assets are owned may have an outsized impact on their final outcome.

Economy

Three common sense reforms that Australia needs

What do frozen bank accounts, mortgage traps and pension penalties have in common? They're all symptoms of a system that makes life much harder. Yet the obvious solutions seem to have escaped the attention of Canberra.

Shares

The hidden cost of government debt for investors

Some of the important effects of rising public debt never make the headlines. Research shows the immediate effects may already be unfolding, influencing corporate behaviour in ways that many investors would never suspect.

Investment strategies

When do fundamentals matter?

Is fundamental investing losing its grip on markets? Investors continue to search for valuation-based explanations for every price move, but the dominant force behind short-term returns may be something else altogether.

Sponsors

Alliances

  • ASA-Logo-RGB-ActiveGreen-web.png

© 2026 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. To the extent any content is general advice, it has been prepared for clients of Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), without reference to your financial objectives, situation or needs. For more information refer to our Financial Services Guide. You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.