When it comes to superannuation, having someone else make all the hard decisions while you get on with life sounds pretty attractive to most people. In the US, this idea has proved to be just that, with the use of so-called lifecycle or target-date funds growing rapidly.
This style of investment strategy uses an investor’s age as a guide to the appropriate level of portfolio risk for their retirement savings and adjusts the risk as they approach their retirement date.
Vanguard reports that among the 2100 defined contribution plans for which it provided record-keeping services in the US in 2010, 79 per cent included a target-dated fund. Within the 3.4 million accounts in these plans, 48 per cent of participants had selected target-date options.
Although lifecycle or target-date funds are nowhere near as popular in Australia, the recent suggestion by the Cooper review for these strategies to be considered by super funds for their MySuper default option is likely to see increasing discussion about their merits.
The concept underpinning these funds is to provide a simple investment solution for defined contribution funds, according to Russell Investments’ managing director of intermediaries, Patricia Curtin.
“They all share a common feature and that is that the investor chooses a fund targeted to the expected date of their planned retirement. The asset allocation is mapped out throughout the life of the fund,” she explained.
Dr Michael Drew, managing director of QIC [Queensland Investment Corporation] Lifecycle Strategies and professor of finance at Griffith University, believes the Cooper recommendation is likely to create fresh interest here.
“These ideas are getting traction in Australia and are getting more attention and discussion,” he said.
Drew is an expert when it comes to lifecycle funds, having spent the past few years modelling their performance and structure. He gave testimony on the strategies to a joint hearing of the US Department of Labor and the Securities Exchange Commission in Washington reviewing target-date funds in the wake of the GFC.
He said the funds have a simple goal: “Lifecycle funds are seeking to manage what is safe and what is risky as it changes over the course of your life.”
Concerns about fund structures
The popularity of target-date funds in the US is due to the convergence of several factors, according to Vanguard Australia chief investment officer, Asia Pacific, Joe Brennan.
“They came out of 401(k) defined contribution funds when fiduciaries were looking for a solution for situations where investors were making poor decisions. Target-date funds came along because members tended to stay in one asset allocation rather than change as they aged,” he said.
According to Drew, there are a few main structures. The first is designed to get the investor to retirement, while others serve as ‘cradle to grave’ solutions.
“A third option is a glide path fund that takes you to and through the retirement and assists with the longevity risks facing a retiree. There are quite a few different models around and the product is continuing to evolve,” he said.
Although popular, target-date funds took a battering during the GFC and this has led to much questioning of the strategy. A recent review by the US Government Accountability Office found that returns over the period 2005-09 for the largest funds with five years of returns ranged from 28 per cent to -31 per cent.
Even the simplicity of target-date funds, which is seen as one of their strengths, is viewed as a problem for some investors.
“Target-date funds have been a ‘one size fits all’ solution to the problem. They are built around the typical investor with that retirement date and so no customisation is possible,” Curtin said.
Lifecycle funds have also been criticised for the variety of asset allocations used by different fund providers for the same target date. Critics claim if managers cannot agree on a single appropriate allocation for a set date, the allocation for a single fund cannot possibly fit all the investors within that fund.
Tactical asset shifts in response to changing market conditions are impossible in these funds. “The glide path cannot take into consideration market conditions in any meaningful way,” Curtin said.
As fund-of-fund structures, there are concerns as the underlying investments of US target-date funds tend to be concentrated in products offered by the same investment house.
Cost can also be an issue in some funds, according to Vanguard Australia principal and head of retail, Robin Bowerman. “One of the criticisms of target-date in the US has been that some funds have used high-cost building blocks and embedded riskier assets into them than investors wanted.”
The biggest problem, however, is the simplistic ‘set and forget’ approach of most lifecycle funds which make allocation switches based solely on age, according to Drew. His work with QUT researcher, Anup Basu, found the account balance upon which the risk is taken (that is, ‘fund size effect’), is far more significant than age. Their research has shown dynamic lifecycle switching strategies incorporating both account balance and age exhibit “superior performance to current investment practices”.
Drew and Basu believe lifecycle strategies need to concentrate on several factors: the real objectives of the investor, asset allocation, dynamic switching strategies, a whole-of-life approach and optionality (which uses derivatives to mitigate the shocks members face over their lifetime).
Without this combination, investors face significant risks from the lifecycle approach — particularly in the important period leading up to retirement. “A GFC-type event in the last five years of working life can destroy 1.5 times a lifetime of super contributions. The key is the last five to 10 years of the accumulation,” Drew said.
Brennan agrees there are issues with the target-date approach. “It is important for people to remember that these are not a panacea for market risk and any investment decision retains risks. Somewhere it has been lost in the explanation that target-date funds are not a guarantee against the risks of investment,” he said.
Regular rebalancing
Despite their problems, lifecycle funds offer many benefits.
“They provide a solution for investors that gives an asset allocation which is constructed properly and at a low cost,” Brennan said.
Regular changes to the fund’s asset allocation as investors age is one of the key advantages of these strategies.
“You get an asset allocation model which is not static and which reflects how you are travelling through life,” Curtin said.
“The asset allocation in these funds tries to mirror the level of risk one wants to take at various stages in life. The benefit is at least mapping that out in the fund over time.”
The simplicity of the lifecycle fund approach is also beneficial, according to Bowerman. “They are simple from an investment perspective as they do not require constant input or change. Investors don’t have to consciously do anything, it is done for them,” he said.
While this is obviously appealing for non-engaged fund members, it also has attractions for more involved investors. “The funds are also popular with sophisticated investors who know what to do, but perhaps do not have time to make the necessary changes to their investment,” Brennan said.
“The Cooper work for MySuper showed target-date funds fit well in that space of non-engaged members, but they also work as members want to move up the spectrum and are seeking more control and involvement.”
Some lifecycle funds can also be cheap. “They are low-cost, simple and have the best investment thinking embedded in the design of one product,” Brennan said.
Bowerman believes this is a powerful feature. “The critical point is around the low cost of target-dated funds. A lot of the Cooper review was around increasing the competitive tension around fees among super funds and these sorts of funds help with that.”
Where to now?
The drawbacks inherent in the current generation of lifecycle funds are seeing many investment houses go back to the drawing board.
According to Curtin, greater flexibility is required and she said Russell is currently considering a conditional asset allocation which will take into consideration a number of factors. “The typical investor needs to have individualised and customised solutions in this new environment,” she said.
“I expect we are going to see a new generation of these types of products emerge. Target-date funds need to update themselves and have less of a ‘one size fits all’ approach.”
Drew agrees: “The more research we do, the more it shows that in the post-Cooper world we will need very sophisticated multi-part solutions.”
He believes there are many issues to address. “In financial services we often talk about the importance of the long run, but time isn’t infinite as the member retires on a specific date. The combination of the size of the money at risk and the retirement date needs to be carefully considered.”
For Curtin, a key development will be funds that do not just target a particular retirement date, but actually take investors through this point and into retirement. “Target-date funds focus to retirement, but now we need to get people through retirement,” she said.
“Russell research shows a huge segment of SMSFs do not want to retire at 65, so working to a definite date is not appropriate for everyone. Some people want to build retirement assets to a specific date, but other want more cradle-to-grave products.”
She believes flexibility is therefore essential. “We have got to develop more tailored solutions and outcomes and focus less on specific dates. It is more about retirement income rather than wealth creation.”
The importance of funds designed to provide appropriate asset allocations for investors both up to and right through retirement is highlighted by research undertaken by Russell. It shows that of every dollar drawn down in retirement, 60 cents comes from investment return earned during the decumulation phase.
Bowerman also believes lifecycle funds can play an important role during retirement. “They can be good for the retirement phase as they help people manage both the asset allocation and the drawdown phase.”
Pros and cons of lifecycle funds
Positives
• Automatic changes to asset allocation
• Regular rebalancing of the portfolio
• Incorporate best thinking about portfolio construction
• Low-cost
Negatives
• One size fits all
• Limited range of funds included
• Difficulty coordinating with other investments
• Can be high-cost
• Switching tied to age, not size of funds