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Not all lifecycle funds are created equal

As the dust begins to settle on the MySuper product landscape (albeit with more rolled out until the end of the year), many have adopted a lifecycle strategy. And while retail groups seem to have dominated the push down this path they are not alone, with both corporate and industry funds using a lifecycle approach. However, not all lifecycle funds have been created equal. There are a number of key features which distinguish the different lifecycle offerings and they can have a significant impact on member outcomes.

Previously I have been a well-informed fence sitter on lifecycle funds (see “Are lifecycle funds appropriate for MySuper products?”). If pushed harder and given only a strict choice of whether or not to take a member’s age into account when designing their underlying investment exposure, I would side on doing so. My greatest reservation remains that there are so many other personal factors to consider that lifecycle funds could be the intermediate technology before we develop a superior approach (some groups are already well down this approach which I call ‘mass personalisation’, particularly overseas). Undoubtedly, good advice based on someone’s detailed personal situation usurps all systematic approaches, but is not a realistic proposition for the entire working population.

Here is a guide to the ‘Big 4’ differences and their impact. These issues are not isolated to Australia – these differences also occur in the US where lifecycle funds have greater prevalence:

1. The shape of the glidepath

The ‘glidepath’ is a simplified summary of the asset allocation through time. A glidepath is generally presented in terms of exposure to growth assets given age and typically steps down as retirement approaches, as shown in Diagram 1 below. The timing and size of the reductions vary, and as a result, these products will produce different lifecycle outcomes for their members. There is no exact answer on what is the optimal glidepath. All we can do is assess the research and reasoning that has gone into the design of specific products. One specific issue is whether the product is designed with an accumulation objective in mind or whether it is designed to roll into a specific allocated pension product with a complementary asset allocation – this is known as the ‘to versus through’ debate.

DB glidepath

DB glidepath

Diagram 1: Example of a glidepath.

2. Age cohorts (buckets) or personal administration

There are two options to administer the glidepath asset allocation. One is to group people into age buckets; each member of that cohort will have identical asset allocation. This is the most common approach, for example those born in the 1970’s, 1980’s, 1990’s, 2000’s etc. An alternative is to administer the lifecycle approach to each member individually. The latter approach has benefits – specifically, it avoids giving people at the extremes of a cohort group the same asset allocation. For example, in some products you may have a scenario where someone aged 51 and 60 have the same asset allocation. There is a risk that cohort or bucket administrative approaches dilute much of the complex calculations that have gone into the glidepath design.

3. Glidepath smoothness

Some glidepaths will make many small re-allocations over time while others may take a smaller number of large steps. This latter approach makes a sizable asset allocation switch regardless of the market fundamentals. Imagine a scenario where shares have fallen heavily and now look attractive but concurrently a lifecycle fund glidepath may reduce exposure to growth assets, locking in losses and removing the ability to participate fully in a recovery. This issue interacts somewhat with (2). A cohort approach with large steps can have a greater impact on lifecycle outcomes than a personally-administered approach with small increments.

4. Active asset allocation

Active asset allocation has become more prominent among super funds, particularly post-GFC where it became obvious that active management within underlying funds provided only a small buffer in difficult market environments. We can see the merit of active allocations in a lifecycle strategy where, as described in (3), transitions may occur at inappropriate times. Of course there is no guarantee that such an approach will work – not all active asset allocation capabilities are created equally either!

These are the Big 4 issues, but there other differences are emerging. Some groups are already considering how best to structure exposure to underlying asset classes through the lifecycle. Again the US provides good guidance to latest market trends. The design of lifecycle funds could be based on administrative capabilities (personally administered approaches likely cost more than a cohort approach), cost, research resources, and even a desire to keep it simple so that underlying members understand what is going on.

Difficult to compare and rate funds

The design of a MySuper fund, where we have balanced funds and a range of different lifecycle fund designs, is a difficult area for an individual to assess. In front of each product there will be smart marketing messages. It is important that those groups who rate super funds are well-equipped to assess different super fund designs. They face a big challenge. Previously they compared funds, the large majority of which adopted a balanced fund approach, and this made for relatively easy performance comparisons. Now there is an extra dimension – fund design and member outcomes. Will these groups perform a deep assessment of the fund design, perhaps using proprietary tools to enable an objective comparison (and cut through the marketing materials), or will they just assess the high level issues considered in the design?

With MySuper we move into an age where the lifecycle approach is more prominent. Be aware that not all lifecycle funds have been created equal. It will be fascinating to watch advancements in this space, and how the groups which rate super funds adapt to the new environment.

John Hewison
September 12, 2013

Alun, you can't see me but I am standing in my office applauding your thoroughly rational and accurate appraisal of the new fad of lifecycle investing.
So as an industry, we have decided to abandon the traditional "risk profiling" compliance protective model (which never worked) and we'll try the "one size fits all" age based lifecycle model instead.
When do we wake we up to the fact that we all have a responsibillity to design strategies to achieve defined outcomes for individual clients, work hard at re-balancing to the model and keeping close to our clients? Whoops sorry, that can't be commoditised can it!
Whilst I am at it, what about the issues of multi generational asset transfer and active cash flow management? What about the recognition that so called "growth" assets can also be extremely effective inflation hedged cash flow assets? I guess this gets lost somewhere in the lifecycle model.
When advisers are looking for ways to demonstrate value-add to their clients, surely these are the factors that make the difference.

Alun Stevens
September 11, 2013

The only claims that are likely to be lodged against trustees are in respect of falls in asset values near to retirement. Those who under perform against inflation for 20 years will find it very difficult to argue that it was the asset allocation decisions 20 years earlier that caused them a loss. They will in fact find it very difficult to quantify a loss. No real causal link + no quantification of loss = no claim.

Against the first type of claim lifecycle funds give trustees a defence in that they can show that they considered the problem and took action and that action was endorsed by professional advisers. Very difficult to prove negligence or liability against this type of defence.

David O'Donnell
September 11, 2013

Well put Alun. I particularly like the line that sums up the deficiency that the lifecycle fund concept fails to address, 'The fact of life is that members near and in retirement generally have two risks - short term asset value risk against their short term cash flow liabilities and long term growth risk against inflation.'.The 'lifecycle fund' concept has simplistic logic, but my opinion is that that it trivialises a task that is not that simple. I wonder if it even reduces potential causes of action by members against trustees, with your examples illustrating clear deficiencies that again in my opinion could be seen to be clearly negligent on the part of an advisor/trustee.

Alun Stevens
September 08, 2013

The lifecycle approach has indeed been adopted by a number of, mainly, commercial funds. Before discussing the various methods for operating them, it is worth reflecting on the benefits and problems of lifecycle funds as a class. The only benefit promoted for these funds is that they de-risk members in the run up to a nominal retirement date and the promotions generally reflect on the impact of the GFC for people retiring at that time. The lifecycle funds supposedly reduce or remove the sequencing risk.

The biggest problem with the composite (ie asset allocation is managed within a composite investment option) is that they don't actually de-risk the investment exposures of these people and do very little if anything for the sequencing risk for those people to whom it is important. They can be plausibly promoted as doing so, but they don't actually do so in practice. Two simple examples at opposite ends of the spectrum of potential client needs demonstrate this. Firstly, someone with a relatively small balance. The comprehensive data I have from most of the largest funds in the country show that this person will almost certainly cash the benefit in - either to take the cash or to move the cash somewhere else like an SMSF or other fund where their main benefit is.

A glide path investment portfolio will reduce the risk of a significant loss by a marginal amount because the assets will still be held in a composite portfolio with quite marked volatility risk. If someone wanting to take their benefit in cash had been invested in one of these portfolios at the time of the GFC, they would have still suffered a material loss because of the need to sell down depressed underlying assets which will still comprise a material proportion of the assets. The lifecycle fund will have failed spectacularly in its primary objective.

As a second case let us consider someone with a much bigger account balance who will be relying on their assets to deliver a retirement income for the rest of their life. They will have short term cash flow needs and a significant long term need to grow their asset base to keep up with inflation. The lifecycle approaches significantly increase the long term growth risk (and thereby also the longevity risk) while (as discussed above) doing virtually nothing for the short term liquidity risk. The long term risk is increased specifically because these funds depress the long term earnings potential too early and too much all in the name of nominally managing short term volatility risk.

Lifecycle funds either increase or do nothing for the risk at both ends of the spectrum for members - and therefore do nothing in between either. They are not a risk reducing tool for members.

The only risk they actually reduce is the risk to trustees from disgruntled members. Trustees have virtually no risk of being sued for under performing over the long term because potential claimants will be very old and their supposed loss will be impossible to quantify. The only real risk they have is being sued inn circumstances like the GFC and would then be able to stand up and show that they had recognised the issue and had done something to remedy it - ie not negligent.

The fact of life is that members near and in retirement generally have two risks - short term asset value risk against their short term cash flow liabilities and long term growth risk against inflation. These two risks simply cannot be managed by a background funds management solution. It is essentially impossible. One can naturally do the maths and match assets and liabilities of the total membership group via a composite portfolio optimised to a particular volatility requirement. Unfortunately this portfolio is guaranteed to be suboptimal for every member (unless of course they all have exactly the same liability profiles). Or to put it another way, lifecycle funds are wrong for everyone.


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