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.