Lifecycle investing, in which an individual’s pension plan is invested in more volatile asset classes such as equities during their younger years, but shifted into safer assets like bonds nearer to retirement, is today widely favoured as an investment strategy for defined contribution pensions in the US.
The approach, which has become one of the most significant drivers of growth for the US mutual fund industry, has become the default option of choice for many workers who are auto-enrolled into defined contribution pensions. The same could easily happen in the UK when a government-sponsored pension system for low to middle earners is introduced in 2012.
In the US, $183bn (£112bn, €142bn) was invested in lifecycle plans at the end of 2007, up from $15bn in 2002, according to Frost & Sullivan, a consultant. The total invested in lifecycle funds is forecast to exceed $540bn by 2014.
Many investment advisers view the approach as a sensible means of reducing risk in retirement accounts and 401K plans, as in theory it enables them to ride out stock market disasters that occur close to an individual’s retirement, although recent performance by target date funds in the US might change this view.
Throwing further doubt on the concept, research* from Queensland, Australia shows the lifecycle approach is likely to be badly flawed. After analysing computer simulations of more than 100 years’ worth of financial returns data from the US market, Anup Basu of the Queensland University of Technology, School of Economics and Finance found the model leaves investors worse off in retirement than if they had pursued alternative strategies.
Mr Basu, whose research will be published in Journal of Portfolio Management next year, warns that lifecycle investing “spells disaster” for members who have built up insufficient assets during their younger years. Should insufficient funds have been accumulated before the switch to bonds is made, he says the approach leads to “poverty in old age.”
One of the reasons for this is conventional lifecycle funds take no account of investment success in the earlier years of person’s plan and therefore risk locking in failure. Because the switch to bonds is made mechanistically, at a predetermined target date, Mr Basu says, “it is a rather naïve strategy”.
“Lifecycle funds are set up by providers with the dual objective of promoting growth in the value of retirement plan assets when members are young and then preserving the value of accumulated wealth as they grow older. Our evidence suggests it is likely to fail on both counts.
“First, the growth potential of the retirement portfolio is extremely low in the early years compared to later years. Second, preserving accumulated wealth by sacrificing growth in the years leading up to retirement is detrimental to the interest of members whose accumulation during younger years is inadequate to meet their financial needs in retirement.
For them, a strategy programmed for preservation — even when there is not much to preserve — is likely to result in poverty at old age.
In the research, Mr Basu was assisted by Michael Drew, professor of Finance at Griffith University, and a former general manager of the Queensland public sector pension scheme, Qsuper.
To evaluate the merits of lifecycle investing, the pair invented an alternative approach, which they call their “contrarian” strategy. This was the inverse of the conventional lifecycle asset allocation approach, in that a pension plan was invested entirely in fixed income when the individual was young then shifted into equities later on. “That actually produced better results,” says Mr Basu.
The research revealed accumulation outcomes for both types of strategy were broadly consistent over the first 20 years. However the outcomes diverged closer to retirement, with the lifecycle strategy failing to keep pace with the contrarian approach, and overall wealth outcomes looking startlingly different.
The contrarian strategy was likely to lead to an additional $500,000 being accumulated in an individual’s pension plan at retirement, on the strength of the member having uninterrupted growth in wages and contribution history of 40 years.
The median wealth accumulated using a contrarian approach was $250,000 more for the lifecycle approach.
Mr Basu says the only redeeming feature of lifecycle strategies is they result in slightly superior terminal wealth in the worst 10 per cent of investment scenarios. However, he adds the differences are so marginal it is “hard to imagine any rational investor picking a lifecycle fund based on this benefit because it comes at the high cost of giving up significant upside potential”.
“Lifecycle switching should be contingent on investment performance — how much a person has accumulated — and not just blindly based on their age,” he says.
In partnership with Alistair Byrne, a senior lecturer in finance at University of Edinburgh Business School (UEBS), Mr Basu is now researching the merits of what he calls a “flip-flop” or “dynamic switching” strategy. This involves switching in and out of equities and bonds according to which asset class is ahead or falling short of targets within individual portfolios.
* Portfolio Size Effect in Retirement Accounts: What Does It Imply for Lifecycle Asset Allocation Funds, to be published in the Journal of Portfolio Management (Summer 2009 issue)
This article was published in the Financial Times (FTfm section) on 3 November 2008