Lifecycle super funds are all the rage. More than 20 have been launched in the past 18 months and billions of dollars of retirement savings are starting to flow their way as part of the government’s simple, low-cost MySuper strategy.
And, on at least one level, they make intuitive sense. Lifecycle funds are intended to provide a default level of protection from a sudden market downturn by slowly shifting a member’s portfolio toward safer assets as members get closer to retirement.
But the evidence suggests that intuition may be leading people astray.
Lifecycle (or target date) funds are particularly popular in the Unites States, where they account for more than $US670 billion in assets, according to Morningstar. But many lifecycle funds failed to insulate members from the sudden downturn caused by the global financial crisis (GFC), sparking a series of questions from the U.S. Securities and Exchange Commission.
Diversification – spreading a portfolio across a range of assets to lower volatility – can’t insulate an investor from ‘systemic’ risks, such as broad-based recessions and other economic crises, which drag down most major asset classes at the same time. Meanwhile, even defensive asset allocations such as bonds can exhibit periods of poor performance, such as during the bond crisis of the mid-90s.
But it is not the only type of risk facing members in lifecycle super funds.
The average Australian is living longer: a 65 year-old man and woman can now expect to live for another 19.1 years and 22 years respectively, according to the Australian Bureau of Statistics. The risk that they will run out of money is known as ‘longevity risk’ and the three ways to tackle it are: spending less, saving more, or extracting higher investment returns. The first two are less palatable than the third, which is also the hardest to deliver.
Only growth assets such as shares and property can deliver higher returns but the average lifecycle fund’s portfolio lowers its exposure to growth assets from 89 per cent to just 35 per cent over a member’s working life, according to Chant West research.
Still, lifecycle funds are not intended to deliver higher returns, but to better manage risk and return. As the GFC highlighted, people are more prone to shift their super funds into cash at the worst possible time – after a downturn, which compounds the problem and ensures they miss out on any subsequent market rebound. The theory suggests that this is less likely to occur in a lifecycle fund, which is supposed to iron out investment ups and downs.
But even here, new research is questioning the effectiveness of lifecycle funds as a risk management strategy.
A recent research paper published in The Journal of Portfolio Management, The Glidepath Illusion: An International Perspective, analysed real investment returns across 19 countries (including Australia) between 1900 and 2009.
It found that balanced funds and strategies which increase a portfolio’s allocation to growth assets produce higher retirement balances than lifecycle funds. Worse, lifecycle strategies also produced lower retirement balances during poor market conditions compared to contrarian strategies. The research suggests that the volatility caused by higher allocations to growth assets such as shares mostly represents upside risk over the long-term.
One of the reasons is that the size of a super fund member’s final retirement balance is largely dictated by returns in the second half (typically 10 to 20 years) of an investor’s working life, when the fund has grown to the point where the power of compounding is accentuated. Shifting into assets with low returns works against the innate power of this growth, and as the experience of similar funds in the United States during the GFC highlighted (where target date funds saw a negative 15 per cent return on average), such funds don’t necessarily insulate members from market shocks.
As with any new approach, these strategies are rapidly evolving. Investors are looking for more efficient and smarter ways to simultaneously retain an element of the growth required for an increasingly lengthy retirement without the risk and volatility that has traditionally accompanied it. Some of these approaches are beginning to be applied in the Australian market and we anticipate that they will ultimately flow through to the current suite of lifecycle funds as providers look for more effective investment approaches.
Until then, investors should keep in mind that while maintaining or even raising their super fund’s equity exposure over time may produce a more volatile ride, it’s still a case of heads you win and tails you don’t lose.
This article was first published in BRW.