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24 November 2024

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Are lifecycle funds appropriate for MySuper products?

The Government’s Stronger Super reforms have significantly raised the profile of lifecycle funds by legitimising their use as a single investment strategy for MySuper products. Treasury’s Stronger Super summary states:

“Lifecycle investment options enable trustees to automatically move members into a different investment mix based on their age and can be particularly relevant as part of a transition to retirement … the Government has decided that trustees will be allowed to use a lifecycle investment option as the single investment strategy for their MySuper product.”

However, Treasury leaves the final decision clearly in the hands of trustees.

“Trustees are best placed to decide whether a lifecycle investment option is best suited to their members.”

We have already seen lifecycle funds chosen as MySuper default options, and within high profile products such as BT Super for Life. Some industry consultants actively promote the merits of lifecycle strategies. But it is far from clear whether lifecycle funds or traditional balanced funds deliver better outcomes. The question remains whether Stronger Super should have allowed lifecycle investment strategies such a prominent role in MySuper.

Lifecycle funds are multi-asset class funds which systematically transition from ‘higher risk’ assets such as equities to ‘lower risk’ assets such as bonds as retirement approaches. They are often called ‘target-date funds’ or in the super industry ‘age-based defaults’. The alternative is traditional balanced funds which provide constant asset class exposure through time.

Lifecycle funds vs lifecycle theory

Lifecycle funds sound like they are closely related to lifecycle theory. This is not necessarily the case and it is worthwhile understanding the history of lifecycle funds. I have written previously on lifecycle theory (see Cuffelinks 1 February 2013). Essentially lifecycle theory takes other components of your life into account when constructing investment portfolios rather than looking at investment portfolios in isolation. This is what good quality financial planning is all about, and there is much academic research on the topic.

So where did lifecycle funds come from? The marketing department of course! Barclays Global Investors is credited with launching the first lifecycle fund in the US in 1993. Lifecycle funds, more commonly called target date funds in the US, are now a large part of the retirement landscape in the US. According to Morningstar, in 2012 around US$400 billion of retirement savings was invested in such strategies. But be clear, especially as MySuper approaches: lifecycle funds are far from unanimously supported amongst researchers.

To many people, myself included, lifecycle funds ‘feel’ logical. And with big name wealth managers and super funds using such strategies, and overseas money flowing into them, shouldn’t we feel comfortable and accept lifecycle strategies as appropriate? Even though it ‘feels’ right, I just can’t personally endorse them until I have fully convinced myself (and I have done a lot of research on the topic) that they improve outcomes.

From the research on lifecycle theory we see a number of reasons why we should reduce exposure to risky assets as retirement approaches. Important examples include:

  • many people experience full employment through their lives and this feels like an annuity income stream. This allows us to accommodate risky asset exposure while we are working. As retirement approaches the support of income drops away and we may be unable to bear the variability that comes from a risky portfolio
  • many of us have flexibility in retirement age (we can choose to retire early or work an extra year or two if we like). This provides flexibility to take on more risky assets. If we haven’t accumulated enough wealth, we can defer retirement. As we approach retirement age, flexibility drops away and we should be more conservative with our exposure to risky assets
  • if we annuitise at retirement to hedge longevity risk (see Cuffelinks 22 March 2013 for an introduction to the mortality component of longevity risk) then we are exposed to annuity purchase price risk. If yields happen to be low at retirement then the size of the income stream that can be purchased is small. One way to hedge this risk is to allocate more to bonds as retirement approaches
  • there are arguments that equity markets mean revert over time, suggesting we can allocate to risky assets while we have time on our side. However as retirement approaches and we need to start drawing down our income stream we become unable to allocate for long enough to experience these longer term outcomes and hence reduce exposure to risky assets.

However, the same body of research gives reasons not to lifecycle:

  • if our jobs are risky and have some correlation with the economy and equity markets then we may view our careers as a large equity-like exposure and diversify this with bonds. As our career risk reduces towards retirement (less time exposure to career risk) we may need to replace this risk with another source of risk and can in fact increase our exposure to equities
  • notwithstanding talk of life annuities becoming more popular, the standard post-retirement solution is likely to remain allocated pensions. We are left with longevity risk, and the need to earn enough returns to fund a post-retirement life. This suggests we should continue to work our accumulated savings hard by maintaining a high exposure to risky assets
  • the young are often heavily mortgaged with a house and so have significant financial exposure to property prices. They may be already bearing substantial risk and so should run conservative portfolios until later in their lives (as the mortgage reduces)
  • the age pension in Australia may provide a backdrop which allows us to continue to take high levels of exposure to risky assets.

Final responsibility rests with trustees

It is far from clear. Financial planners are best placed as they can take personal situations into account. For those designing super fund defaults there are many complex issues which need to be considered and modelled. These include inflation, wages, unemployment risk and career breaks, investment risk, mortality risk (idiosyncratic and systematic), the age pension, taxes and superannuation rules, savings rates, home ownership, post-retirement product solutions, philanthropy, risk aversion and bequest motives, and all across different household structures. Not an easy list, and I haven’t seen any research that incorporates all of these considerations. You can see the Government’s predicament: it is inconclusive whether balanced funds or lifecycle funds are most appropriate. Thus they have left final responsibility with the trustees of the super funds. Effectively they are saying balanced funds and lifecycle funds are worthy of consideration but do your own homework.

Investors should question what they read on lifecycle funds, and if possible request the basis and modelling behind the decision to go down the lifecycle path. The super fund ratings groups are doing this, especially as MySuper approaches. One asset consultant has said that lifecycle funds will ”provide better retirement outcomes to members”. This could well be a myth as on average this statement is untrue, because we have less dollar-weighted exposure to the risky assets that we expect to outperform over time. They do however reduce the risk of large stressful drawdowns prior to retirement so the worst case outcomes may be less painful. So the true benefit of lifecycle funds would be based on a risk-adjusted basis. Unfortunately assessing risk aversion of individuals has always been a grey area.

Remember that ‘lifecycle fund’ is a marketing term and not the same as ‘lifecycle theory’, and you should delve a little deeper before accepting this intuitively obvious investment solution for retirement. Of course much of the same could be said of balanced funds.

 

3 Comments
Warren Bird
April 21, 2013

I have a problem with lifecycle thinking that automatically assumes that new entrants to super don't need their money for 40 years so it should all go into long duration, higher risk assets that are assumed to grow over decades.

This is all well and good for someone committed to saving and investment with an understanding of risk and return over time. But many young people don't have this understanding when they enter the superannuation system.

What if they enter the system just as a significant cyclical downturn in the market takes place, as many have in recent years? They see money taken from their wages without them being given any choice and then see it falling in value. They get discouraged from saving and think little of super. Therefore, they don't learn the value of accumulating savings and 'the beauty of compound interest'.

I know young people in just this situation.

I think the default option for new entrants should be cash and bonds. They should have other alternatives explained to them, but they should be put into a low risk options at the outset. That way it is what they put in that dominates, and their fund will grow. After a few years they can then see the benefits of saving and then be once again offerred higher risk and higher growth opportunities - once they appreciate the benefits of saving and investing.

This won't cost them in the long run if they miss a rising stock market, because at this stage their balances are low enough that contributions totally dominate fund value over investment returns.

And isn't the core issue that the system has always tried to address the fact that people don't save enough. We can keep on compulsorily increasing the SGC, but if we are to get people to believe in saving and in super then we have to make sure that their experience of being in the system is a positive one.

David Bell
April 22, 2013

Hi Warren,

What you touch on is an interesting behavioural aspect of saving and one on which exists little research. As such we end up in a difficult situation where we all exchange anecdotes; but it is hard to talk about facts about the population.

The broad focus of my article is financial outcomes. I say this point up front because in between the financial outcomes and the behavioural issue you raise is the medium of education. One could easily argue that any young people who are deterred by poor investment outcomes in their early years haven't been educated about the need to take risk to achieve long term savings outcomes. Taking an appropriate amount of risk from a young age provides a better chance for an acceptable long term outcome to be experienced.

There are two points I think are important. The first point I make is that the retirement income system has progressed to one where, providing reasonable return outcomes, retirement outcomes for the young who experience 9% - 12% SG all their lives will be reasonable. The Henry Tax Review is a good starting point for this source of information. I'm not saying outstanding but Henry suggests acceptable outcomes. This takes into account the Aged Pension of course. The idea of voluntary savings is really for those on higher incomes because they have the potential to save more, and they may need to save more to preserve their (likely higher) lifestyle.

As an aside it is worth noting that Henry suggested 9% was a sufficient level of compulsory savings and that taking more might impinge on other important lifecycle activities such as buying a house. So the case that we require voluntary savings is not clear cut. If voluntary saving is not required, though obviously it is better if people do save more, and the system is one of compulsory contributions, then this provides greater ability for trustees to focus on longer term outcomes. The bumps along the way can be smoothed with better education.

Because superannuation is compulsory (for the large majority) and because we have the potential to educate members, my thinking is anchored by a consideration of financial outcomes. As such I think it is important that the young take a relatively high level of investment risk to help members achieve an acceptable retirement outcome.

(Note that the above comments do not apply to those who have not had their lives exposed to a 9%+ SG system. They are in a different and somewhat difficult situation).

So if the system is compulsory and there is a lack of education which you have highlighted then I think some paternalism is appropriate in the form of trustees taking on an appropriate amount of risk to help members in default funds achieve an acceptable retirement outcome. When I look at the financial aspects, I see a system which for new entrants will provide acceptable outcomes and voluntary contributions are only required for aspirational goals. So I think paternalism, in the form of relatively high investment risk when young, combined with education, is more appropriate than what you are suggesting.

My second comment is that I don't view cash and bonds as necessarily safe investments, bonds particularly. My starting point is that any discussion of lifecycle outcomes needs to be in terms of real outcomes. In this perspective the returns from cash and bonds are smaller. Additionally bonds could be viewed as more risky because yields generally rise when inflation is rising so the real outcome from bonds in such an environment is very poor (an article I am working on for another day!). Finally the definition of risk is crucially important. Are annual return statements or is the likelihood of achieving an acceptable retirement outcome more important (ie. the definition of risk we should be focussing on)? I suggest the latter and a long-term holding in a low returning portfolio runs a high likelihood of failing to achieve that acceptable outcome.

If the young begin in 'safe' investments, when is the switching point? It is not obvious to me. Indeed there is the risk that the young grow into middle-aged people anchored by the anxiety of negative short term returns and unable to ever take on a level of investment risk which, if borne over the long term, should help achieve acceptable outcomes.

I understand and can concur anecdotally with the behavioural issue you raise. I think it is an important area for future research. But I don't agree with your proposed solution. We have a compulsory system. In terms of achieving acceptable outcomes, paternalism (in terms of targeting an appropriate level of risk) combined with better education is my preferred solution.

Cheers,

David

Paul C
April 19, 2013

David, great article. It's good to see a well balanced view on Lifecycle. Financial outcomes aside, I think you nailed the behavioural aspect of why Lifecycle feels right for a lot of people, when you state (a Lifecycle approach...reduce(s) the risk of large stressful drawdowns prior to retirement so the worst case outcomes may be less painful.

 

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