Lifecycle investing and you

PORTFOLIO POINT: Lifecycle investing – adjusting your portfolio as you age – is a topic investors should understand.

Lifecycle investing is a hot topic in institutional circles both here and abroad. While you might think that lifecycle investing – or asset allocation based on retirement target dates – isn’t relevant to you as an active personal investor, it essentially boils down to knowing how much growth and defensive assets you should have in your portfolio for your age. Today I’ll look at how institutions try to answer this question for investors before showing you how you can apply these insights to your own situation.

A short history of lifecycle investing

About 40 years ago Burton Malkiel, author of the best-seller A Random Walk Down Wall Street, argued that you should adjust your investment mix as you age – in short, to desensitise your investments and hence the quality of your retirement to fluctuating share prices the closer you are to retirement.

He recommended you should “invest your age in bonds” (or, looked at the other way, have 100% minus your age, as a percentage in growth assets like equities). This is referred to as the “birthday rule” and it means every year you should allocate 1% more of your retirement savings into defensive bonds and 1% less in shares. There are variants of this rule including having 110% minus your age and 120% minus your age in equities.

An extreme version of this rule was recently suggested by Yale professors Ian Ayres and Barry Nalebuff, who suggest you should invest 200% of your assets in stocks when you’re in your 20s and 30s (using leverage) and then reduce this percentage non-linearly with age to about 40% by age 60. The idea of gearing up your super, not surprisingly, earned the professors some hate-mail in the current environment.

Moshe Milevsky, a Canadian professor who wrote the aptly named Are You a Stock or a Bond?, offers an interesting twist by suggesting the career you are in should also guide your investment strategy. If you’re a 40 year-old public servant or tenured professor, consider your job a bond and invest more heavily in equities. On the other hand, if you are a stockbroker or investment banker, you should invest in bonds despite what you tell your clients to do.

While this all sounds sensible, let’s do some numbers to put this into perspective.

Lifecycle investing by the numbers

In the figure below the range in retirement savings that one might have accumulated by age 65 under the following scenarios is shown:

• if you reduced your equity exposure each year for 30 years from age 35 accordingly to four versions of the birthday rule (shown as blue bars);
• if you invested with a fixed percentage of equities over the same period (shown as green bars).

In the latter case, the percentage of equities (48, 57, 67 and 77%) is that required to save the same median amount as the corresponding birthday rule (100 minus age, 110 minus age, 120 minus age, 130 minus age) chosen specially to make a like-for-like comparison. Put another way, if you want to end up with the same median chance of having a real $1.43 million at age 65, you could either follow Malkiel’s “100 minus age” birthday rule or invest every year with a fixed 48% in equities.

The range of outcomes arises from studying 100, 30 year long saving and investing simulations beginning first in 1875, then in 1876 '¦ and finally beginning in 1975. This for someone starting at age 35 with $100,000, who saves $20,000 plus 4% annually. The final result is adjusted for inflation over that time period.

This plot shows:

• The higher the equity mix, the more you can expect to have for retirement.
• However, the amount you will have is uncertain.
• The uncertainty increases with equity mix and is significant.
• A lifecycle approach consistently reduces this uncertainly, but only slightly.
• In actual terms this reduction is about $50,000 or 5%.

This comparison doesn’t make too much of a case for lifecycle investing.

Perhaps a better way of looking at this is how portfolios fell in value differently during the GFC. If you followed the birthday rule, at age 65 you would have had 35% in equities, and would have seen your portfolio fall 10% in value. However, if you were instead in a fixed 50% equity portfolio, your retirement assets would have been crunched by double that. In the absence of a quick recovery in the stockmarket, that might mean you have 20%, not 10%, less to live off in retirement.

When you invest more in equities early in life using a lifecycle approach, you buy yourself the luxury of being able to invest more conservatively later in life when you have a bigger nest egg.

If instead you invest with a fixed percentage of assets in equities through your lifetime, as most people do by staying in a default fund, you might not be taking enough risk early in your career when you can afford to, and then be taking on too much risk later, when you can’t.

Overseas Institutional experience – improvement needed

US investors have embraced lifecycle investing. They do this by investing in “target retirement date funds”, where you pick a fund that shares the same decade of your retirement. About three-quarters of US 401k plans have target-date funds on their menu and about 40% of investors use them. Assets in these funds have rocketed from $69 billion in 2005 to $256 billion in 2009, according to Morningstar. They represent a great case study for Australians.

Surprising to many, these funds performed poorly in 2008, sparking a SEC enquiry. The at, or near, retirement 2000 and 2010 funds lost on average 23%, with some dropping as much as 41% in value. The younger investor’s average 2050 fund declined 39% versus the S&P 500 index of 38%. One of the causes revealed was the differing “glide path” of declining equities that each target date fund uses. This is shown in the figure below from Ibbotson Associates, where each coloured line is the age-based allocation to equities adopted by a different fund.

Although there is a consensus that equity composition should decrease with age (on average about 1.25% per year, not 1%, incidentally), there is no consensus on what it should start or finish with! You can see from the chart that one fund invested a 69 year-old investor’s portfolio 30% in equities (lower purple line), while another had 70% in equities (upper orange line). No surprise then that there was a wide range of performance outcomes, mostly poor, and there is now a call for greater standardisation and transparency. On the plus side, there was evidence these funds eliminated dangerous extreme allocations of being wrongly all in equities or all in cash.

Although not often mentioned, the type of assets you invest might also change with age. For instance, Ibbotson Associates shares my affinity for inflation-linked bonds, especially in retirement, where they suggest this should grow from 0% to at least 15% of your overall allocation.

Australian Institutional experience – watch this space

In Australia, only a few funds have introduced lifestage strategies.

BT’s new Super for Life offers six target date funds labelled and selected according to the decade you were born (1940s through to the 1990s). If you’re aged in your 50s and invested in the 1950s birth fund you would currently be 59% invested in equities. If you’re in your 60s and invested in the 1940s fund, you would be only 36% invested in shares or growth assets. Why your birth date predicts your retirement age, I don’t know.

Industry fund Health Super offers a “Life Cycle Option”, which avoids them introducing multiple new funds like BT. Instead, members are moved from their Long-Term Growth fund to the Medium-Term Growth fund when they turn 50 and then to the Balanced fund when they turn 60. This means if you are aged in your 50s you would have 67% in equities (or 77% if you agree with me “alternative defensive” is both an oxymoron and should be counted as equity) and when aged over 60 you would have 57% (or 67% similarly) in equities. This is much higher than BT and also reflects the strong preference industry funds have for unlisted alternative assets, which I find hard to classify.

Just like in the US, as others introduce similar funds we’ll find there are different interpretations of how much growth assets you should have at what age. At least this will provide a distraction to the current labelling problem “what’s a balanced fund”?

Some people are suggesting that the Cooper report’s call for a single diversified MySuper fund can be met through a set-and-forget lifestage investment fund. I disagree and so did Jeremy Cooper and his panel.

“While the age pension reduces the effect of investment risk on low and middle income earners, the Panel also considered other means of reducing risk in the pre-retirement phase; specifically life cycling investment options and reserving. However, the analysis suggested that there is not a strong case for mandating either lifecycle investing or reserving mechanisms to smooth investment returns. Submissions also argued against mandatory measures in this regard. Instead, the Panel believes the best approach is for trustees to consider carefully default options in the light of overall member needs and for members to consider their individual circumstances as they approach retirement”.

This is saying to fund operators, rather than go to the expense of creating multiple options, instead allow investors to change their investment mix as their needs and situation change. This cuts across the main recommendation for a single style investment fund and means operators will need to still offer a range of coarse adjusting father, mamma and baby bear style multi-sector funds or the ability to fine tune a mix of them or, better yet, single sector funds.

A big challenge in institutional investing is super funds knowing what your needs and circumstances are. Reducing your equity exposure with age is sensible but to how much depends on for instance:

• if you are you receiving other regular income like from a defined benefit pension, annuity, Centrelink, a property or a reverse mortgage such that you can take on more risk, and need and are comfortable doing so?; or

• these funds are all you have and only just fund what you need to live off, or you can’t stop worrying about your daily super fund balance, which likely means you can’t afford to take any risk? and perhaps you should also consider an annuity.

I suspect only you or your adviser can work that out.

What this means to you

For the personal investor, lifecycle investing should be a powerful reminder to check whether you are taking on enough risk early in life or too much closer to retirement. I am sorry for those investors in 2007 whose glide path altitude was too high in shares and wish they had heard about this concept earlier. It is probably not the right idea now to abandon equity investing altogether for the security of bonds, or alternatively to ratchet up your equity mix hoping to win back losses.

The previous chart about the US experience recommends you have a fixed equity mix once you’re retired. I agree and find for most this means having 40–60% in equity-like assets. Not enough equities, and cost rises might erode your wealth. Too much and a GFC Mark II will get you!

For those with many years to go to retirement, without knowing anything else about you, having perhaps 115% minus your age in equities (or your age minus 15% in bonds) is a starting point.

However just as a fund can’t yet accurately predict your needs, neither can I with these benchmarks.

Doug Turek is the managing director and principal adviser of independent money management and wealth advisory firm Professional Wealth.